ACCA Advanced Corporate Reporting 2005

ATe
INTERNATIONAL
ACCA
PAPER 3.6
ADVANCED CORPORATE REPORTING
(INTERNATIONAL)
STUDY SYSTEM
Accountancy Tuition Centre (International Holdings) Ltd 2005 (i)
No responsibility for loss occasioned to any person acting or refraining from action as a
result of any material in this publication can be accepted by the author, editor or
publisher.
This training material has been published and prepared by Accountancy Tuition Centre Limited
16 Elmtree Road
Teddington
TWl18ST
United Kingdom.
Editorial material Copyright Accountancy Tuition Centre (International Holdings) Limited, 2005.
All rights reserved. No part of this training material may be translated, reprinted or
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in writing from the Accountancy Tuition Centre Limited.
Accountancy Tuition Centre (International Holdings) Ltd 2005 (ii)
INTRODUCTION
INTRODUCTION
This Study System has been specifically written for The Chartered Association of Certified
Accountants Part 3 examination, Paper 3.6 Advanced Corporate Reporting (International).
It provides comprehensive coverage of the core syllabus areas and is designed to be
used interactively with the ATC system oftuition providing you with the knowledge,
skill and confidence to succeed in your ACCA studies.
SYLLABUS
Aim
To ensure that candidates can exercise judgement and technique in corporate reporting
matters encountered by accountants and can react to current developments or new
practice.
Objectives
On completion of this paper candidates should be able to:
explain and evaluate the implications of an accounting standard or proposed
accounting standard for the content ofpublished financial information
explain and evaluate the impact on the financial statements ofbusiness
decisions
explain the legitimacy and acceptability of an accounting practice proposed
by a company
prepare financial statements for complex business situations
analyse fmancial statements and prepare a report suitable for presentation to a
variety ofusers
evaluate current practice in the context needs of users and the objectives of
financial reporting
evaluate current developments in corporate reporting in the context of their
practical application, implications for corporate reporting, and the underlying
conceptual issues and
demonstrate the skills expected in Part 3.
POSITION OF THE PAPER IN THE OVERALL SYLLABUS
This paper is the final assessment of the candidates' skills in the area of corporate
reporting. The paper builds on the technical skills studied in Paper 1.1 Preparing
Financial Statements and Paper 2.5 Financial Reporting by requiring candidates to
demonstrate the high level technical and evaluatory skills expected of an accountant.
The paper complements the skills acquired in studying the other core papers in Part 3
of the ACCA examination structure.
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INTRODUCTION
Syllabus content
1 The International Accounting Standard Board's (IASB) regulatoryframework
a International Accounting Standards, Exposure Drafts, Discussion Papers,
Standard Interpretation Committee pronouncements including accounting for
equity and liabilities, assets, provisions and contingencies, segments, related
parties, fmancial instruments, taxes, leases, retirement benefit costs. Also
International Financial Reporting Standards.
b The content of the IASC's regulatory framework in a given range of practical
situations
c The problems with the current and proposed changes to the IASC's
regulatory framework including measurement and recognition issues.
d The impact of current and proposed regulations on the financial statements of
the entity.
e The effect of business decisions and proposed changes in accounting practice
by the entity on the financial statements.
f The legitimacy of current accounting practice and its relevance to users of
corporate financial statements.
2 Preparation ofthe financial statements ofcomplex business entities
a The financial statements of complex groups including vertical and mixed
groups.
b Group cash flow statements.
c Accounting for group reorganisations and restructuring including demergers,
take-overs and group schemes.
d Accounting for foreign currency transactions and entities.
3 Preparation ofreports for external and internal users
a Appraisal of financial and related information, the purchase of a business
entity, the valuation of shares and the reorganisation of an entity.
b Appraisal of the impact of changes in accounting policies and the regulatory
framework on shareholder value.
c Appraisal of the business performance of the entity including quantitative and
qualitative measures ofperformance and the potential for corporate failure.
d The assessment ofthe impact ofprice level changes and available methods of
valuation on business decisions and performance.
e The effectiveness of corporate governance within an entity.
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INTRODUCTION
4 Current issues and developments
a The accounting impact of environmental, cultural and social factors on the
entity.
b The impact of the content offmancial statements on users including changes
in design and content of interim and year-end fmancial statements and
alternate ways of communicating results to users.
c Proposed changes in the structure ofnational and international regulation and
the impact on global harmonisation and standardisation.
d The applicability of the lASC's regulatory framework to small and medium
sized entities.
e Current developments in corporate reporting.
5 Ethical considerations
a Ethics and business conduct.
Excluded topics
The following topic is specifically excluded from the syllabus:
lAS 30 Disclosure in Financial Statements ofBanks and Similar Financial
Institutions.
Key areas of the syllabus
Key topic areas are as follows:
group accounting, group cash flow statements and foreign currency
translation
discussion papers, exposure drafts and recent International Accounting
Standards
problems with current International Accounting Standards and the impact of
changes therein on the entity
preparation of reports in an advisory capacity including share valuation, and
purchase of a business
changes in organisational structure, reconstructions, demergers, etc.
the potential for business failure and problems with the business including
financial analysis, corporate failure prediction and measurement of corporate
performance
environmental and social accounting and the impact of culture
corporate governance and the dissemination of information to users
current issues.
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INTRODUCTION
The main thrust of the syllabus will be the preparation of a set of group fmancial
statements, advising clients on current standards and changes therein, reporting
business performance including environmental and social reporting and corporate
governance, and appraising current issues. It is important to realise that other areas of
the syllabus will be also examined but they are not considered as important.
Approach to examining the syllabus
The examination is a three hour paper divided into two sections.
Section A will normally comprise one compulsory question on group financial
statements including group cash flows and foreign currency translation. This question
will be technically demanding and could have a discursive element in it.
Section B will comprise four questions out of which candidates should select three
questions. These questions will involve advising, discussing and reporting on issues
and topics in corporate fmancial reporting.
The questions will view the subject matter from the perspective of the preparer of
financial statements and from the perspective of the accountant as an advisor.
Invariably a technical understanding ofthe subject matter will be required and
candidates will have to apply their knowledge to given cases and scenarios.
Advice as to current and future reporting requirements and their impact on reported
corporate performance will be an important element of these questions. Additionally
current issues and developments in fmancial reporting will be examined on a discursive
basis.
Number of marks
Section A: One compulsory question
Section B: Choice of3 from 4 questions
(25 marks each)
Additional information
25
75
100
Candidates need to be aware that questions involving knowledge of new examinable
regulations will not be set until at least six months after the last day of the month in
which the regulation was issued.
The Study Guide provides more detailed guidance on the syllabus. Examinable
documents are listed in the Exam Notes section of the Student Accountant.
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EXAMINATION TECHNIQUE
Time allocation
Divide your time in proportion to the marks on offer. To allocate your time multiply the
marks for each question by 1.7 minutes. Ifyou allocate 1.8 minutes per mark you will find
that at the end of the exam you need a couple more minutes!
e.g. 25 mark question should take you 25 x 1.7 = 43 minutes
Stick to this time allocation.
The first marks are the easiest to gain in each question, so don't be tempted to overstep the time
allocation on one question to tidy up a complicated answer, start the next question instead.
Numerical questions
Before starting a computation, picture your route. Do this by jotting down the steps you are
going to take and imagining the layout ofyour answer.
Set up a pro-forma structure to your answer before working the numbers.
Use a columnar layout if appropriate. This helps to avoid mistakes and is easier for the marker
to follow.
Include all your workings and cross-reference them to the face ofyour answer.
A clear approach and workings will help earn marks even if you make an arithmetic mistake.
If you do spot a mistake in your answer, it is not worthwhile spending time amending the
consequent effects of it. The marker ofyour script will not punish you for errors caused by an
earlier mistake.
Don't ignore marks for written recommendations or comments based upon your computation.
These are easy marks to gain.
If you could not complete the calculations required for comment then assume an answer to the
calculations. As long as your comments are consistent with your assumed answer you can still
pick up all the marks for the comments.
Case Study/Scenario based questions
Read the requirements carefully to identify
Instruction e.g. "outline, discuss ....."
Content eg "the factors, the advantages "
VehiclelFormat eg "report, memo, letter "
Addressee eg "the board, the accountant "
Read the scenario quickly to identify
Company name, dates, nature ofbusiness, performance.
Recall the technical knowledge you have learned relating to the content from the requirements
and your quick read of the scenario.
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Read the scenario again slowly and actively
o highlighting key points, or
o noting implications in the margin, and
o noting points on a plan of your answer.
Draw together your technical knowledge and the points from the scenario. Do this by
thinking and rearranging your plan, before you write up your answer.
Written questions
Planning
Read the requirements carefully at least twice to identify exactly how many points you are
being asked to address.
Jot down relevant thoughts on your plan
Give your plan a structure which you will follow when you write up the answer.
Presentation
Use headings, indentation and bullet points to give your answer structure and to make it more
digestible for the marker.
Use short paragraphs for each point that you are making.
Use "bullet points" where this seems appropriate.
Separate paragraphs by leaving at least one line of space between each one.
Style
Long philosophical debate does not impress markers. Concise, easily understood language scores
marks.
Lots ofpoints briefly explained tends to score higher marks than one or two points elaborately
explained.
Imagine that you are a marker, you would like to see a short, concise answer
which clearly addresses the requirement.
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CONTENTS
Session Page
1 GAAP and the IASB 0101
2 International issues 0201
3 Framework for the preparation and presentation of financial statements 0301
4 Substance over form 0401
5 lAS 1 Presentation of fmancial statements 0501
6 lAS 8 Accounting policies, changes in accounting estimates and errors 0601
7 lAS 18 Revenue 0701
8 lAS 11 Construction contracts 0801
9 lAS 16 Property, plant and equipment 0901
10 lAS 23 Borrowing costs 1001
11 lAS 20 Accounting for government grants & disclosure of government assistance 1101
12 lAS 17 Leases 1201
13 lAS 38 Intangible assets 1301
14 lAS 40 Investment properties 1401
15 lAS 41 Agriculture 1501
16 lAS 36 Impairment of assets 1601
17 lAS 37 Provisions, contingent liabilities and contingent assets 1701
18 lAS 12 Income taxes 1801
19 lAS 32 and lAS 39 Financial instruments 1901
20 lAS 19 Employee benefits 2001
21 IFRS 2 Share-based payments 2101
22 Regulatory framework 2201
23 Group accounts - Revision ofbasics 2301
24 lAS 22 Goodwill 2401
25 Group accounts - More complex groups 2501
26 Group accounts - Disposals 2601
27 Group accounts - Piecemeal acquisition 2701
28 lAS 28 Investments in associates 2801
29 lAS 31 Interests in joint ventures 2901
30 lAS 21 The effects of changes in foreign exchange rates 3001
31 Changes in organizational structure 3101
32 Share valuation 3201
33 Analysis and interpretation 3301
34 lAS 7 Cash flow statements 3401
35 The effects of changing prices 3501
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CONTENTS
Session
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lAS 33 Earning per share
lAS 14 Segment reporting
IFRS 5 Non-current assets held for sale and discontinued operations
lAS 10 Events after the balance sheet date
lAS 24 Related parties
lAS 34 Interim financial reporting
Corporate reporting issues
IFRS 1 First-time adoption ofIntemational Financial Reporting Standards
Index
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CONTENTS
SESSION 00
Introduction
Syllabus
Aim
Objectives
Position of the paper in the overall syllabus
Syllabus content
Excluded topics
Key areas of the syllabus
Approach to examining the syllabus
Additional information
Examination technique
Time allocation
Numerical questions
Case Study/Scenario based questions
Written questions
SESSION 01
GAAP and the IASB
1 GAAP
1.1 What is GAAP?
1.2 Sources of GAAP
1.3 Role of statute and standards
2 International Federation of Accountants (IFAC)
2.1 What is it?
2.2 Membership
2.3 Technical committees
2.4 Accounting v auditing
3 ThelASB
3.1 What is it?
3.2 Objectives
3.3 Structure
4 International fmancial reporting standards (IFRSs)
4.1 Importance
4.2 Development of lASs
4.3 Interpretation of lASs
4.4 Benchmark and allowed alternative treatments
4.5 Scope and application
4.6 Authority
5 The big GAAP/little GAAP debate
5.1 The debate
5.2 Difficulties
5.3 Arguments for
5.4 Arguments against
6 International fmancial reporting interpretations committee (SIC).
6.1 Background
6.2 Approach
6.3 Changes
6.4 SICs/IFRICs in issue (as examinable documents)
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CONTENTS
7 Relationship ofIASC with other bodies
7.1 Intergovernmental bodies
7.2 National standard setting bodies (NSSBs)
8 G4+ 1 GROUP
SESSION 02
International issues
1 International harmonisation
1.1 Introduction
1.2 Environmental factors
1.3 General comment
2 Advantages of harmonisation
2.1 Multinational enterprises (MNEs)
2.2 Multinational accounting firms
2.3 Investors
2.4 Others
3 Barriers to harmonisation
4 Progress on harmonisation
4.1 IASB
4.2 The IOSCO project
4.3 Growth of importance of lASs
4.4 Problems associated with the further adoption of lASs
5 The role of other organisations in harmonisation
5.1 European Union directives
5.2 Others
6 lAS vs national alternatives
SESSION 03
Framework for the preparation and presentation of fmancial statements
1 Purpose and Status
1.1 Purpose
1.2 Scope
1.3 Financial statements
1.4 Application
1.5 Users and their information needs
2 The Objective of Financial statements
2.1 Financial position, performance and changes in fmancial position
3 Underlying Assumptions
3.1 Accrual basis
3.2 Going concern
4 Qualitative Characteristics of Financial statements
4.1 Principal qualitative characteristics
4.2 Understandability
4.3 Relevance
4.4 Reliability
4.5 Comparability
5 Elements of fmancial statements
5.1 Defmitions
5.2 Recognition
5.3 Measurement bases
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CONTENTS
6 Concepts of capital and capital maintenance
6.1 Concepts of capital
6.2 Concepts of capital maintenance and the determination ofprofit
SESSION 04
Substance over form
1 Why substance matters
1.1 Introduction
1.2 Recognition of assets and liabilities
2 Reporting the substance of transactions
2.1 Objective
2.2 Recognition and derecognition
3 Examples
3.1 Consignment inventory
3.2 Sale and repurchase agreements
3.3 Quasi subsidiaries
3.4 Factoring of debts
SESSION 05
lAS 1 Presentation of financial statements
1 Introduction
1.1 Objective
1.2 General purpose financial statements
1.3 Application
2 Financial Statements
2.1 Representation
2.2 Objectives of financial statements (see the Framework)
2.3 Components
2.4 Supplementary statements
3 Overall considerations
3.1 Fair presentation and compliance with lASs
3.2 Emphasis
3.3 Departure from lAS
3.4 Going Concern
3.5 Accrual basis of accounting
3.6 Consistency of presentation
3.7 Materiality and aggregation
3.8 Offsetting
3.9 Comparative information
4 Structure and Content
4.1 "Disclosure"
4.2 Identification of fmancial statements
4.3 Reporting date and period
4.4 Terms used
5 Balance Sheet
5.1 The current/non-current distinction
5.2 Current assets
5.3 Current liabilities
5.4 Overall structure
5.5 Presentation of balance sheet items
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CONTENTS
6 Income Statement 0514
6.1 Presentation of income statement items 0514
6.2 Structure of the income statement 0515
7 Statement of Changes in Equity 0517
7.1 A separate statement 0517
7.2 Function 0517
7.3 Structure of notes 0518
7.4 Items which are taken directly to equity 0520
8 The G4+1 Position Paper on reporting fmancia1performance 0521
8.1 What is Performance Reporting? 0521
8.2 Scattered Information about Performance 0521
8.3 Recycling 0522
8.4 Why have 2 statements? 0522
8.5 The G4+1 Position Paper Proposals 0522
8.6 IASB position 0523
9 Notes to the financial statements 0523
9.1 Structure 0523
9.2 Disclosure of accounting policies 0524
9.3 Key sources of estimation uncertainty 0524
9.4 Other disclosures 0524
10 IASC discussion paper - business reporting on the internet 0524
SESSION 06
lAS 8 Accounting policies, changes in accounting estimates and errors
1 Background 0602
1.1 Performance 0602
1.2 Disaggregation 0602
1.3 Reporting aspects ofperformance 0603
2 Introduction 0604
2.1 Scope 0604
2.2 Defmitions 0604
3 Accounting policies 0605
3.1 Selection and application 0605
3.2 Consistency of accounting policies 0606
3.3 Changes in accounting policy 0606
3.4 Disclosure 0607
4 Changes in accounting estimate 0610
4.1 Introduction 0610
4.2 Accounting treatment 0610
4.3 Disclosure 0610
5 Prior period errors 0611
5.3 Disclosures 0611
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CONTENTS
SESSION 07
lAS 18 Revenue
1 Introduction
1.1 Scope
1.2 Defmitions
1.3 Measurement of revenue
1.4 Disclosure
2 Sale of goods
3 Rendering of services
4 Interest, royalties and dividends
5 specific examples
5.1 Sale of Goods
5.2 Specific examples - Rendering of Services
5.3 Specific examples - Interest, Royalties and Dividends
SESSION 08
lAS 11 Construction contracts
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1 Introduction 0802
1.1 Scope 0802
1.2 Defmitions 0802
1.3 Key issues 0802
1.4 Revenue 0803
1.5 Contract costs 0803
1.6 Exam comments 0804
2 Recognition and measurement 0804
2.1 The rules 0804
2.2 Calculations 0806
2.3 Recognition 0808
3 Presentation and disclosure 0809
SESSION 09
lAS 16 Property, plant and equipment
1 Introduction
1.1 Scope
1.2 Exclusions
1.3 Defmitions
2 Recognition
2.1 Criteria
3 Initial Measurement at cost
3.1 Components of cost
3.2 Exchange of assets
4 Subsequent Costs
4.1 Running costs
4.2 Part replacement
4.3 Major inspection or overhaul costs
5 Measurement after Recognition
5.1 Accounting policy
5.2 Cost Model
5.3 Revaluation Model
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CONTENTS
6 Revaluations 0905
6.1 Fair value 0905
6.2 Frequency 0906
6.3 Accumulated Depreciation 0906
6.4 Increase/decrease 0906
7 Depreciation 0908
7.1 Accounting standards 0908
7.2 Depreciable amount 0908
8 Recovery of Carrying Amount 0909
8.1 Impairment 0909
8.2 Compensation 0909
9 Derecognition 0909
9.2 Derecognition date 0910
10 IFRS 5 disposal of non-current assets and presentation of discontinued operations 0910
10.1Reasons for issuing the standard 0910
10.2Main features of the standard 0911
11 Disclosure 0912
11.1For each class 0912
11.2Others 0912
11.3Items stated at revalued amounts 0913
11.4Encouraged 0913
12 Non - depreciation 0913
12.1Background 0913
12.2Arguments employed 0914
12.3lAS 16 0914
SESSION 10
lAS 23 Borrowing costs
1 Introduction
1.1 Recognition
1.2 Arguments
1.3 Scope
1.4 Defmitions
2 Benchmark treatment
2.1 Recognition
2.2 Disclosure
3 Allowed alternative treatment
3.1 Recognition
3.2 Borrowing costs eligible for capitalisation
3.3 Commencement of Capitalisation
3.4 Suspension of Capitalisation
3.5 Cessation of Capitalisation
3.6 Disclosure
4 Consistency of treatment
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CONTENTS
SESSION 11
lAS 20 Accounting for government grants & disclosure of government assistance
1 Introduction 1102
1.1 Scope 1102
1.2 Defmitions 1102
2 Government grants 1103
2.1 Criteria 1103
2.2 Forgivable loans 1103
2.3 Broad approaches to accounting treatment 1103
2.4 lAS 20 treatment 1104
2.5 Non-monetary government grants 1104
2.6 Presentation of grants related to assets 1104
2.7 Presentation of grants related to income 1105
2.8 Repayment of government grants 1105
3 Government Assistance 1105
3.1 Defmition 1105
3.2 Excluded from government grants but are included as government assistance 1106
3.3 Issue 1106
3.3 Loans at nil or low interest rates 1106
4 Disclosure 1106
4.1 Matters 1106
5 SIC - 10: Government assistance - No specific relation to operating activities 1106
SESSION 12
lAS 17 Leases
1 Introduction 1202
1.1 Traditional accounting for leases (pre lAS 17) 1202
1.2 Problem 1202
1.3 Overview 1202
1.4 Scope 1202
1.5 Defmitions 1203
2 Type of arrangement 1205
2.1 Lease classification; 2 types 1205
2.2 Risks and rewards of ownership 1205
2.3 Indicators 1205
2.4 Terms of the lease 1206
2.5 Comment on classification 1206
2.6 Land and buildings 1206
2.7 SIC-27: Evaluating the Substance of Transactions Involving the Legal Form
of a Lease 1207
3 Lessee accounting for a finance lease 1210
3.1 Principles 1210
3.2 Rentals in arrears 1211
3.3 Rentals in advance 1213
3.4 Disclosures - finance leases 1216
4 Lessee accounting for an operating lease 1218
4.1 Lessee accounting for an operating lease 1218
4.2 SIC-15: Operating Leases - Incentives 1218
4.3 Disclosures 1219
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CONTENTS
5 Lessor accounting for a finance lease
5.1 Background
5.2 Recognition
5.3 Allocation of finance income
5.4 Disclosure in respect of fmance leases
6 Lessor accounting for an operating lease
7 Sale and leaseback transactions
7.1 Background
7.2 Sale and leaseback as finance lease
7.3 Sale and leaseback as an operating lease
8 G4+1 discussion Paper on Leases
SESSION 13
lAS 38 Intangible assets
1 Introduction to lAS 38
1.1 Scope
1.2 Defmitions
1.3 Defmition criteria
2 Recognition and initial measurement
2.1 General criteria
2.2 Initial measurement - cost
2.3 Subsequent expenditure
3 Internally generated intangible assets
3.1 Internally generated goodwill
3.2 Other internally generated assets
3.3 Specific recognition criteria for internally generated intangible assets
3.4 Recognition of expenses and costs
4 Measurement after recognition
4.1 Cost model
4.2 Revaluation model
4.3 Active markets
4.4 Accounting entries on revaluation
5 Usefullife
5.1 Factors
5.2 Finite useful lives
5.3 Indefinite useful lives
6 Impairment and derecognition
6.1 Impairment losses
6.2 Retirements and disposals
7 Disclosure
7.1 Intangible assets
7.2 Revaluations
7.3 Research and development expenditure
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CONTENTS
SESSION 14
lAS 40 Investment properties
1 Introduction
1.1 Objective
1.2 Scope
1.3 Defmitions
2 Recognition and measurement
2.1 Rule
2.2 Initial Measurement
2.3 Meaning of cost
2.4 Expenditure after initial recognition
3 Measurement after recognition
3.1 Fair value model
3.2 Exceptional circumstances
3.3 The cost model
3.4 Transfers
3.5 Disposals
3.6 Change in method
4 Disclosure
SESSION 15
lAS 41 Agriculture
1 Introduction
1.1 Objective
1.2 Scope
1.3 Defmitions
1.4 Commentary
2 Recognition and measurement
2.1 Recognition
2.2 Measurement
2.3 Commentary
2.3 Gains and losses
2.4 If fair value cannot be determined
3 Government grants
4 Presentation and disclosure
4.1 Presentation
4.2 Disclosure
SESSION 16
lAS 36 Impairment of assets
1 Introduction
1.1 Objective of the standard
1.2 Defmitions
2 Basic rules
2.1 All assets
2.3 Indications ofpotential impairment loss
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CONTENTS
3 Measurement ofrecoverable amount
3.1 General principles
3.2 Fair value less costs to sell
3.3 Value in use
4 Cash-generating units
4.1 Basic concept
4.2 Allocating shared assets
5 Accounting for impairment loss
5.1 Basics
5.2 Allocation within a cash-generating unit
6 Subsequent review
6.1 Basic provisions
6.2 Reversals of impairment losses
7 Disclosure
7.1 For each class of assets
7.2 Segment reporting
7.3 Material impairment losses recognised or reversed
SESSION 17
lAS 37 Provisions, contingent liabilities and contingent assets
1 Introduction
1.1 Objective
1.2 Scope
1.3 Defmitions
1.4 The relationship between provisions and contingent liabilities
2 Recognition
2.1 Recognition of provisions
2.2 Recognition issues
2.3 Contingent assets and liabilities
3 Measurement
3.1 General rules
3.2 Specific points
4 Changes in provisions
5 IFRIC 1
5.1 Scope
5.2 Issue
5.3 Consensus
5.4 Transition
6 Application of the rules to specific circumstances
6.1 Future operating losses
6.2 Onerous contracts
6.3 Specific application - Restructuring
7 Provisions for repairs and maintenance
7.1 Refurbishment Costs - No Legislative Requirement
7.2 Refurbishment Costs - Legislative Requirement
8 Disclosures
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1621
1621
1622
1623
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1624
1624
1702
1702
1702
1702
1704
1704
1704
1705
1708
1708
1708
1709
1709
1709
1709
1710
1710
1711
1712
1712
1712
1713
1715
1715
1716
1717
CONTENTS
SESSION 18
lAS 12 Income taxes
1 Introduction 1802
1.1 Overview 1802
1.2 Scope 1802
1.3 Defmitions 1802
1.4 Recognition of current tax liabilities and current tax assets 1803
1.5 Accounting for withholding tax 1803
2 Deferred taxation - introduction 1804
2.1 Underlying problem 1804
3 Deferred taxation - The concept illustrated 1805
3.1 Scenario 1805
3.2 Analysis - balance sheet approach 1806
3.3 After the company has accounted for deferred tax the financial statements
will be as follows 1807
4 Accounting for deferred taxation - basics 1808
4.2 Calculation of the balance sheet amounts 1808
4.3 Jargon 1809
5 Accounting for deferred tax - detailed rules 1813
5.1 Recognition of deferred tax liabilities 1813
5.2 Recognition of deferred tax assets 1815
5.3 Accounting for the movement on the deferred tax balance 1817
6 Complications 1818
6.1 Rates 1818
6.2 Change in rates 1819
6.3 SIC 21 - Income Taxes - Recovery of Revalued Non-Depreciable Assets 1820
6.4 SIC 25 - Income Taxes - Changes in the Tax Status of an Entity or its
Shareholders 1821
7 Business Combinations 1822
7.2 Temporary differences arising on the calculation of goodwill 1823
7.3 Temporary differences arising due to the carrying amount of the investment
and the tax base 1824
7.4 Inter company transactions 1826
8 Presentation and disclosure 1827
8.1 Presentation 1827
8.2 Disclosure 1827
9 Appendix 1829
SESSION 19
lAS 32 and lAS 39 Financial instruments
1 Background
1.1 Traditional accounting
1.2 Financial instruments
1.3 History
2 Application and scope
2.1 lAS 32
2.2 lAS 39
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CONTENTS
3 Definitions 1905
3.1 From lAS 32 1905
3.2 From lAS 39 1906
4 Presentation (lAS 32) 1908
4.1 Liabilities and equity 1908
4.2 Settlement in own equity instruments 1909
4.3 Offset 1910
4.4 Interest, dividends, losses and gains 1911
4.5 Compound instruments 1911
4.6 Contingent settlement provisions 1912
4.7 Treasury shares 1913
5 Disclosure (lAS 32) 1913
5.1 Rules 1913
5.2 Illustrative notes - Nokia 1918
5.3 ED7 Financial Instruments: Disclosures 1922
6 Recognition (lAS 39) 1922
6.1 Initial recognition 1922
6.2 Examples 1923
6.3 Embedded derivatives 1923
7 Derecognition 1924
7.1 Derecognition of a fmancia1 asset 1924
7.2 Derecognition of a fmancia1liability 1926
8 Measurement (lAS 39) 1926
8.1 Initial measurement of fmancia1 assets and fmancial1iabi1ities 1926
8.2 Fair value considerations 1927
8.3 Subsequent measurement of financia11iabilities 1927
8.4 Subsequent measurement of financial assets 1927
9 Hedging 1928
9.1 lAS 39 defmitions 1928
9.2 Hedging instruments 1929
9.3 Hedged items 1929
10 Hedge accounting 1929
10.1 Background 1929
10.2 Fair value hedges 1930
10.3 Cash flow hedges 1932
SESSION 20
lAS 19 Employee benefits
1 Introduction 2002
1.1 Key problem 2002
1.2 Objective 2002
1.3 Scope 2002
1.4 Defmitions 2002
2 Short term employee benefits 2004
2.1 Types 2004
2.2 Accounting for short-term employee benefits 2004
3 Post retirement benefits 2004
4 Defined contribution schemes 2005
4.2 Accounting for defined contribution schemes 2005
4.3 Recognition and Measurement 2005
4.4 Disclosure 2005
Accountancy Tuition Centre (International Holdings) Ltd 2005 (xxii)
CONTENTS
5 Accounting for defined benefit schemes 2006
5.2 Accounting for defined benefit schemes 2007
5.3 Amendment to lAS 19 2015
6 Sundry guidance 2016
6.1 Actuarial Valuation Method 2016
6.2 Discount Rate 2016
6.3 Regularity 2016
7 Past Service Cost 2017
8 Disclosure 2018
SESSION 21
IFRS 2 Share-based payments
1 Share-based payments 2102
1.1 Need for a standard 2102
1.2 Key issues 2102
1.3 Objective of IFRS 2 2102
1.4 Scope 2103
1.5 Effective date 2103
2 Definitions 2103
2.1 Share-based payment transaction arrangement 2103
2.2 Types of transactions 2104
3 Recognition 2105
3.1 On receipt or acquisition 2105
4 Measurement 2105
4.1 Fair value 2105
4.2 Equity-settled transactions 2105
4.3 Granting of equity instruments 2106
4.4 Indirect measurement 2111
4.5 Valuation technique 2111
4.6 Cash-settled transactions 2112
5 Disclosures 2112
5.1 Purpose 2112
5.2 Nature and extent of schemes in place 2112
5.3 How fair value was determined 2113
5.4 Effect of expenses arising 2114
SESSION 22
Regulatory framework
1 Introduction
1.1 Defmitions
1.2 Accounting for subsidiaries in separate financial statements
1.3 Truth and fairness
2 Inclusions
2.1 Parent and control
2.2 SIC-12: Consolidation - Special Purpose Entities
2.3 Potential voting rights
2.4 Purchase method
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2204
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CONTENTS
3 Sundry provisions ofIAS 27
3.1 Results of intra-group trading
3.2 Accounting year ends
3.3 Accounting policies
3.4 Date of acquisition or disposal
4 Exemption frompreparing group accounts
4.1 Rule
4.2 Rationale
5 Disclosure
5.1 lAS 27 disclosures
5.2 IFRS 3 disclosures
6 Transitional provisions
6.1 Previously recognised goodwill
6.2 Previously recognised negative goodwill
6.3 Previously recognised intangible assets
SESSION 23
Group accounts - Revision ofbasics
I The issue
1.1 Background
1.2 Defmitions
1.3 Rule
1.4 Types of consolidation
2 Conceptual background
3 The technique - consolidated balance sheets
4 Question approach
4.1 Specific steps
5 Unrealised profit
5.1 Background
5.2 The group suffers the whole charge
5.3 The group shares the charge with the minority interest where appropriate.
5.4 Exception
5.5 Deferred tax
6 Consolidated income statements
6.1 Control and ownership
6.2 Unrealised profits on trading
6.3 Non current asset transfers
6.4 Mid-year acquisitions
SESSION 24
lAS 22 Goodwill
I Goodwill
1.1 Purchase method
1.2 Defmition
1.3 Features of goodwill
2 Fair value of purchase consideration
Solution I
3 Identifiable assets and liabilities
3.1 Introduction
3.2 Provisions
3.3 Contingent liabilities
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2207
2208
2208
2208
2209
2212
2212
2212
2212
2302
2302
2302
2302
2302
2303
2303
2304
2304
2306
2306
2306
2306
2307
2309
2310
2310
2310
2310
2311
2402
2402
2402
2402
2403
2404
2405
2405
2405
2405
CONTENTS
4 Fair value of the identifiable assets and liabilities
4.1 General guidelines
4.2 Provisional accounting
4.3 Subsequent adjustments
5 Accounting for the revaluation in the accounts of subsidiary entitys
5.1 Exam complication
5.2 How is the revaluation accounted for?
6 Accounting for goodwill
6.1 Positive goodwill
6.2 Excess ofacquirer's interest over cost
7 Discussion topics
7.1 Should an asset be recognised at all?
7.2 Impairment review vs amortisation
SESSION 25
Group accounts - More complex groups
2406
2406
2407
2408
2410
2410
2410
2413
2413
2413
2414
2414
2416
1 Types of structure 2502
2 Status of the investment 2503
2.1 Status is always based on control 2503
2.2 In the above illustration P effectively owns 2503
3 Technique 2503
3.1 There are 2 possible approaches to consolidations involving sub subsidiaries. 2503
3.2 Direct technique 2504
3.3 Sub subsidiary 2505
3.4 Sub associate 2507
3.5 Timing of acquisitions 2508
3.6 D shaped groups 2508
3.7 Income statement consolidations 2509
SESSION 26
Group accounts - Disposals
1 Introduction
1.1 Accounting issues
2 Disposal possibilities
3 Treatment in parent's own accounts
4 Treatment in group accounts
4.1 Summary
4.2 Consolidated income statement - "pattern of ownership"
4.3 Consolidated income statement - Profit / loss on disposal
5 Deemed disposals
5.1 Background
5.2 Accounting treatment - Income statement
5.3 Accounting treatment - Balance sheet
6 Demergers
6.2 Treatment by P Inc
6.3 Treatment by R Inc
7 Summary
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2603
2604
2605
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2612
2612
2613
2618
2618
2619
2619
2619
CONTENTS
SESSION 27
Group accounts - Piecemeal acquisition
1 Piecemeal acquisitions
1.1 Introduction
2 Trade investment becoming a subsidiary
3 Trade investment becoming an associate
4 Increase in stake in subsidiary
5 Associate becoming a subsidiary
5.1 Introduction
5.2 Consolidated balance sheet
5.3 Consolidated income statement
SESSION 28
lAS 28 Investments in associates
1 Equity accounting
1.1 Background
1.2 Scope
1.3 Defmitions
1.4 Significant influence
1.5 Separate fmancia1 statements
2 Accounting treatment
2.1 Relationship to a group
2.2 Basic rule
2.3 Equity accounting
2.4 Treatment in a consolidated balance sheet
2.5 Treatment in a consolidated income statement
2.6 Recognition of losses
2.7 Accounting policies and year ends
2.8 Impairment
2.9 Exemptions to equity accounting
3 Inter-company items with an associate
3.1 Inter-company trading
3.2 Dividends
3.3 Unrea1isedprofit
4 Disclosure
4.1 Investments in associates
4.2 Using the equity method
SESSION 29
lAS 31 Interests in joint ventures
1 lAS 31
1.1 Scope
2 Joint ventures
2.1 Defmitions
2.2 Forms ofjoint venture
2.3 Characteristics
3 Jointly controlled operations
3.1 Description
3.2 Presentation and accounting
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2704
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2707
2707
2707
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2802
2802
2803
2803
2804
2804
2804
2804
2804
2805
2810
2812
2813
2813
2814
2815
2815
2815
2816
2817
2817
2817
2902
2902
2902
2902
2903
2903
2904
2904
2904
CONTENTS
4 Jointly controlled assets
4.1 Description
5 Jointly controlled entities
5.1 Description
5.3 Transactions between venturer and a joint venture
5.4 SIC-13: Jointly Controlled Entities - Non-Monetary Contributions by
Venturers
5.5 Exemptions to proportionate consolidation and equity methods
5.6 Separate fmancial statements of a venturer
5.7 Reporting the interests of an investor
5.8 Ceasing to be a venturer in a joint venture
6 Disclosure
6.1 Contingencies
6.2 Interests
7 Consolidation methods - Summary
SESSION 30
lAS 21 The effects of changes in foreign exchange rates
1 Accounting issues
1.1 Introduction
1.2 Key issues
1.3 Scope
1.4 Defmitions
2 Individual company stage
2.1 Accounting treatment - basic transactions
3 Exceptions to the basic rules
3.1 Net investment in a foreign operation
4 Consolidated financial statements
4.1 Nature of exchange difference
4.2 Identifying the functional currency
5 Foreign operation - (closing rate method)
5.1 Presentation currency
5.2 Supplementary information
5.3 lAS 21 Foreign currency translation
5.4 Calculation of exchange difference
5.5 Goodwill
6 Foreign associates
7 Disposal of foreign operation
8 Disclosure
9 SIC - 7; Introduction of the Euro
SESSION 31
Changes in organizational structure
1 Corporate reconstruction
1.1 Background
1.2 Protection ofthe stakeholders
1.3 Questions
1.4 Appraisal of the scheme
1.5 Order in which interested parties are ranked on a winding up
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2909
2910
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2914
2915
2916
2916
2916
2916
2916
2917
2918
3002
3002
3002
3002
3002
3003
3003
3006
3006
3007
3007
3008
3009
3009
3009
3009
3010
3011
3014
3014
3015
3015
3102
3102
3102
3103
3106
3106
CONTENTS
2 Purchase of own shares
2.1 Legal background
2.2 Creditors buffer
2.3 Accounting rules
3 Distributable profit
3.1 What is a distribution?
3.2 Meaning ofrealised
3.3 Revaluations can have a number of impacts on distributable profits.
SESSION 32
Share valuation
I Reasons
2 Methods
2.1 Introduction
2.2 Asset based methods
2.3 Earnings based methods
2.4 Dividends based
3 Regulatory environment (using the uk as an example)
3.1 City code on takeovers and mergers
3.2 Monopolies & Mergers Commission
SESSION 33
Analysis and interpretation
I Accounting issues
2 Users and user focus
2.1 Introduction
2.2 Investors
2.3 Employees
2.4 Lenders
2.5 Suppliers and other creditors
2.6 Customers
2.7 Government and their agencies
2.8 Public
3 Interpretation of financial statements
3.1 Use of ratios
3.2 Limitations of ratios
3.3 Influences on ratios
3.5 Business factors
3.6 Other indicators
4 Accounting ratios
5 Performance
5.1 Significance
5.2 Key ratios
5.3 Commentary
6 Short term liquidity
6.1 Significance
6.2 Key ratios
6.3 Commentary
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3202
3202
3202
3203
3203
3204
3204
3204
3302
3302
3302
3303
3304
3305
3305
3306
3306
3306
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3306
3306
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3312
3312
3312
3313
CONTENTS
7 Long term solvency 3314
7.1 Significance 3314
7.2 Key ratios 3314
7.3 Commentary 3315
8 Efficiency 3317
8.2 Key ratios 3317
8.3 Commentary 3318
9 Investors' ratios 3319
9.2 Key ratios 3319
9.3 Commentary 3320
10 Creative accounting 3321
11 Corporate failure prediction models 3322
11.1 Altman 3322
11.2 Argenti 3323
11.3 Problems associated with using the models 3323
12 Trend analysis 3324
12.2 Specific cost and price indices 3324
12.3 General price indices 3324
13 Interpretation technique 3325
SESSION 34
lAS 7 Cash flow statements
1 Scope 3402
1.1 Applies to all entities 3402
1.2 Importance of cash flow 3402
1.3 Benefits of cash flow information 3402
1.4 Defmitions 3402
2 Presentation of a Cash Flow Statement 3403
2.1 Classification 3403
3 Reporting Cash Flows from Operating Activities 3404
3.1 Direct method 3404
3.2 Indirect method 3404
3.3 Techniques 3404
4 Reporting Cash Flows from Investing and Financing Activities 3405
4.1 Separate reporting 3405
4.2 Investing activities 3405
4.3 Financing 3407
5 Components of Cash and Cash Equivalents 3407
5.1 Reconciliation 3407
6 Proforma 3408
6.1 Direct method 3408
6.2 Indirect method 3409
6.3 Notes to the cash flow statement 3409
7 Group cash flow statements 3410
7.2 Minority interests 3410
7.3 Associated undertakings 3411
7.4 Acquisition and disposal of subsidiaries 3413
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CONTENTS
8 Additional disclosures
8.1 Analysis of cash and cash equivalents
8.2 Major non cash transactions
8.3 Cash and cash equivalents not held by the group
8.4 Reporting futures, options and swaps
8.5 Voluntary disclosures
9 Further considerations - interpretation of cash flow statements
9.1 Introduction
9.2 Illustration
9.3 Comments
SESSION 35
The effects of changing prices
1 Introduction
1.1 Limitation of historical cost accounting
1.2 Holding gains
1.3 Conclusions
1.4 Effects oflower inflation
2 Design of systems of accounts
2.1 Purpose
2.2 Defmition
2.3 3 decisions
2.4 Combinations
2.5 Double entries
3 Current purchasing power
3.1 Background
3.2 Specific adjustments
4 Current cost accounts - ocm version
4.1 Background
6 lAS 29 - Financial Reporting in Hyperinflationary Economies
6.1 The problem
6.2 Solution
6.3 Historical Cost Financial Statements - balance sheets
6.4 Historical Cost Financial Statements - Income Statement
6.5 Gain or Loss on Net Monetary Position
6.6 Current Cost Financial Statements
6.7 Taxes
6.8 Cash Flow Statement
6.9 Corresponding Figures
6.10 Consolidated Financial Statements
6.11 Economies Ceasing to be Hyperinflationary
6.12 Disclosures
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3419
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3504
3504
3504
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3507
3508
3508
3508
3509
3509
3509
3511
3511
3511
3511
3512
3512
3512
3513
3513
3513
3513
3513
3513
CONTENTS
SESSION 36
lAS 33 Earning per share
I Introduction
1.1 Earnings performance
1.2 Scope
1.3 Defmitions
2 Basic earnings per share (EPS)
3 Basic EARNINGS
3.1 Which earnings?
4 Basic weighted average number of ordinary shares
4.1 Partly paid shares
4.2 Issues for consideration
4.3 Issues of shares where no consideration is received
5 Multiple capital changes
6 Diluted eps
6.1 Purpose
6.2 Method
6.3 Options
7 Order of dilution
7.1 Background
7.2 Method
7.3 Contracts that may be settled in sharesChyba! Zalozka neni definovana,
8 Disclosure
SESSION 37
lAS 14 Segment reporting
I Introduction
1.1 Purpose
1.2 Scope
1.3 Defmitions
2 Reporting
2.1 Primary versus secondary
2.2 Business segments
2.3 Geographical segments
2.4 Usual basis
2.5 Reportable segments
2.6 Disclosures
2.7 Analysis of revenue
2.8 Analysis of assets
2.9 Sundry disclosures
3 Illustration
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3603
3603
3603
3604
3604
3608
3609
3609
3609
3613
3615
3615
3615
3617
3617
3702
3702
3702
3702
3705
3705
3705
3705
3706
3706
3707
3707
3707
3707
3708
CONTENTS
SESSION 38
IFRS 5 Non-current assets held for sale and discontinued operations
1 Introduction
1.1 Reasons for issuing IFRS 5
2 Definitions
2.1 Component of an entity
2.2 Disposal group
2.3 Discontinued operation
3 Held for sale classification
3.1 Defmitions
3.2 Held for sale non-current assets
3.3 Abandoned non-current assets
3.4
3.5 Changes to a plan of sale
4.1 Purpose
4.2 Discontinued operations
4.3 Continuing operations
SESSION 39
lAS 10 Events after the balance sheet date
3802
3802
3802
3802
3802
3803
3804
3804
3804
3806
3806
3807
3807
3807
3807
3808
3809
1 Introduction 3902
1.1 Objective 3902
1.2 Scope 3902
1.3 Defmitions 3902
2 Recognition and Measurement 3902
2.1 Adjusting events 3902
2.2 Non adjusting events 3903
2.3 Dividends 3903
2.4 Going Concern 3903
3 Disclosure 3904
SESSION 40
lAS 24 Related parties
1 Introduction
1.1 Scope
1.2 Defmitions
1.3 Parties deemed not to be related
2 The Related Party Issue
2.1 Affect on reporting enterprise
2.2 Methods for pricing related party transactions
3 Disclosure
3.1 Situations where related party transactions may lead to disclosures
3.2 Disclosure required
3.3 Aggregation
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4003
4003
4004
4004
4004
4004
4007
CONTENTS
SESSION 41
lAS 34 Interim fmancial reporting
1 Scope
2 Content of an interim Financial Report
2.1 Minimum Components
2.2 Condensed Balance Sheet
2.3 Condensed Income Statement
2.4 Condensed Cash Flow Statement
2.5 Changes in Equity
2.6 Selected Note Disclosures
3 Recognition and Measurement
3.1 General comment
3.2 Tax charge
3.3 Use of Estimates
SESSION 42
1 Operating and financial review (OFR)
1.1 Background
1.2 OFR in the UK
2 Corporate governance
2.1 Defmition
2.2 Corporate governance in other countries
2.3 Cadbury Report
2.4 Hampel Report
2.5 The way ahead
3 Sarbanes - oxley
3.1 Background
3.2 Main requirements
SESSION 43
IFRS 1 First-time adoption of International Financial Reporting Standards
1 Introduction
1.1 Background
1.2 Objective
1.3 Scope
1.4 Defmitions
1.5 Stages in transition to IFRSs
1.6 Transition overview
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4102
4102
4103
4103
4104
4104
4104
4104
4202
4202
4202
4204
4204
4204
4204
4205
4206
4207
4207
4207
4302
4302
4302
4302
4303
4304
4305
CONTENTS
2 Opening IFRS balance sheet
2.1 Recognition and measurement principles
2.2 Exemptions from other IFRSs
2.3 Property, plant and equipment
2.4 Business combinations
2.5 Employee benefits
2.6 Cumulative translation differences
2.7 Compound fmancial instruments
2.8 Assets and liabilities of subsidiaries
2.9 Designation of previously recognised fmancial instruments
2.10 Share-based payment transactions
2.11 Insurance contracts
2.12 Decommissioning liabilities
2.13 Mandatory exceptions to retrospective application
3.1 Explanation of transition
3.2 Reconciliations
3.3 Other disclosures
4 Practical matters
4.1 Overview
4.2 Making the transition
INDEX
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4311
4311
4311
4311
4312
4312
4313
4315
4316
4316
4316
4316
4320
4320
4321
GAAP
GAAP AND THE IASB
OVERVIEW
Objectives
To describe the concept ofGAAP.
To describe the objectives ofthe International Accounting Standards Board (IASB)
and its relationship with other bodies and the development, scope and use of
International Accounting Standards (lASs).
What is GAAP?
Sources ofGAAP
Role ofstatute and standards
L...------r--------'
INTERNATIONAL
FEDERATION OF
ACCOUNTANTS
What is it?
Membership
Technical committees
Accounting v auditing
THEIASB
What is it?
Objectives
Structure
L...------r--------'
BIG GAAP VS
LITTLEGAAP
DEBATE
INTERNATIONAL
FINANCIAL
REPORTING
STANDARDS
RELATIONSHIP
OFIASCWITH
OTHER BODIES
The debate
Difficulties
Argumentsfor
Arguments against
Importance
Development
Interpretation
Benchmark and allowed
alternative treatments
Scope and application
Authority
Intergovernmental bodies
National standard setting
bodies
INTERNATIONAL
FINANCIAL
REPORTING
INTERPRETATIONS
COMMITEE
Background
Approach
Changes
SICs in issue
G4+ I GROUP
Accountancy Tuition Centre (International Holdings) Ltd 2005 0I0I
GAAP AND THE IASB
1 GAAP
1.1 What is GAAP?
GAAP (Generally Accepted Accounting Principles) is a term used to describe how
financial statements are prepared in a given environment.
GAAP is a general term.
o UK GAAP, US GAAP, lAS GAAP are more specific statements.
The term mayor may not have legal authority in a given country.
It is a dynamic concept. It changes with time in accordance with changes in the
business environment.
1.2 Sources of GAAP
Regulatory Framework
The body of rules and regulations, from whatever source, which an entity must
follow when preparing accounts in a particular country for a particular purpose. eg:
o Statute
o Accounting standards - Statements issued by professional accounting
bodies which lay down rules on accounting for different issues. e.g.:
International Accounting Standards/lnternational Financial
Reporting Standards
Financial Reporting Standards (U.K.)
Financial Accounting Standards (U.S.A.).
Other sources
o lASs - In countries where these have not been adopted they have an
influence on local standards because the provisions ofthe lAS will be
considered by the local standard setting body
o Best practice - Methods of accounting developed by companies (industry
groups) in the absence of rules in a specific area.(e.g. oil exploration
costs).
1.3 Role of statute and standards
Varies from country to country
o Some countries have a very legalistic approach to drafting financial
statements. The legal rules are detailed and specific and the system is
often geared to the production of a profit figure for taxation purposes.
o Some countries adopt an approach where statute provides a framework of
regulation and standards then fill in the blanks. e.g. in the UK.
Statute Companies Acts 1985 and 1989
Standards SSAPs and FRSs
Accountancy Tuition Centre (International Holdings) Ltd 2005 0102
GAAP AND THE IASB
Note: The legislation ofEU member states is based on EU directives
o Some countries have little in the way of statute and rely largely on
standards e.g. the USA
Note: Although there is no accounting statute as such in the USA there is a
body of the federal government called the Securities and Exchange
Commission (SEC) which oversees the accounting regulations issued by the
profession. The SEC can veto accounting treatments and demand regulation
to be enacted in new areas. Companies in the USA probably face the most
highly regulated environment in the world.
2 INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)
2.1 What is it?
IFAC is a non-profit, non-governmental, non-political organisation of accountancy
bodies that represents the worldwide accountancy profession.
Its' mission is to develop and enhance the profession to provide services of
consistently high quality in the public interest.
2.2 Membership
Accountancy bodies recognised by law or consensus within their countries.
Membership in IFAC automatically includes membership in the International
Accounting Standards Board (IASB).
2.3 Technical committees
International Auditing Practices Committee (IAPC) - issues International
Standards on Auditing (ISAs).
Forum on Ethics - publishes a Code of Ethics for Professional Accountants.
Others
o Education
o Financial and Management Accounting
o Public Sector
o Information Technology
o Membership.
GAAP AND THE IASB
2.4 Accounting v auditing
Accounting Auditing
The classification and recording of
Objective is to express an opinion

actual transactions in monetary terms. whether the financial statements are
The presentation and interpretation of

prepared, in all material respects, in
the results of transactions.
accordance with a financial reporting
framework.
3 THEIASB
3.1 What is it?
The IASB was called the International Accounting Standards Committee (lASe)
until April 2001.
The IASC was an independent private sector body and was set up in 1973. It is the
sole body having responsibility and authority to issue pronouncements on
international accounting standards.
It has a very wide membership. As at March 2001 it had 153 member associations
from 112 countries representing over 2,000,000 accountants.
3.2 Objectives
To develop, in the public interest, a single set of high quality, understandable and
enforceable global accounting standards that require high quality, transparent and
comparable information in financial statements and other fmancial reporting to
help participants in the worlds capital markets and other users make economic
decisions
To promote the use and rigorous application of those standards, and
To bring about convergence of national accounting standards and lASs to provide
high quality solutions.
3.3 Structure
3.3.1 lJvervie1V
TRUSTEES
I
I I I
STANDARDS INTERNATIONAL
ADVISORY BOARD FINANCIAL
COUNCIL REPORTING
INTERPRETATIONS
COMMITTEE
GAAP AND THE IASB
3.3.2 Trustees
19 individuals from diverse geographical and functional backgrounds.
The trustees will:
o appoint the members of the:
Board
Standing advisory council
Standing interpretations committee
o monitor the IASB's effectiveness
o secure funding
o approve the IASB' s budgets
o have responsibility for constitutional change.
3.3.3 Board
14members appointed by the trustees.
The board has complete responsibilities for all technical matters including:
o preparation and issue ofIASs
o preparation and issue of exposure drafts
o setting up procedures for reviewing comments received on documents
published for comment
o issue bases for conclusions.
3.3.4 Standards advisory council
About 45 members all appointed by the trustees.
The council provides a forum for participation by organisations and individuals
with an interest in international financial reporting.
Will meet at least 3 times a year.
The council will
o advise the board on agenda decisions and priorities
o pass on views of the council members on the major standard setting
projects
o give other advice to the trustees and the board.
3.3.5 International Financial Reporting Interpretations Committee
Covered in a later section - see paragraph 6.
GAAP AND THE IASB
4 INTERNATIONAL FINANCIAL REPORTING STANDARDS (lFRSs)
4.1 Importance
Ultimately, IASs will form the basis of international financial reporting.
The IASC concentrated on essentials. It endeavoured not to make lASs so
complex that they cannot be applied effectively on a worldwide basis.
4.2 Development of lASs
Only for major projects
Issued by a simple majority of the board
Draft statement ofprinciples

or discussion document
L- ----,- --'.
Published for all standards
Issued on approval by 8 out of 14 board members
Exposure draft
--------.-----_1:
International Accounting
Standard
Issued on approval by 8 out of 14 board members
Since the IASB took over the role of the IASC in 2001, all new standards are
issued as International Financial Reporting Standards (lFRSs). Standards issued by
the IASC were International Accounting Standards (lASs). Both terms are
acceptable to mean accounting standards in general.
4.3 Interpretation of lASs
Steps taken by the IASC to achieve consistent interpretation include
o comparability and improvements project - resulted in the revision of 13
IASs. "Alternative accounting treatments" (see below) were reduced or
eliminated and disclosure requirements reviewed in the context of the
Framework -see later session 3
o publication of draft statement ofprinciples - to make IASB intentions
clear
o issue of a newsletter "Insight" - provides regular updates and explains
technical decisions
o issue of interpretations by the Standing Interpretations Committee (SIC),
renamed International Financial Reporting Interpretations Committee
(lFRlC).
GAAP AND THE IASB
4.4 Benchmarkand allowedalternative treatments
Where IASs permit two accounting treatments for like transactions and events
o one is often designated the benchmark treatment
o the other is the allowed alternative treatment.
The advantage of allowing two treatments (in cases where there is an allowed
alternative) is that it increases the acceptability of the standard.
The disadvantage is that it reduces the comparability of fmancial statements.
Dilly IAS 23 Borrowing Costs now has a benchmark and allowed alternative
treatment, all other standards have been revised to eliminate the benchmark and
allowed alternative.
However, some standards still have options available, ie IAS 16 Property, Plant
and Equipment allows assets to be valued either using a cost or revaluation model.
4.5 Scope and application
lASs apply to the published financial statements of any commercial, industrial or
business reporting entity (whether public or private sector).
lASs apply to both separate and consolidated financial statements.
Any limitation on the applicability of specific IASs is made clear in the lAS.
lASs are not intended to apply to immaterial items.
An IAS applies from a date specified in the standard and is not retroactive unless
indicated to the contrary. (Note: this is often the case!)
Exclusions
Non-business aspects ofpublic sector entities.
Private sector not-for-profit (NFP) entities.
4.6 Authority
lASs do not override local regulations governing the issue of financial statements
in a particular country.
Neither the IASB nor the accountancy profession has the power to enforce
international agreement or to require compliance.
GAAP AND THE IASB
5 THE BIG GAAPILITTLE GAAP DEBATE
5.1 The debate
There has been a consensus for a long time that reporting requirements are biased
towards larger companies, and ignore the needs of small companies.
Compliance places a burden on small companies. This burden includes:
o the cost of considering whether a particular standard is applicable to the
entity,
o the cost of assembling the information,
o the cost of auditing the information, and
o the loss of commercial advantage arising from increased disclosure.
The issue of the application of accounting standards to small companies has been
the subject of numerous studies in the UK and around the world. The debate has
revolved around whether accounting standards should apply equally to all financial
statements that purport to present a true and fair view, or whether small companies
should be exempted from the need to comply with certain standards.
5.2 Difficulties
Difficulties include:
o the choice of a method of determining which companies should be
allowed exemption from the general GAAP, and
o the choice ofwhich accounting rules such companies should be exempt
from.
In considering how to distinguish between categories of companies a number of
factors could be used including:
o the extent to which there is public interest in an entity,
o its complexity, the separation of ownership and control, and
o its size. (It has been recognised that while size is not the most important
factor, it is the easiest to apply).
The Accounting Standards Board in the UK has introduced a modified GAAP for
certain companies based on size. They have chosen size as the easiest to apply.
This has met with an amount of criticism, most commentators feeling that the
separation of ownership would be a more useful criterion.
GAAP AND THE IASB
5.3 Arguments for
The purpose of a set of accounts is to communicate with these users. However, for
a simple concern, some of the complex rules that are in force today may serve to
hinder communication and not aid it.
The complex calculations, the quantity of disclosure and the technical terminology
called for by accounting standards may serve to make the accounts of small
companies incomprehensible to their users.
The owners ofpublic companies are not generally involved in managing the
business. For this reason, a relationship of accountability exists between owners
and managers. This is not the case for owner managed entity's.
In short standards fail to take adequate account ofthe needs of the users.
o The users ofpublic companies' financial statements include:
existing and potential shareholders,
loan creditors,
fmancial analysts and advisers,
the financial press,
employees.
o The users of small companies' fmancial statements include:
owner-managers,
bankers, and
tax authorities.
The recent developments in international standard setting have been driven by the
desire to achieve endorsement by IOSCO. The requirements of the newer standards
are not necessarily appropriate to smaller entities.
5.4 Arguments against
Empirical research has not found that small companies find complying with
accounting standards a matter for concern.
Small entities normally have very few major accounting issues that need to be
addressed, simply because of their size. In practice, this means that many of the
lASs have negligible impact on the small company.
For companies already in existence, accounts formats with full disclosure will
already be in place.
In 2004 the IASB issued a discussion paper entitled Preliminary Views on
Accounting Standards for Small and Medium-sized Entities. The aim of the paper
was to gather views of interested parties on whether there should be some form of
reduced GAAP and if so what form should it take. It is expected that an IASB
working party will be looking into this issue during 2005/2006.
GAAP AND THE IASB
6 INTERNATIONAL FINANCIAL REPORTING INTERPRETATIONS
COMMITTEE (SIC).
6.1 Background
This committee was reconstituted in December 2001 to take over the role of the
Standing Interpretations Committee (SIC). The SIC was founded in April 1997
with the objective of developing conceptually sound and practicable interpretations
of lASs to be applied on a global basis where the standards are silent or unclear.
It is made up of a team of accounting experts from 13 countries appointed by the
IASC.
6.2 Approach
The SIC uses the approach described in lAS 8 i.e.:
o making analogies with the requirements and guidance in International
Accounting Standards dealing with similar and related issues,
o applying the defmitions, recognition and measurement criteria for assets,
liabilities, income and expenses set out in the IASC Framework, and
o taking into consideration the pronouncements of other standard setting
bodies and accepted industry practices to the extent, but only to the
extent, that these are consistent with international GAAP.
The interpretations were originally issued as SIC 1, SIC 2 etc
After approval by the board the interpretations become part of the IASC's
authoritative literature. The pronouncements have the same status as an lAS.
6.3 Changes
The IASB has renamed this committee and the interpretations that they produce.
The committee is now known as the International Financial Reporting
Interpretations Committee (IFRIC) and they will now be issuing IFRIC's. All
SIC's currently in existence will still be known as SIC's but any new interpretation
will be known as IFRIC 1, IFRIC 2 etc.
GAAP AND THE IASB
6.4 SICslIFRICs in issue (as examinable documents)
The following interpretations are in issue as at November 2004
SIC (Relating to) Title Examinable
and contained
in session
SIC-7 IAS21
Introduction of the Euro
30
SIC -10 IAS20
Government assistance - No specific relation to operating
11
activities
SIC -12 IFRS 3 &lAS 27
Consolidation - Special purpose entities
23
SIC -13 IAS 31
Jointly controlled entities - Non-monetary contributions by
29
venturers
SIC - 15 IAS 17
Operating leases - incentives
12
SIC -21 IAS 12
Income taxes - Recovery ofrevalued non depreciable assets
18
SIC -25 IAS 12
Income taxes - Changes in the tax: status of an entity or its
18
shareholders
SIC -27 IAS 17
Evaluating the Substance of Transactions in the Legal Form ofa
12
lease
SIC -29 IAS 1
Disclosure - Service Concession Arrangements
5
SIC - 31 IAS 18
Revenue - Barter Transactions Involving Advertising Services
7
SIC - 32 IAS 38
Intangible Assets - Website Costs
13
IFRlC-l IAS 37
Changes in Existing Decommissioning, Restoration and Similar
17
Liabilities
GAAP AND THE IASB
7 RELATIONSIDP OF rxsc WITH OTHER BODIES
7.1 Intergovernmental bodies
Those concerned with improvement and harmonisation of financial statements
include:
o the European Commission,
o the Working Group on Accounting Standards of the Organisation for
Economic Co-operation and Development (OECD working group),
o the United Nations Intergovernmental Working Group of Experts on
International Standards of Accounting and Reporting (UN ISAR group).
7.2 National standard setting bodies (NSSBs)
The European Commission and the United States Financial Accounting Standards
Board (FASB).
o participate in IASC consultative groups, and
o attend board meetings.
IASC, FASB and the Federation des Experts Compatables Europeens (FEE)
organise an international conference of standard setting bodies.
Representatives ofNSSBs are invited to discuss EDs and develop papers.
IASC representatives have visited more than 45 NSSBs to discuss matters of
common interest.
GAAP AND THE IASB
8 G4+1GROUP
This is a group of standard setters made up of the standard setting bodies from
Australia, Canada, New Zealand, UK and USA with observers from the lASC. The
objective of the group was to promote International harmonisation by the
identification and discussion of major issues in international reporting. Together
the six standard setting bodies have significant influence on international
accounting.
The members share the following objectives:
o To provide quality accounting standards for the primary purpose of
providing information useful to capital market participants,
o To seek common solutions to financial reporting issues, and
o To seek a common conceptual framework.
The members further their common objectives by:
o Analysis and discussion of fmancial reporting issues,
o Exchanging ideas and approaches, and
o Pursuing projects that have the potential to align financial reporting
standards across member jurisdictions.
They have released discussion papers on the following areas (amongst others);
o Business combinations (See session 29)
Recommends doing away with pooling ofinterests
o Leasing (See session 12)
Recommends the capitalisation ofall non cancellable leases
o Reporting financial performance (See session 5)
Recommends the replacing income statement and the statement of
changes in equity with a "A statement ofcomprehensive income".
o Joint ventures and similar arrangements (See session 28)
Recommends the use ofequity accounting (not proportionate
consolidation) for reporting interests in joint ventures.
o Share based payments (see session 21)
Proposes rules for the recognition and measurement oftransactions paid
for by the issue ofshares
The role of this body has now been taken over by the lASB, as have the
consultation papers that were issued by G4+1.
GAAP AND THE IASB
FOCUS
You should now be able to:
discuss the nature ofthe changing role of the IASB;
describe the applicability of lAS's, IFRS's for small companies;
discuss the solutions to differential financial reporting both nationally and
internationally.
INTERNATIONAL ISSUES
OVERVIEW
Objectives
To discuss the advantages and disadvantages of harmonisation.
To explain the reconciliation ofprofits obtained under different GAAPs.
INTERNATIONAL
HARMONISATION
ADVANTAGES OF
HARMONISATION
BARRIERS TO
HARMONISATION
PROGRESS ON
HARMONISATION
THE ROLE OF OTHER
ORGANISATIONS IN
HARMONISATION
lAS vs. NATIONAL
ALTERNATIVES
Introduction
Environmental factors
General comment
Multinational enterprises (MNEs)
Multinationalaccountingjlrms
Investors
Others
lASE
The IOSeOproject
Growth ofimportance oflASs
Problems associated with thefurther
adoption oflASs
European Union directives
Others
1 INTERNATIONAL HARMONISATION
1.1 Introduction
There has been a strong tendency to globalisation in recent years resulting in
the formation of increased numbers of larger multinational companies.
Operating divisions of such companies are subject to different reporting rules
in each country.
1.2 Environmental factors
The form of financial statements is influenced by the environment in the
jurisdiction.
Environmental factors which influence accounting (and auditing) practices
include:
o Economic development,
o Language,
o Global perspective,
o Interdependence on other economies,
o Global capital markets,
o Growth in multinational enterprises,
o Government involvement,
o Needs of users and preparers of financial statements,
o Importance of the accounting profession,
o Local orientation of accounting practice and profusion of
accounting standards,
o Inflation,
o Culture,
o Legal and political system,
o Education system and academic influence,
o Historical events, and
o Foreign investment in the country.
In particular the needs of users are an important influence on the accounting
rules in each jurisdiction.
Jurisdiction Comment
USA and UK Information is produced for owners and potential owners
with the stock market having an important influence.
Germany There is often heavy institutional investment reducing the
need for information to individual shareholders as the
institutions may have board representation.
France Financial statements are used for macro economic
purposes with the government determining the
information that it needs to be included in the accounts.
Italy The large number of family businesses reduces the need
for published information.
South American countries The accounts are often used for tax purposes.
1.3 General comment
Harmonisation of accounting would result in all companies anywhere in the
world reporting:
o Position;
o Performance;
o Changes in financial position;
in the same way.
This would lead to greater market efficiency through the quality ofthe
information and should make raising fmance cheaper and easier.
2 ADVANTAGES OF HARMONISATION
2.1 Multinational enterprises (MNEs)
Harmonisation would benefit the multinationals as follows:
o Leads to improved management control.
o Leads to improved access to funds. (The provider of capital would
find it easier to appraise the companies/divisions).
o The multinational itself would find it easier to appraise investments.
o The preparation of group accounts would be easier.
o Accounting expertise within the multinational would become
transferable between countries.
o Cost of complying with a single framework would be cheaper than
a large number of local regulatory frameworks.
o Similarly, the costs of monitoring such compliance would be
reduced.
Note that multinational enterprises are a drivingforce in the move towards
international harmonisation.
2.2 Multinational accounting firms
The fact that the firm taken, as a whole would provide services in a
standardised environment should lead to improved quality control.
It would be easier to train staff to deal with multinational accounting issues.
Harmonisation should lead to reduced costs of:
o training
o compliance
o transferring expertise
Note that the "big 4" accountingfirms have an important role to play in the
move towards international harmonisation because oftheir influence in
accounting matters in individualjurisdictions.
2.3 Investors
Investor confidence should increase with the ability to compare and
understand the investment opportunities presented by multinationals.
Improved confidence should lead to a reduction in cost of capital.
2.4 Others
Harmonisation would make it easier for developing countries and emerging
free market economies to adopt acceptable systems of fmancial reporting.
Harmonisation reduces market friction and will therefore enhance cross
border trade.
3 BARRIERS TO HARMONISATION
Language is a significant barrier. Harmonisation requires adoption of a
universally accepted business language.
English is the international language ofbusiness due to the importance ofthe
US economy but even for native speakers there is the possibility ofconfusion.
For example, the term "stock" has a different use in the UK and Australia
than it does in the USA.
Countries with strong accounting traditions and professions may feel that the
standards that they have developed are more appropriate.
Different governments lay different emphasis on accounts.
o In some countries the accounts are primarily used as the basis oftax
computations whilst,
o In others they report performance to other parties.
Different countries traditionally draft standards to serve different uses.
o
o
o
UK
Russia
Germany-
owners
taxation
creditors
Often companies prepare sets offinancial statements in different GAAPfor
different purposes
True harmonisation would require the existence of a strong accounting
profession in each country together with a government with the will to adopt
a standardised system. These factors are not always prevalent.
4 PROGRESS ON HARMONISATION
4.1 IASB
It has a very wide membership. As at March 2001 it had 153 member
associations from 112 countries representing over 2,000,000 accountants.
The objectives of the IASB are:
o To develop, in the public interest, a single set ofhigh quality,
understandable and enforceable global standards that require high
quality, transparent and comparable information in fmancial
statements and other financial reporting to help participants in the
worlds capital markets and users make economic decisions,
o To promote the use and rigorous application of those standards, and
o To bring about convergence of national accounting standards and
IASs to high quality solutions.
4.2 The IOSCO project
IOSCO is the international organisation of stock exchange regulators. In 1995
the IASC agreed to produce a set of core standards covering all of the main
and general issues in accounting. The 2 bodies have liased in determining the
IASC's programme for revising standards.
The aim was that on completion of these core standards IOSCO would
endorse them as satisfactory for use in the preparation of financial statements
that could be used in world wide cross border listings.
This endorsement was given in May 2000.
Approval for use in individual stock exchanges is not automatic following
endorsement. This will only happen when individual regulatory authorities
take action at a national level. However the endorsement is seen as a major
step towards international harmonisation.
The US body, the SEC, is represented on IOSCO and has backed the IASC's
efforts. The support of the SEC was essential as endorsement could only
proceed with a unanimous approval by a working party set up for the
purpose. The support of the SEC is also widely seen as crucial to the future
success ofIASs. Companies need and want access to US capital markets.
Endorsement was given as IOSCO were satisfied that:
o The core standards constitute a comprehensive generally accepted
basis of accounting,
o The standards are ofhigh quality resulting in:
comparability,
transparency, and
full disclosure.
o The standards can be rigorously interpreted and applied.
4.3 Growth of importance of lASs
In recent years;
Many countries have based their standards closely or exactly on IAS (e.g.
Singapore, Nigeria, and Kenya).
They are being widely adopted by emerging economies.
More and more large multinational companies are adopting them to satisfy
investor needs in the various markets from which they raise finance (e.g.
Adidas, Deutsche Bank).
The European Commission has recently stated that the majority of standards
are compatible with European directives.
The governments of France and Germany are drafting legislation to enable
their multinationals to adopt IASs in their group accounts.
Many stock exchanges already accept IAS based accounts (e.g. London,
Frankfurt, and Hong Kong).
Australia has adopted a policy of ensuring that its accounting standards are
harmonised with IASs. Compliance with Australian standards automatically
ensures compliance with lASs.
The adoption oflAS is still in its infancy but these will become more and
more important infuture years (sooner rather than later).
4.4 Problems associated with the further adoption of lASs
Companies must apply all IASs before they can describe their accounts as
compliant. In some countries it is felt this will cause the loss of necessary
flexibility.
Choices allowed in the IASs may lead to lack of comparability.
Different interpretation of the same rule may result in like items being
accounted for in different ways.
Entity's may feel that the disclosures will result in the loss of competitive
advantage.
Enforcement of the standards is a big problem. The IASC have no power to
ensure compliance. This will be up to the local regulatory authorities and the
"big 4 " have an important part to play in this respect.
5 THE ROLE OF OTHER ORGANISATIONS IN HARMONISATION
5.1 European Union directives
The ED guides legislation of member states through the issue of directives.
Examples:
Directive Area covered
4
th
directive Form and content of financial statements
7
th
directive Group accounts
8
th
directive Regulation of auditors
The adoption ofthese directives by member states has resulted in the ED
moving towards harmonisation.
There are two further barriers to harmonisation within the ED.
Problem Progress
Lack of a single currency The ED has introduced the Euro
Different countries still use The ED has recently said that all entity's
different standards quoted on a stock exchange in the
community must comply with lAS by
2005.
As stated above, all ED listed companies must adopt lASs by 2005. This
means entity's with a 31 December year end must prepare and lAS opening
balance sheet as at 1 January 2004. Problems associated with first time
adoption of lASs are dealt with in session 44.
In July 2003 the UK has stated that any non-listed UK company may choose
to prepare their accounts in accordance with lAS's.
Emergent economies in Eastern Europe are incorporating the ED directives
into their accounting acts (to further their ambitions to join the ED) and often
adopt lASs.
5.2 Others
Other important international bodies have committees which advise on
accounting matters e.g.
o UN
o OEeD
o WTO
6 lAS VS NATIONAL ALTERNATIVES
IAS GERMANY FRANCE USA UK JAPAN KOREA
CONTENTS
BS
1
P&L/Income statement

------------------------------------------ ALL ------------------------------------
Note on accounting policies
J
Segment reporting
y y y y y y
N
Cash Flow statement Y Optional Optional Y Y Y Y
CONCEPTS
Accruals/Going concern ---------------------------------------------- ALL ---------------------------------
Substance over form
y
varies N Y Y Varies Y
ASSET ACCOUNTING
Historical cost --------------------------------------------- ALL ----------------------------------
Revaluation Y N Y N Y N Y
Capitalisation of interest Y Y Y Y
Allowed
N
y
FIXED ASSETS
AnyoverUEL Y Y Y Y
Specified
Declining balance
y y y
Straight line Y Y Y
sum of digits
y y
unit ofproduction
y y y
Finance lease capitalised
y
varies N Y Y N Y
INTANGffiLES
Goodwill;
Write off to reserves N Y N N N N N
May be carried as a
permanent item N N N N Y N N
capitalised and amortise N Y Y N Y Y Y
period of amortisation
specified N N 20 5 5
Capitalized and tested for Y Y
impairment
R&D
Deferred Y N Y Y Y Y Y
Income Statement Y Y Y Y Y Y Y
STOCKVALUATION
Lower of cost +NRV Y Y Y Y
Lower of cost +MY Y Y Y
GROUPS
Acquisition accounting --------------------------------------------- ALL ----------------------------------
Uniting of interests N Y N N N Y Y
Equity accounting --------------------------------------------- ALL ----------------------------------
Some regulatory authorities allow foreign entity's to use their own GAAP for
the purposes of satisfying local listing requirements but ask them to submit a
reconciliation of the different profit figures. An example of such a
reconciliation (together with explanatory notes) is given on the next page.
December 31
1t
1004
Profit under UK GAAP
Bull of coDloUdation
Sm
1,000
iThe storyTh;group acqiiired:Ii-i iioidiilgiiia-SUbsidiarY- fui $8i)0Dion --...:
: 30
th
September 2004. This hadbeen accounted for as a uniting ofinteresl IAS :
i does not allow the use of Uniting ofInterest so the treatment has to be changed :
_-----_. _ _-----_._ _-----_._.:
Remove profit for the year (120)
Add post acquisition profit (3/12 x 120) 30
Less goodwill impairment for period (5)
Leue classification
I"
:. ---:
: GAAP. The IAS criteria are stricter resulting in thelease being reclassified as a :
i. ._ .:
Remove rental from. profit by adding it back.
Deduct depreciation
Deduct finance charge
Valuation offlnandal assets
;" The grouphoids-&mciai assetswhlcii"ii-cairieii ai-cost:uruh 3-9 -" "-:
i. _.i
20
(15)
(10)
UK.GAAP - cost
IAS 39 - fair value
Only themovement on the fair value need be
recognised as the30 relates to prior period
Deferred. taxation
2003
100
130
30
2004
100
150
50 20
:-UKaMPrecognises iiefeiTed-tUlliliniIi-fuii approach- ;"jib-----.:
i. .i
UKGAAP IAsn
Deferred tax liability b1f 100 400
Charge to the income statement 20 100 (80)
Deferred tax liability elf 120 500
Profit under lAS
@ AccmmIBDlly Tuition Centre (lntmnatiODll1 HoldingB) Ltd 2005 0210
840
FOCUS
Evaluate the developments and the impact on global harmonisation and
standardisation;
Assess proposed changes to international regulation;
Identify the reasons for major differences in accounting practices;
Restate overseas financial statements in line with lASs and IFRS's.
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
OVERVIEW
Objective
To set out the concepts that underlie the preparation and presentation of
financial statements for external users.
PURPOSE AND
STATUS
THE OBJECTIVE
OF FINANCIAL
STATEMENTS
UNDERLYING
ASSUMPTIONS
Accrual basis
Going concern
QUALITATIVE
CHARACTERISTICS OF
FINANCIAL STATEMENTS
Purpose
Scope
Financial statements
Application
Users and their iriformation needs
Financial position, performance and
changes infinancial position
CONCEPTS OF CAPITAL
AND CAPITAL
MAINTENANCE
Concepts ofcapital
Concepts ofcapital maintenance
and the determination ofprofit
ELEMENTS OF
FINANCIAL
STATEMENTS
Principal qualitative
characteristics
Understandability
Relevance
Reliability
Comparability
Definitions
Recognition
Measurement bases
1 PURPOSE AND STATUS
1.1 Purpose
To assist the Board ofIASB in
o developing future IFRSs and reviewing existing IASs
o promoting harmonisation of regulations etc by providing a basis for
reducing the number of alternative accounting treatments permitted
by IASs.
To assist national standard setting bodies in developing national standards.
To assist preparers of financial statements in applying lASs and in dealing
with topics that have yet to form the subject of an lAS.
To assist auditors in forming an opinion as to whether fmancial statements
conform with IASs.
To assist users offmancial statements in interpreting information contained in
financial statements prepared in conformity with IASs.
To provide those who are interested in the work ofIASB with information
about its approach to the formulation ofIASs.
In short to provide a conceptual framework as a foundation for the
preparation and appraisal of accounting standards.
1.2 Scope
Objective of fmancial statements.
Underlying assumptions.
Qualitative characteristics that determine the usefulness of information in
financial statements.
Defmition, recognition and measurement of elements.
Concepts of capital and capital maintenance.
1.3 Financial statements
Included
o Balance sheet
o Income statement
o Statement of changes in fmancial position (e.g. a statement of cash
flows)
o Integral notes, other statements and explanatory material.
Not included
o reports by directors
o statements by chairman
o discussion and analysis by management and similar items included
in a financial or annual report.
1.4 Application
Financial statements of all commercial, industrial and business reporting
entities, whether public or private.
1.5 Users and their information needs
Users Information needs
Investors and their
Risk and return of investment. Need information

advisers
for decision-making (buy, hold or sell?)
to assess ability to pay dividends.
Employees and their
Stability and profitability of employers.

representatives
Ability to provide remuneration, retirement benefits

and employment opportunities.
Lenders
Whether loans and interest will be paid when due.
Suppliers and other
Whether amounts owing will be paid when due.

trade creditors
Customers
Continuance - important for long-term involvement

with, or dependence on, the entity.
Governments and
Allocation of resources and, therefore, activities of

their agencies entities.
Information to regulate activities, determine

taxation policies and as the basis for national
income and similar statistics.
Public
Contribution to local economy including number of

employees and patronage of local suppliers.
Trends and recent developments in prosperity and

range of activities.
2 THE OBJECTIVEOF FINANCIALSTATEMENTS
To provide information about
o the financial position,
o the financial performance, and
o changes in financial position of an entity
that is useful to a wide range of users in making economic decisions.
Also, to show the results of management's stewardship (i.e. accountability for
resources entrusted to it).
2.1 Financial position, performance and changes in financial position
Information that enables users to evaluate
o ability of entity to generate cash and cash equivalents
o timing and certainty of their generation.
FINANCIAL FINANCIAL CHANGES IN
POSITION PERFORMANCE FINANCIAL
POSITION
Affected by
In particular profitability.
To assess investing,
economic resources
fmancing and operating
To predict capacity to activities.

controlled
generate cash flows from
financial structure
existing resource base.
To assess ability to
generate cash and cash
liquidity and
To form judgements about equivalents and needs to

solvency effectiveness with which utilise those cash flows.
capacity to adapt to
additional resources might
changes.
be employed.
=> BALANCE SHEET => INCOME STATEMENT => SEPARATE STATEMENT
3 UNDERLYING ASSUMPTIONS
3.1 Accrual basis
Effects of transactions and other events are
o recognised when they occur, and
o recorded in the accounting records and reported in the financial
statements of the periods to which they relate.
3.2 Going concern
Assumption that an entity will continue in operation for the foreseeable
future.
Therefore there is neither the intention nor need to liquidate or curtail
materially the scale of operations.
4 QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS
Attributes that make information provided in fmancial statements useful to users.
4.1
Principal qualitative characteristics

Relateto
Presentation I I---c-o-n-te-n-t--
o Understandability 0 Relevance
o Comparability 0 Reliability
4.2 Understandability
Users are assumed to have a reasonable knowledge ofbusiness and economic
activities and accounting and a willingness to study information with
reasonable diligence.
Information about complex matters should not be excluded on the grounds
that it may be too difficult for certain users to understand.
4.3 Relevance
Quality helps users
o evaluate past, present or future events.
o confirm or correct their past evaluations.
Relevance of information is affected by

---n-s-n-a-tur-e---I I---M-a-te-n-' a-li-ty---
Nature alone may be
sufficient to determine
relevance.
4.4 Reliability
Information is material if its omission or
misstatement could influence the
economic decisions ofusers taken on the
basis of the financial statements.
Depends on size of item or error judged
in the particular circumstances of its
omission or misstatement.
=> a threshold or cut-off point rather than
being a primary qualitative characteristic.
Free from material error and bias.
Can be depended upon by users to represent faithfully that which it either
purports to represent or could reasonably be expected to represent.
Reliability encompasses:
o faithful representation - e.g. meeting recognition criteria
o substance over form - substance and economic reality, not merely
legal form - see session 4
o neutrality - free from bias
o prudence - including a degree of caution in making estimates under
conditions of uncertainty, such that assets or income are not
overstated and liabilities or expenses are not understated
o completeness (within bounds of materiality and cost) - an omission
can cause information to be false or misleading and thus unreliable.
4.5 Comparability
Users need to be able to compare
o fmancial statements of an entity through time - to identify trends in
fmancial position and performance
o fmancial statements of different entities - to evaluate relative
fmancial position, performance and changes in fmancial position.
Therefore we need consistent measurement and display of financial effect of
like transactions and other events.
Users must be informed of accounting policies employed, any changes in
those policies and the effects of such changes.
Financial statements must show corresponding information for preceding
periods.
5 ELEMENTS OF FINANCIAL STATEMENTS
5.1 Definitions
"Elements" are broad classes of the financial effects of transactions grouped
according to their economic characteristics.
An asset is
o a resource controlled by the entity
o as a result ofpast events
o from whichfuture economic benefits are expected to flow.
A liability is
o a present obligation ofthe entity
o arising from past events
o settlement of which is expected to result in an outflow ofresources
embodying economic benefits.
Equity is
o the residual interest
o in the assets of the entity
o after deducting all its liabilities.
Income is
o increases in economic benefits during the accounting period
o in the form of inflows (or enhancements) of assets or decreases of
liabilities
o that result in increases in equity
o other than those relating to contributions from equity participants.
Expenses are
o decreases in economic benefits during the accounting period
o in the form of outflows (or depletions) of assets or incurrences of
liabilities
o that result in decreases in equity
o other than those relating to distributions to equity participants
The Framework defines assets, liabilities and equity, and the definitions for
income and expenses follow on from those. Therefore it is said that the
Framework takes a balance sheet approach.
5.2 Recognition
5.2.1 Meaning
The process of incorporating in the balance sheet or income statement an item
that meets the definition of an element and satisfies the criteria for
recognition - noted below.
It involves the depiction of the item in words and by a monetary amount and
the inclusion of that amount in the balance sheets or income statement totals.
Items that satisfy the recognition criteria shall be recognised.
The failure to recognise such items is not rectified by disclosure of the
accounting policies used nor by notes or explanatory material.
5.2.2 Recognition criteria
It is probable that any future economic benefit associated with the item will
flow to or from the entity and
The item has a cost or value that can be measured with reliability.
5.3 Measurement bases
Assets Liabilities
Historical cost
The amount paid (or the fair
The amount received in

value of the consideration given) exchange for the obligation.
to acquire them at the time of
their acquisition.
Current cost
The amount that would have to
The undiscounted amount that

be paid if the same or an would be required to settle the
equivalent asset was acquired obligation currently.
currently.
Realisable
The amount that could currently
At settlement values (i.e. the

(settlement) be obtained by selling the asset undiscounted amounts expected
value in an orderly disposal. to be paid to satisfy the liabilities
in the normal course of
business).
Present value
Present discounted value of the
Present discounted value of the

future net cash inflows that the future net cash outflows that are
item is expected to generate in expected to be required to settle
the normal course ofbusiness. the liabilities in the normal
course of business.
6 CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE
6.1 Concepts of capital
6.1.1 Financial concept
Capital is synonymous with the net assets or equity of the entity.
6.1.2 Physical concept
Capital is regarded as the productive capacity of the entity based on, e.g.
units of output per day.
6.2 Concepts of capital maintenance and the determination of profit
6.2.1 Financial capital maintenance
Profit is earned only ifthe fmancial (or money) amount ofthe net assets at
the end of the period exceeds the financial (or money) amount of net assets at
the beginning of the period (after excluding any distributions to/contributions
from owners during the period).
6.2.2 Physical capital maintenance
Profit is earned only if the physical productive capacity (or operating
capability) ofthe entity at the end of the period exceeds the physical
productive capacity at the beginning of the period (after excluding any
distributions to/contributions from, owners during the period).
FOCUS
discuss what is meant by a conceptual framework;
describe the objectives offmancia1 statements and the qualitative
characteristics of fmancia1 information;
define the elements of financial statements;
apply the above definitions to practical situations.
SUBSTANCE OVER FORM
OVERVIEW
Objective
To explain the need for substance over form accounting.
To describe the issues to be addressed in assessing the commercial form of a
transaction.
To cover the analysis of certain common substance over form examples.
WHY SUBSTANCE
MATTERS
REPORTING THE
SUBSTANCE OF
TRANSACTIONS
EXAMPLES
Introduction
Recognition ofassets and liabilities
Objective
Recognition and derecognition
Consignment inventory
Sale and repurchase agreements
Quasi subsidiaries
Factoring ofdebts
SUBSTANCE OVER FORM
1 WHY SUBSTANCE MATTERS
1.1 Introduction
Financial statements must reflect the true substance oftransactions if they are
to show a true and fair view.
Ultimately fmancial statements must follow the Framework which states that
if information reflects substance it has the characteristic of reliability.
Usually substance (ie commercial effect) = legal form. For more complex
transactions this may not be the case.
1.2 Recognition of assets and liabilities
The key issue underlying the treatment of a transaction is whether an asset or
liability should be shown in the balance sheet.
In recent years some companies have devised increasingly sophisticated "off
balance sheet financing" schemes whereby it was possible for them to hold
assets and liabilities which did not actually appear on the balance sheet
according to the local GAAP. This is one of the most important issues in
financial reporting. Some countries have issued accounting standards to
address this point specifically.
The concept of substance over form has existed as a concept in lAS for many
years. If companies had been following lAS some of the reporting problems
which have occurred would not have arisen.
The release ofIAS 39 Financial Instruments: Recognition and Measurement
will greatly improve accounting for financial instruments and complex
hedging arrangements.
2 REPORTING THE SUBSTANCE OF TRANSACTIONS
2.1 Objective
To ensure that financial statements reflect the substance of transactions.
2.2 Recognition and derecognition
Recognise item only if
o it meets definition of asset/liability, and
o monetary amount can be measured with sufficient reliability.
Cease to recognise an asset only if
o all significant access to benefits, and
o all significant exposure to risks inherent in those benefits have been
transferred to others.
SUBSTANCE OVER FORM
3 ~ P S
3.1 Consignment inventory
This is very common in the car industry. Consignment inventory is held by
the dealer but legally owned by the manufacturer.
The issue is who should record the inventory as an asset?
This will depend on whether it is the dealer or the manufacturer who bears
the risks and benefits from the rewards of ownership.
Treatment - Is the inventory an asset of the dealer at delivery?
o Ifyes - the dealer recognises the inventory on the balance sheet
with the corresponding liability to the manufacturer
o If no - do not recognise inventory on balance sheet until transfer of
title has crystallised (manufacturer recognises inventory until then).
Illustration 1
David Wickes, a car dealer buys cars from FMC (a large multi-national car manufacturer) on
the following terms.
Legal title passes on sale to the public or when the car is used for demonstration.
The car is paid for when legal title passes. The price to David is determined at the
date of delivery.
David must pay interest at 10% on cost for the period from delivery to payment.
David has the right to return the cars to FMC. This right has never been exercised in
10 years of trading.
David's year end is 31 December 2004.
Required:
Using as an example a car delivered to David on 30 September 2004 and still held at the year
end explain how David should account for the transaction.
SUBSTANCE OVER FORM
Solution 1
(1) Have the risks and rewards of ownership passed to David on delivery?
Conclusion
Factors
Right to return inventory
Price reflects an
interest charge varying
with time (:.
slow movement risk)
Risk/reward
passed?
No
(but it has never been exercised
so for all intents andpurposes
the risk/reward actually does
pass on delivery)
Yes
On balance the risks and rewards of ownership pass to David on delivery. The
transaction should be treated as a purchase of inventory on credit.
(2) Journal entries
On receipt of car Dr Purchases
Cr Payables
Up to date of earlier sale to third party or use as a demonstator
Dr Interest payable
Cr Payables (accrued interest)
SUBSTANCE OVER FORM
3.2 Sale and repurchase agreements
Here, an asset is sold by A to B on terms such that A repurchases the asset in
certain circumstances.
The issue is to decide whether the substance of the transaction is
o a sale, or
o raising of fmance on an asset still held.
Treatment in A's accounts
Was there in substance a sale?
On "repurchase" Recognise purchase,
including any interest
payable, as cost of sales
A On "sale" Recognise sale and
any profit
Leave asset in alance sheet.
Record proceeds as a
liability. Accrue for any
interest payable
Settle liability and accrued
payable
Effect Effect
Finance cost recognised on
Finance cost recognised

repurchase (as part of cost of
on "sale" (as interest
sales)
payable)
Finance is offbalance sheet
Finance is on balance sheet

SUBSTANCE OVER FORM
Illustration 2
Christov is a vodka manufacturer. The company manufactures vodka out of the finest wheat
grain. The manufacturing process involves a maturing period of 3 years. The vodka is sold
at cost +200%.
On the first day of its accounting period Christov sold 100,000 litres of 1 year old vodka to
Watnest plc, a bank, on the following terms.
Sale price $500,000 (cost).
Christov has the option to repurchase the vodka at any time over the next 2 years at
cost + a mark up.
The mark up is based on an annual rate of interest of 12% and will be prorated.
Watnest has the option to sell the vodka to Christov in 2 years time at a price based
on a similar formula.
Required:
Explain how Christov should account for this transaction at inception and at the year end.
Solution 2
(1) Has there in substance been a sale?
Is the repurchase likely to happen? If so it is not a real sale and the legal form
should be set aside.
Factors
Sale is unusual - sale at cost/to a bank - indicates that it is not a real sale.
A mirror image put and call option means that the repurchase is bound to
occur.
Christov is paying a borrowers return.
Therefore the sale is not a real sale but a financing arrangement.
(2) Journal entries
$ $
On "sale" Dr Cash 500,000
CrPayables 500,000
At year end Dr Income statement 60,000
CrPayables 60,000
On "repurchase" Dr Payables 620,000
CrCash 620,000
(assumes repurchase is at the end of the 2 year period)
Tutorial note - Ifin substance there had been a sale
On "sale"
On "repurchase"
Dr Cash
Cr Revenue
Dr Cost ofsales
CrCash
$ $
500,000
500,000
620,000
620,000
The example presumes simple interest
SUBSTANCE OVER FORM
3.3 Quasi subsidiaries
A controlled undertaking
but
not a legal subsidiary
,r
Benefit and risk source
equivalent to a subsidiary
,
IConsolidate as a subsidiary I
Illustration 3
A hotel company, Company H, sells some of its hotels to Company B, the
subsidiary of a bank. B is financed by loans from the bank at normal interest rates.
H and B enter into a management contract whereby H undertakes the complete
management of the hotels. It is remunerated for this service by a management
charge which is set at a level which absorbs all the profits ofB after paying the
interest on its loan finance. There are also arrangements which give H control over
the sale of any of the hotels by B, and any gain or loss on such sales also reverts to it
through adjustment of the management charge.
Required:
Giving reasons, show how H should record the above.
Solution 3
In these circumstances, it is clear that the bank's legal ownership ofB is oflitt1e
relevance. All the profits ofB go to H, and the bank's return is limited to that ofa
secured lender. In substance, H holds the equity interest in both B and the hotels that it
owns. B will therefore be regarded as a quasi subsidiary ofH and will be consolidated
by it. As a result, all transactions between the two companies will be eliminated from
the group accounts of H, and the group balance sheet will show the hotels as an asset
and the bank loans as a liability. The group profit and loss account will show the full
trading results of the hotels and the interest charged by the bank on its loans, while the
inter-company management charge will be eliminated on consolidation.
SUBSTANCE OVER FORM
3.4 Factoring of debts
The "seller" transfers debts to a "factor" for an agreed % of the value of the
debts. Again, the key issue is the extent to which the risks and rewards of
ownership have been transferred.
Possible treatments.
o debts no longer an asset of the seller derecognition.
o debts remain an asset of the seller separate presentation
FOCUS
explain the nature of the off balance sheet problem and the principle of
substance over form;
discuss common forms of off balance sheet finance and current regulations in
this area;
discuss the perceived problems of current regulatory requirements including
recognition and measurement issues.
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
OVERVIEW
Objective
To prescribe the basis for presentation of general purpose financial statements
by setting out:
o overall considerations;
o guidelines for structure;
o minimum requirements for content.
Accountancy Tuition Centre (International Holdings) Ltd 2005 050I
SCOPE
Objective
General purposefinancial statements
Application
FINANCIAL
STATEMENTS
OVERALL
CONSIDERATIONS
Representation
Objectives offinancial statements
Components
Supplementary statements
Fair presentation and compliance with lASs
Emphasis
Departurefrom lAS
Going Concern
Accrual basis ofaccounting
Consistency ofpresentation
Materiality and aggregation
Offietting
Comparative information
STRUCTURE AND
CONTENT
BUSINESS REPORTING
ONTHEINTERNET
"Disclosure"
Identification offinancial statements
Reporting date and period
Termsused
BALANCESHEETS
The current/non-current distinction
Current assets
Current liabilities
Overall structure
Presentation ofbalance sheet items
INCOME STATEMENT
Presentation ofincome statement items
Structure ofthe income statement
- G4+1 POSITION PAPERON
REPORTING FINANCIAL
PERFORMANCE
What is Performance Reporting?
Scattered Information about Performance
Recycling
Why have 2 statements?
The G4+1 Position Paper Proposals
lASH position
STATEMENT OF
CHANGES INEQUITY
NOTESTOFINANCIAL
STATEMENTS
A separate statement
Function
Structure ofnotes
Items which are taken directly to equity
Structure
Disclosure ofaccountingpolicies
Key sources ofestimation uncertainty
L- ---'. Other disclosures
1 INTRODUCTION
1.1 Objective
To prescribe the content of general purpose financial statements in order to
ensure comparability with:
o the entity's own financial statements, and
o fmancial statements of other entity's.
o overall considerations for the presentation,
To achieve this the standard sets out:
o guidelines for the structure, and
o minimum requirements for content of fmancial statements.
1.2 General purpose financial statements
1.2.1 Meaning
Financial statements intended to meet the needs ofusers who are not in a
position to demand reports tailored to specific information needs.
May be presented separately or within another public document (eg annual
report or prospectus).
1.3 Application
To financial statements of individual entity's and consolidated financial
statements of groups.
To all types of entity's including banks, insurance and other financial
institutions.
To entity's with a profit objective (including public sector business entity's).
2 FINANCIAL STATEMENTS
2.1 Representation
Financial statements are a structured fmancial representation of
o fmancial position of, and
o transactions undertaken by an entity.
2.2 Objectives of financial statements (see the Framework)
To provide information useful to a wide range of users in making economic
decisions about:
o fmancial position
o performance
o cash flows.
To show the results of management's stewardship.
To meet this objective financial statements provide information about an
entity's:
o assets
o liabilities
o equity
o income and expenses including gains and losses
o cash flows.
2.3 Components
A complete set of fmancial statements includes
o Balance sheet
o Income statement
o A statement of changes in equity
o Cash flow statement
o Accounting policies and explanatory notes.
2.4 Supplementary statements
Entities may also present additional information on a voluntary basis, eg
o A fmancial review by management
o Environmental reports
o Value added statements.
Any additional statements presented are outside the scope ofIFRSs.
3 OVERALL CONSIDERATIONS
3.1 Fair presentation and compliance with lASs
Financial statements shall "present fairly"
o fmancial position
o fmancial performance
o cash flows.
Achieved by appropriate application ofIASs (and any necessary additional
disclosures).
Inappropriate accounting treatments are NOTrectified by
o disclosure of accounting polices used
o notes or explanatory material.
3.2 Emphasis
In virtually all circumstances fair presentation is achieved by compliance in
all material respects with applicable lASs. Compliance with lASs shall be
disclosed.
Fair presentation requires
o selection and application of appropriate accounting policies
o presentation of information (including accounting policies) in a
manner which provides relevant, reliable, comparable and
understandable information.
Additional disclosures when the requirements of lASs are insufficient to
enable users to understand the impact ofparticular transactions on the
financial position and performance of the entity.
3.3 Departure from lAS
In extremely rare circumstances, if compliance would be misleading, and
therefore departure from a standard is necessary to achieve a fair
presentation, the entity must disclose
o that management has concluded that the financial statements fairly
present the entity's fmancial position, performance and cash flows
o that it has complied in all material respects with applicable lASs
except that it has departed from a standard in order to achieve a fair
presentation
o the standard from which the entity has departed, the nature of
departure, including the treatment that the standard would require
together with the reason why that treatment would be misleading in
the circumstances and the treatment adopted
o the financial impact of the departure on the entity's net profit or
loss, assets, liabilities, equity and cash flows for each period
presented.
Where an lAS is applied before its effective date, that fact shall be disclosed.
3.4 Going Concern
Management shall
o assess the entity's ability to continue as a going concern
(considering all information available for the foreseeable future)
o prepare fmancial statements on a going concern basis (unless
management consider that it is probable that the entity will be
liquidated/cease trading)
o disclose material uncertainties which may affect the going concern
concept.
The degree of consideration depends on the facts in each case. Ifthe entity
has a history ofprofitable operation and ready access to financial resources
detailed analysis may not be required before a conclusion is reached.
In other cases management may need to consider a wide range of factors, eg
o current and expected future profitability
o debt repayment schedules
o sources of finance.
Foreseeable future is at least, but not limited to, 12 months from the balance
sheet date.
When financial statements are not prepared on a going concern basis, that
fact shall be disclosed, together with the basis on which the fmancial
statements are prepared and the reason for departing from the going concern
concept.
3.5 Accrual basis of accounting
An entity shall prepare its financial statements (except the cash flow statement) under the
accrual basis of accounting.
3.5.1 Concept
Assets, liabilities, equity, income and expenses are
o recognised when they occur (not as cash or its equivalent is
received or paid) and
o recorded in the accounting records and reported in the fmancial
statements ofthe periods to which they relate.
3.5.2 "Matching" concept
Expenses are recognised on the basis of a direct association between
o costs incurred and
o earning of specific items of income.
3.6 Consistency of presentation
Presentation and classification of items in financial statements shall be retained from one
period to the next.
3.6.1 Exceptions
The change will result in a more appropriate presentation (eg if there is a
significant change in the nature of the entity's operations).
A change is required by an accounting standard or an interpretation.
3.7 Materiality and aggregation
lAS I defmes materiality as 'omissions or misstatements of items are
material if they could, individually or collectively, influence the economic
decisions ofusers taken on the basis of the financial statements. Materiality
depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination
of both, could be the determining factor'.
Material items Immaterial amounts
Present separately in financial
Aggregate with amounts of similar

statements. nature or function (on face of fmancial
statements or in notes)
Need not be presented separately.

Materiality provides that the specific disclosure requirements ofIASs need
not be met if a transaction is not material.
3.8 Offsetting
Assets and liabilities, and income and expenses, shall not be offset unless
another standard or interpretation requires or allows the use of offsetting.
Offsetting, except when the offset reflects the substance of a transaction,
would detract the ability ofusers to understand the events that occurred and
would inhibit the assessment of the entity's future cash flows.
A provision ofbad or doubtful debts against receivables is not seen as
offsetting as this provision is an adjustment on an asset valuation.
The standard does allow some netting off of items within the income
statement, eg
o gains/losses on sale of non-current assets are reported after
deducting the carrying value from the proceeds
o expenditure related to a recognised provision, where reimbursement
occurs from a third party, may be netted off against the
reimbursement
o gainllosses relating to a group of similar transactions will be
reported on a net basis, eg foreign exchange gains and losses. Any
material gain or loss shall be reported separately.
3.9 Comparative information
Numerical information in the previous Narrative and descriptive information in
period the previous period
DISCLOSE unless an lAS
INCLUDE when relevant to

permits/requires otherwise. understanding current period's financial
statements, eg re legal disputes
When the presentation/classification of items in the financial statements is
amended
o ifpracticable, reclassify comparatives and disclose nature, amount
and reason for reclassification;
o if impracticable, disclose reason for not reclassifying and the nature
of the changes that would otherwise have been made.
4 STRUCTURE AND CONTENT
4.1 "Disclosure"
lAS 1 uses the term in a broad sense, encompassing items presented on the
face of each fmancial statement as well as in the notes to the fmancial
statements.
4.2 Identification of financial statements
Financial statements shall be clearly identified and distinguished from other
information in the same published document (eg annual report or prospectus).
4.2.1 Importance
lASs apply only to the financial statements and not to other information so
users must be able to distinguish information prepared using lASs from other
information not subject to accounting requirements.
4.2.2 Information to be prominently displayed (and repeated where necessary)
Component of the fmancial statements presented (eg balance sheet).
Name of reporting entity.
Whether fmancial statements cover an individual entity or a group.
Balance sheet date or the period covered by the financial statements (as
appropriate).
Presentation currency.
Level of precision used (eg 000, millions, etc).
4.3 Reporting date and period
Financial statements shall be presented at least annually.
In exceptional circumstances where an entity's balance sheet date changes
and the statements are presented for a period longer or shorter than a year the
entity shall disclose
o reason for a period other than one year being used
o fact that comparative amounts for the income statement, changes in
equity, cash flow statement and related notes are not comparable.
4.4 Terms used
The standard applies a terminology that is consistent with all other standards
but it does not prohibit the use of other terms as long as the meaning is clear
(eg non-current assets = fixed assets).
5 BALANCE SHEET
5.1 The current/non-current distinction
An entity shall present current and non-current assets and current and non-
current liabilities as separate classifications on the face of the balance sheet,
unless when presentation based on liquidity order provides more relevant and
reliable information. This may be the case for financial institutions.
Whichever method is adopted, where a classification includes amounts that
will be recovered in less than 12 months and more than 12 months, an entity
shall disclose the amount to be settled or recovered after more than 12
months.
A separate classification:
o distinguishes net assets that are continuously circulating as working
capital from those used in long-term operations,
o highlights assets expected to be realised within the current
operating cycle, and liabilities due for settlement in the same
period.
Other useful information
o maturity dates of trade and other receivables and payables
o inventories expected to be recovered more than one year from the
balance sheet date.
5.2 Current assets
An asset shall be classified as "current" when it satisfies one of the following
criteria:
o is expected to be realised, or is intended for sale or consumption, in
the normal course of the operating cycle, or
o is held primarily for trading purposes
o is expected to be realised within 12 months of the balance sheet date, or
o is cash or cash equivalent which is not restricted in use.
Note there are two conceptual views of the term current
Liquidity approach
Classification of assets and liabilities into current and non-current is intended to give an approximate
measure of an entity's liquidity (i.e. it's ability to carry on it's activities on a day to day basis without
encountering financial stringencies). (Criterion: - Will items be realised / liquidated in the near
future?)
Operating cycle approach
Classification is intended to identify those resources and obligations of the entity that are continuously
circulating. (Criterion: - Will items be consumed or settled within the normal operating cycle ofthe
entity?)
All other assets shall be classified as "non-current".
5.3 Current liabilities
A liability shall be classified as "current" when
o expected to be settled in the normal course of the operating cycle
o held primarily for the use ofbeing traded
o due to be settled within 12 months of the balance sheet date
o the entity does not have an unconditional right to defer settlement
for at least 12 months after the balance sheet date.
All other liabilities shall be classified as "non-current".
Refinancing of a long-term loan, falling due within 12 months, after the
balance sheet date will still require the loan to be classed as a current liability.
Any refinancing or restructuring of loan payments after the balance sheet date
will qualify for disclosure as a non-adjusting event in accordance with IAS 10
Events after the Balance Sheet Date.
5.4 Overall structure
There is no prescribed format though IAS 1 presents a format as an
illustration.
There are 2 main types of format found in practice. They differ in respect of
which form of the accounting equation that they are an expansion of.
o Net assets (assets - liabilities) = Capital
o Assets = Capital +Liabilities
Illustrations
lAS 1 suggested format UK format
ASSETS $ $
Non current assets 50 Non current assets 50
Current assets 40 Current assets 40
Current liabilities

Net current assets 10
Total assets less current
liabilities
Non current liabilities
Total assets 90
BALANCES TO; BALANCES TO;
EQUITY AND LIABILITIES
Capital and reserves 50 Capital and reserves 50
Non current liabilities 10
Current liabilities 30
90 50
Each of the above would be consistent with IAS practice.
5.5 Presentationof balance sheet items
Certain items must be shown on the face of the balance sheet. The minimum
requirements for these line items are as follows (note that the order in which
they appear is not specified).
o Property, plant and equipment
o Investment property
o Intangible assets
o Financial assets
o Assets and assets included in disposal groups classed as held for
sale
o Investments accounted for under the equity method
o Biological assets
o Inventories
o Trade and other receivables
o Cash and cash equivalents
o Trade and other payables
o Liabilities included in disposal groups classed as held for sale
o Current tax assets or liabilities
o Deferred tax assets or liabilities
o Provisions
o Financial liabilities
o Minority interest, to be presented as part of equity
o Issued equity capital and reserves.
An entity shall disclose either on the face of the balance sheet or in the notes
to the balance sheet further sub classifications of the line items presented
classified in a manner appropriate to the entity's operations.
The detail provided in sub classifications depends on specific requirements of
other lASs and the size, nature and amounts involved. The disclosures will
vary for each item.
Typically companies will present the main headings on the face of the
balance sheet and the detail in the notes to the accounts.
6 INCOME STATEMENT
6.1 Presentation of income statement items
Certain items must be shown on the face of the income statement. The
minimum requirements for these line items are as follows
o Revenue
o Finance costs
o Share ofprofits and losses of associates and joint ventures
accounted for under the equity method
o Tax expense
o Total of (i) post tax profit or loss of discontinued operations and (ii)
post tax gain or loss recognised on the measurement to fair value
less costs to sell on the disposal of assets or disposal groups of a
discontinued operation
o Profit or loss for the period.
The profit or loss for the period shall be allocated between equity holders of
the parent and minority interest. This disclosure shall be made on the face of
the income statement.
Classification of items as extraordinary is not permitted.
An entity shall provide an analysis of expenses using a classification based on
either nature or function.
This shall be performed either on the face of the income statement or in the
notes though presentation on the face is encouraged.
6.2 Structure of the income statement
This is determined by the way in which the entity chooses to comply with the
above requirements to analyse expense items as discussed above.
Nature of expenditure method Function of expenditure method
Expenses are aggregated by nature eg
Classifies expenses as
- depreciation - cost of sales
- purchases of materials - distribution
- transport costs - administrative activities.
- wages and salaries
Advantages - nature Advantage - function
Simple to apply in many small entities
Provides more relevant info to users
No arbitrary allocations :.
Disadvantage - function
More objective
Cost allocation can be arbitrary and
Less judgement required involves considerable judgement.

Illustration
Classification by nature $ Classification by function $
Revenue X Revenue X
Other operating income X Cost of sales (X)
Changes in inventories of fmished Gross profit'(loss) X
goods & WIP X/(X)
Work performed by entity and Distribution costs (X)
capitalised X
Raw materials and consumables (X) Administrative expenses (X)
used
Staff costs (X)
Depreciation and amortisation
expense (X)
Other operating expenses (X) Other operating expenses (X)
Finance cost (X) Finance cost (X)
Income from associates X Income from associates X
Profit before tax X Profit before tax X
Income tax expense X Income tax expense X
Profit after tax X Profit after tax X
Attributable to: Attributable to:
Equity holders of the parent X Equity holders of the parent X
Minority Interest X Minority Interest X
Entity's classifying expenses by function shall disclose additional
information on the nature of expenses, including depreciation and
amortisation expense and staff costs.
An entity shall disclose either on the face of the income statement, or in the
statement of changes in equity or in the notes, the amount of dividends in
total and per share, recognised as distributions to equity holders, for the
period covered by the financial statements.
7 STATEMENT OF CHANGES IN EQUITY
7.1 A separate statement
An entity shall present as a separate component of its financial statements, a
statement showing
o profit or loss for the period
o each item of income and expense, gain or loss recognised directly
in equity, and total thereof
o sum of the above two amounts split between equity holders ofthe
parent and minority interest
o cumulative effect of changes in accounting policy and the
correction of errors (per lAS 8 - see session 6).
In addition an entity shall present either within this statement or in the notes:
o capital transactions with/distributions to owners
o accumulated profit or loss
balance at beginning ofperiod
balance at the balance sheet date
movements for period
o a reconciliation between carrying amount of the following at the
beginning and end of the period
each class of equity
share premium
each reserve.
7.2 Function
Change in equity in the period reflects the change in the net assets in the
period (ie the change in wealth) under the particular measurement basis used.
This change represents the total gains and losses generated by the entity in
the period together with changes resulting from transactions with
shareholders.
lAS 1 requires all items of income and expense to be included in the
determination of the profit for the period unless an lAS permits or requires
otherwise. Therefore there maybe significant gains and losses which do not
appear in the income statement. These disclosures ensure that such items are
highlighted for the users of the accounts so that they are in possession of all
information necessary to judge the performance of the entity.
7.3 Structure of notes
The requirements may be satisfied in a number ofways.
In many jurisdictions a columnar format is adopted with a separate column

for each element within equity (this is known as a movement on reserves
note).
Attributable to equity holders ofthe parent Minority
interest
Share Share Revaluation Retained Total Total
capital premium reserve earnings
$ $ $ $ $
Balance blf X X X X X X X
Change in
accounting policy (X) (X) (X) (X)
Restated balance X X X X X (X) X
Surplus on
revaluation of X X X X
property
Deficit on
revaluation of (X) (X) (X) (X)
investments
Net gains and losses
not recognised in the
income statement X X X X
Net profit for the X X X X
period
Dividends (X) (X) (X)
Issue of share capital X X X X
Balance elf X X X X X X X
An alternative approach would be to present a separate component of the

financial statements which shows the gains and losses arising in the period. If
this approach is adopted the entity will need to support it with notes showing
the movements and reconciliation of each separate element of equity in order
to comply with the standard.
$
Surplus on revaluation of properties
Deficit on revaluation of investments
Net gains and losses not recognised in the income
statement
Net profit in the period
Total recognised gains and losses
Attributable to:
x
(X)
X
X
X
Equity holders ofthe parent X
Minority interest X
7.4 Items which are taken directly to equity
The following transactions which are taken directly to equity (it is not an
exhaustive list)
o IAS 8 - Prior period adjustments to correct an error or on the
introduction of a new accounting policy.
o IAS 16 - Revaluation surpluses recognised when adopting the
revaluation model for the subsequent measurement of non current
assets.
o IAS 36 - Impairment losses on assets carried at a previously
recognised surplus.
o IAS 36 - Reversals of impairment losses previously taken to equity.
o IAS 21 - Foreign exchange differences arising on a monetary item
that is, in substance, part of a net investment in a foreign entity.
o IAS 21 - Foreign exchange differences arising on consolidation of
foreign entities.
o IAS 39 - Fair valuation adjustments on the year end revaluation of
"available for sale fmancial assets".
o IAS 12 - Deferred tax insofar as it relates to a transaction which has
gone directly to equity.
8 THE G4+1 POSITION PAPER ON REPORTING FINANCIAL
PERFORMANCE
Reporting fmancia1performance is an area in which there are significant
differences between the existing standards in the jurisdictions of the G4+1
organisations.
8.1 What is Performance Reporting?
Reporting information about an entity's performance is an important
objective offmancia1 statements. Traditionally, the income statement has
been viewed as the performance statement, with components of the income
statement used to record different aspects ofperformance.
Some aspects ofperformance have been reported outside the traditional
income statement, directly in equity. This is particularly true for reporting
changes in fair values of assets and liabilities.
Under IAS 1, Presentation ofFinancial Statements, an entity shall present, as
a separate component of its financial statements, a statement showing:
o the net profit or loss for the period,
o each item of income and expense, gain or loss which, as required by
other Standards, is recognised directly in equity, and the total of
these items, and
o the cumulative effect of changes in accounting policy and the
correction of errors under lAS 8.
8.2 Scattered Information about Performance
Reporting income, expenses, gains, losses, and recognised value changes
elsewhere than in the income statement results in a scattering of information
about various aspects of an entity's fmancia1performance. A key conclusion
in the G4+1 Position Paper is that performance information shall be reported
in a single financial statement.
o Currently some value changes are reflected in profit or loss for the period - (eg
reductions of assets for impairments)
o Some value changes are taken directly to equity - (eg revaluation surpluses)
8.3 Recycling
This is where a transaction reported directly in equity is later reported again
in the net profit or loss usually when realised). lASs may require or prohibit
this.
o foreign exchange differences arising on translation of a net
investment in a foreign entity under lAS 21, The Effects of
Changes in Foreign Exchange Rates (recycling to net profit or loss
is required when the investment is disposed of); and
o recycling to profit or loss is prohibited for surpluses on the
revaluation ofproperty, plant and equipment (lAS 16, Property,
Plant and Equipment). If the asset is sold the surplus is taken to
accumulated profits directly.
The IASC decisions on whether to report changes in values to income or
equity, and if reported initially in equity whether they should be recycled,
have been made on an ad hoc basis.
8.4 Why have 2 statements?
The traditional answer to this question has been that it is to allow the income
statement to do its job: ie:
o To show realised items
o To show the result of exchange transactions
o To show the results of management actions
The G4+1 group has concluded that this is no longer justifiable.
8.5 The G4+1 Position Paper Proposals
The main proposals in the G4+1 Position Paper are:
o fmancial performance should be presented in one statement rather
than two or more statements,
o the single statement of fmancial performance should be divided into
three components:
the results of operating (or trading) activities,
the results of financing and other treasury activities, and
other gains and losses.
o recycling should not be generally permitted,
o the category of extraordinary items should be abolished, and
abnormal or exceptional items should not be reported as a separate
category of revenue or expenses,
o results of continuing and discontinued operations should be
segregated, and
o changes in accounting policy should be reported by retrospectively
applying the new policy with restatement of prior periods.
These final three points have been adopted by revisions to existing standards
and issue ofnew standards
8.6 IASB position
IASB has a working party working with FASB on the way forward on
reporting financial performance. They had previously been working with the
UK ASB on this area but were unable to reach a consensus on how to take the
project forward.
9 NOTES TO THE FINANCIAL STATEMENTS
9.1 Structure
Objectives of notes to the financial statements
o to present information about
the basis of preparation of the fmancial statements
specific accounting policies selected and applied for
significant transactions and events.
o to disclose information required by lASs that is not presented
elsewhere
o to provide additional information which is not presented on the face
of the fmancial statements but is necessary for a fair presentation.
Presentation
o notes shall be presented in a systematic manner.
o each item on the face of the balance sheet, income statement and
cash flow statement shall be cross-referenced to notes.
Normal order ofpresentation is as follows:
o statement of compliance with lASs,
o statement of measurement basis and accounting policies applied,
o supporting information for items presented on the face of each
fmancial statement in the order in which each line item and each
fmancial statement is presented,
o other disclosures, including
contingencies, commitments and other financial disclosures
non-fmancial disclosures.
9.2 Disclosure of accounting policies
Matters to be disclosed in respect of significant accounting policies
o measurement basis (or bases) used
o each specific accounting policy that is significant to a fair
presentation.
Disclosure is required ofjudgements management has made in the process of
applying an entity's accounting policies that have the most significant effect
on amounts recognised.
9.3 Key sources of estimation uncertainty
Disclosure shall be made about key assumptions concerning the future, and
key sources of estimation uncertainty at the balance sheet date, that have a
significant risk of causing a material adjustment to the carrying value of
assets and liabilities within the next fmancial year.
The disclosure shall include information of:
o their nature; and
o their carrying amount at the balance sheet date.
Amount of dividends declared but not recognised as a distribution during the
period
Amount of cumulative preference dividends not recognised
Domicile and legal form of the entity, to include country of incorporation
Description of the nature of the entity's operations and its principal activities
Name of the parent and ultimate parent of the group
10 lAse DISCUSSION PAPER- BUSINESS REPORTING ON THE
INTERNET
The IASC paper states that "the growing significance of electronic
performance reporting and eCommerce brings opportunities, challenges and
implications for the accounting profession and ultimately the applicable
regulatory organisations".
A growing number of companies have web sites and more and more of them
are placing business reporting information including financial data on these
sites.
This causes a potential problem. Financial statements are subject to an audit
but information posted to the web is not. Information extracted or presented
out of context maybe misleading. Furthermore the accounting profession
should move with the times and recognise the importance of the web as a
means of disseminating information.
The lASe discussion proposes that the lASe should draft a code of conduct
for reporting on the internet. The recommendations for the content of the
code include the following:
o the same data as that published should be included on line. Thus if
the financial statements are presented in more than I GAAP each
should be available on the internet and these should be clearly
identified so that a user knows when he is moving out of lAS
fmancial statements. A reconciliation of each GAAP to lAS should
be posted too.
o information on the web should not be contradictory to the
information published in other formats (this includes press
releases).
o fmancial or other information that is not derived from the lAS
fmancial statements may also be posted on the web. Such
information should not be presented in such a way to suggest that it
conforms to an lAS standard.
o if only excerpts of fmancial statements are published on the web
then they should be clearly identified as such and reference should
be made as to where the full fmancial statements can be found or
obtained.
o supplementary information that has been released by the entity but
is not widely available (eg briefmgs to investment analysts) should
be provided online to the benefit of all stakeholders.
o if the financial statements are translated and the translated fmancial
statements have not been audited then this should be clearly stated.
o information should be provided in the language of an entity's key
stakeholders. This may mean that the information has to be
translated from the primary reporting language.
FOCUS
describe the structure and content of general purpose financial statements;
explain the overall considerations which underlie their presentation;
explain the relevance of the current/non-current distinction;
present fmancial information, as appropriate:
on the face of the balance sheet;
on the face of the income statement;
in the notes;
describe the structure and content ofnotes;
understand the current discussion about the structure ofreports on fmancial
performance;
explain the issues facing the profession in respect ofbusiness reporting on the
internet.
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
OVERVIEW
Objective
To explain the need for guidance on reporting performance.
To prescribe the classification, disclosure and accounting treatment of certain
items in the income statement.
BACKGROUND
INTRODUCTION
ACCOUNTING
POLICIES
CHANGES IN
ACCOUNTING
ESTIMATE
PRIOR PERIOD
ERRORS
Performance
Disaggregation
Reporting aspects ofperformance
Scope
Definitions
Selection and Application
Consistency ofaccountingpolicies
Changes in accountingpolicy
Disclosure
Introduction
Accounting treatment
Disclosure
Introduction
Disclosures
1 BACKGROUND
1.1 Performance
The objective offmancial statements is to provide information about the
financial position, performance and changes in financial position of an entity
that is useful to a wide range of users in making economic decisions.
The economic decisions that are taken by users of financial statements
require an evaluation of the ability ofan entity to generate cash and cash
equivalents and of the timing and certainty of their generation.
Users are better able to evaluate this ability to generate cash and cash
equivalents if they are provided with information that focuses on the fmancial
position, performance and changes in fmancial position of an entity.
Information about the performance of an entity, in particular its profitability,
is required in order to:
o assess potential changes in the economic resources that it is likely
to control in the future,
o predict the capacity of the entity to generate cash flows from its
existing resource base, and
o form judgements about the effectiveness with which the entity
might employ additional resources.
Information about variability ofperformance is important in this respect.
1.2 Disaggregation
Inorder to make economic decisions users of the accounts need to understand
the composition of figures in as much detail as possible. There is a trend in
reporting to provide more detailed information about the composition of key
elements of the fmancial statements. In short the information may be
analysed, either on the face of the statements or in notes to the accounts, into
component parts to better aid understanding.
For example:
o Disclosure of material and unusual items which are part of ordinary
activities,
o Information on discontinued operations, and
o Segmental reporting.
Users can use such information to make better quality forecasts in respect of
the entity.
1.3 Reporting aspects of performance
Relevant standards are:
lAS 8 - Accounting Policies, Changes in Accounting Estimates and Errors
lAS 1 - Presentation ofFinancial Statements
lAS 14 - Segmental Reporting
lAS 7 - Cash flow Statements
IFRS 5 - Non-current Assets Heldfor Sale andDiscontinued Operations
In considering the reporting of fmancial performance the following areas need to be
covered:
The form and content of the income statement
o Structure (lAS 1)
o Which items must be taken through the income statement (lAS 1)
o Classification of material items (lAS 1)
o Disclosure in respect of discontinued operations (IFRS 5)
Other statements ofperformance
o Segmental reports (lAS 14)
o Cash flow statements (lAS 7)
o Statements showing changes in equity (lAS 1)
Other non mandatory disclosures
o Operating and financial reviews
Corporate governance
Note that many of these areas are covered elsewhere in this system. All ofthese areas
need to be incorporated into an understanding of how international GAAP provides
information to enable users to understand performance.
2 INTRODUCTION
2.1 Scope
lAS 8 shall be applied in selecting and applying accounting policies and
accounting for changes in accounting policies, changes in accounting
estimates and corrections of prior period errors.
2.2 Definitions
Accountingpolicies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting fmancial
statements.
Changes in accounting estimate are adjustments to the carrying value of an
asset or liability, or the amount of annual consumption of an asset, that results
from the assessment of the present status of, and expected future benefits and
obligations associated with, assets and liabilities. These changes arise due to
new information or developments and therefore are not to be classed as
correction of errors.
Examples of changes in accounting estimate are:
o A receivable balance that is subsequently not recovered.
o Changes to the usefu1life of a depreciable non-current asset
International Financial Reporting Standards are Standards and
Interpretations adopted by the lASH. They comprise:
o International Financial Reporting Standards;
o International Accounting Standards;
o International Financial Reporting Interpretations Committee
pronouncements; and
o Standing Interpretations Committee pronouncements
Prior period errors are omissions and misstatements, relating to the fmancial
statements of previous periods arising from a failure to use, or misuse,
information that:
o Was available when those fmancial statements were authorised for
issue
o Could reasonably be expected to have been obtained and taken into
account in the preparation and presentation of the financial
statements.
Errors may include the effects of mathematical mistakes, mistakes in
application of accounting policies, oversights and fraud.
3 ACCOUNTING POLICIES
3.1 Selection and application
When a standard or interpretation applies to a transaction, the accounting
policy or policies applied to that transaction shall be determined by applying
the relevant standard or interpretation along with any relevant
implementation guidance issued by the lASH.
If there is no applicable standard or interpretation relating to a transaction,
management shall use its judgement in developing and applying an
accounting policy resulting in information that:
o is relevant to the economic decision making needs ofusers
o is reliable
o represents faithfully
o reflects the economic substance of the transaction
o is neutral
o is prudent
o is complete in all material aspects.
Management when making judgement may well consider requirements of
accounting standards dealing with similar transactions, the definitions and
recognition criteria in the Framework, recent pronouncements of other
standard-setting bodies that use a similar conceptual framework, and any
other accounting literature denoting best practice within a particular industry.
Illustration 1
Kitty has recently purchased a Van Gogh painting to display in their client reception area,
with the hope it will lead to more contracts and that the painting will appreciate in value.
There is no specific accounting standard that deals with these types of asset, but lAS 40
Investment Property does deal with a particular type of asset that is being held for capital
appreciation.
It would therefore seem appropriate to use lAS 40 as justification to value the painting at fair
value year on year.
3.2 Consistency of accounting policies
An entity shall be consistent in selection and application of accounting
policies to transactions of a similar nature.
lAS 2 Inventories requires inventory to be valued at lower of cost and net
realisable values. In identifying cost it allows a number ofpossible formulas,
such as FIFO or weighted average. The same cost formula must be applied to
similar items of inventory, but a different cost formula can be applied to a
different classification of inventory.
lAS 23 Borrowing Costs allows certain borrowing costs to be included in the
cost of a qualifying asset. If the capitalisation policy is selected then
borrowing costs relating to ALL qualifying assets must be capitalised.
3.3 Changes in accounting policy
3.3.1 When
An entity shall only change its accounting policy if:
o it is required to do so by a standard or interpretation; or
o it would result in the financial statements providing more relevant
and reliable information.
As users of financial statements will wish to see trends in an entity's financial
statements it would not be appropriate for an entity to change its accounting
policy whenever it wishes.
If an entity decides to adopt the revaluation model of lAS 16 Property, Plant
and Equipment this would be classed as a change in accounting policy.
3.3.2 How
If a new accounting standard is issued the transitional provisions ofthat
standard will be applied to any change of accounting policy. When lAS 39
Financial Instruments, Recognition and Measurement was fITSt issued it
required entity's to value and recognise all derivative instruments in an
entity's balance sheet with effect from 1 January 2001.
If the new standard does not have any transitional provisions, or it is a
voluntary change in policy, then the entity shall apply the change in policy
retrospectively.
When a change is applied retrospectively, an entity shall adjust the opening
balance of each affected part of equity for the earliest period presented and
the comparative amounts disclosed for each prior period as if the new policy
had always been applied.
If it is not practicable to apply the effects of a change in policy to prior
periods then the standard allows the change ofpolicy to be made from the
earliest period for which retrospective application is practicable.
3.4 Disclosure
3.4.1 Change due to new standard or interpretation
Title ofnew standard or interpretation and the nature ofthe change in policy.
When applicable, that the change is made in accordance with the standard's
transitional provisions, a description ofthose provisions and the effect that
the provisions might have on future periods.
For the current period and each prior period presented the amount ofthe
adjustment for each line item affected within the financial statements.
The amount of the adjustment relating to periods before those presented.
If retrospective restatement is not practicable, the circumstances that led to
the existence of the condition and a description of how and from when the
change has been applied.
3.4.2 Voluntary change inpolicy
Nature ofthe change in policy
Reasons why the new policy provides more reliable and relevant information.
For the current period and each prior period presented the amount ofthe
adjustment for each line item affected within the financial statements.
The amount of the adjustment relating to periods before those presented.
change has been applied.
Illustration 2
Alpha, an incorporated entity has previously followed a policy of capitalisation of
development expenditure. It has recently decided to adopt the provisions ofIAS 38 Intangible
Assets, for the year ending 31st December 2004. Alpha has been advised by their auditors that
the expenditure previously capitalised does not qualify for capitalisation under the recognition
criteria set out in the standard.
The notes to the accounts for the year ended 31st December 2003 in respect of the deferred
development expenditure was as follows;
Balance at 1st January 2003
Additions
$
1,000
500
2004 2003
(as previously
published)
$ $
1,200 1,100
(800) (680)
400 420
$ $
3,000 2,580
400 420
3,400 3,000
Statement of changes in equity (extract)
Balance as at 1st January
Profit for the year
Balance as at 31st December
Amortisation (400)
Balance at 31st December 2003 1,100
During the year ended 31st December 2004 the company has expensed all expenditure in the
period on projects, in respect of which, expenditure had previously been capitalised, and no
amortisation has been charged in the income statement in 2004.
The following are extracts from the draft accounts for the year ended 31st December 2004.
Income statements
Expenses
Profit for the year
Revenue
Required:
Show how the income statement and statement of changes in equity would appear in the
financial statements for the year ended 31st December 2004 processing the necessary
adjustments in respect of the change in accounting policy by applying the new policy
retros ectivel .
Solution
Income statements
Revenue
Expenses
Profit for the year
Statement of changes in equity (extract)
2004 2003
(as restated)
$ $
1,200 1,100
(800) (780)
400 320
$ $
Balance as at Ist January 2004
As previously stated
Prior period adjustment
Profit for the year
Balance as at 31st December 2004
Notes
3,000
(1,100)
1,900
400
2,300
2,580
(1,000)
1,580
320
1,900
I The entity amortised $400 in 2003 but spent $500. The policy would have been to
write off the amount of expenditure directly to the income statement, therefore the
entity needs to adjust last year's figures by an extra $100 expense.
The adjustment against last year's income statement ($100) has the effect of
restating it to what it would have been ifthe company had been following the same
policy last year. This is important because the income statements as presented shall
be prepared on a comparable basis.
2 The balance left on the deferred expenditure account at the end ofthe previous year
(1,100) is written off against the accumulated profit that existed at that time.
This 1,100 is made up of an amount that arose last year (the difference between the
amount spent ($500) and the amount amortised ($400), and the balance that existed
at the beginning of the previous year ($1,000.
These amounts are written off against last year's profit and the opening balance on
the accumulated profit last year, respectively.
4 CHANGES IN ACCOUNTINGESTIMATE
4.1 Introduction
Many items recognised in the financial statements must be measured with an
element of estimation attached to them.
o Receivables may be measured after allowing for a general bad debt
provision
o Inventory is measured at lower of cost or net realisable value but
must provide for obsolescence
o A provision under lAS 37 by its very nature may be an estimation
of future economic benefits to be paid out
o Non-current assets are depreciated, the charge takes into account
the expected pattern of consumption of the asset and its expected
useful life. The consumption pattern and expected life are estimates.
4.2 Accounting treatment
As soon as a change in circumstances occur which affect the estimates
previously made, the effect of that change shall be recognised prospectively
by including in the current and future (where relevant) periods profit and loss.
A change in estimate is not an error or a change in accounting policy and
therefore does not impact upon prior period statements.
If the change in estimate affects the measurement of assets or liabilities then
the change shall be recognised by adjusting the carrying amount of the asset
or liability.
4.3 Disclosure
The nature and amount of a change in estimate that has an effect in the
current period or is expected to have an effect in future periods.
If it is not possible to estimate the effects on future periods then that fact must
be disclosed.
5 PRIOR PERIODERRORS
5.1 Introduction
These are defined as 'omissions from, and misstatements in, the entity's
financial statements for one or more prior periods arising from the failure to
use or, misuse of, reliable information that was available and could
reasonably be expected to have been obtained when those prior period
financial statements were authorised for issue'.
The amount of the correction of an error that relates to prior periods shall be
reported by adjusting the opening balance of retained earnings and restating
comparative information.
The financial statements ofthe current period are presented as if the error had
been corrected in the period in which the error was originally made.
However, an entity does not reissue the financial statements of prior periods.
If it is not practicable to determine the period specific effects of an error on
comparative information for prior periods presented, the entity shall restate
the opening balances for the earliest period practicable.
5.3 Disclosures
Nature of the error
For each prior period presented the amount of the correction for each line
item affected within the financial statements
The amount of the correction at the beginning ofthe earliest period presented.
error has been corrected.
FOCUS
explain the need for an accounting standard in this area;
prepare an income statement in accordance with the requirements of lAS 8;
describe the circumstances where a change in accounting policy is justified;
account for the correction of prior period errors and changes in accounting
policies.
IAS 18 REVENUE
OVERVIEW
Objective
To describe the principles of revenue recognition
INTRODUCTION
I
SALE OF GOODS
I
RENDERING OF
SERVICES
I
INTEREST, ROYALTIES
AND DIVIDENDS
I
SPECIFIC EXAMPLES
Scope
Definitions
Measurement ofrevenue
Disclosure
Sale ofGoods
Rendering ofServices
Interest, Royalties and Dividends
IAS 18 REVENUE
1 INTRODUCTION
1.1 Scope
Revenue arising from
Sale of Rendering Use of entity assets
goods of services yielding interest,
royalties and dividends
Including goods
Typically involves
Interest - charges for use of

produced/purchased performance of a cash/cash equivalents or
for resale egs contractually agreed amounts due
taskover an agreed
merchandise period of time.
Royalties - charges for use of

purchased by a
long-term assets e.g. patents,
retailer
trademarks, copyrights and
land and property
computer software
held for resale.
Dividends - distributions of
profits to equity holders.
1.2 Definitions
Revenue is the gross inflow of economic benefits during the period arising in
the course of ordinary activities of an entity when those inflows result in
increases in equity, other than increases relating to contributions from equity
participants.
Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm's length transaction.
1.3 Measurement of revenue
At fair value of the consideration received or receivable.
Taking into account trade discounts and volume rebates allowed.
Illustration 1
Accounting policies (extract)
Valuation methods and definitions
Sales to customers
Sales to customers represent sales of products and
services rendered to third parties, net of general price
reductions and sales taxes.
Nestle Consolidated accounts 2002
IAS 18 REVENUE
Illustration 2
1. Accounting policies
Revenue recognition
Turnover, which excludes intergroup sales, represents invoiced sales and is stated net of value
added taxes. Much of the Group's activity is conducted under Production Sharing Agreements
("PSAs") which involve the delivery of a share of the production to the host government and as
such represents a form of taxation. Turnover excludes royalties paid in oil and the share of oil
attributable to host governments under PSAs.
Energy Africa 2002
1.4 Disclosure
Accounting policies adopted for revenue recognition
Amount of each significant category of revenue recognised during the period.
2 SALE OF GOODS
Revenue recognition criteria
D Significant risks and rewards of ownership are transferred to the buyer
D Neither continuing managerial involvement nor effective control
over goods sold are retained
D The amount of revenue can be measured reliably
D It is probable that economic benefits associated with the transaction
will flow to entity
D Costs (to be) incurred in respect ofthe transaction can be measured
reliably.
The passing of risks and rewards is critical to revenue recognition.
D If legal title passes but risk and rewards are retained, no sale shall
be recognised. eg:
where the entity retains obligation for unsatisfactory
performance not covered by normal warranty provisions,
or
where the receipt of revenue is contingent on the buyer
selling the goods on, or
goods are to be installed and the installation is a
significant part of the contract and remains uncompleted,
or
the buyer has the right to rescind and the seller is
uncertain about the outcome.
D If legal title does not pass but the risks and rewards do then the
transaction shall be recognised as a sale.
IAS 18 REVENUE
Cost recognition
D Usually revenue and expenses are to be recognised simultaneously.
D Expenses can normally be measured reliably when other conditions
for revenue recognition have been satisfied.
D Revenue cannot be measured when the related expenses cannot be
measured reliably. In such cases proceeds shall be recognised as a
liability not a sale.
3 RENDERING OF SERVICES
D Recognise revenue by reference to the stage of completion ofthe
transaction at the balance sheet date (but only ifthe outcome can be
estimated reliably).
this is known as the percentage completion method
it is applied in lAS 11 Construction contracts
it provides useful information on service activity in the
period.
Stage of completion shall be estimated using the method that measures
reliably the services performed. May include:
D surveys of work completed (known as work certified).
D services performed as a percentage of total services.
D proportion of costs to date to total estimated costs.
Reliable estimate of outcome is subject to the following conditions (all must
be satisfied).
D The amount ofrevenue can be measured reliably,
D It is probable that the economic benefits associated with the
transaction will flow to the entity,
D The stage of completion of the transaction can be measured reliably,
D Costs to complete can be measured reliably.
lAS 18 REVENUE
Ability to make reliable estimate depends on
D Agreement with the customer about
enforceable rights of each party
consideration to be exchanged
manner and the terms of settlement
D Existence of an effective internal financial reporting and budgeting
system.
If outcome cannot be measured reliably recognise the revenue only to the
extent of the expenses recognised that are recoverable.
Illustration 3
Notes to the consolidated financial statements (extract)
Revenue recognition
Sales from the majority of the Group are recognized when persuasive
evidence of an arrangement exists, delivery has occurred, the fee is fixed
and determinable and collectibility is probable.
Sales and cost of sales from contracts involving solutions achieved
through modification of telecommunications equipment are recognized
on the percentage ofcompletion method when the outcome of the contract
can be estimated reliably. Completion is generally measured by reference
to cost incurred to date as a percentage of estimated total project costs.
NOKIA ANN U A LAC C 0 U N T S 2 0 0 2
Illustration 4
NOTES TO THE STATEMENTS OF INCOME (extract)
[1] Net sales
Sales are recognized upon delivery of goods or rendering of services to third parties and
are reported net of sales taxes and rebates. Revenues from contracts that contain
customer acceptance provisions are deferred until customer acceptance occurs or the
contractual acceptance period has lapsed. Allocations to provisions for rebates to
customers are recognized in the period in which the related sales are recorded based on
the contract terms. Payments relating to the sale or outlicensing of technologies or
technological expertise - once the respective agreements have become effective - are
immediately recognized in income if all rights to the technologies and all obligations
resulting from them have been relinquished under the contract terms. However, if rights to
the technologies continue to exist or obligations resulting from them have yet to be
fulfilled, the payments received are recorded in line with the actual circumstances.
Notes to Consolidated Financial Statements of the Bayer Group
IAS 18 REVENUE
4 INTEREST, ROYALTIES AND DIVIDENDS
D It is probable that economic benefits will flow to the entity and
D The amount of the revenue can be measured reliably.
Recognition bases
D Interest - a time proportion basis
D Royalties - an accrual basis in accordance with the substance of the
agreement
D Dividends - when the shareholder's right to receive payment is established.
5 SPECIFICEXAMPLES
5.1 Sale of Goods
The law in different countries may determine the point in time at which the
entity transfers the significant risks and rewards of ownership. The examples
in this section need to be read in the context of the laws relating to the sale of
goods in the country in which the transaction takes place.
5.1.1 Bill and hold sales
Delivery is delayed at the buyer's request but the buyer takes title and accepts
billing
Revenue is recognised when the buyer takes title, provided:
D it is probable that delivery will be made;
D the item is on hand, identified and ready for delivery to the buyer at
the time the sale is recognised;
D the buyer specifically acknowledges the deferred delivery
instructions; and
D the usual payment terms apply.
Revenue is not recognised when there is simply an intention to acquire or
manufacture the goods in time for delivery.
IAS 18 REVENUE
5.1.2 Goods shipped subject to conditions
5.1.2.1 Condition - installation and inspection
Revenue is normally recognised when the buyer accepts delivery, and
installation and inspection are complete. However, revenue is recognised
immediately upon the buyer's acceptance of delivery when:
o The installation process is simple in nature, (e.g. the installation of a
piece of equipment which only requires unpacking and connection
ofpower) or
o The inspection is performed only for purposes of final
determination of contract prices, (e.g. shipments of commodities
e.g. iron ore).
5.1.2.2 Condition - on approval when the buyer has negotiated a limited right of
return
If there is uncertainty about the possibility ofreturn, revenue is recognised
when the shipment has been formally accepted by the buyer or the goods
have been delivered and the time period for rejection has elapsed.
5.1.2.3 Consignment sales - Under these contracts the buyer undertakes to sell the
goods on behalfofthe seller
Revenue is recognised by the shipper when the goods are sold by the
recipient to a third party.
5.1.2.4 Cash on delivery sales
Revenue is recognised when delivery is made and cash is received by the
seller or its agent.
5.1.3 Layaway sales
Goods are delivered only when the buyer makes the fmal payment in a series
of instalments.
Revenue from such sales is recognised when the goods are delivered.
However, revenue may be recognised earlier, i.e. when a significant deposit
is received, provided the goods are on hand, identified and ready for delivery
to the buyer, when experience indicates that most such sales will actually
proceed to completion.
5.1.4 Orders whenpayment (orpartial payment) is received in advance ofdelivery
for goods not presently held in inventory
Revenue is recognised when the goods are delivered to the buyer.
IAS 18 REVENUE
5.1.5 Sale and repurchase agreements
Under these agreements the two parties enter into an agreement where the
seller may repurchase the goods at some later date. For example:
D As the result of an explicit agreement;
D The seller has a call option to repurchase;
D The buyer has a put option to require the repurchase, by the seller,
ofthe goods.
Revenue is recognised according to the substance of the transaction.
D If the substance of the arrangement is that the seller has transferred
the risks and rewards of ownership to the buyer revenue shall be
recognised.
D If the substance of the arrangement is that the seller retains the risks
and rewards of ownership (even if legal title is transferred) the
transaction is a financing arrangement and does not give rise to
revenue.
5.1.6 Sales to intermediateparties, such as distributors, dealers or othersfor
resale
Revenue from such sales is generally recognised when the risks and rewards
of ownership have passed.
However, when the buyer is acting, in substance, as an agent, the sale is
treated as a consignment sale.
5.1.7 Subscriptions topublications and similar items
When the items involved are of similar value in each time period, revenue is
recognised on a straight-line basis over the period in which the items are
despatched.
When the items vary in value from period to period, revenue is recognised on
the basis of the sales value of the item despatched in relation to the total
estimated sales value of all items covered by the subscription.
5.1.8 Installment sales
Contracts where the consideration is receivable in instalments.
Revenue attributable to the sales price, exclusive of interest, is recognised at
the date of sale.
Note that the sale price is the present value of the consideration, determined
by discounting the instalments receivable at the imputed rate of interest.
The excess of cash receipts over the initial sale price recognised is interest
and shall be recognised as revenue as it is earned, on a time proportion basis
that takes into account the imputed rate of interest.
IAS 18 REVENUE
5.1.9 Real estate sales
Revenue is normally recognised when legal title passes to the buyer.
However the basic transaction might be subject to complication e.g.
D In some jurisdictions the equitable interest in a property may pass at
a date which is different to that at which legal title passes
D Real estate may be sold with a degree of continuing involvement by
the seller such that the risks and rewards of ownership have not
been transferred.
In such cases revenue shall be recognised to reflect the substance of the
transaction.
5.2 SPECIFIC EXAMPLES - Rendering of Services
5.2.1 Installationfees
Recognise as revenue by reference to the stage of completion ofthe
installation, unless they are incidental to the sale of a product in which case
they are recognised when the goods are sold.
5.2.2 Servicingfees included in the price ofthe product
Recognised as revenue over the period during which the service is performed.
The amount to be deferred is enough to cover the expected costs of the
services under the agreement, plus a reasonable profit on those services.
5.2.3 Advertising commissions
Media commissions - recognise when the related advertisement or
commercial appears before the public.
Production commissions - recognise by reference to the stage of completion
of the project.
5.2.4 Admissionfees
Recognise when the event takes place.
When a subscription to a number of events is sold, the fee is allocated to each
event on a basis which reflects the extent to which services are performed at
each event.
5.2.5 Tuitionfees
Revenue is recognised over the period of instruction.
IAS 18 REVENUE
5.2.6 Initiation, entrance and membershipfees
Recognise as revenue when no significant uncertainty as to its collectability
exists as long as it is a membership fee only and any other service is paid for
separately.
If the fee entitles the member to other benefits it is recognised on a basis that
reflects the timing, nature and value of the benefits provided.
5.2.7 Franchise fees
Franchise fees may cover the supply of initial and subsequent services,
equipment and other tangible assets, and know-how.
Franchise fees are recognised as revenue on a basis that reflects the purpose
for which the fees were charged.
5.2.7.1 Supplies ofequipment and other tangible assets
The amount, based on the fair value of the assets sold, is recognised as
revenue when the items are delivered or title passes.
5.2.7.2 Supplies ofinitial and subsequent services
The initial fee is recognised as the initial service is completed
Fees for the provision of continuing services are recognised as revenue as the
services are rendered.
Sufficient fee must be deferred to cover the costs of continuing services and
to provide a reasonable profit on those services. (This means that some of the
fee for the initial service may need to be deferred to satisfy this requirement).
5.2.7.3 Continuingfranchise fees
Recognise as revenue as the services are provided or the rights used.
IAS 18 REVENUE
5.3 SPECIFIC EXAMPLES - Interest, Royalties and Dividends
5.3.1 Licencefees and royalties
Fees and royalties received are normally recognised in accordance with the
substance of the agreement.
Such fees may be received for the use of an entity's assets e.g.
o Trademarks
o Patents
o Software
o Music copyright
o Motion picture films
As a practical matter, this may be on a straight-line basis over the life of the
agreement, for example, when a licensee has the right to use certain
technology for a specified period of time.
If receipt of a licence fee or royalty is contingent on the occurrence of a
future event revenue is recognised only when it is probable that the fee or
royalty will be received, (which is normally when the event has occurred).
FOCUS
outline the principles of the timing ofrevenue recognition;
discuss and give examples ofthe various points in the production and sales
cycle where it may, depending on circumstances, be appropriate to recognise
gains and losses;
describe the lASH's "balance sheet approach" to revenue recognition within
its Framework and compare this to the requirements of lAS 18 Revenue.
IAS 18 REVENUE
IAS 11 CONTRUCTION CONTRACTS
OVERVIEW
Objective
To describe and explain the accounting treatment for construction contracts.
INTRODUCTION
RECOGNTION
AND
MEASUREMENT
PRESENTATION
AND
DISCLOSURE
Scope
Definitions
Key issues
Revenue
Contract costs
Exam comments
The rules
Calculations
Recognition
1 INTRODUCTION
1.1 Scope
lAS 11 shall be applied in accounting for construction contracts in the financial statements of
contractors.
1.2 Definitions
A construction contract is 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
A fixed price contract is a construction contract in which the contractor agrees to a fixed
contract price, or a fixed rate per unit of output, which in some cases is subject to cost
escalation clauses
A cost plus contract is a construction contract in which the contractor is reimbursed for
allowable or otherwise defmed costs, plus a percentage of these costs or a fixed fee.
Construction contracts include:
o Contracts for the rendering of services which are directly related to the
construction of the asset, for example, those for the services of project
managers and architects; and
o Contracts for the destruction or restoration of assets, and the restoration of
the environment following the demolition of assets.
Contrast with speculative building work without afirm sale contract.
This is work-in- ro ess and is valued at the lowert 0 cost and net realisable value.
1.3 Key issues
Revenue andprofit recognition
Contracts may last several years. Costs are incurred, and customer is billed, over duration of
contract.
Potential treatments
o Recognise all revenue and related costs in the income statement only on completion
of contract, or,
o Recognise revenue and costs in the income statement as contract progresses.
Accruals and prudence
o Should recognise revenues and costs as they are earned and incurred.
o Should only recognise profits when cash realisation is reasonably certain, but make
provision for costs and losses when foreseen.
o Prudence may conflict with accruals.
lAS 11 requires that the costs and revenues associated with a contract shall be recognised in
the income statement as the contract activity progresses.
1.4 Revenue
Contract revenue shall comprise:
o the initial amount ofrevenue agreed in the contract, and
o 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 ofbeing reliably measured.
Contract revenue is measured at the fair value ofthe consideration received or receivable.
Its measurement is affected by a variety ofuncertainties that depend on the outcome of future
events. The estimates often need to be revised as events occur and uncertainties are resolved.
Therefore, the amount of contract revenue may increase or decrease from one period to the
next. For example:
o a contractor and a customer may agree variations or claims that increase or decrease
contract revenue in a period subsequent to that in which the contract was initially
agreed,
o the amount ofrevenue agreed in a fixed price contract may increase as a result of
cost escalation clauses,
o the amount of contract revenue may decrease as a result ofpenalties arising from
delays caused by the contractor in the completion of the contract, or
o when a fixed price contract involves a fixed price per unit of output, contract
revenue increases as the number of units is increased.
1.5 Contract costs
Contract costs comprise:
o costs that relate directly to the specific contract,
o costs that are attributable to contract activity in general and can be allocated to the
contract, and
o such other costs as are specifically chargeable to the customer under the terms of the
contract.
Costs that relate directly to a specific contract include:
o site labour costs, including site supervision,
o costs of materials used in construction,
o depreciation ofplant and equipment used on the contract,
o costs of moving plant, equipment and materials to and from the contract site,
o costs ofhiring plant and equipment,
o costs of design and technical assistance that is directly related to the contract,
o the estimated costs of rectification and guarantee work, including expected warranty
costs, and
o claims from third parties.
These costs may be reduced by any incidental income that is not included in contract revenue,
for example income from the sale of surplus materials and the disposal of plant and equipment
at the end of the contract.
1.6 Exam comments
The examiner has stated that IAS 11 will not feature heavily in the 3.6 exam, these notes are
provided as a refresher from your P2.5 studies. Do not spend to much time on this session.
2 RECOGNITION AND MEASUREMENT
2.1 The rules
2.1.1 CTeneral
Contracts shall be considered on a contract by contract basis.
The impact that a contract will have on the financial statements depends on the estimate of the
future outcome of the contract.
The rules in lAS 11 provide for three possibilities.
o Contracts which are expected to make a profit and where the outcome is reasonably
certain.
o Contracts where a loss is expected.
o Contracts where the outcome cannot be assessed with reasonable certainty.
2.1.2 Specific
When the outcome of a construction 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 ofthe contract activity at the
balance sheet date. (Profit will be taken)
When it is probable that total contract costs will exceed total contract revenue, the expected
loss shall be recognised as an expense immediately.
When the outcome of a construction contract cannot be estimated reliably:
o revenue shall be recognised only to the extent of contract costs incurred that
it is probable will be recoverable, and
o contract costs shall be recognised as an expense in the period in which they
are incurred.
2.1.3 Commentary
Situation How is revenue How are costs Comments
measured? measured for
recognition in the
income statement?
Profit is being taken By reference to the The costs incurred in Revenue> costs
stage of/percentage reaching the stage of therefore profit is
completion method completion are taken recognised.
to the income
statement as cost of
sales.
Often this is If the same
achieved by applying % completion is
the percentage applied to revenue
completion to the and costs then this
total costs that are will result in that
expected to occur percentage ofthe
over the life of the total estimated profit
contract. being recognised
Loss making By reference to the As a balancing figure Loss maybe
contracts stage of/percentage to interact with the recognised at any
completion method revenue that has stage of a contract.
been recognised and Eg an entity may
generate the required have signed a
loss. contract that it
knows will make a
loss. In such a case
the loss shall be
recognised when the
contract is signed.
Contracts where the To equal the cost The costs incurred in Revenue = costs
outcome is uncertain figure the period shall be
expensed The usual source of
uncertainty is that
the contract is still
quite young. Eg it
may be deemed
imprudent to take
profit on a 10 year
contract when it is
only 1 year old.
The accounting shall be performed so as to recognise revenue and costs that have arisen in the
period. This is done by calculating the amounts in total that shall be recognised by the year
end and then adjusting them for what has been recognised in earlier years.
2.1.4 Stage ofcompletion
The recognition of revenue and expenses by reference to the stage of completion of a contract
is often referred to as the percentage of completion method.
o Contract revenue is matched with the contract costs incurred in reaching the stage of
completion, resulting in the reporting ofrevenue, expenses and profit which can be
attributed to the proportion of work completed.
o This method provides useful information on the extent of contract activity and
performance during a period. The standard does not specify a single method for
calculating the percentage of completion. Methods include
the proportion that contract costs incurred for work performed to date bear to
the estimated total contract costs,
surveys of work performed, or
completion of a physical proportion of the contract work.
An expected loss on the construction contract shall be recognised as an expense immediately.
Note that:
o amounts billed are irrelevant in determining revenue to be taken to the income
statement;
o costs incurred by the year end (and therefore appearing in the cost accounts) may be
an irrelevant figure in determining cost of sales.
2.2 Calculations
2.2.1 Basics
Make all calculations on contract by contract basis. There is no netting-off ofprofits on, or
assets relating to, one contract against losses or liabilities on another.
Steps to obtain figures for the income statement.
(a) Calculate total expected profit
Contract price
Less Costs to date
Estimated future costs
$
X
(X)
(X)
X
(b) Calculate the stage of completion
I
Acceptable methods include
I
I
I I
Sales basis Cost basis
Value of work done to date Costs to date
Total sales value Total costs
(lAS 11 does not specify a method).
(c) Calculate revenue and costs for the year
(i) Calculate attributable revenue and costs to date (using proportion above)
(ii) Deduct any revenue and costs taken in earlier income statements.
(iii) If cannot prudently recognise profit, include same amount in the income
statement for both revenue and cost of sales to give a nil profit.
Illustration 1
Tanner Ltd - year ended 31 December 2003
$
Costs to date 1,500
Future expected costs 1,000
Work certified to date 1,800
Expected sales value 3,200
Revenue taken in earlier years' income statements 1,200
Cost taken in earlier years' income statements 950
Required
Calculate the figures to be taken to the income statement in respect ofrevenue and costs year
ended 31 December 2003 on both a sales and a costs basis.
Solution 1
(a) Calculate total expected profit
Sales
Less Costs to date
Expected costs
$
3,200
(1,500)
(1,000)
700
(b) Pecentage completion
Sales basis
1,800/3,200 = 0.5625 = 56.25%
(c) Calculate revenue and costs for the year
Costs basis
1,500/2,500 = 0.6 = 60%
To date Prior
period $
To date Prior
period $
Revenue 3,200 x 56.25% = 1,800 -1,200= 600 3,200 x 60% = 1,920 -1200 = 720
Cost of sales 2,500 x 56.25% = 1,406 - 950 = (456) 2,500 x 60% = 1,500 - 950 = (550)
Profit
2.3 Recognition
144 170
The basic double entry for each contract is quite straightforward
D When costs are actually incurred on the contract the double entry is:
Dr Contract account X
Cr Cash/accruals/expenses X
D When payments on account are received/when amounts billed the double entry is:
X
D
Dr Cash/Receivables
Cr Contract account
The double entry for the revenue to be recognised is:
Dr Contract account X
Cr Income statement - Sales
X
X
D The double entry for the costs to be recognised is
Dr Income statement - Cost of sales
Cr Contract account
X
X
This transfers revenues and costs that have been accumulated in the contract account to the
income statement.
3 PRESENTATION AND DISCLOSURE
An entity shall disclose:
o The amount of contract revenue recognised as revenue in the period,
o The methods used to determine the contract revenue recognised in the
period,and
o The methods used to determine the stage of completion of contracts in
progress.
An entity shall disclose each of the following for contracts in progress at the
balance sheet date:
o The aggregate amount of costs incurred and recognised profits (less
recognised losses) to date,
o The amount of advances received, and
o The amount of retentions.
An entity shall present
o The gross amount due from customers for contract work as an asset,
and
o The gross amount due to customers for contract work as a liability.
The standard says that the gross amount due to or from customers is the net amount
of
o Costs incurred plus recognised profits, less
o The sum of recognised losses and progress billings.
Illustration 2
Company Flora
Contracts as at 31 December 2003
Contract value
A
$000
100
B
$000
100
c
$000
80
Costs to date 40
Estimated costs to complete 30
2
58
75
25
Billings 15.6 67
Date started 1.1.2003 30.11.2003 1.1.2003
% completion
Required:
45% 3% 80%
Prepare extracts from the accounts of Flora as at 31 December 2003.
Solution 2
WI W2 W3 $000
Revenue 45 2 64 111
COS 31.5 2 84 (117.5)
13.5 (20) (6.5)
Contract revenue recognised as revenue in the period: 111
Contract costs incurred and recognised profits ( less recognised losses)
to date 110.5
Gross amounts due from customers for contract work (37.9 + 2) 39.9
Gross amounts due to customers for contract work 12
WORKINGS
A B C Total
Contract costs incurred 40 2 75 117
Profits /losses 13.5 (20) (6.5)
53.5 2 55 110.5
Billings (15.6) (67) (82.6)
37.9 2 (12) 27.9
lAS 11 CONTRUCTION CONTRACTS
(1) Contract A - Profit making
Contract account
Costs incurred
Revenue recognised
Balance bId
$ $
40 Billings 15.6
45 Costs recognised 31.5
Balance clf 37.9
85 85
37.9
Amount owed by customers = 37.9
(2) Contract B - too soon to take profit
Contract account
Costs incurred
Revenue recognised
Balance bId
$ $
2 Billings 0
2 Costs recognised 2
Balance clf 2
4 4
2
Amount owed by customers = 2
(3) Contract C - loss making contract
Contract account
Costs incurred
Revenue recognised
Balance clf
Amount owed to customers = 12
$
75
64
12
151
Billings
Costs recognised
Balance bId
$
67
84
151
12
Accountancy Tuition Centre (International Holdings) Ltd 200S 0811
FOCUS
define a construction contract and describe why recognising profit before completion is
generally considered to be desirable;
discuss if the above may be profit smoothing;
describe the ways in which contract revenue and contract costs may be recognised;
calculate and disclose the amounts to be shown in the financial statements for construction
contracts.
IAS 16 PROPERTY,PLANTAND EQUIPMENT
OVERVIEW
Objective
To prescribe the accounting treatment for tangible non current assets.
tion
edamounts
overhaul
INTRODUCTION DISCLOSURES
Scope
For each class
Exclusions
Others
Definitions
Items stated at revalu

. --_ ........... -
------- -------_. ---_.-----_..---- ..
RECOGNITION
INITIAL
SUBSEQUENT
MEASUREMENT -
COSTS
Criteria
AT COST
Componentsofcost
Running costs
Exchange ofassets
Part replacement
Major inspectionor
costs
MEASUREMENT
AFTER REVALUATIONS
RECOGNITION
Accountingpolicy
Fair value
Cost Model
Frequency
RevaluationModel
AccumulatedDeprecia
Increase/decrease
DEPRECIATION
NON
DEPRECIATION
Accountingstandards
Background
Depreciableamount
Arguments employed
IA.S 16
RECOVERY OF
CARRYING
AMOUNT
Impairment
Compensation
DERECOGNITION
Derecognitiondate
IFRS 5 DISPOSAL OF NON-
CURRENT ASSETS AND
PRESENTATION OF
DISCONTINUED
OPERATIONS
Reasonsfor ISsue
Mainfeatures
MEASUREMENT
II:> Tuition Cen1re (InternationalHoldings)Ltd 2005 0901
IAS 16 PROPERTY, PLANT AND EQUIPMENT
1 INTRODUCTION
1.1 Scope
This standard shall be applied in accounting for property, plant and
equipment except when another IAS requires or permits a different treatment.
1.2 Exclusions
lAS 16 does not apply to
o biological assets that relate to agricultural activity (IAS 41)
o mineral rights and reserves such as oil, natural gas and similar non-
regenerative resources.
1.3 Definitions
Property, plant and equipment are tangible assets that:
o are held for use in the production or supply of goods or services or
for rental or for admin purposes and
o are expected to be used during more than one period.
Depreciation is systematic allocation of depreciable amount of an asset over its useful life.
Depreciable amount is the cost (or other amount substituted for cost) less its
residual value.
Useful life is either the period oftime over which an asset is expected to be
used, or the number ofproduction or similar units expected to be obtained
from the asset.
Cost is the amount of cash/cash equivalents paid or the fair value of other
consideration given to acquire an asset at the time of its acquisition or
construction.
Residual value is the estimated amount that an entity would currently obtain
from the disposal of the asset, after deducting the estimated costs of disposal,
if the asset were already of an age and in the condition expected at the end of
its useful life.
Fair value is the amount for which an asset could be exchanged between
knowledgeable, willing parties in an arm's length transaction.
Carrying amount is the amount at which an asset is recognised in the balance
sheet after deducting any accumulated depreciation and accumulated
impairment losses thereon.
Impairment loss is the amount by which the carrying amount of an asset
exceeds its recoverable amount.
Entity-specific value - The present value of the cash flows expected to arise
from the continuing use of an asset and from its disposal at the end of its
useful life.
2 RECOGNITION
2.1 Criteria
An item ofproperty, plant and equipment shall be recognised when:
o it is probable thatfuture economic benefits associated with the asset
will flow to the entity, (satisfied when risks and rewards have
passed to entity), and
o the cost of the asset to the entity can be measured reliably.
Usually readily satisfied because exchange transaction evidencing purchase
identifies cost. For self-constructed asset, a reliable measurement of cost can
be made from transactions with third parties for the acquisition ofmaterials,
labour and other inputs used.
In certain circumstances it is appropriate to allocate the total expenditure on
an asset to its component parts and account for each component separately.
3 INITIAL MEASUREMENT AT COST
Property, plant and equipment shall initially be measured at cost.
3.1 Components of cost
Purchase price, including import duties and non-refundable purchase taxes
(after deducting trade discounts and rebates.)
Directly attributable costs ofbringing the asset to location and working
condition, for example:
o costs of employee benefits (e.g. wages) arising directly from
construction or acquisition;
o costs of site preparation;
o initial delivery and handling costs;
o installation and assembly costs;
o costs of testing proper functioning (net of any sale proceeds of
items produced); and
o professional fees (e.g. architects and engineers).
An initial estimate of dismantling and removal costs (i.e.
"decommissioning") the asset and restoring the site on which it is located.
The obligation for this may arise either:
o on acquisition of the item; or
o as a consequence ofusing the item other than to produce inventory.
3.2 Exchange of assets
Cost is measured at fair value of asset received, which is equal to fair value of
the asset given up (e.g. trade-in or part-exchange) adjusted by the amount of
any cash or cash equivalents transferred. Except when:
o the exchange transaction lacks commercial substance; or
o the fair value of neither the asset received nor the asset given up is
reliably measurable.
Whether an exchange transaction has commercial substance depends on the
extent to which the reporting entity's future cash flows are expected to
change as a result of the transaction.
4 SUBSEQUENT COSTS
The issue is whether subsequent expenditure is capital expenditure (i.e. to the
balance sheet) or revenue expenditure (i.e. to the income statement).
4.1 Running costs
The carrying amount of an item ofproperty, plant and equipment does not
include the costs of day-to-day servicing of the item.
Servicing costs (e.g. labour and consumables) are recognised in profit or loss
as incurred.
Often described as "repairs and maintenance" this expenditure is made to
restore or maintain future economic benefits.
4.2 Part replacement
Some items (e.g. aircraft, ships, gas turbines, etc) are a series of linked parts
which require regular replacement at different intervals and so have different
useful lives.
The carrying amount of an item ofproperty, plant and equipment recognises
the cost of replacing a part when that cost is incurred, if the recognition
criteria are met.
The carrying amount of replaced parts is derecognised (i.e. treated as a
disposal).
4.3 Major inspection or overhaul costs
Performing regular major inspections for faults, regardless of whether parts
of the item are replaced, may be a condition of continuing to operate an item
of property, plant and equipment (e.g. an aircraft).
The cost of each major inspection performed is recognised in the carrying
amount, as a replacement, if the recognition criteria are satisfied.
On initial recognition an estimate will be made of the inspection costs and
that amount will be depreciated over the period to the 1st inspection. This
amount is part of the original cost recognised and is not an additional
component of cost.
Any remaining carrying amount of the cost of the previous inspection (as
distinct from physical parts) is derecognised.
Illustration 1
An airline is required by law to perform a major overhaul on each aeroplane's engines
every five years. The engines may be identified as assets with a separate life from the
rest of the aeroplane and written off to zero over five years. Overhaul expenditure might
at first sight seem to be a repair to the aeroplane but it is actually a replacement ofthe
engine. As such it must be capitalised.
5 MEASUREMENTAFTER RECOGNITION
5.1 Accounting policy
An entity may choose between the cost model and the revaluation model.
However, the same policy must be applied to each entire class of property,
plant and equipment.
Classes include land, land and buildings, factory plant, aircraft, vehicles,
office equipment, fixtures and fittings' etc
5.2 Cost Model
Carry at cost less any accumulated depreciation and any accumulated
impairment losses.
5.3 Revaluation Model
Carry at a revalued amount, being fair value at the date of the revaluation less any
subsequent accumulated depreciation and any accumulated impairment losses.
To use this model fair values must be reliably measurable.
Before the revision of lAS 16, these were referred to as the "benchmark" and
"allowed alternative" treatments, respectively. The elimination of alternatives was
one of the principal objectives of the Improvements project.
6 REVALUATIONS
6.1 Fair value
6.1.1 Land and buildings
Market value is determined by appraisal normally undertaken by
professionally qualified valuers.
6.1.2 Plant and equipment
Fair value is usually market value determined by appraisal.
If there is no market-based evidence of fair value (e.g. because items are of a
specialised nature or rarely sold), fair value is estimated using:
D depreciated replacement cost; or
Depreciated replacement cost is what a new equivalent
asset would cost (i.e. replacement cost) less depreciation.
Items of plant and equipment are often insured for this
amount if not for replacement cost under a "new for old"
policy.
D an income approach.
6.2 Frequency
Revaluations must be made sufficiently regularly to ensure no material
difference between carrying amount and fair value at the reporting date.
Frequency depends on movements in fair values. When fair value differs
materially from carrying amount, a further revaluation is necessary.
Items within a class may be revalued on a rolling basis within a short period
of time provided revaluations are kept up to date.
6.3 Accumulated Depreciation
At the date of the revaluation accumulated depreciation is either:
(i) restated proportionately with the change in gross carrying amount so
that the carrying amount after revaluation equals its revalued amount;
(ii) eliminated against gross carrying amount and the net amount restated
to the revalued amount.
6.4 Increase/decrease
On an asset-by-asset basis:
D Increase shall be credited directly to equity under heading
"revaluation surplus".
D However a revaluation increase must be taken to income to the
extent that it reverses a revaluation decrease ofthe asset that was
previously recognised as an expense.
D Decrease shall be recognised as an expense in income statement for
the period.
D However, a revaluation decrease must be charged directly against
any related revaluation surplus to the extent that it is covered by that
surplus.
lAS 16 PROPERTY, PLANT AND BQUIPMHNT
Rlustratio1l 2
An asset was purchased for $100 on the 1 January 2003. The entity has adopted the
revaluation model for subsequent measurement ofthe asset.
Asset Revaluation Income
reserve statement
1.1.2003 100
20 20Cr
31.12.2003 120 20Cr
1.1.2004 120 20Cr
(15) (15) Dr
31.12.2004 105 SCr
1.1.2005 105 5Cr
(9) (5) Dr 4Dr
31.12.2005 96
!" Therimj,iWi"iS" taken'to"""""
_
deficitis"taken"to"the""""
: income statement unless
: it reverses a surplus held
_ .
!- "AgaiIlthe- deBcit iiitaken--
: to equity but only to the
: extent it reverses the
: previously recognised
surplus with the rest to
..,"""""""

4 Cr : that reverses the
. previously expensed
deficit is taken to the
income statement The
rest is taken directly to
equity.
11 Cr
96
15
111
1.1.2006
31.12.2006
---
For simplicity annual depreciation hasbeen excluded from this illustration.
However, depreciation would be charged each year before the revaluation
adjustment is made.
The revaluation surplus may be transferred directly to retained earnings when
the surplus is realised. Realisation occurs as the asset is consumed or
disposed of. Ifthe transfer is madeover the remaining life of the asset then
the transfer to retained earnings will be an annual transfer based on the
difference in depreciation charge under historical cost and the revalued
amount.
However, it is not recycled (i.e. it is not included within profit or loss on
disposal).
@ AccmmIBDlly Tuition Centre (IntamatiODll1 HoldingB) Ltd 2005 0907
7 DEPRECIATION
7.1 Accounting standards
Depreciable amount shall be allocated on a systematic basis over the useful
life of the asset. Note that the term depreciable amount is the cost or
revaluation. Depreciation is based on the carrying value in the balance sheet.
Depreciation method, useful life and residual value must be reviewed at least
at each financial year-end. If expectations differ from previous estimates the
change(s) are accounted for as a change in an accounting estimate in
accordance with lAS 8.
The depreciation method shall reflect the pattern in which the asset's
economic benefits are consumed.
The depreciation charge for each period shall be recognised as an expense
unless it is included in the carrying amount of another asset.
Each part of an item of property, plant and equipment that is significant (in
relation to total cost) is separately depreciated.
7.2 Depreciable amount
7.2.1 Useful life
Factors to be considered:
o expected usage assessed by reference to expected capacity or
physical output;
o expected physical wear and tear (depends on operational factors e.g.
number of shifts, repair and maintenance programme, etc);
o technical obsolescence arising from:
changes or improvements in production; or
change in market demand for product or
service output;
o legal or similar limits on the use (e.g. expiry dates of related
leases).
Asset management policy may involve disposal of assets after a specified
time therefore useful life may be shorter than economic life.
Repair and maintenance policy may also affect useful life (e.g. by extending
it or increasing residual value) but do not negate the need for depreciation.
7.2.2 Depreciation period
Depreciation commences when an asset is available for use.
Depreciation ceases at the earlier of
o the date the asset is classed as held for sale in accordance with
IFRS 5; or
o the date the asset is derecognised.
Depreciation does not cease when an asset is idle or retired from active use
(unless it is fully depreciated). However, depreciation may be zero under the
''units of production method" .
7.2.3 Land and buildings
These are separable assets and are dealt with separately for accounting
purposes, even when they are acquired together.
o Land normally has an unlimited useful life and is therefore not
depreciated.
o Buildings normally have a limited useful life and are depreciable assets.
8 RECOVERY OF CARRYINGAMOUNT
8.1 Impairment
To determine whether an item ofproperty, plant and equipment is impaired
an entity applies lAS 36 - Impairment ofassets
Impairment losses are accounted for in accordance with lAS 36.
8.2 Compensation
In certain circumstances a third party will compensate an entity for an
impairment loss, for example, insurance for fire damage or compensation for
compulsory purchase ofland for a motorway.
Such compensation must be included in the income statement when it
becomes receivable. Recognising the compensation as deferred income or
deducting it from the impairment or loss or from the cost of a new asset is not
appropriate.
9 DERECOGNITION
Balance sheet - Eliminate on disposal or when no future economic benefits
are expected from use ("retirement") or disposal.
Income statement - Recognise gain or loss (difference between estimated net
disposal proceeds and carrying amount) unless a sale and leaseback (lAS 17).
Gains are not classified as revenue.
Illustration 3
[19] Property, plant and equipment (extract)
When assets are closed down, sold, or abandoned, the difference between the
net proceeds and the net carrying amount of the assets is recognized as a gain or loss in
other operating income or expenses, respectively.
9.2 Derecognition date
The revenue recognition principle in IAS 18 Revenue for sales of goods
applies also to sales of items ofproperty, plant and equipment.
10 IFRS 5 DISPOSAL OF NON-CURRENT ASSETS AND
PRESENTATION OF DISCONTINUED OPERATIONS
10.1 Reasons for issuing the standard
"Norwalk Agreement" - Convergence of accounting standards around the
world is one of the prime objectives of the IASB. IASB has agreed with the
Financial Accounting Standards Board (FASB) in the United States a
memorandum of understanding that sets out the two boards' commitment to
convergence. As a result of that understanding the boards have undertaken a
joint short-term project with the objective of reducing differences between
IFRSs and US GAAP that are capable of resolution in a relatively short time
and can be addressed outside current and planned major projects.
One aspect of that project involves the two boards considering each other's
recent standards with a view to adopting recent high quality accounting
solutions. The standard arises from the IASB's consideration of the FASB
Statement No. 144 Accountingfor the Impairment or Disposal ofLong-Lived
Assets (SFAS 144), issued in 2001.
SFAS 144 addresses three areas:
(i) impairment oflong-lived assets to be held and used (not addressed
byIFRS 5);
(ii) the classification, measurement and presentation of assets held for
sale; and
(iii) the classification and presentation of discontinued operations.
The extensive differences between IFRSs and US GAAP on
impairment oflong-lived assets to be held and used were not
thought capable ofresolution in a relatively short time.
The standard achieves substantial convergence with the requirements of
SFAS 144 relating to held for sale assets and discontinued operations.
10.2 Main features of the standard
The "held for sale" classification is adopted using the same criteria as those
contained in SFAS 144.
It introduces the concept of a disposal group.
Held for sale assets or disposal groups are carried at the lower of carrying
amount and fair value less costs to sell.
Held for sale assets or disposal groups are not depreciated.
Held for sale assets and assets and liabilities included in a disposal group are
presented separately on the face of the balance sheet
IAS 35 Discontinuing Operations will be withdrawn (see later session)
The definition of a discontinued operation will be changed from "a separate
major line of business or geographical area" to "any unit whose operations
and cash flows can be clearly distinguished operationally and for financial
reporting purposes".
The timing of the classification as a discontinued operation will also be
changed.
IAS 35 classifies an operation as discontinuing at the earlier of:
the entity entering into a binding sale agreement; and
the board of directors approving and announcing a formal disposal
plan.
The standard classifies an operation as discontinued:
at the date the entity has actually disposed of the operation; or
when the operation meets the criteria to be classified as held for
sale.
Results of discontinued operations are presented separately on the face of the
income statement.
Retroactive classification as a discontinued operation, when the discontinued
criteria are met after the balance sheet date, is prohibited.
11 DISCLOSURE
11.1 For each class
Measurement bases used for determining gross carrying amount.
Depreciation methods used.
Useful lives or the depreciation rates used.
Illustration 4
Property, plant and equipment
Property, plant and equipment are stated at cost less accumulated depreciation.
Depreciation is recorded on a straight-line basis over the expected
useful lives of the assets as follows:
Buildings and constructions 20-33 years
Machinery and equipment 3-10 years
Land and water areas are not depreciated.
NOKIA ANN UA LAC C 0 U N T S 2 0 0 2
Gross carrying amount and accumulated depreciation at beginning and end of
period. Accumulated impairment losses are aggregated with accumulated
depreciation.
A reconciliation of carrying amount at beginning and end ofperiod showing:
o additions (i.e. capital expenditure);
o disposals;
o acquisitions through business combinations;
o increases or decreases resulting from revaluations;
o impairment losses (i.e. reductions in carrying amount);
o reversals of impairment losses;
o depreciation;
o net exchange differences arising on translation of functional
currency into reporting currency;
o other movements.
11.2 Others
Existence and amounts of restrictions on title, and property, plant and
equipment pledged as security.
Expenditures on account ofproperty, plant and equipment in the course of
construction.
Contractual commitments for the acquisition of property, plant and equipment.
Compensation from third parties for items impaired, lost or given up that is included
in profit or loss, if not disclosed separately on the face of the income statement.
11.3 Items stated at revaluedamounts
Effective date of revaluation.
Whether an independent valuer was involved.
Methods and significant assumptions applied to estimate fair values.
The extent to which fair values were determined:
o directly (i.e. by reference to observable prices in an active market or
recent market transactions on arm's length terms); or
o estimated using other valuation techniques.
For example indices may be used to determine replacement cost.
Carrying amount of each class of property, plant and equipment that would
have been included in the fmancial statements had the assets been carried
under the cost model.
Revaluation surplus, indicating movement for period and any restrictions on
distribution ofbalance to shareholders.
11.4 Encouraged
Carrying amount of temporarily idle property, plant and equipment.
Gross carrying amount of any fully depreciated property, plant and equipment
that is still in use.
Carrying amount ofproperty, plant and equipment retired from active use and
held for disposal.
When the cost model is used, the fair value of property, plant and equipment
when this is materially different from the carrying amount.
12 NON- DEPRECIATION
12.1 Background
It has long been argued that certain assets shall not be subject to the general
rule that all assets should be depreciated.
Many companies in some jurisdictions have taken to the practice of not
depreciating certain of their assets.
12.2 Arguments employed
Assets are maintained to a very high standard. This maintenance cost is
charged to the income statement in lieu of depreciation.
The residual value is at least equal to the carrying value (maybe due to
maintenance).
Assets have a very long useful economic life such that depreciation is not
material.
Asset is not currently in use.
12.3 lAS 16
Repair and maintenance policy may affect useful life (eg by extending it or
increasing residual value) but the standard says that this does not negate the
need to charge depreciation. It would seem that the standard dictates that
depreciation must be charged in all circumstances but it is likely that a case
can be made for non depreciation on the grounds that the residual value is
bigger than the carrying value of the asset.
FOCUS
define and explain the purposes of and necessity for depreciation;
discuss and illustrate methods of depreciation;
show and explain disclosure in accordance with lAS 16;
discuss non depreciation of non current assets;
account for revaluation gains and losses and the depreciation ofrevalued
assets;
account for the disposal ofrevalued assets;
discuss the effect of revaluations on distributable profits;
discuss the problem areas in accounting for non current assets.
IAS 23 BORROWING COSTS
OVERVIEW
Objective
To describe the accounting treatment of borrowing costs.
INTRODUCTION
BENCHMARK
TREATMENT
ALLOWED
ALTERNATIVE
TREATMENT
CONSICTENCY OF
TREATMENT
Recognition
Arguments
Scope
Definitions
Recognition
Disclosure
Recognition
Borrowing costs eligiblefor capitalisation
Commencement ofCapitalisation
Suspension ofCapitalisation
Cessation ofCapitalisation
Disclosure
1 INTRODUCTION
1.1 Recognition
Companies borrow in order to fmance their activities. Companies pay interest
(fmance charges) on the amounts borrowed.
How should such debits for interest be recognised in the fmancial statements
o always as an expense, or
o are there circumstances which justify capitalisation as an asset?
(This would defer recognition in the income statement to a later
period.)
1.2 Arguments
Capitalisation of interest
Arguments for Arguments against
1 Accruals 1 Accruals
Better matching of cost (interest) to Benefit is use of money. Interest
benefit (use of asset). should be reflected in the income
statement in the period for which the
company has the use of the cash.
2 Comparability 2 Comparability
Improved. Better comparison between Distorted. Similar assets at different
companies which buy the assets and costs depending on the method of
those which construct. fmance.
3 Consistency 3 Consistency
Interest treated like any other costs. Interest treated differently from period
to period.
4 Reported profit distorted.
1.3 Scope
lAS 23 shall be applied in accounting for borrowing costs
1.4 Definitions
Borrowing costs are interest and other costs incurred by an entity in
connection with the borrowing of funds.
o Included within the defmition may be;
Interest on bank overdraft and bank borrowings
Amortisation of discounts or premiums related to
borrowings
Amortisation of any directly attributable costs related to
borrowings
Finance charges in respect of fmance leases
Exchange differences arising from foreign currency
borrowings to the extent they are regarded as an
adjustment to interest costs
Preference dividend when preference capital is classed as
debt.
A qualifying asset is an asset that necessarily takes a substantial period of
time to get ready for its intended use or sale.
2 BENCHMARKTREATMENT
2.1 Recognition
Borrowing costs shall be recognised as an expense in the period in which
they are incurred.
2.2 Disclosure
The financial statements shall disclose the accounting policy adopted for
borrowing costs.
3 ALLOWED ALTERNATIVE TREATMENT
3.1 Recognition
Borrowing costs shall be recognised as an expense in the period in which
they are incurred except to the extent that they are capitalised below.
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. The amount ofborrowing costs eligible for capitalisation shall be
determined in accordance with the provisions ofthe standard.
A qualifying asset is an asset that necessarily takes a substantial period of
time to get ready for it's intended use or sale. Examples include
o Inventories that require a substantial period of time to bring them to
a saleable condition e.g. Whisky
o Manufacturing plant
o Power generation facilities
o Investment properties
but not
o Inventories routinely manufactured or otherwise produced in large
quantities on a repetitive basis over a short period of time, nor
o Assets ready for their intended use or sale when acquired.
3.2 Borrowing costs eligible for capitalisation
Borrowing costs that are directly attributable to acquisition, construction or
production is taken to mean those borrowing costs that would have been
avoided if the expenditure on the qualifying asset had not been made.
When an entity borrows specifically for the purpose of funding an asset the
identification of the borrowing costs presents no problem.
o The amount capitalised shall be the actual borrowing costs net of
any income earned on the temporary investment of those
borrowings.
It is sometimes difficult to establish a direct relationship between asset and
funding. eg:
o Central coordination of financing activity
o Groups may use a range of debt instruments at varying rates to lend
to other members of the group
o Borrowing in foreign currency when the group operates in a highly
inflationary economy.
Judgement is required.
If funds are borrowed generally;
D amount ofborrowing costs eligible for capitalisation shall be
determined by applying a capitalisation rate to the expenditures on
that asset
D the capitalisation rate shall be the weighted average ofthe
borrowing costs applicable to the borrowings of the entity that are
outstanding during the period, other than borrowings made
specifically for the purpose of obtaining a qualifying asset
D the amount ofborrowing costs capitalised during a period shall not
exceed the amount of borrowing costs incurred during that period.
In some circumstances, it is appropriate to include all borrowings of the
parent and its subsidiaries when computing a weighted average of the
borrowing costs; in other circumstances, it is appropriate for each subsidiary
to use a weighted average ofthe borrowing costs applicable to its own
borrowings.
Example 1
7 year loan
25 year loan
Bank overdraft
An entity has three sources ofborrowing in the period
Outstanding liability
$000
8,000
12,000
4,000 (average)
Required:
Interest charge
$000
1,000
1,000
600
a. Calculate the appropriate capitalisation rate if all of the borrowings are used to
fmance the production of qualifying assets but none of the borrowings relate to a
specific qualifying asset.
b. Ifthe 7 year loan is an amount which can be specifically identified with a qualifying
asset calculate the rate which should be used on the other assets.
Solution
3.3 Commencement of Capitalisation
Capitalisation shall commence when:
o expenditures for the asset are being incurred,
o borrowing costs are being incurred, and
o activities that are necessary to prepare the asset for its intended use
or sale are in progress.
Expenditures on a qualifying asset include only
o payments of cash,
o transfers of other assets, or
o the assumption of interest-bearing liabilities. Expenditures are
reduced by any progress payments received and grants received in
connection with the asset.
The average carrying amount of the asset during a period, including
borrowing costs previously capitalised, is normally a reasonable
approximation of the expenditures to which the capitalisation rate is applied
in that period.
The activities necessary to prepare the asset for its intended use or sale
include
o physical construction of the asset.
o technical and administrative work prior to the commencement of
physical construction, such as the activities associated with
obtaining permits prior to the commencement of the physical
construction.
Such activities exclude
o the holding of an asset when no production or development that
changes the asset's condition is taking place.
o e.g. borrowing costs incurred while land is under development are
capitalised during the period in which activities related to the
development are being undertaken. However, borrowing costs
incurred while land acquired for building purposes is held without
any associated development activity do not qualify for
capitalisation.
3.4 Suspension of Capitalisation
Capitalisation shall be suspended during extended periods in which active
development is interrupted.
Capitalisation is not normally suspended
o during a period when substantial technical and administrative work
is being carried out.
o when a temporary delay is a necessary part of the process of getting
an asset ready for its intended use or sale.
o e.g. capitalisation continues during the extended period needed for
inventories to mature or the extended period during which high
water levels delay construction of a bridge, if such high water levels
are common during the construction period in the geographic
region involved.
3.5 Cessation of Capitalisation
Capitalisation shall cease when substantially all the activities necessary to
prepare the qualifying asset for its intended use or sale are complete.
An asset is normally ready for its intended use or sale when the physical
construction of the asset is complete even though routine administrative work
might still continue. Ifminor modifications, such as the decoration of a
property to the purchaser's or user's specification, are all that are outstanding,
this indicates that substantially all the activities are complete.
When the construction of a qualifying asset is completed in parts and each
part is capable of being used while construction continues on other parts,
capitalisation ofborrowing costs shall cease when substantially all the
activities necessary to prepare that part for its intended use or sale are
completed.
3.6 Disclosure
The financial statements shall disclose:
o the accounting policy adopted for borrowing costs,
o the amount ofborrowing costs capitalised during the period, and
o the capitalisation rate used to determine the amount ofborrowing
costs eligible for capitalisation.
4 CONSISTENCY OF TREATMENT
lAS 8 requires an entity to be consistent in its use of accounting policies,
once adopted that policy shall not be changed unless it is required to do so by
a new standard or the change would give more reliable and relevant
information.
If an entity applies the allowed alternative treatment to a qualifying asset then
it must adopt that policy of capitalisation for all qualifying assets.
FOCUS
describe advantages and disadvantages to expensing and capitalising interest;
apply the benchmark and allowed alternative treatments of IAS 23;
calculate the amount of interest that should be capitalised under the allowed
alternative treatment;
describe and identify qualifying assets as defined in IAS 23.
Accountancy Tuition Centre (International Holdings) Ltd 2005 l008
EXAMPLE SOLUTIONS
Solution 1
(a) Capitalisation rate
1,000,000 +1,000,000 + 600,000
8,000,000 +12,000,000 + 4,000,000
= 10.833%
(b) Capitalisation rate
1,000,000 +600,000
12,000,000 + 4,000,000
=10%
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
OVERVIEW
Objective
To account for the transfer of resources from government and indicate the
extent to which entity's benefit from such assistance during the reporting
period.
To facilitate comparison of an entity's fmancial statements with prior periods
and other entity's.
GOVERNMENT
GRANTS
Criteria
Forgivable loans
Broad approaches to
accounting treatment
lAS 20 treatment
Non-monetary government
grants
Presentation ofgrants related
to assets
Presentation ofgrants related
to income
Repayment ofgovernment
grants
INTRODUCTION
DISCLOSURE
Matters
Scope
Definitions
Effective date
GOVERNMENT
ASSISTANCE
Definition
Excludedfrom government
grants but are included as
government assistance
Issue
Loans at nil or low interest rates
SIC 10 GOVERNMENT ASSISTANCE
- NO SPECIFIC RELATION TO
OPERATING ACTMTIES
1 INTRODUCTION
Government assistance takes manyforms varying both in nature ofthe assistance given
and in conditions attached. Its purpose may be to encourage an entity to embark on a
course ofaction that it would not otherwise have taken.
1.1 Scope
lAS 20 shall be applied in
o accounting for and disclosure of government grants, and
o disclosure of other forms of government assistance.
lAS 20 does not deal with
o accounting for government grants in financial statements reflecting
the effects of changing prices or in supplementary info of a similar
nature
o income tax benefits (eg income tax holidays, investment tax credits,
accelerated depreciation allowances and reduced income tax rates)
o Government participation in the ownership of the entity.
1.2 Definitions
Government refers to government, government agencies and similar bodies
whether local, national or international.
Government grants are assistance by governments in the form of transfers of
resources to an entity in return for past or future compliance with certain
conditions relating to operating activities. They exclude those forms of
government assistance which cannot reasonably have a value placed on them
and transactions with government which cannot be distinguished from the
normal trading transactions of the entity.
Grants related to assets are government grants whose primary condition is
that an entity qualifying for them shall purchase, construct or otherwise
acquire long-term assets. Subsidiary conditions may also be attached
restricting the type or location of the assets or the periods during which they
are to be acquired or held.
Grants related to income are government grants other than those related to
assets.
Forgivable loans are loans which the lender undertakes to waive repayment
of under certain prescribed conditions.
Government assistance is action by government designed to provide an
economic benefit specific to an entity or range of entitys qualifying under
certain criteria.
2 GOVERNMENT GRANTS
2.1 Criteria
Government grants shall not be recognised until there is reasonable assurance
that
o the entity will comply with the conditions attaching to them, and
o the grants will be received.
Receipt of a grant does not of itself provide conclusive evidence that
conditions have been or will be fulfilled.
A grant is accounted for in the same manner whether received in cash or a
reduction of a liability to the government.
2.2 Forgivable loans
Definition - the lender undertakes to waive repayment under certain
prescribed conditions.
A forgivable loan from government is treated as a grant when there is
reasonable assurance that the entity will meet the terms for forgiveness.
2.3 Broad approaches to accounting treatment
Capital approach Income approach
Credit directly to shareholders'
Take to income over one or

interests. more periods
Argumentsfor Arguments for
Financing device should be
Receipts from a source other

dealt with in balance sheet. than shareholders, should not be
credited directly to
No repayment is expected :. shareholders'interests.

credit directly to shareholders'
interests.
Government grants are rarely

gratuitous but earned through
Grants are not earned but are an compliance with conditions and
incentive without related costs meeting obligations.
:. it is inappropriate to
recognise the grant in the IS.

Match with associated costs
which the grant is intended to
compensate.
As extension of fiscal policies,

deal with IS as for taxes.
2.4 lAS 20 treatment
Recognise as income over the periods necessary to match them with related
costs which they are intended to compensate, on a systematic basis. Eg grants
related to
o depreciable assets - over periods in which depreciation is charged
o non-depreciable assets - over periods bearing cost of meeting
obligations
Receipts basis does not accord with accruals .: only acceptable ifno other
basis exists
Do not credit directly to shareholders' interests.
Compensation for expenses or losses already incurred or for immediate
financial support with no future related costs shall be recognised as income in
the period receivable, as an extraordinary item if appropriate.
2.5 Non-monetary government grants
Where a grant takes the form of a transfer of a non-monetary asset for the use
of the entity (Eg land or other resources) we usually account for both the
grant and the asset at fair value. As an alternative, both the asset and the
grant may be recorded at a nominal amount
2.6 Presentation of grants related to assets
Acceptable alternatives in the balance sheet are to:
EITHER OR
0 Set up grant as deferred 0 Deduct grant in arriving at
income. carrying amount of asset.
0 Income recognised on a 0 Income recognised over UEL
systematic and rational basis by way of a reduced
overUEL. depreciation charge.
Disclose separately in the cash flow statement regardless ofthe balance sheet
presentation.
2.7 Presentation of grants related to income
Acceptable alternatives in income statement are to:
EITHER OR
D Credit separately or under D Deduct in reporting related
general heading eg "Other expense.
income".
Argumentfor Argumentfor
D Inappropriate to net income D Expenses might not have
and expense item. been incurred if grant had not
been available.
D Separation of grant from
expense facilitates D :. presentation without
comparison with other offsetting may be misleading.
expenses.
2.8 Repayment of government grants
Account for as a revision to an accounting estimate.
Related to income Related to an asset
D Apply first against any D Increase carrying amount of
unamortised deferred credit asset or reduce deferred
D Recognised excess
income balance
immediately as an expense. D Recognise cumulative
additional depreciation
immediately as an expense.
3 GOVERNMENT ASSISTANCE
3.1 Definition
Government action designed to provide an economic benefit specific to
entity's qualifying under certain criteria.
Does not include indirect benefits (eg provision ofinfrastructure
(transport/irrigation, etc) in development areas or imposition oftrading
constraints on competitors.
3.2 Excluded from government grants but are included as government assistance
Assistance which cannot reasonably have Transactions which cannot be
a value placed on it distinguished from normal trading
transactions
Examples Example
Free technical or marketing advice
Government procurement policy

responsible for a portion of sales.
Provision of guarantees.
Existence ofbenefit might be

unquestioned but segregating
trading activities from government
assistance could be arbitrary.
3.3 Issue
Significance ofbenefit may be such that disclosure of nature, extent and
duration of assistance is necessary in order that the financial statements may
not be misleading.
3.3 Loans at nil or low interest rates
Such items are a form of government assistance, but benefit is not quantified by
imputation of interest.
4 DISCLOSURE
4.1 Matters
Accounting policy adopted for government grants including methods of
presentation adopted.
Nature and extent of government grants recognised and an indication of other
forms of government assistance providing direct benefit.
Unfulfilled conditions and other contingencies attaching to government assistance
recognised.
5 SIC - 10: GOVERNMENT ASSISTANCE - NO SPECIFIC RELATION
TO OPERATING ACTIVITIES
Issue
o The issue is whether such government assistance is "a government
grant" within the scope of lAS 20 and shall therefore be accounted
for in accordance with this Standard.
Consensus
o Such assistance meets the definition of government grants in lAS
20. Such grants shall therefore not be credited directly to
shareholders' interests.
FOCUS
describe and apply the recognition criteria in lAS 20 Accountingfor
government grants and disclosure ofgovernment assistance;
describe the different methods of presenting grants in the balance sheet and
the income statement;
describe the disclosure requirements in relation to government assistance.
lAS 17 LEASES
OVERVIEW
Objective
To describe the accounting for leases from the viewpoint of the lessee and the
lessor.
ip
ases
Traditional accountingfor le
INTRODUCTION
Problem:
Overview
Scope
Definitions
TYPES OF
Lease classification; 2 types
ARRANGEMENT

Risks and rewards ofownersh
Indicators
Terms ofthe lease
Comment on classification
Land and buildings
SIC27
........... ... .
:
!
~
ACCOUNTING
FORAN
OPERATING
LEASE
ACCOUNTING
FORA
FINANCE
LEASE
G4 + I DISCUSSION PAPER
Background
Recognition
Allocation offinance
income
Disclosure in respect of
finance leases
! LESSOR ACCOUNTING
L----------------
1
unting
operating
LESSEE ACCOUNTING
1---- --- -------------------
-----_.._- -------_.
ACCOUNTING ACCOUNTING
FORA FORAN
FINANCE OPERATING
LEASE LEASE
Principles
Lesseeacco
Rentals in arrears for an 0
Rentals in advance lease
Disclosures - finance
SIC 15
leases
Disclosures
SALE AND LEASEBACK
TRANSACTIONS
Background
Sale and leaseback as finance lease
Sale and leaseback as an operating lease
lAS 17 LEASES
1 INTRODUCTION
1.1 Traditional accounting for leases (pre lAS 17)
In the books of the lessee:
o
o
1.2 Problem
Balance sheet
Income statement -
No accounting
Instalments due on an accruals basis.
Certain types oflease resulted in the lessee owning the asset in SUBSTANCE
and being liable to future payments.
For all practical purposes the lessee would own the asset but the balance
sheet would not show
o the asset nor
o the liability.
1.3 Overview
Leases were the first transactions where an accounting standard specifically
applied the principle of substance over form in order for the accounts to show
a true and fair view.
The original lAS I specified substance over form as a general consideration
governing the selection of accounting policies.
Key ratios significantly affected by this treatment are
o gearing, and
o return on capital employed.
1.4 Scope
lAS 17 applies to accounting for all leases except for
o lease agreements to explore for or use natural resources, such as oil,
gas, timber, metals and other mineral rights
o licensing agreements for such items as motion picture films, video
recordings, plays, manuscripts, patents and copyrights.
lAS 17 LEASES
1.5 Definitions
A lease is an agreement whereby the lessor conveys to the lessee in return for
a payment, or series ofpayments, the right to use an asset for an agreed
period of time.
Finance lease is a lease which transfers substantially all risks and rewards
incident to ownership of an asset. Title mayor may not eventually be
transferred.
Operating lease is a lease other than a finance lease.
Lease term is 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 lease the asset, with or without further payment.
Minimum lease payments are the payments over the lease term that the lessee
is or can be required to make (excluding costs for services and taxes to be
paid by and be reimbursable to the lessor) together with
o in the case of the lessee, any amounts guaranteed by the lessee or
by a party related to the lessee
o in the case of the lessor, any residual value guaranteed to the lessor
by either
the lessee,
a party related to the lessee, or
an independent third party.
The inception ofthe lease is the earlier of the date of the lease agreement or
of a commitment by the parties to the principal provisions of the lease.
Useful life is the estimated remaining period from the beginning of the lease
term, without limitation by the lease term, over which the economic benefits
embodied in the asset are expected to be consumed by the entity.
The interest rate implicit in the lease is the discount rate that, at the inception
of the lease, causes the aggregate present value of:
o the minimum lease payments, and
o the unguaranteed residual value
to be equal to the fair value of the leased asset and any initial direct costs of
the lessor.
The lessee's incremental borrowing rate ofinterest is the rate of interest the
lessee would have to pay on a similar lease or, if that is not determinable, the
rate that, at the inception ofthe lease, the lessee would incur to borrow over a
similar term, and with a similar security, the funds necessary to purchase the
asset.
lAS 17 LEASES
Illustation 1
S is a bank. As at lotJanuary 2004 it purchased an asset, at a cost of $50,000, which it has just
signed contracts to lease out as follows
Lessee Terms Comments
B 5 years in arrears at A manufacturing company
$lO,OOOpa
C Year 6 and 7 in arrears at A manufacturing company
$8,000 pa which is a subsidiary ofB
D Year 9 and lOin arrears A manufacturing company
at $5,000 pa which is completely
unrelated to B
The scrap value at year 10 is estimated at $2,000.
Required:
State which flows should be included in the following;
a) The lessees minimum lease payments
b) The lessors minimum lease payments
c) The calculation of the interest rate implicit in the lease
Solution 1
Time
1-5
6-7
9-10
10
Lessee's minimum
lease payments
10,000
8,000
Lessor's
minimum lease
payments
10,000
8,000
5,000
Interest rate
implicit in the
lease
10,000
8,000
5,000
2,000
Tutorial note
The interest rate implicit in the lease is
7.8%. You will not be required to
calculate this for the purposes ofthe
exam.
lAS 17 LEASES
2 TYPE OF ARRANGEMENT
2.1 Lease classification; 2 types
Finance lease
o Is a lease that transfers substantially all of the risks and rewards
incident to ownership of an asset
o title mayor may not eventually be transferred.
Operating lease
o is a lease other than a finance lease.
2.2 Risks and rewards of ownership
Risks may be represented by the possibility of
o losses from idle capacity or technological obsolescence
o variations in return due to changing economic conditions.
Rewards may be represented by the expectation of
o profitable operation over the asset's economic life
o gain from appreciation in value or realisation of residual value.
2.3 Indicators
lAS 17 lists the following as examples of situations where a lease would
normally be classified as a fmance lease:
o the lease transfers ownership of the asset to the lessee by the end of
the lease term
o the lessee has the option to purchase the asset at a bargain price and
it seems likely that, at the inception of the lease, that this option
will be exercised
o the lease term is for the major part of the useful life of the asset
even if title is not transferred
o at the inception of the lease, the present value of the minimum lease
payments is greater than, or equal to substantially all of the fair
value of the leased asset
o the leased assets are of a specialised nature such that only the lessee
can use them without major modifications being made
o if the lessee can cancel the lease any losses associated with the
cancellation are borne by the lessee
lAS 17 LEASES
o gains or losses from the fluctuation in the fair value of the residual
fall to the lessee (for example in the form of a rent rebate equalling
most of the sales proceeds at the end of the lease) and
o the lessee has the ability to continue the lease for a secondary
period at a rent which is substantially lower than market rent.
2.4 Terms of the lease
The status of the lease may often be determined from an examination of the
lease terms. A transference of risks and rewards is assumed if
o the lessee will use the asset for most of its useful economic life
o the lessee bears the cost normally associated with ownership (eg
insurance, maintenance, idle capacity)
o the present value of the amounts guaranteed by the lessee is
materially equivalent to the cost ofpurchase
o any amounts accruing to the lessor at the end of the lease are
relatively small.
2.5 Comment on classification
The criteria concentrates on the major risk ofpurchase - that of bearing the
capital cost.
If the lessee guarantees to bear substantially all of the capital cost of the asset
(fair value) then it shall be treated as a purchase ie a finance lease. (lAS 17
does not specify what "substantially all" means but it is often set at 90% or
more in the GAAP of individual countries)
If a lessee bears substantially all of the cost then he would only do so if he
was getting substantially all ofthe use of the asset i.e. if in substance he
owned the asset.
2.6 Land and buildings
2.6.1 Land
Normally has an indefinite useful life.
Iftitle does not pass at the end of the lease term risks and rewards are not
passed therefore the lease will normally be classified as an operating lease.
2.6.2 Buildings
Useful life will probably extend well beyond the lease term.
Iftitle does not pass at the end of the lease term risks and rewards are not
passed the lease will be classed in the same way as other leased assets.
lAS 17 LEASES
2.6.3 Separation
The land and buildings value inherent in the lease shall be accounted for
separately. The lease payments shall be allocated between the two elements
based on the relative fair values ofthe land and buildings elements.
Iftitle ofboth elements is expected to pass on completion of the lease both
parts shall be classed as finance leases.
Iftitle does not pass and the land has an indefmite life then the land element
shall be treated as an operating lease, the building element will be classed in
accordance with the normal rules ofIAS 17.
If it is not possible to allocate the lease payments between the land and
buildings element then the lease shall be treated as a fmance lease unless it is
clear that both elements are an operating lease.
2.6.4 Investment property
The lessee may treat the asset as an investment property in accordance with IAS 40.
The lessee, however, must treat the lease as a finance lease, even if it would
not normally be classed as a finance lease and the investment property must
be valued using the fair value model under lAS 40.
2.7 SIC-27: Evaluatingthe Substance of TransactionsInvolving the Legal Formof a Lease
An entity may enter into a transaction or a series of structured transactions
(an arrangement) with an unrelated party or parties (an Investor) that involves
the legal form of a lease. For example, an entity may:
o lease assets to an investor and lease the same assets back;
Such an arrangement may be designed to achieve a tax advantage for the
Investor that is shared with the entity in theform ofafee, and not to convey
the right to use an asset.
or
o legally sell assets and lease the same assets back.
2.7.1 Issues
How to determine whether a series of transactions is linked and shall be
accounted for as one transaction.
Whether the arrangement meets the definition of a lease (IAS 17); and ifnot:
o whether a separate investment account and lease payment
obligations that might exist represent assets and liabilities of the
entity (e.g. consider Illustration 2);
o how the entity shall account for other obligations resulting from the
arrangement; and
o how the entity shall account for a fee it might receive from an investor.
lAS 17 LEASES
2.7.2 Consensus
A series of transactions involving the legal form of a lease is linked (and shall
be accounted for as one transaction) when the overall economic effect cannot be
understood without reference to the series of transactions as a whole.
For example, when the series of transactions are closely interrelated, negotiated as a
single transaction, and takes place concurrently or in a continuous sequence.
Note that this principle is established in JAS 11 "Construction Contracts" .
lAS 17 applies when the substance of an arrangement includes the
conveyance ofthe right to use an asset for an agreed period oftime.
Indicators that individually demonstrate that, in substance, a lease is not
involved include:
o an entity retaining all the risks and rewards incident to ownership of
the underlying asset and enjoying substantially the same rights to its
use as before the arrangement;
o the primary reason for the arrangement being to achieve a particular
tax result, rather than to convey the right to use the asset; and
o an option being included that make its exercise almost certain.
For example, a put option that is exercisable at a price sufficiently higher
than the expectedfair value when it becomes exercisable.
"The Framework" defmitions of asset and liability shall be applied in
determining whether, in substance, a separate investment account and lease
payment obligations shall be recognised.
Other obligations of an arrangement, including any guarantees provided and
obligations incurred upon early termination, shall be accounted for under lAS
37 or lAS 39, depending on the terms.
lAS 18 criteria for revenue arising from rendering of services shall be applied
to the facts and circumstances of each arrangement to determine when to
recognise a fee.
The fee shall be presented in the income statement based on its economic
substance and nature.
lAS 17 LEASES
Illustration 2
ABC leases an asset to an investor (the headlease) and leases the same asset back for a
shorter period oftime (the sublease). At the end ofthe sublease period:
ABC has a purchase option to buy back the rights ofthe Investor;
If ABC does not exercise that option, the Investor has options to receive a
minimum return on its investment in the headlease (returning the underlying
asset to ABC, or requiring ABC to provide a return on the Investor's
investment in the headlease).
The arrangement is designed predominantly to generate tax benefits that are shared
between ABC and the investor.
ABC needs to use the underlying asset, which is specialised, to conduct its business.
The substance ofsuch arrangement is that the entity receives afee for
executing the agreements, and retains the risks and rewards incident to
ownership ofthe specialised asset.
2.7.3 Disclosure
The following disclosure is required in each period for any arrangement that
does not, in substance, involve a lease under lAS 17:
o a description of the arrangement including:
the underlying asset and any restrictions on its use;
the life and other significant terms of the arrangement;
the transactions that are linked together, including any options; and
o the accounting treatment applied to any fee received, including:
the amount recognised as income in the period; and
the line item of the income statement in which it is included.
Disclosure shall be provided individually for each arrangement or in
aggregate for each class of arrangement.
A class is a grouping ofarrangements with underlying assets ofa similar
nature (e.g. electricity generators).
Illustration 3
An airline leases an aircraft to another airline for its entire economic life and leases the
same aircraft back under the same terms and conditions as the original lease. The two
airlines have a legally enforceable right to set off the amounts owing to one another,
and an intention to settle these amounts on a net basis.
lAS 17 LEASES
The terms and conditions and period ofeach ofthe leases are the same, so
the risks and rewards ofownership are the same before and after the
arrangement. The amounts owing are offset so there is no retained credit
risk. The substance ofthe arrangement is that no transaction has occurred.
Illustration 4
Company X legally sells an asset to Company Y and leases the same asset back.
Company Y is obliged to return. the asset to Company X at the end of the lease period
at an amount that has the overall practical effect, when also considering the lease
payments to be received, ofproviding Company Y with a yield of LIBOR plus 2%
annually on the purchase price.
Company X's risks and rewards incident to ownership have not substantively
changed. The substance ofthe arrangement is that Company X has obtained
finance secured on the asset. Company Y's obligation to return the asset
precludes recognition ofa sale by Company X
3 LESSEE ACCOUNTING FOR A FINANCE LEASE
3.1 Principles
Record the asset and the finance lease payable at the lower of
o the present value of amounts guaranteed by the lessee (Minimum
lease payments) or
o the fair value of asset
Depreciation shall be charged on a consistent basis with those assets that are
owned and in accordance with lAS 16.
If there is no reasonable certainty that the lessee will obtain ownership by the
end of the lease term depreciate the asset over:
Rentals repay capital and fmance charge (interest)
Interest shall be allocated to the income statement so as to give constant rate
of charge on outstanding balance, or an approximation thereto.
lAS 17 LEASES
I
Use
I
I
I
OR
I
Actuarial method (this uses the
Sum of the digits (this can be an
interest rate implicit in the lease)
effective approximation to the
actuarial method)
Note that straight line recognition is generally
not acceptable
Tutorial note
Rentals in arrears
Interest is carried by each ofthe rentals
Rentals in advance
The first payment is capital only. Interest is carried by each of the rentals except the
first
3.2 Rentals in arrears
lllustration 5
H entered into a finance lease on l8tJanuary 2004. The terms of the lease were 20 payments
of $100 6 monthly in arrears. The cash price of the asset was $1,200.
The interest rate implicit in the lease is 5.5% (per 6 month period)
Required:
a) Showthe interest allocation for the first 3 six month periods using:
(i)
(ii)
Sum of the digits
Actuarial method
b) Show howthe lease would be carried in the financial statements of H as at
30
th
June 2004 using the sum of the digits to allocate interest.
Solution a
WI Total finance charge
s
Rentals (20 x $100) 2,000
Cash price of the asset (l,200)
800
lAS 17 LEASES
W2 Allocation of interest - sum of the digits
Period Weighting Fraction Interest
(x$800) charge
1 20 20/210 76
2 19 19/210 72
3 18 18/210 68
4 17 17/210 64
-!- -!-
20 1 1/210 4
n(n + 1)
210
2
W3 Allocation of interest - actuarial method
Period Amount owed at the Interest@ Rental Amount owed at the
start ofthe period 5.5% end ofthe period
1 1,200 66 (100) 1,166
2 1,166 64 (100) 1,130
3 1,130 62 (100) 1,092
4 Etc (100)
Solution b
Finance lease a able
30/06/04 Cash
30/06/04 Ba1c/d
Tutorial note:
31112/04 Cash
30/06/05 Cash
1/1/04 Non current assets
100 30/06/04 Interest
1,176
1,276
01/07/04 Ba1bid
100 31112/04Interest
100 30/06/05 Interest
1,200
76
1,276
1,176
72
68
Analysis of payable
Current (100+100 - (72+68
NonCurrent
60
1,116
(17 x 100 - (800 - (76+72+68))
lAS 17 LEASES
Note to the accounts
At the 30
th
June 2004 the company is committed to the following payments under a
finance lease:
Not later than 1year
Later than 1 year and not later than 5 years
Later than five years
MLP PV
$ $
200 185
800 631
900 360
1,900 1176
NOTE: The PV calculation has been calculated for you. This
would probably not be an examination requirement
Depreciation
$1,200 x 6/12 = $60
lOyears
Non current assets will include an amount of$1,140 (1,200 - 60)
3.3 Rentals in advance
Illustration 6
H entered into a finance lease on 1st January 2004. The terms of the lease were 20 payments
of $100 6 monthly in advance. The cash price of the asset was $1,200.
The interest rate implicit in the lease is 6.1% (per 6 month period)
Required:
(a) Show the interest allocation for the first 3 six month periods using:
(i) Sum ofthe digits
(il) Actuarial method
(b) Show how the lease would be carried in the financial statements of H as at
30
th
June 2004 using the sum of the digits to allocate interest.
The first payment is capital only
Interest is not allocated to the final period because the loan was
completely repaid at the beginning of that period - Therefore for the sum
of the digits calculation n = 19
lAS 17 LEASES
WI Total finance charge
Rentals (20 x $100)
Cash price of the asset
$
2,000
(1,200)
800
4
Interest
charge
80
76
72
67
1/190
19
18
17
16
J.
1
1
2
3
4
J.
19
Allocation of interest - sum of the digits
Period Weighting Fraction
(x$800)
19/190
18/190
17/190
16/190
W2
n(n +1)
2
190
W2 Allocation of interest - actuarial method
Period Amount owed at Rental Interest Amount owed at
the start ofthe @6.1% the end ofthe
period period
1 1,200 (100) 1,100 67 1,167
2 1,167 (100) 1,067 65 1,132
3 1,132 (100) 1,032 63 etc
Solution b
Finance lease a able
1/1/04 Cash 100 1/1/04 Non current assets 1,200
30/06/04Interest 80
30/06/04Bal cld 1,180
1,280 1,280
01/07/04Cash 100 01/07104 Bal bid 1,180
Tutorial note:
31/12/04Interest 76
01/01/05 Cash 100
lAS 17 LEASES
Analysis of payable
Current (100+100) -76)
(of the $124, $44 is the repayment of capital
and $80 is the interest to be paid in the next
payment)
NonCurrent
(17 x 100 - (800 - (80+76)
124
1,056
= 1,180
Note to the accounts
At the 30
th
June 2004 the company is committed to the following payments under a
finance lease:
Not later than 1 year
Later than 1 year and not later than 5 years
Later than five years
NOTE: The PV calculation has been calculated for you. This
would probably not be an examination requirement
Depreciation
$1,200 x 6/12 = $60
lOyears
Non current assets will include an amount of$I,140 (1,200 - 60)
MLP PV
$ $
200 194
800 585
900 401
1900 1,180
lAS 17 LEASES
3.4 Disclosures - fmance leases
For each class of asset the net carrying amount of assets at each balance sheet
date.
It is appropriate that the amount of assets used by the lessee that are the
subject offmance leases be separately identified in the financial statements. It
is often useful to have this disclosure presented by each major class of asset.
Best practice is to either;
o provide the same table reconciling opening and closing cost and
depreciation as is given for owned assets, or
o combine with owned assets and make disclosure of the total.
Illustration 7
[9] Interest expense - net (extract)
Finance leases are capitalized under property, plant and equipment in compliance
with lAS 17 (Leases). The interest portion of the lease payments, amounting to 34 million
(2001: 9 million), is reflected in interest expense.
[19] Property, plant and equipment (extract)
In accordance with lAS 17 (leases), assets leased on terms equivalent to
financing a purchase by a long-term loan (finance leases) are capitalized at the lower of
their fair value or the present value of the minimum lease payments. The leased assets are
depreciated over their estimated useful life except where subsequent transfer of title is
uncertain, in which case they are depreciated over their estimated useful life or the
respective lease term, whichever is shorter. The future lease payments are recorded as
financial liabilities.
Capitalized property, plant and equipment includes assets with a total net value of
504 million (2001: 588 million) held under finance leases. The gross carrying amounts of
these assets total 1, 106 million (2001: 1,229 million). These assets are mainly
machinery and technical equipment with a carrying amount of 358 million (gross amount:
864 million) and buildings with a carrying amount of105 million (gross amount: 140
million). In the case of buildings, either the present value of the minimum lease payments
covers substantially all of the cost of acquisition, or title passes to the lessee on expiration
of the lease.
Liabilities related to these leased assets shall be shown separately from other
liabilities, differentiating between the current and long-term portions.
Repayment terms and interest rates for loans falling due in more than one
year.
A reconciliation between the total ofminimum lease payments at the balance
sheet date, and their present value.
lAS 17 LEASES
In addition, an entity shall disclose the total of minimum lease payments at
the balance sheet date, and their present value, for each of the following
periods:
o not later than one year
o later than one year and not later than five years
o later than five years.
Illustration 8
Liabilities under finance leases are recognized as financial obligations if the
leased assets are capitalized under property, plant and equipment. They are stated at
present values. Lease payments totaling 899 million (2001: 1,174 million), including
191 million (2001: 293 million) in interest, are to be made to the respective lessors in
future years.
The liabilities associated with finance leases mature as follows:
Of which
million Lease payments interest Liability
2003 151 30 121
2004 103 28 75
2005 100 26 74
2006 71 17 54
2007 53 15 38
After 2007 421 75 346
899 191 708
lAS 17 LEASES
4 LESSEE ACCOUNTING FOR AN OPERATING LEASE
4.1 Lessee accounting for an operating lease
Rentals are charged as an expense in the income statement on a straight line
basis over the lease term unless another systematic basis is representative of
the time pattern of the users benefit.
No balances appear in the balance sheet other than accruals and prepayments
on rented rather than owned assets.
Illustration 7
Under a lease agreement Williamson plc pays an initial installment of $100,000 and
then 3 years rental of $100,000 pa on the first day of each year. The asset has a life of
6 years.
Required:
Calculate the charge to the income statement each year and any balance on the balance
sheet at the end ofthe first year.
Solution
Income statement
$100,000 +$300,000
3 years
$133,333
Balance sheet at
end of 1st year
$
= 200,000
(133,333)
66,667
paid
charged
prepayment
4.2 SIC-15: Operating Leases - Incentives
4.2.1 Issue
Lessors often give incentives to induce a potential lessee to sign up for a
lease. Incentives include:
o rent-free periods; or
o contributions by the lessor to the lessee's relocation costs.
The issue is how shall such incentives be recognised, in respect of operating
leases, by both the lessee and lessor.
lAS 17 LEASES
4.2.3 (7onsensus
Lease incentives shall be considered an integral part of the consideration for
the use of the leased asset.
The lessee shall recognise the aggregate benefit of the incentives as a
reduction of the rental expense over the lease term, on straight line basis
unless another systematic basis is representative of the time pattern ofthe
lessee's benefit from the use ofthe asset.
lAS 17 requires an entity to treat incentives as a reduction of lease income or
lease expense. As they are an integral part of the net consideration agreed for
the use of the leased asset, incentives shall be recognised by both the lessor
and the lessee over the lease term, with each party using a single amortisation
method applied to the net consideration.
4.3 Disclosures
Lessees shall make the following disclosures for operating leases:
o the total of future minimum lease payments under non-cancellable
operating leases for each of the following periods:
not later than one year
later than one year and not later than five years
later than five years.
lAS 17 LEASES
5 LESSOR ACCOUNTING FOR A FINANCE LEASE
5.1 Background
In substance the lessor does not own the asset.
In substance he has made a loan to the lessee at an amount equal to the net
investment in the lease.
Dr Receivable
Cr Cash
The lessor receives rentals. These pay off the capital element of the loan and
provide interest income (earnings).
5.2 Recognition
Lessors shall recognise assets held under a finance lease in their balance
sheets and present them as a receivable at an amount equal to the net
investment in the lease.
Net investment in the lease is the gross investment in the lease less unearned
finance income.
Gross investment in the lease is the aggregate of the minimum lease
payments under a finance lease from the standpoint of the lessor and any
unguaranteed residual value accruing to the lessor.
Unguaranteed residual value is that portion ofthe residual value of the leased
asset (estimated at the inception of the lease), the realisation of which by the
lessor is not assured or is guaranteed solely by a party related to the lessor.
Unearnedfinance income is the difference between the lessor's gross
investment in the lease and its present value.
5.3 Allocation of finance income
Finance income shall be recognised based on a pattern reflecting a constant
periodic rate of return on the lessors net investment outstanding.
5.4 Disclosure in respect of finance leases
Lessors shall make the following disclosures for finance leases:
o a reconciliation between the total gross investment in the lease at
the balance sheet date, and the present value of minimum lease
payments receivable at the balance sheet date
o the total gross investment in the lease and the present value of
minimum lease payments receivable at the balance sheet date, for
each ofthe following periods:
lAS 17 LEASES
6 LESSORACCOUNTINGFORAN OPERATINGLEASE
Lessors shall present assets subject to operating leases in the balance sheet in
accordance with the nature of the asset.
Lease income shall be recognised in the income statement on a straight line
basis, unless another systematic basis is more representative.
Lessors shall make the following disclosures for operating leases:
o for each class of asset, the gross carrying amount, the accumulated
depreciation and accumulated impairment losses at the balance
sheet date
the depreciation recognised in income for the period
impairment losses recognised in income for the period
impairment losses reversed in income for the period.
o The future minimum lease payments under non-cancellable
operating leases in the aggregate and for each of the following
periods
o A general description of the lessors significant leasing
arrangements.
lAS 17 LEASES
7 SALE AND LEASEBACK TRANSACTIONS
7.1 Background
Occurs where company transfers legal title to an asset to another party but
retains use of asset on a lease. Usual purpose is to raise finance.
The rentals and the sale price are usually interdependent as they are
negotiated as a package and need not represent fair values.
Accounting treatment depends on whether the leaseback is fmance or
operating.
7.2 Sale and leaseback as finance lease
The substance ofthe transaction is that there is no sale - risks and rewards of
ownership have not passed from the original lessee.
Any excess of sales proceeds over the carrying amount shall not be
immediately recognised as income in the financial statements of a seller-
lessee. If such an excess is recognised, it shall be deferred and amortised over
the lease term.
If the leaseback is a finance lease, the transaction is a means whereby the
lessor provides fmance to the lessee, with the asset as security.
Treat the transaction as a sale followed by a leaseback
o A "profit" is recognised but deferred. ie it is carried as a credit
balance in the balance sheet and released to the income statement
over the life ofthe lease.
o The asset and lease creditor are reinstated at the fair value of the
asset.
Example 1
Olga Inc disposes of an asset by way of a fmance lease. The net book value is
$70,000, the sale proceeds are at fair value of $120,000 and the useful economic life
is 5 years. There are 5 annual rentals of $28,000.
Required:
Set out the journal entries on disposal, and spreading fmance charges and
depreciation on a straight line basis, calculate the total profit effect of the lease each
year.
lAS 17 LEASES
Treat as a sale followed by a leaseback
Journal entries on disposal
Dr
Cr
Dr
Cr
Income statement each year
$
$ $
lAS 17 LEASES
7.3 Sale and leaseback as an operating lease
Substance of the transaction is that there is a sale and profit may be
recognised.
If the leaseback is an operating lease, and the rentals and the sale price are
established at fair value, there has in effect been a normal sale transaction and
any profit or loss is normally recognised immediately.
If the sale price is below fair value, any profit or loss shall be recognised
immediately except that:
o if the loss is compensated by future rentals at below market price, it
shall be deferred and amortised in proportion to the rental payments
over the period for which the asset is expected to be used.
If the sale price is above fair value, the excess over fair value shall be
deferred and amortised over the period for which the asset is expected to be
used.
Example 2
Friends Inc has an asset with a net book value of $70,000. The fair value is $100,000. It
would like to enter into a sale and operating leaseback agreement and it has been offered the
following from three different banks.
Sale price Annual rental for 5 years
(a) $100,000 $28,000
(b) $120,000 $28,000
(c) $80,000 $20,000 (ie below market price)
(d) As (c) except that suppose the net book value was $95,000.
Required:
Record the transaction in each case. Assuming the transaction occurs at the start ofyear 1
show the income statement effect on year 1 of the transaction in each case.
lAS 17 LEASES
Solution
(a) Sale at fair value ($100,000)
Recording of transaction IS effect in year 1
$ $
Dr
Cr
Cr
(b) Sale> fair value ($120,000)
$ $
Dr
Cr
Cr
Cr
(c) Sale < fair value ($80,000) with profit on sale
$ $
Dr
Cr
Cr
(d) Sale < fair value ($80,000) with loss on sale and future rentals at < market price
Recording of transaction
$
Dr
Cr
Dr
$
IS effect in year 1
lAS 17 LEASES
8 G4+1 DISCUSSIONPAPER ON LEASES
lAS 17 requires radically different accounting for finance leases and
operating leases. In the financial statement oflessees, a fmance lease will
result in the recognition of an asset and an obligation for the leased asset and
related fmancing. An operating lease will not give rise to either an asset or
liability and the regular lease payments are recorded as they are incurred. A
lessor in a finance lease records the asset associated with the lease
receivables; under an operating lease this asset is not recognised.
The discussion paper (which dealt mainly with accounting by lessees)
concluded the following:
o The distinction between operating and financia11eases is arbitrary
and unsatisfactory. lAS 17 does not provide for the recognition in
lessees' balance sheets of material assets and liabilities arising from
operating leases.
o Comparability (and hence usefulness) of fmancial statements would
be enhanced ifpresent treatment of operating leases and financial
leases were replaced by an approach that applied the same
requirements to all leases.
It goes on to make the following specific recommendations.
o For lessees, the objective shall be to record, at the beginning of the
lease term, the fair value of the rights and obligations that are
conveyed by the lease.
o Leases currently classified as operating leases would be capitalised
(giving rise to assets and liabilities), but only to the extent of the
fair values of the rights and obligations that are conveyed by the
lease. Thus, where a lease is for a small part of an asset's economic
life, only that part would be reflected in the lessee's balance sheet.
o The fair value of the rights obtained by a lessee would be measured
as the present value ofthe minimum payments required by the
lease.
o Lessors shall report financial assets (representing amounts
receivable from the lessee) and residual interests as separate assets,
since they are subject to quite different risks. The amounts reported
as financial assets by lessors would, in general, be the converse of
the amounts reported as liabilities by lessees.
lAS 17 LEASES
FOCUS
You shall now be able to:
define the essential characteristics of a lease;
describe and apply the method of determining a lease type (i.e. an operating
or finance lease);
explain the effect on the fmancial statements of a fmance lease being
incorrectly treated as an operating lease;
account for operating leases in the fmancial statements;
account for finance leases in the fmancial statements oflessor and lessees;
outline the principles of IAS 17 and its main disclosure requirements;
discuss the problem areas in lease accounting, including classification,
termination, tax variation clauses;
account for sale and leaseback transactions and recognition of income by
lessors;
discuss and account for proposed changes in lease accounting and its impact
on corporate fmancial statements.
lAS 17 LEASES
EXAMPLE SOLUTIONS
Solution 1
Treat as a sale followed by a leaseback
Journal entries on disposal
$ $
Dr
Dr
Cash 120,000
Cr Non current asset (NBV)
Deferred profit (120,000 - 70,000)
Non current asset 120,000
Cr Lease creditor
70,000
50,000
120,000
Income statement each year
$
D
.. (120,000J
epreciation 5
In
{
(5 x 28,000) -120,000)}
terest
5
(
50,000J
Release of deferred profit --5-
24,000
4,000
(10,000)
18,000
lAS 17 LEASES
Solution 2
(a) Sale at fair value ($100,000)
Dr Cash
Cr Asset
Cr IS
(b) Sale> fair value ($120,000)
$
100,000
IS effect in year 1
$ Profit on disposal
Rental
70,000
30,000
$
30,000
(28,000)
2,000
Dr Cash
Cr Asset
Cr IS
Cr Deferred income
IS effect in year 1
$
$ $ Profit on disposal
120,000 - immediate 30,000
70,000
d f d (20,000J
4,000
30,000
- eerre --
5
20,000
Rental (28,000)
6,000
(c) Sale < fair value ($80,000) with profit on sale
Dr Cash
Cr Asset
Cr IS
$
80,000
$ Profit on disposal
Rental
70,000
10,000
$
10,000
(20,000)
(10,000)
(d) Sale < fair value ($80,000) with loss on sale and future rentals at < market price
Dr Cash
Cr Asset
Dr Deferred loss
$
80,000
15,000
$
95,000
IS effect in year 1
$
(
15,000J
Deferred loss -5- (3,000)
Rental (20,000)
(23,000)
lAS 17 LEASES
INTRODUCTION
TO IAS 38
IAS 38 INTANGIBLE ASSETS
OVERVIEW
Objective
To explain the accounting rules for intangible non-current assets.
Scope
L-------r---...J. Definitions
Definition criteria
General criteria
Initial measurement - cost
Subsequent expenditure
MEASUREMENT
AFTER
RECOGNITION
RECOGNITION
AND INITIAL
MEASUREMENT
IMPAIRMENT
AND
DERECOGNITION
INTERNALLY
GENERATED
!NTANGIBLE ASSETS
Internally generated goodwill
Other internally generated assets
Specific recognition criteria
Expenses and costs
DISCLOSURE
Cost model
Revaluation model
Active market
Accounting entries
USEFUL LIFE
Factors
Finite
Indefinite
Impairment losses Intangible assets
Retirements and disposals Revaluations
Research and development
1 INTRODUCTION TO lAS 38
1.1 Scope
The standard applies to all intangibles except:
o those covered specifically by other standards (lAS 2, lAS 11,
lAS 12, lAS 19, lAS 32, lAS 39, IFRS 3, IFRS 4 and IFRS 5);
and:
o mineral rights and expenditure on exploration for, development and
extraction ofminerals, etc.
1.2 Definitions
Intangible assets are identifiable non-monetary assets without physical substance.
Some intangibles may be contained in or on a physical medium, eg software
on afloppy disk or embedded within the hardware. Judgement has to be used
to determine which element is more significant, i.e. the intangible or the
tangible asset.
Example 1
Classify each ofthe following assets as either tangible or intangible:
(l) the operating system of a personal computer
(2) an off-the-shelf integrated publishing software package
(3) specialised software embedded in computer controlled machine tools
(4) a "firewall" controlling access to restricted sections of an Internet website.
An asset is a resource:
D controlled by an entity as a result ofpast events; and
D from which future economic benefits are expected to flow to the entity.
Examples of intangibles include:
D Patents;
D Copyrights (e.g. computer software);
D Licences;
D Intellectual property (e.g. technical knowledge obtained from development activity);
D Trade marks including brand names and publishing titles;
D Motion picture films and video recordings.
1.3 Definition criteria
1.3.1 "Identifiability"
An intangible asset, whether generated internally or acquired in a business
combination, is identifiable when it:
D is separable; or
So it is capable ofbeing separated or dividedfrom the entity and sold,
transferred, licensed, rented or exchanged, either individually or together
with a related contract, asset or liability.
D arises from contractual or other legal rights.
These rights are regardless ofwhether they are transferable or separable
from the entity or from other rights and obligations.
These criteria distinguish intangible assets from goodwill acquired in a
business combination.
1.3.2 "Control"
Control means:
D the power to obtain the future economic benefits from the
underlying resource; and
D the ability to restrict the access of others to those benefits.
Control normally stems from a legal right that is enforceable in a court of
law. However, legal enforceability is not a prerequisite for control as the
entity may be able to control the future economic benefits in some other way.
Expenditure incurred in obtaining market and technical knowledge, increasing
staff skills and building customer loyalty may be expected to generate future
economic benefits. However, control over the actions of employees and
customers is unlikely to be sufficient to meet the definition criterion especially
where there are non-contractual rights.
An entity may seek to protect the technical talent or knowledge ofcertain
skilled staffby including a "non-compete" or "restraint oftrade" clause into
their contracts ofemployment. The entity may be able to secure thefuture
economic benefits ofsuch staffduring a notice period and restrict the access
ofothers for a period after they have left (t'gardening leave ").
1.3.3 "Future economic benefits"
These are net cash inflows and may include increased revenues and/or cost
savings.
The use ofintellectual property in a production process may reduce future
production costs rather than increase future revenues.
2 RECOGNITION AND INITIAL MEASUREMENT
2.1 General criteria
An intangible asset should be recognised when it:
D complies with the definition of an intangible asset (see above); and
D meets the recognition criteria set out in the standard.
The recognition criteria are that:
D it is probable that future economic benefits specifically attributable
to the asset will flow to the entity; and
D the cost of the asset can be measured reliably.
The probability of future economic benefits should be assessed using
reasonable and supportable assumptions, with greater weight being given to
external evidence.
The recognition of internally generated intangible assets is covered later in
this session.
2.2 Initial measurement- cost
Intangible assets should be measured initially at cost.
An intangible asset may be acquired:
o separately;
o as part of a business combination;
o by way of a government grant;
o by an exchange of assets.
2.2.1 Separate acquisition
The cost ofthe intangible asset can usually be measured reliably when it has
been separately acquired (e.g. purchase of computer software).
As the price paid will normally reflect expectations of future economic
benefits, the probability recognition criteria is always considered to be
satisfied for separately acquired intangible assets.
"Cost" is determined according to the same principles applied in accounting
for other assets. For example:
o Purchase price +import duties +non-refundable purchase tax.
o Deferred payments are included at the cash price equivalent and the
difference between this amount and the payments made are treated
as interest.
As with other assets, expenditure that would not be classified as "cost"
include those associated with:
o Introducing a new product or service (including advertising and promotion);
o Conducting business in a new location or with a new class of customer;
o Administration and other general overheads;
o Initial operating costs and losses;
o Costs incurred while an asset capable of operating in the manner
intended has not yet been brought into use;
o Costs incurred in redeploying the asset.
Worked example 1
Kirk is an incorporated entity. On 31 December it was successful in a bid to acquire
the exclusive rights to a patent that had been developed by another entity. The amount
payable for the rights was $600,000 immediately and $400,000 in one years time. Kirk
has incurred legal fees of $87,000 in respect ofthe bid. Kirk operates in a jurisdiction
where the government charges a flat rate fee (a "stamp duty") of $1,000 for the
registration of patent rights.
Kirk's cost of capital is 10%.
Required:
Calculate the cost of the patent rights on initial recognition.
Worked solution 1
Cash paid
Deferred consideration ($400,000 x 1/1.1)
Legal fees
Stamp duty
Cost on initial recognition
2.2.2 Business combination
$
600,000
363,636
87,000
1,000
1,051,636
The cost of an intangible asset acquired in a business combination is its fair
value at the date of acquisition, irrespective ofwhether the intangible asset
had been recognised by the acquiree before the business combination.
(IFRS 3 "Business Combinations")
The fair value of intangible assets acquired in business combinations can
normally be measured with sufficient reliability to be recognised separately
from goodwill.
There is a rebuttable presumption that if the intangible asset has a fmite
useful life, its fair value can be measured reliably.
As fair value reflects market expectations about the probability of future
economic benefits, the probability recognition criteria is always met for
intangible assets acquired in a business combination.
Any In-Process Research and Development (IPRD) ofthe aquired entity shall
be included as an intangible asset of the group even though the subsidiary
would not have included it as an asset in its separate balance sheet.
Fair value at the date of the acquisition might be measured using:
D the current bid price in an active market (where one exists);
D the price of the most recent, similar transactions for similar assets;
D multiples applied to relevant indicators such as earnings;
D discounted future net cash flows.
Using a weightedprobability where there is a range ofpossible outcomes
demonstrates uncertainty rather than inability to measurefair value reliably.
Although an intangible asset acquired as part of the business combination
must be separable, this may only be possible if it is considered to be part of a
related tangible or intangible asset.
Such a group of assets is recognised as a single asset separately from
goodwill if the individual fair values ofthe assets within the group are not
reliably measured.
Such recognition removes from goodwill as many intangible assets as possible.
Illustration 1
In acquiring a company, two separable intangible assets are identified - a magazine's
publishing title and a related subscriber database. Although similar databases are
traded, the fair value of the publishing title cannot be reliably measured as it cannot be
sold without the database. The two intangible assets are therefore recognised as a
single asset and the fair value ofboth as a single asset established.
Illustration 2
The term "brand" and "brand name" are general marketing terms that are often used to
refer to a group of complimentary assets, eg a trademark, its related trade name,
formulas, recipes and technical expertise. In a business combination, complementary
assets are recognised and valued as one group of assets if the fair values ofthe
individual assets comprising the "brand" cannot be reliably measured.
The only circumstances in which it might not be possible to measure fair
value reliably are when the intangible asset arises from legal or other
contractual rights and either:
D is not separable; or
D is separable but there is no history or evidence of exchange
transactions for the same or similar assets.
Worked example 2
Picard is an incorporated entity. On 31 December it paid $10,000,000 for a 100%
interest in Borg.
At the date of acquisition the net assets ofBorg as shown on its balance sheet had a fair
value of $6,000,000. In addition Borg also held the following rights:
(1) The brand name "Assimilation", a middle of the range fragrance. Borg had
been considering the sale of this brand just prior to its acquisition by Picard.
The brand had been valued at $300,000 by Brand International, a reputable
firm of valuation specialists, who had used a discounted cash flow technique.
(2) Sole distribution rights to a product "Lacutus". It is estimated that the future
cash flows generated by this right will be $250,000 per annum for the next 6
years. Picard has determined that the appropriate discount rate for this right
is 10%. The 6 year, 10% annuity factor is 4.36.
Ignore taxation.
Required:
Calculate goodwill arising on acquisition.
Worked solution 2
Picard will recognise the two intangible assets on consolidation. They are taken into
account when the cost of acquisition is allocated in accordance with IFRS 3 Business
Combinations.
Cost
Net assets recognised in Borg's balance sheet
Brand acquired
Distribution rights (250,000 x 4.36)
Goodwill on acquisition
$000
10,000
6,000
300
1,090
7,390
2,610
Worked example 3
A water extraction company was obtained as part of a business combination for a cost
of $1,000,000. The fair value ofthe net assets at the date of acquisition was $750,000.
A licence for the extraction of the water had been granted to the company prior to the
acquisition by the local authority for an administration fee of$l,OOO. Whilst extremely
valuable to the company (as without the licence the business could not operate), the
licence cannot be sold other than as part of the sale of the business as a whole.
Required:
Calculate goodwill arising on acquisition.
Worked solution 3
The water extraction rights were obtained as part of a business combination. Without
these rights, the acquiree cannot extract water and therefore could not operate as a
business.
The rights cannot be sold separately without the business and cannot be grouped with
any other intangible assets acquired as part of the business.
They cannot, therefore, be identified separately from goodwill.
Cost
Net assets recognised on balance sheet
2.2.3 Government grant
$
1,000,000
(750,000)
250,000
Some intangible assets may be acquired free of charge, or for nominal
consideration, by way of a government grant (e.g. airport landing rights, licences to
operate radio or television stations, import quotas, rights to emit pollution).
Under lAS 20 Accountingfor Government Grants and Disclosure ofGovernment
Assistance both the intangible asset (debit entry) and the grant (credit entry) may
be recorded initially at either fair value or cost (which may be zero).
Illustration 3
Neelix is an entity involved in the harvest and production of foodstuffs. On 31
December it was awarded a fishing quota of 1,000 tonnes of cod per annum for 5 years.
The quota requires a registration fee of$l,OOO. The fair value of the fishing quota is
$10,000,000 (net of the registration fee).
Analysis
Measurement of the intangible asset on initial recognition is at either:
Cost or
$1,000
Fair value
$10,000,000
Note that the credit entry falls to be treated as a grant under IAS 20. It may
be presented in the balance sheet in one of two ways:
(1) As deferred income
(2) As a deduction from the carrying value of intangible asset.
Offsetting, i.e. (2), is equivalent to ignoring it completely (there would be no
amortisation) and so not permitted under certain GAAP. Therefore the
deferred credit treatment of a grant is likely to be preferable.
2.2.4 Exchanges ofassets
The cost of an intangible asset acquired in exchange for a non-monetary asset
(or a combination of monetary and non-monetary assets) is measured at fair
value unless:
o the exchange transaction lacks commercial substance; or
o the fair value of neither the asset received nor the asset given up is
reliably measurable.
Ifthe acquired asset is not measured at fair value, its cost is measured at the
carrying amount of the asset given up.
An exchange transaction has commercial substance if, for example, there is a
significant difference between the risk, timing and amount of cash flows from
the asset received and those of the asset transferred.
2.3 Subsequent expenditure
2.3.1 Intangible assets
In most cases, there are no additions to an intangible asset, nor the
replacement ofparts of such assets.
Most subsequent expenditures maintain the expected future economic benefits
embodied in an existing intangible asset and do not meet the defmition of an
intangible asset and lAS 38 recognition criteria.
Also, it is often difficult to attribute subsequent expenditure directly to a
particular intangible asset rather than to the business as a whole.
Therefore, only rarely will subsequent expenditure be recognised in the
carrying amount of an asset. Normally, such expenditure must be written off
through profit and loss.
Subsequent expenditure on brands, mastheads, publishing titles, customer
lists etc (whether internally or externally generated) must always be
recognised as an expense.
In the rare circumstances that subsequent expenditure meets the basic asset
recognition criteria, it is added to the cost of the intangible asset.
2.3.2 Acquired in-process research and development
Subsequent expenditure on an acquired in-process research and development
project is accounted for like any cost incurred in the research of development
phase of internally generated intangible asset (see next section).
o Research expenditure - expense when incurred.
o Development expenditure - expense when incurred if it does not
satisfy the asset recognition criteria.
o Development expenditure that satisfies the recognition criteria -
add to the carrying amount of the acquired in-process research or
development project.
3 INTERNALLY GENERATED INTANGIBLE ASSETS
3.1 Internally generated goodwill
Internally generated goodwill is not recognised as an asset.
Although goodwill may exist in any business its recognition as an asset is
precluded because it is not an identifiable resource (i.e. it is not separable nor
does it arise from contractual or other legal rights) controlled by the entity
that can be measured reliably at cost.
When goodwill is "crystallised" by a business acquisition it is recognised as
an asset and accounted for in accordance with IFRS 3.
3.2 Other internally generated assets
It is sometimes difficult to assess whether an internally generated intangible
asset qualifies for recognition. Specifically it is often difficult to:
o identity whether there is an identifiable asset that will generate
probable future economic benefits; and
o determine the cost ofthe asset reliably.
It is sometimes difficult to distinguish the cost of generating an intangible
asset internally from the cost of maintaining or enhancing the entity's
internally generated goodwill or of running day-to-day operations.
Internally generated brands, mastheads, publishing titles, customer lists and
items similar in substance are not recognised as intangible assets.
Such expenditures cannot be distinguishedfrom the cost ofdeveloping the
business as a whole.
3.3 Specific recognition criteria for internally generated intangible assets
In addition to complying with the general requirements for the recognition
and initial measurement of an intangible asset (see Section 2.1), an entity
must also apply the following to all internally generated intangible assets.
Generation of the asset must be classified into:
o a "research phase"; and
o a further advanced "development phase".
If the research and development phases of a project cannot be distinguished
they should be regarded as research only and written off as expenditure
through profit and loss.
3.3.1 Accounting in the research phase
An entity cannot demonstrate that an intangible asset exists that will generate
probable future economic benefits during the research phase.
Expenditure on research should be recognised as an expense when it is incurred.
Examples of research activities are:
o activities aimed at obtaining new knowledge;
o the search for, evaluation and fmal selection of, applications of
research fmdings or other knowledge;
o the search for alternatives for materials, devices, products,
processes, systems or services; and
o the formulation, design, evaluation and final selection ofpossible
alternatives for new or improved materials, devices, products,
processes, systems or devices.
3.3.2 Accounting in the development phase
An intangible asset arising from development should be recognised if, and
only if, an entity can demonstrate all of the following:
o the technical feasibility of completing the intangible asset so that it
will be available for use or sale;
o its intention to complete the intangible asset and use it or sell it;
o its ability to use or sell the intangible asset;
o how the intangible asset will generate probable future economic benefits;
o the availability of adequate technical, fmancial and other resources to
complete the development and to use or sell the intangible asset; and
o its ability to measure the expenditure attributable to the intangible
asset during its development reliability.
Examples of development activities are:
o the design, construction and testing ofpre-production or pre-use
prototypes and models;
o the design of tools, jigs, moulds and dies involving new technology;
o the design, construction and operation of a pilot plant that is not of
a scale economically feasible for commercial production; and
o the design, construction and testing of a chosen alternative for new or
improved materials, devices, products, processes, systems or services.
Expenditure on an intangible item that was initially recognised as an expense
(e.g. research) should not be recognised as part of the cost of an intangible asset
at a later date (e.g. after the development phase has commenced).
Illustration 4
An entity is developing a new production process. The amount of expenditure in the
year to 31 December 2004 is as follows:
1 January to 30 November
1 December to 31 December
$
2,160
240
2,400
On 1 December the entity was able to demonstrate that the production process met the
criteria for recognition as an intangible asset. The amount estimated to be recoverable
from the process (including future cash outflows to complete the process before it is
available for use) is $1,200.
Analysis
At 31 December 2004 the production process is recognised as an intangible
asset at a cost of $240 (expenditure incurred since 1 December when the
recognition criteria were met). The intangible asset is carried at this cost
(being less than the amount expected to be recoverable).
The $2,160 expenditure incurred before 1 December is recognised as an
expense because the recognition criteria were not met until that date. This
expenditure will never form part of the cost of the production process
recognised in the balance sheet.
Illustration 4 - continued
Expenditure in 2005 is $4,800. At 31 December 2005, the amount estimated to be
recoverable from the process (including future cash outflows to complete the process
before it is available for use) is $4,500.
Analysis
At 31 December 2005, the cost of the production process is $5,040 (240 +
4,800). The entity recognises an impairment loss of$540 to adjust the
carrying amount before impairment loss ($5,040) to its recoverable amount
($4,500).
This impairment loss will be reversed in a subsequent period ifthe
requirements for the reversal of an impairment loss in lAS 36 Impairment of
Assets are met.
3.3.3 Research and development acquired as part ofa business combination
An in-process research and development project acquired as part of a
business combination should be recognised separately from goodwill if:
o the project meets the definition of an intangible asset; and
o its fair value can be measured reliably. (IFRS 3)
The strict recognition criteria are not required to be met.
An acquiree's in-process research and development project meets the definition
ofan intangible asset when it:
o meets the definition of an asset; and
o is identifiable, ie is separable or arises from contractual or other legal
rights.
If the in-process research and development meets the definition of an
intangible asset, it will be separately recognised from goodwill irrespective of
whether the asset had been recognised by the acquiree before the business
combination.
3.4 Recognition of expenses and costs
Expenditure on an intangible item shall be recognised as an expense when it
is incurred unless:
o it forms part ofthe cost of an intangible asset that meets the
recognition criteria; or
o the item is acquired in a business combination and cannot be
recognised as an intangible asset.
Where an intangible item acquired in a business combination cannot be
recognised as an intangible asset, the expenditure (included in the cost of the
business combination) is subsumed within the amount attributed to goodwill
at the acquisition date.
Reliable measurement of costs requires a costing system that is able to
identify costs to particular courses of action.
The cost of an internally generated intangible asset comprises all directly
attributable costs necessary to create, produce, and prepare the asset to be capable
of operating in the manner intended by management.
Examples include:
o costs of materials and services used;
o salaries, wages and other employment related costs;
o fees to register a legal right;
o depreciation of equipment used in the development phase;
o amortisation ofpatents and licences used to generate the intangible asset;
o other directly attributable costs;
o overhead costs that can be allocated on a reasonable and consistent basis.
Costs that are not components of the cost of an internally generated intangible
asset include:
o selling, administration and other general overhead costs;
o identified inefficiencies and initial operating losses incurred before
the asset achieves planned performance;
o costs that have previously been expensed (e.g. during a research
phase) must not be reinstated;
o training expenditure.
Expenditure incurred to provide future economic benefits for which no
intangible asset can be recognised is expensed when incurred. Examples,
except when they form part ofthe cost of a business combination, include:
o research costs;
o pre-opening costs for a new facility;
o plant start-up costs incurred prior to full scale production (unless
capitalised in accordance with lAS 16);
o legal and secretarial costs incurred in setting up a legal entity;
o training costs involved in running a business or a product line;
o advertising and related costs.
This does not preclude recognising a prepayment when payment for goods or
services has been made in advance of the delivery of goods or the rendering
of services.
Illustration 5
$lmwas paid to acquire a small cosmetics company to be accounted for
under IFRS 3 "Business Combinations". At the date of acquisition a
purchased brand with a fair value of $100,000 was separately identified
and expenditure of $50,000 had been incurred by the cosmetics company
in identifying a new product. It was anticipated that a further $75,000
would be spent before a commercial product could be identified and the
development phase commenced.
The $lm paid as the cost ofthe business combination, reflects the
research and development already carried out by the business.
Analysis
The intangible assets of $100,000 at fair value would be recognised
separately from goodwill.
Identification of a new product constitutes research. However, acquired in-
process research and development project is recognised if it meets the
definition of an intangible asset and its fair value can be measured reliably.
(IFRS 3) The fair value could be very different to cost.
The expected further costs of $75,0000 would not be recognised at the date of
acquisition because they have not yet been incurred. When incurred, they
would be expensed through profit and loss as research expenditure.
4 MEASUREMENTAFTERRECOGNITION
An entity can choose either a cost or revaluation model.
4.1 Cost model
Cost less any accumulated amortisation and any accumulated impairment
losses.
4.2 Revaluation model
Revalued amount, being fair value at the date of the revaluation less any
subsequent accumulated amortisation and any accumulated impairment
losses.
Fair value must be determined by reference to an active market (see below).
This is different to the treatment of revaluation under lAS 16 where
depreciated replacement cost can be used when there is no evidence of
market value.
Revaluations must be sufficiently regular that carrying amount at the balance
sheet is not materially different from fair value.
The revaluation model does not allow:
o the revaluation of intangible assets that have not previously been
recognised as assets;
o the initial recognition of intangible assets at amounts other than
their cost.
The revaluation is carried out according to the same principles applied in
accounting for other assets. For example:
o Surplus is taken directly to equity;
o Deficit is expensed unless covered by a previously recognised
surplus;
o All intangibles in the class must be revalued, etc.
4.3 Active markets
The revaluation of intangibles will be uncommon in practice as it is not
expected that an active market will exist for most intangible assets in that:
o they will not be homogeneous (most are unique);
o willing buyers and sellers may not be normally found at any time;
o prices are not usually available to the public.
For example, active markets cannot exist for brands, newspaper mastheads,
music and film publishing rights, patents and trademarks. Each item is
unique, transactions are relatively infrequent and contracts are negotiated
between individual buyers and sellers.
However, examples do exist of active markets for intangible assets - freely
transferable taxi licences, fishing licences and production quotas.
Illustration 6
In 1990, in the United States, legislation was introduced to authorise sulphur dioxide
pollution at a limited rate from power-generating systems - an emission right. Such
rights are no longer granted. Organizations reducing their emissions through, for
example, modernisation, then had excess pollution rights (i.e. an ability to pollute
which was surplus to their requirements). An active market in emission rights emerged
as new plants sought to buy the excess.
4.4 Accounting entries on revaluation
A surplus is credited directly to equity as "revaluation surplus" (unless
reversing a deficit in respect of the same asset which was previously
recognised as an expense)
A deficit is recognised as an expense (unless covered by a revaluation surplus
in respect ofthe same asset).
Any balance on the revaluation surplus, which is included in equity, may be
transferred to retained earnings when the surplus is realised (e.g. on retirement or
disposal).
Where some of the surplus is realised as the asset is used by the entity, the
difference between amortisation based upon the revalued amount and amortisation
that would have been charged based on the asset's historical cost is a transfer to
retained earnings.
This is effected through the statement ofchanges in equity, not the income
statement.
Worked example 4
Janeway is an entity that operates in a jurisdiction and in a type ofbusiness where
production quotas are under strict government control. Demand for the quotas exceeds
supply.
Production quotas must be applied for and if awarded are held for a period of 5 years.
There is an active market for production quotas based on production volume and the
price per unit is regularly quoted in the fmancial press.
A fee of $1,000 is payable on application for a quota and if awarded the quota can only
be taken up on payment ofa further fee of $100,000.
Janeway applied for a production quota in September 2004. A quota was awarded in
December 2004. All fees have been paid.
Analysis
Application fee
Take up fee
1,000
100,000
This fee is expensed.
This fee is capitalised as an intangible asset.
Worked example 4 (continued)
Janeway wishes to adopt the revaluation model for the subsequent measurement ofthe
intangible asset and to revalue the asset on an annual basis. The fair values of the
quota at the next two year ends are as follows:
Required:
December 2005
December 2006
$
98,000
79,000
Prepare a reconciliation of the carrying amount at the beginning and end of each
of the next two years showing:
(i) amortisation recognised during the period;
(li) increases or decreases resulting from revaluations.
Worked solution 4
Carrying Income Revaluation Retained Notes
value statement reserve earnings
$ $ $ $
Carrying amount
1 January 2005 100,000
Amortisation for the year ended
31 December 2005 (20,000) 20,000 1
Historical cost carrying amount
31 December 2005 80,000
Revaluation 18,000 18,000
31 December 2005 98,000 18,000 2
Carrying amount
1 January 2006 98,000 18,000
Amortisation for the year ended
31 December 2006 (24,500) 24,500 3
Carrying amount before revaluation 73,500
Revaluation 5,500 5,500
Realisation ofrevaluation reserve
(24,500 - 20,000) (4,500) 4,500 4
31 December 2006 79,000 19,000
1 Amortisation is chargedfor the period up to the date ofthe
revaluation. This is based on the carrying value during the period.
2 The increase in carrying value is credited directly to the revaluation
reserve. This will be reflected in the statement ofchanges in equity
under lAS 1 Presentation ofFinancial Statements.
3 The amortisation is based on the carrying value of$98,000 written
offover the remaining useful life of4 years.
4 As the asset is amortised the revaluation surplus is realised. This
realisation is reflected as a transfer between the revaluation reserve
and retained earnings. It is measured as the difference between the
historical cost depreciation ($20,000) and the depreciation ofthe
revalued amount ($24,500).
5 USEFULLIFE
5.1 Factors
The useful life of an intangible asset should be assessed as fmite or indefmite.
A fmite useful life is assessed as a period of time or number of production or
similar units. An intangible asset with a fmite life is amortised. "Indefinite"
does not mean "infmite".
Useful life is regarded as indefmite when there is no foreseeable limit to the
period over which the asset is expected to generate net cash inflows.
This must be based on an analysis ofall ofthe relevant factors. An intangible
asset with an indefinite life is not amortised.
Factors to be considered in determining useful life include:
o expected usage of the asset by the entity;
o typical product life cycles for the asset;
o public information on estimates of useful lives of similar types of
assets that are similarly used;
o technical, technological, commercial or other obsolescence;
For example, computer software is susceptible to technological obsolescence
and so has a short useful life.
o stability ofthe industry in which the asset operates;
o changes in market demand for the output from the asset;
o expected actions by competitors or potential competitors;
o the level of maintenance expenditure or of funding required and the
entity's ability and intent to reach this level;
o legal or similar limits on the use of the asset, such as the expiry
dates of related leases; and
o whether or not the useful life ofthe asset is dependent on the useful
life of other assets ofthe entity.
5.2 Finite useful lives
5.2.1 Contractual or other legal rights
The useful life of an intangible asset arising from contractual or other legal
rights should not exceed the period of such rights, but may be shorter.
Illustration 7
An entity has purchased an exclusive right to operate a passenger and car ferry for
thirty years. There are no plans to construct tunnels or bridges to provide an alternative
river crossing in the area served by the ferry. It is expected that this ferry will be in use
for at least thirty years.
Illustration 8
An entity has purchased an exclusive right to operate a wind farm for 40 years. The
cost of obtaining wind power is much lower than the cost of obtaining power from
alternative sources. It is expected that the surrounding geographical area will demand a
significant amount ofpower from the wind farm for at least 25 years.
The entity amortises the right to generate power over 25 (rather than 40) years.
Where such rights are renewable the useful life includes renewal periods if
there is evidence that the entity will renew without significant cost.
Such evidence may be based on past experience or thirdparty consent. Ifcost
ofrenewal is significant it represents, in substance, a new intangible asset.
5.2.2 Amortisation
The depreciable amount of an intangible asset should be allocated on a
systematic basis over the best estimate of its useful life.
Amortisation begins when the asset is available for use.
When it is in the location and condition necessaryfor it to be capable of
operating as intended.
Amortisation ceases at the earlier of the date that the asset is:
o classified as held for sale; or
IFRS 5 "Non-current Assets Heldfor Sale and Discontinued
Operations" applies.
o derecognised.
It does not cease when an intangible asset is temporarily idle, unless it is
fully depreciated.
The amortisation method used should reflect the pattern in which the asset's
economic benefits are consumed by the entity. If that pattern cannot be
determined reliably, the straight-line method should be adopted.
The amortisation charge for each period is recognised in profit or loss unless
it is permitted to be included in the carrying amount of another asset.
For example, the amortisation ofa patent right exercised to manufacture a
product would be a cost included in inventory.
5.2.3 Residual value
The residual value of an intangible asset is assumed to be zero unless the
following conditions are met:
o there is a commitment by a third party to purchase the asset at the
end of its useful life; or
o there is an active market for that type of intangible asset; and:
residual value can be measured reliably by reference to
that market; and
it is probable that such a market will exist at the end of
the useful life.
Ifthe residual value ofan intangible asset increases to an amount equal to or
greater than the asset's carryingamount, the asset's amortisationcharge is zero-
unless and until its residual value subsequently decreases to an amount
below the asset's carrying amount.
An asset with a residual value implies an intention to dispose of it before the
end of its economic life. Thus development costs, for example, are unlikely
to have a residual value (other than zero).
5.2.4 Review
The amortisation period and the amortisation method should be reviewed at
least at each financial year end.
Any changes in period or method are a change in estimate and accounted for
in accordance with lAS 8 "Accounting Policies, Changes in Accounting
Estimates and Errors".
Example 2
On 1 April 2004 Brook established a new research and development unit to acquire
scientific knowledge about the use of synthetic chemicals for pain relief. The
following expenses were incurred during the year ended 31 March 2005.
(1) Purchase ofbuilding for $400,000. The building is to be depreciated on a
straight line basis at the rate of 4% per annum on cost.
(2) Wages and salaries of research staff $2,355,000.
(3) Scientific equipment costing $60,000 to be depreciated using a reducing
balance rate of 50% per annum.
Required:
Calculate the amount of research and development expenditure to be recognised
as an expense in the year ended 31 March 2005.
Proforma solution
The following costs should be written off:
$
Building depreciation
Wages and salaries of research staff
Equipment depreciation
Example 3
In its first year of trading to 31 July 2005 Eco-chem incurred the following expenditure
on research and development, none of which related to the purchase ofproperty, plant
and equipment.
(1) $12,000 on successfully devising processes to convert the sap extracted from
mangroves into chemicals X, Y and Z.
(2) $60,000 on developing an analgesic medication based on chemical Z.
No commercial uses have yet been discovered for chemicals X and Y.
Commercial production and sales of the analgesic commenced on 1 April 2005 and are
expected to produce steady profitable income during a five year period before being
replaced. Adequate resources exist for the company to achieve this.
Required:
Determine the maximum amount of development expenditure that may be carried
forward at 31 July 2005 under lAS 38.
Solution
5.3 Indefinite useful lives
An intangible asset with an indefinite useful life is:
D not amortised; but
D tested for impairment:
annually; and
whenever there is an indication of impairment.
Reassessing a usefu11ife as fmite rather than indefinite is an indicator that the
asset may be impaired.
The usefu11ife is reviewed each period to determine whether events and
circumstances continue to support an indefmite useful life assessment.
Jfnot, the change in accounting estimate is accounted/or in accordance with lAS 8.
6 IMPAIRMENT AND DERECOGNITION
6.1 Impairment losses
lAS 36 Impairment 0/Assets contains provisions regarding:
D when and how carrying amounts are reviewed;
D how recoverable amount is determined; and
D when an impairment loss is recognised or reversed.
The purpose of testing for impairment is to ensure recovery of the carrying
amount. Note that the uncertainty about recovering the cost of an intangible
asset before it is available for use (e.g. development costs) is likely to be
greater than when it is brought into use.
6.2 Retirements and disposals
An intangible asset should be derecognised (i.e. eliminated from the balance
sheet):
D on disposal; or
D when no future economic benefits are expected from its use or disposal.
Gains or losses arising are determined as the difference between:
D the net disposal proceeds; and
D the carrying amount ofthe asset.
Gains or losses are recognised as income or expense in the period in which
the retirement or disposal occurs. Gains are not classified as revenue.
However, lAS 17 "Leases" may require otherwise on a sale and leaseback.
7 DISCLOSURE
Illustration 9
Research and development
Research and development costs are expensed as they are incurred, except
for certain development costs, which are capitalized when it is
probable that a development project will be a success, and certain criteria,
including commercial and technological feasibility, have been met.
Capitalized development costs, comprising direct labor and related overhead
are amortized on a systematic basisover their expected useful lives
between two and five years.
NOKIA ANN U A LAC C 0 U N T S 2 0 03
The disclosure requirements ofIAS 38 are comparable to, but more extensive
than, those ofIAS 16 "Property, Plant and Equipment".
7.1.1 General
The financial statements should disclose the accounting policies adopted for
intangible assets and, in respect of each class of intangible assets:
o whether useful lives are indefmite or finite and, if finite:
the useful lives or the amortisation rates used;
the amortisation methods used;
Illustration 10
Accounting policies
Intangible assets
This heading includes separately acquired intangible assets
such as management information systems, intellectual property
rights and rights to carry on an activity (i.e. exclusive
rights to sell products or to perform a supply activity). Intangible
assets are depreciated on a straight-line basis, management
information systems over a period ranging between
three to five years, other intangible assets over five to twenty
years. Where a period in excess of twenty years is used, this
is separately disclosed for each element of intangible asset
together with the principal factors determining that useful
life. The recoverable amount, as well as depreciation period
and depreciation method are reviewed annually. The depreciation
is allocated to the relevant headings in the income
statement.
Internally generated intangible assets are recognized,
provided they generate future economic benefits and their
costs are well identified. They consist mainly of management
information systems.
Nestle Consolidated accounts 2003
o the gross carrying amount and any accumulated amortisation (including
accumulated impairment losses) at the beginning and end of the period;
o the line item of the income statement in which any amortisation is included;
o a reconciliation ofthe carrying amount at the beginning and end of the period
showing all movements that have arisen in the period analysed by type.
Illustration 11
12. Intangible assets
Capitalized d v lopment costs
Acquisition cost Jan. 1
Addilions
Impairment and write-offs
Acc umulated amortization Dec. 31
Net carrying amount Dec. 31
2003 2002
EURm EURm
1707 1314
218 418
-455 - 25
- 933 -635
537 1072
1429 1601
20 10
- 151 - 182
- 1 112 -953
186 476 Net carrying amount Dec . 31
Goodwlll
Ac quisition cost Jan. 1
Additions
Impairment charges (Note 7)
Accumulated amorlization Dec . 31
524 533
87 75
-44 - 72
-13 -12
-369 -332
185 192 Net carrying amount Dec . 31
Other IntangIble assets
Acquisition cost Jan. 1
Addilions
Disposals
Translali on differences
Accumulated amortization Dec. 31
NOKIA ANN U A LAC C 0 U N T S 2 0 0 3
7.1.2 Individually material intangible assets
Disclose the nature, carrying amount and remaining amortisation period of
any individual intangible asset that is material to the financial statements as a
whole.
In determining whether or not an individual intangible asset "is material"
consider, for example:
o its cost or carrying value in relation to total intangible assets and
total assets;
o the amount expensed during the year (in respect ofamortisation
and/or impairment) in relation to net profit or loss.
Illustration 12
Intangible assets
Acquired intangible assets other than goodwill are recognized at cost and amortized by
the straight-line method over a period of 4 to 15 years, depending on their estimated
useful lives. Write-downs are made for impairment losses. Assets are written back if the
reasons for previous years' write-downs no longer apply. Scheduled amortization for
2003 has been allocated to the cost of goods sold, selling expenses, research and
development expenses or general administration expenses.
Goodwill, including that resulting from capital consolidation, is capitalized in
accordance with lAS 22 (Business Combinations) and amortized on a straight-line basis
over a maximum estimated useful life of 20 years. The value of goodwill is reassessed
regularly based on impairment indicators and written down if necessary. In compliance
with lAS 36 (Impairment of Assets), such write-downs of goodwill are measured by
comparison to the discounted cash flows expected to be generated by the assets to which
the goodwill can be ascribed. Amortization and write-downs of capitalized goodwill are
recorded as other operating expense.
Self-created intangible assets generally are not capitalized. Certain development costs
relating to the application development stage of internally developed software are,
however, capitalized in the group balance sheet. These costs are amortized over the
useful life of the software from the date it is placed in service.
7.1.3 Indefinite useful life
Disclose the carrying amount and reasons supporting the assessment of an indefinite
useful life (this includes describing the factors that played a significant role in
determining that the asset has an indefinite useful life).
7.1.4 Change in accounting estimate
lAS 8 requires an entity to disclose the nature and amount of a change in an
accounting estimate that has a material effect in the current period or is
expected to have a material effect in subsequent periods. Such disclosure may
arise from changes in:
D the assessment of an intangible asset's useful life;
D the amortisation method; or
D residual values.
7.1.5 Impairment
Information on impairment of intangible assets is made in accordance with
lAS 36.
7.1.6 Acquired by way ofgovernment grant
For intangible assets acquired by way of a government grant and initially
recognised at fair value:
o the fair value initially recognised for these assets;
o their carrying amount; and
o whether they are measured after recognition under the cost model
or the revaluation model.
7.1.7 Other
The existence and carrying amounts of intangible assets whose title is
restricted and the carrying amounts of intangible assets pledged as security
for liabilities.
The amount of contractual commitments for the acquisition of intangible
assets.
7.2 Revaluations
The following should be disclosed when assets are carried at revalued amounts:
o the effective date ofthe revaluation (by class);
o the carrying amount ofthe revalued intangible assets (by class);
o the carrying amount that would have been recognised using the cost
model (by class);
o the amount of the revaluation surplus that relates to intangible
assets at the beginning and end of the period, indicating movements
in the period and any restrictions on the distribution ofthe balance
to shareholders;
o the methods and significant assumptions applied in estimating fair
values.
7.3 Research and development expenditure
Disclose the total cost ofresearch and development that has been recognised
as an expense during the period.
FOCUS
distinguish between goodwill and other intangible assets;
discuss the nature and possible accounting treatments of internally-generated
goodwill;
define the criteria for the initial recognition and measurement of intangible
assets;
describe and apply the requirements ofIAS 38 to internally generated assets
other than goodwill (e.g. research and development).
EXAMPLE SOLUTIONS
Solution 1 - Tangible versus intangible assets
(1) Tangible: the operating system (e.g. DOS or Windows) ofa personal
computer is an integral part ofthe related hardware and should be accounted
for under IAS 16 Property, Plant and Equipment.
(2) Intangible: such computer software (e.g. QuarkXpress) is not an integral part
of the hardware on which it is used.
(3) Tangible: specialised software integrated into production line "robots" is
similar in nature to (1).
(4) Intangible: companies developing "firewall" software to protect their own
websites may also sell the technology to other companies.
Solution 2 - Research and development write-off
The following costs should be written off:
Building depreciation (400,000 x 4%)
Wages and salaries of research staff
Equipment depreciation (60,000 x 50%)
Solution 3 - Maximum carry forward
Cost
$
16,000
2,355,000
30,000
2,401,000
(1) This is research expenditure which cannot be capitalised under any
circumstances and must therefore be expensed to the income statement
(2) Initially recognise cost $60,000. Residual value is presumed to be zero.
Amortisation
Amortise from 1 April 2005 for a period of 5 years.
Charge for 4 months is: 4/
60
x $60,000 = $4,000
Carrying amount
$60,000 - $4,000 = $56,000.
This is the maximum carry forward, assuming no impairment.
lAS 40 INVESTMENT PROPERTIES
OVERVIEW
Objective
To describe the accounting treatment of investment properties.
INTRODUCTION
RECOGNITION AND
MEASUREMENT
MEASUREMENT
AFTER
RECOGNITION
DISCLOSURE
Objective
Scope
Definitions
Effective Date
Rule
Initial Measurement
Meaning ofcost
Expenditure after initial
recognition
Fair value model
Exceptional circumstances
The cost model
Transfers
Disposals
Change in method
1 INTRODUCTION
1.1 Objective
lAS 40 prescribes the accounting treatment for investment property and the
related disclosure requirements.
1.2 Scope
lAS 40 shall be applied in the recognition, measurement and disclosure of
investment properties.
lAS 40 shall be applied in the measurement of investment properties:
o held by a lessee under a finance lease, and
o held by a lessor and leased out under an operating lease.
lAS 40 does not deal with those matters covered under lAS 17 Leases. lAS
17 states that if an asset obtained through a lease and is treated as an
investment property by the lessee then that lease must be treated as a fmance
lease with the investment property measured using the fair value model of
lAS 40.
The standard does not apply to
o Biological assets in respect of agricultural activity, and
o mineral rights and reserves and similar non-regenerative resources.
1.3 Definitions
Investment property is 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:
o use in the production or supply of goods or services or for
administrative purposes, or
o sale in the ordinary course ofbusiness.
Owner-occupiedproperty is property held by the owner (or by the lessee
under a finance lease) for use in the production or supply of goods or services
or for administrative purposes.
Examples ofproperty include:
o land held for long-term capital appreciation rather than for short-
term sale in the ordinary course ofbusiness,
o land held for a currently undetermined future use,
o a building owned by the reporting entity (or held under a fmance
lease) and leased out under operating leases, and
o a building that is vacant but is held to be leased out.
The following do not meet the definition of investment property:
o property held for sale in the ordinary course of business,
o property being constructed for third parties (included in lAS 11
Construction Contracts),
o owner-occupied property (see lAS 16 Property, Plant and
Equipment), and
o property that is being constructed or developed for future use as an
investment property. (lAS 16 - Property, plant and equipment
applies).
2.1 Rule
Investment property shall be recognised as an asset when
o it is probable that the future economic benefits that are attributable
to the investment property will flow to the entity, and
o the cost ofthe investment property can be measured reliably.
2.2 Initial Measurement
An investment property shall be measured initially at its cost, which is the
fair value of the consideration given for it, and will include any transaction
costs.
2.3 Meaning of cost
The cost of a purchased investment property comprises its purchase price,
and any directly attributable expenditure. Directly attributable expenditure
includes, for example, professional fees for legal services and property
transfer taxes.
The cost of a self constructed investment property is its cost at the date when
the construction or development is complete.
If an investment property is acquired through a fmance lease the initial cost
recognised shall be in accordance with lAS 17 Leases.
2.4 Expenditure after initial recognition
Day to day costs of running the investment property are expensed as incurred.
If a part of an investment property requires replacement during the useful life
of the property the replacement part is capitalised when the cost is incurred as
long as the recognition criteria are met. Any value remaining in respect of the
replaced part will be de-recognised as the new cost is capitalised.
This follows the replacement part principle oflAS 16 Property, Plant and
Equipment.
3 MEASUREMENT AFTER RECOGNITION
An entity shall choose either the fair value model or the cost model as
described in the standard and apply that policy to all of its investment
properties.
3.1 Fair value model
After initial recognition, an entity that chooses the fair value model shall
measure all of its investment property at its fair value (except in exceptional
circumstances).
A gain or loss arising from a change in the fair value of investment property
shall be included in net profit or loss for the period in which it arises.
Fair Value Measurement Considerations
Fair value is the amount for which an asset could be exchanged between
knowledgeable, willing parties in an arm's length transaction.
o "knowledgeable, willing parties"- knowledgeable means that both the
willing buyer and the willing seller are reasonably informed about:
the nature and characteristics of the investment property,
its actual and potential uses, and
the state of the market as of the date of valuation.
o a willing buyer is motivated, but not compelled to buy. He is neither over-
eager nor determined to buy at any price. This buyer is also one who
purchases in accordance with the realities of the current market, and with the
current market expectations.
o a willing seller is neither an over-eager nor a forced seller, prepared to sell at
any price, nor one prepared to hold out for a price not considered reasonable
in the current market. The willing seller is motivated to sell the investment
property at market terms for the best price attainable in the open market after
proper marketing, whatever that price may be.
o an arm's-length transaction is one between parties who do not have a
particular or special relationship that makes prices of transactions
uncharacteristic of the market. The fair value transaction is presumed to be
between unrelated parties, each acting independently.
In summary, fair value is measured as the most probable price reasonably obtainable
in the market at the date of valuation in keeping with the fair value definition. It is the
best price reasonably obtainable by the seller and the most advantageous price
reasonably obtainable by the buyer. The fair value of investment property shall reflect
the actual market state and circumstances as of the effective valuation date, not as of
either a past or future date.
The fair value of investment property is an estimated amount rather than a
predetermined or actual sale price. It is the price at which the market expects a
transaction that meets all other elements of the fair value definition would be
completed on the date of valuation.
The fair value shall reflect the actual market and circumstances at the balance sheet
date, not as of either a past or future date.
3.2 Exceptional circumstances
There is a rebuttal presumption that an entity will be able to determine the
fair value of an investment property reliably on a continuing basis.
However in exceptional circumstances where there is clear evidence, when an
entity, that has chosen the fair value model, first acquires an investment
property to which fair value cannot be determined on a reliable and
continuing basis, then that property shall be measured in accordance with the
cost model ofIAS 16
The entity measures all its other investment property at fair value.
3.3 The cost model
After initial recognition, an entity that chooses the cost model shall measure
all of its investment property using the cost model in lAS 16 Property, Plant
and Equipment, that is at cost less any accumulated depreciation and
impairment losses.
An investment property, measured under the cost model, that is subsequently
classed as held for sale in accordance with IFRS 5 NCA heldfor sale and
discontinued operations shall be measured in accordance with that standard.
IFRS 5 requires NCA held for disposal to be measured at the lower of its
carrying value and fair value less costs to sell. Once an asset is classed as
held for disposal it will no longer be depreciated.
3.4 Transfers
Transfers to and from investment property shall be made when and only
when there is a change in use evidenced by:
o commencement of owner occupation for a transfer from investment
property to owner occupied property
o commencement of development with a view to sale for a transfer
from investment property to inventories
o end of owner occupation for a transfer from owner occupied
property to investment property
o commencement of an operating lease to another party for a transfer
from inventories to investment property
o end of construction or development for a transfer from property in
the course of construction to investment property.
3.5 Disposals
An investment property shall be derecognised on disposal or when the
investment property is permanently withdrawn from use and no future
economic benefits are expected from its disposal.
Any gains or losses on the retirement of an asset are calculated as the
difference between the carrying value ofthe asset and the disposal proceeds
and are included in the net profit or loss for the period.
3.6 Change in method
A change from one model to the other model shall be made only ifthe change
will result in a more appropriate presentation. IAS 40 states that this is
highly unlikely to be the case for a change from the fair value model to the
cost model.
Example 1
A company has four investment properties, A, B, C and D. Before the implementation
of IAS 40, it had the following accounting policy:
"Investment properties are valued on a portfolio basis at the fair value at the year-end,
with any net gain recognised in the investment property revaluation reserve. Dilly net
losses from revaluation are transferred to income statement"
At 1.01.2004, the carrying amounts of each of the four properties were $IOOm.
At 31.12.2004, following a professional appraisal of value, the properties were valued
at:
A $140m
B $130m
C $95m
D $90m
Required
Show how the application of IAS 40 would change the financial statements of the
company ifthe fair value model is chosen.
Solution 1
Example 2
An investment property company has been constructing a new building for the last 18 months. At
31.12.2003, the cinema was nearing completion, and the costs incurred to date were:
Materials, labour and sub-contractors
Other directly attributable overheads
Interest on borrowings
$m
14.8
2.5
1.3
It is the company's policy to capitalise interest on specific borrowings raised for the purpose of
fmancing a construction. The amount of borrowings outstanding at 31.12.2003 in respect of this
project is $18m, and the interest rate is 9.5%pa.
During the three months to 31.3.2004 the project was completed, with the following additional costs
incurred:
Materials, labour and sub-contractors
Other overhead
$m
$1.7
$0.3
On 31.3.2004, the company obtained a professional appraisal of the cinema's fair value, and the
valuer concluded that it was worth $24m. The fee for his appraisal was $0.1m, and has not been
included in the above figures for costs incurred during the 3 months.
The cinema was taken by a national multiplex chain on an operating lease as at 1.04.2004, and was
immediately welcoming capacity crowds. The lease agreement allows for annual revisions, and thus
it was clear that it was worth even more than the valuation at 31.3.2004. Following a complete
valuation of the company's investment properties at 31.12.2004, the fair value of the cinema was
established at $28m.
Required
Set out the accounting entries in respect of the cinema complex for the year ended 31.12.2004.
Solution 2
4 DISCLOSURE
An entity shall disclose
o The method and significant assumptions applied in determining fair
value
o The extent to which the fair value is based on a valuation by an
independent valuer
o The amounts included in the income statement for
rental income
direct operating expenses (including repairs) that
generated rental income during the period
direct operating expense (including repairs) that did not
generate rental income during the period
When applying the fair value model an entity shall also disclose a
reconciliation of the carrying amount at the beginning and end ofthe period
and the movements in the period.
When applying the cost model an entity shall also disclose
o the depreciation method used
o the useful lives or the depreciation rates used
o a reconciliation of the carrying amount at the beginning and end of
the period and the movements in the period, and
o the fair value of the property or a note stating that the fair value
cannot be determined reliably and giving a description of the
property for which we cannot obtain the fair value of and if possible
a range of estimates within which the fair value is likely to be.
FOCUS
Discuss the way in which the treatment of investment properties may differ
from other properties;
apply the requirements of IAS 40 to Investment properties;
account for investment properties including fair value and cost models, and
definitional issues.
EXAMPLE SOLUTIONS
Solution 1
Under the company's existing accounting policy, they would carry the investment
properties in the Balance Sheet at 31.12.2004 at a total of $455m, and the net gain
would be recorded in the revaluation reserve (455 - 400 = 55).
Applying lAS 40 (fair value model), the company would still carry the properties at
$455m, but the net gain of $55m would be recorded in the income statement.
Solution 2
Costs incurred in the 3 months to 31.3.2004
Dr Asset under construction
Cr Cash/Creditors
Cr Cash/Creditors
Cr Interest expense
WORKING
Outstanding borrowings
Interest for 3 months
$m $m
1.7
1.7
0.3
0.3
0.43
0.43
$18m
$18m x 3/12 x 9.5% = 0.43m
Accumulated costs at the date oftransfer into investment properties:
Costs to 31.12.2003 (14.8 + 2.5 + 1.3)
Costs to 31.03.2004 (1.7 + 0.3 + 0.43)
Investment property initially recognized
$m
18.6
2.43
21.03
Note: The receipt ofthe professional valuation at 31.3.2004 has not improved the
profit earningpotential ofthe asset. The valuation itselfis also irrelevant
since lAS 40 states that initial recognition shall be at cost.
At 31.12.2004
Dr Investment property (28 - 21.03)
Cr Income statement
$m
6.97
$m
6.97
Being the increase in fair value following first subsequent re-measurement.
IAS 41 AGRICULTURE
OVERVIEW
Objectives
To outline the accounting rules for agriculture.
INTRODUCTION
RECOGNITION AND
MEASUREMENT
GOVERNMENT
GRANTS
PRESENTATION AND
DISCLOSURE
Objective
Scope
Definitions
Commentary
Recognition
Measurement
Commentary
Gains and losses
Iffair value cannot be determined
Presentation
Disclosure
lAS 41 AGRICULTURE
1 INTRODUCTION
1.1 Objective
The standard prescribes the accounting treatment and the presentation and
disclosure s related to agricultural activity.
1.2 Scope
lAS 41 covers the following when they relate to agricultural activity:
o biological assets,
o agricultural produce at the point of harvest, and
o government grants as described in the standard.
lAS 41 does not cover:
o land related to agricultural activity (see lAS 16), or
o intangible assets related to agricultural activity (see lAS 38).
1.3 Definitions
Agricultural activity is the management by an entity of the biological
transformation of biological assets into agricultural produce for sale, into
agricultural produce, or into additional biological assets.
A biological asset is a living animal or plant.
Biological transformation comprises the processes of growth, degeneration,
production, and procreation that cause qualitative and quantitative changes in
a biological asset.
Harvest is the detachment ofproduce from a biological asset or the cessation
of a biological asset's life processes
Agricultural produce is the harvested product of the entity's biological assets.
lAS 41 AGRICULTURE
1.4 Commentary
Agricultural activity covers a diverse range of activities, including raising
livestock, forestry, annual or perennial cropping, cultivating orchards and
plantations, floriculture, and aquaculture.
The common features of agricultural activity are as follows:
o Capability to change - living animals and plants are capable of
biological transformation.
o Management of change - management facilitates biological
changes by enhancing or stabilising conditions (ie temperature,
moisture, nutrient levels, fertility and light).
o Measurement of change - the change in quality (ie ripeness,
density, fat cover, genetic merit) or quantity (weight, fibre length,
cubic metres, and number ofbuds).
2.1 Recognition
An entity should recognise a biological asset when, and only when:
o The entity controls the asset as a result of past event,
o It is probable that future economic benefits associated with the asset
will flow to the entity, and
o The fair value can be measured reliably.
2.2 Measurement
A biological asset should be measured on initial recognition and at each
balance sheet date at its fair value less estimated point of sale costs, except
where the fair value cannot be measured reliably.
Agricultural produce harvested from an entity's biological assets should be
measured at its fair value less estimated point of sale costs at the point of
harvest. Such measurement is cost at that date when applying IAS 2 or
another applicable lAS.
lAS 41 AGRICULTURE
Illustration 1
A farmer owned a dairy herd at 1 January 2004. The number of cows in the
herd was 100. The fair value of the herd at this date was $5,000. The fair
values of two-year animals at 31 December 2003 and three-year old animals
at 31 December 2004 are $60 and $75, respectively.
Separating out the value increases of the herd into those relating to price
change and those relating to physical change gives the following valuation:
$
Fair value at 1 January 2004 5,000
Increase due to price change (100 x ($60 - $50)) 1,000
Increase due to physical change (100 x ($75 - $60)) 1,500
Fair value at 31 December 2004 7,500
2.3 Commentary
Point of sale costs include commissions to brokers/dealers, levies by
regulatory agencies and transfer taxes and duties. They do not include
transport and other costs necessary to get the asset to the market.
If an active market exists for a biological asset or agricultural produce, the
quoted price in that market is the appropriate basis for determining the fair
value of that asset. If an entity has access to different active markets, the
entity uses the most relevant one, ie if the entity has access to two markets, it
would use the price existing in the market expected to be used.
If an active market does not exist, an entity uses one or more of the
following, when available, in determining fair value:
o The most recent market transaction price, provided that there has
been no significant change in economic circumstances between the
date of that transaction and the balance sheet date,
o Market prices for similar assets with adjustment to reflect
differences, and
o Sector benchmarks such as the value of an orchard expressed per
export tray, bushel, or hectare, and the value of cattle expressed per
kilogram of meat.
In some circumstances market determined prices or values may not be
available for a biological asset in its present condition. In such cases, an
entity uses the present value of expected net cash flows from the asset
discounted at a current market determined pre-tax rate in determining fair
value.
lAS 41 AGRICULTURE
Cost may sometimes approximate fair value, particularly when:
o Little biological transformation has taken place since initial cost
incurrence (ie for fruit tree seedlings planted immediately before
the balance sheet date), or
o The impact of the biological transformation on price is not expected
to be material (ie initial growth in a 30 year pine plantation
production cycle).
2.3 Gains and losses
A gain or loss arising on initial recognition of a biological asset at fair value
less point of sale costs (as point of sale costs need to be deducted) and from a
change in fair value less estimated point of sale costs of a biological asset
should be included in net profit or loss for the period in which it arises.
A gain or loss arising on initial recognition of agricultural produce at fair
value less estimated point of sale costs should be included in net profit or loss
for the period in which it arises.
2.4 If fair value cannot be determined
If the fair value on initial recognition cannot be determined for a biological
asset as market determined prices or values are not available and for which
alternative estimates of fair value are determined to be clearly unreliable, the
biological asset should be valued at cost less accumulated depreciation and
any impairment losses. Once the fair value of the asset can be reliably
determined an entity should measure it at fair value less estimated point of
sale costs.
lAS 41 AGRICULTURE
Example 1
As at 31 December 2004, a plantation consists of 100 Insignis Pine trees that were
planted 10 years earlier. Insignis Pine takes 30 years to mature, and will ultimately be
processed into building material for houses or furniture. The entity's weighted average
cost of capital is 6% per annum.
Only mature trees have established fair values by reference to a quoted price in an
active market. The fair value (inclusive of current transport costs to get 100 logs to
market) for a mature tree of the same grade as in the plantation is:
As at 31 December 2004: 171
As at 31 December 2005: 165
Required:
(a) Assuming immaterial cash flow between now and the point of harvest,
estimate the fair value of the plantation as at:
(i) 31 December 2004; and
(ii) 31 December 2005.
(b) Analyse the gain between the two balance sheet dates into:
(i) a price change; and
(ii) a physical change.
3 GOVERNMENT GRANTS
An unconditional government grant related to a biological asset measured at
its fair value less estimated point of sale costs should be recognised as
income when, and only when the government grant becomes receivable.
If a government grant related to a biological asset measured at its fair value
less estimated point of sale costs is conditional, including where a
government grant requires an entity not to engage in specified agricultural
activity, an entity should recognise the government grant as income when,
and only when, the conditions attaching to it are met.
lAS 41 AGRICULTURE
4 PRESENTATIONAND DISCLOSURE
4.1 Presentation
An entity should present the carrying amount of it biological assets separately
on the face of its balance sheet.
4.2 Disclosure
An entity should disclose
The aggregate gain or loss arising during the current period on initial
recognition of biological assets and agricultural produce and from the change
in the fair value less estimated point of sale costs ofbiological assets.
A description of each group of biological assets.
If not disclosed elsewhere in the financial statements:
o The nature of its activities involving each group ofbiological
assets, and
o Non fmancial measures or estimates of the physical quantities of:
each group of the entity's biological assets at the end of
the period,
output of agricultural produce during the period.
The methods and significant assumptions applied in determining the fair
value of each group of agricultural produce at the point of harvest and each
group ofbiological asset
The fair value less the estimated point of sale costs of agricultural produce
harvested during the period, determined at the point of harvest.
The existence and carrying amount ofbiological assets whose title is
restricted, and the carrying amounts of biological assets pledged as security
for liabilities.
The amount of commitments for the development or acquisition of biological
assets.
Financial risk management strategies related to agricultural activity.
lAS 41 AGRICULTURE
A reconciliation of changes in the carrying amount ofbiological assets
between the beginning and the end of the current period, including:
o The gain or loss arising from changes in fair value less estimated
point of sale costs,
o Increases due to purchases and business combinations,
o Decreases due to sales and harvests
o Net exchange differences arising on the translation of financial
statements of a foreign entity.
(Comparative information in not required)
Ifthe fair value cannot be reasonable determined
If the entity measures biological assets at their cost less any accumulated
depreciation and any accumulated impairment losses:
o A description of the biological assets,
o An explanation of why the fair value cannot be measured reliably,
o If possible, the range of estimates within which fair value is likely
to lie,
o The depreciation method used and the useful lives or depreciation
rates used,
o The gross carrying amount and the accumulated depreciation (and
impairment losses) at the beginning and end of the period,
o Any gain or loss recognised on disposal,
o The impairment losses or reversals recognised in the period,
o Depreciation charged in the period.
Ifthe fair value ofbiological assets previously measured at their cost less any
accumulated depreciation and any accumulated impairment losses becomes
reliably measurable during the current period
A description ofthe biological assets,
An explanation of why fair value has become reliably measurable, and
The effect of the change.
lAS 41 AGRICULTURE
Government grants
The nature and extent of government grants recognised in the fmancial
statements,
Unfulfilled conditions and other contingencies attaching to government
grants, and
Significant decreases expected in the level of government grants.
FOCUS
account for biological assets, agricultural produce at the point of harvest and
government grants.
discuss the recognition and measurement criteria including treatment of gains
and losses, and the inability to measure fair value reliably.
identify what is and what is not scoped into the standard on agriculture.
present and disclose information relating to agriculture.
lAS 41 AGRICULTURE
EXAMPLE SOLUTION
(a) Estimate offair value
(i) 31 December 2004
The mature plantation would have been valued at 17,100.
17,100 =5332
1.06
20
'
(il) 31 December 2005
The mature plantation would have been valued at 16,500.
16,500 = 5,453
1.06
19
(b) Analysis ofgain
The difference in fair value of the plantation between the two balance sheet
dates is 121 (5,453 - 5,332) which will be reported as a gain in the income
statement, analysed as follows:
(i) Price change
Relates to the biological asset's state as at the previous balance sheet date"
V 1
. "I" h b 1 h 16,500
a ue at pnces prevai mg as at t e current a ance s eet --20-
1.06
less
value at prices prevailing as at the previous balance sheet date
Loss
(il) Physical change
This is calculated at current prices.
Value in its state as at the current balance sheet
less
value in its state as at the previous balance sheet date (as in (ij)
Gain
5,145
5,332
187
5,453
5,145
308
lAS 36 IMPAIRMENT OF ASSETS
OVERVIEW
Objective
To give guidance on the recognition and reversal of impairment losses.
MEASURMENT OF
RECOVERABLE
AMOUNT
INTRODUCTION
BASIC RULES
Objective ofthe standard
Definitions
All assets
Intangible assets
Indications ofpotential
impairment loss
CASH
GENERATING
UNITS
General principles
Fair values less costs to
sell
Value in use
Basic concept
Allocating shared assets
ACCOUNTING FOR Basics
IMPAIRMENT Allocation within a cash-
LOSS generating unit
SUBSEQUENT
REVIEW
DISCLOSURE
Basic provisions
Reversals ofimpairment
losses
For each class ofasset
Segment reporting
Material impairment losses
e Accountancy Tuition Centre (International Holdings) Ltd 2005 1601
1 INTRODUCTION
1.1 Objective of the standard
Prudence is a widely applied concept in the preparation of fmancial
statements. A specific application ofprudence is that assets should not be
carried in the balance sheet at a value, which is bigger than the cash flows
which they are expected to generate in the future.
Several standards (lAS 16, lAS 28 and lAS 31) include a requirement that
states that if the recoverable amount of an asset is less than its carrying value
("impairment"), then the carrying value should be written down immediately
to this recoverable amount.
lAS 36 prescribes detailed procedures to be followed in terms of identifying
impairments and accounting for them. It applies to all assets (including
subsidiaries, associates and joint ventures) except those covered by the
specific provisions of other statements, i.e:
o inventories (lAS 2);
o assets arising from construction contracts (lAS 11);
o deferred tax assets (lAS 12);
o financial assets that are included in the scope of lAS 39;
o assets arising from employee benefits (lAS 19);
o investment property that is measured at fair value (lAS 40);
o biological assets measured at fair value less estimated point-of-sale costs (lAS 41);
o non-current assets classified as held for sale (IFRS 5).
1.2 Definitions
An impairment loss - is the amount by which the carrying amount of an asset
exceeds its recoverable amount.
Recoverable amount - is the higher of an asset's fair value less costs to sell
and its value in use.
Fair value less costs to sell- is the amount obtainable from the sale of an
asset (in an arm's length transaction between knowledgeable, willing parties)
less costs of disposal.
Value in use - is the present value of the future cash flows expected to be
derived from an asset (or cash-generating unit).
A cash-generating unit - is the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from
other assets or groups of assets.
The concept ofa cash-generating unit is a solution to the problem of
measuring value in use and comparison with carrying value.
2 BASIC RULES
2.1 All assets
At each balance sheet date an entity should assess whether there is any
indication that an asset (or cash-generating unit) may be impaired. If any
such indication exists, the entity should estimate the recoverable amount of
the asset.
If no indications of a potential impairment loss are present there is no need to
make a formal estimate ofrecoverable amount, except for intangible assets
with indefinite useful lives.
Irrespective of whether there is any indication of impairment, the following
intangible assets must be test annually for impairment:
o those with an indefmite useful life;
o those not yet available for use;
o goodwill acquired in a business combination.
The impairment tests for these assets may be performed at any time during an
annual period, provided they are performed at the same time every year.
Note that all other assets (including intangibles that are amortised) are tested
at the end of a reporting period.
Where an intangible asset with an indefinite life forms part of a cash-
generating unit and cannot be separated, that cash-generating unit must be
tested for impairment at least annually, or whenever there is an indication that
the cash-generating unit may be impaired.
2.3 Indications of potential impairment loss
An entity should consider the following indications ofpotential impairment
loss - both external and internal- as a minimum.
2.3.1 External sources ofinformation
During the period, an asset's market value has declined significantly more
than would be expected as a result of the passage of time or normal use.
Illustration 1
Meade is an entity, which owns a subsidiary called Lee. Lee is a property development
company with extensive holdings in Malaysia. The Malaysian economy has moved
into a deep recession.
The recession is an indication that the carrying value of Lee in Meade's accounts might
be greater than the recoverable amount. Meade must make a formal estimate of the
recoverable amount of its investment in Lee.
Significant changes with an adverse effect on the entity have taken place
during the period, or will take place in the near future, in the technological,
market, economic or legal environment in which the entity operates.
Illustration 2
Buford is an entity involved in the manufacture of steel. It owns a steel production
facility constructed in 1998. The facility has ten blast furnaces each ofwhich is being
written off over 30 years from the date of construction.
Recent technological innovations have resulted in a new type of furnace coming onto
the market. This furnace offers efficiency improvements which the manufacturers
claim will reduce the unit cost of a tonne of steel by 15-20%. The company that
supplied the furnaces for Buford has recently introduced a series of price cutting
measures to try to preserve its own market share.
The market for the grade of steel that Buford produces is very price sensitive and price
is often used as a basis of competition in this market. A major competitor has
announced that it is constructing a new plant that will utilise the new technology.
The existence of the new technology and the announcement by the competitor are
indications that Buford's blast furnaces might be impaired. Buford should make a
formal estimate of the recoverable amount of its blast furnaces (or possibly the
production plant as a whole if it is deemed to be a cash-generating unit - see later).
Market interest rates or other market rates of return on investments have
increased during the period, and those increases are likely to affect the
discount rate used in calculating an asset's value in use and decrease the
asset's recoverable amount materially.
Illustration 3
Gibbon is an entity which owns a 60% holding in Pickett, an unquoted entity. Both
entities operate in a country with a stable economy. The government ofthe country
has recently announced an increase in interest rates.
The increase in interest rates will cause a fall in value of equity holdings (all other
things being equal). This is due to the fact that risk free investments offer a higher
return making them relatively more attractive. The market value of equity will adjust
downwards to improve the return available on this sort of investment.
The increase in interest rates is an indication that Gibbon's holding in Pickett might be
impaired. Gibbon should make a formal estimate of the recoverable amount of its
interest in Pickett.
The carrying amount of the net assets of the reporting entity is more than its
market capitalisation.
Illustration 4
Sickles is a quoted entity. The carrying value of its net assets is $100m. The market
capitalisation of the entity has recently fallen to $80m.
The value of the entity as compared to the carrying value of its net assets indicates that
its assets might be impaired. Sickles should make a formal estimate ofthe recoverable
amount of its assets.
2.3.2 Internal sources ofinformation
Evidence is available of obsolescence or physical damage.
Illustration 5
Custer is an entity which manufactures machinery. It makes use of a large number of
specialised machine tools. It capitalises the machine tools as a non-current asset and
starts to depreciate the tools when they are brought into use.
A review of the non-current asset register in respect of machine tools has revealed that
approximately 40% of the value held relates to machine tools purchased more than two
years ago and not yet brought into use.
The age of the machine tools and the fact that they have not yet been brought into use
is an indication that the asset may be impaired. Custer should make a formal estimate
of the recoverable amount of its machine tools.
Significant adverse changes have taken place during the period, or are
expected to take place in the near future, in the extent to which, or manner in
which, an asset is used or is expected to be used.
Illustration 6
Hood is a small airline. It owns a Dash 8 aircraft which it purchased to service a
contract for passenger flights to a small island. The rest of its business is long-haul
freight shipping.
It has been informed that its licence to operate the passenger service will not be
renewed after the end ofthis current contract which finishes in 6 months time. It is
proposing to use the aircraft in a new business venture offering pleasure flights.
The change in the use of the asset that is expected to take place in the near future is an
indication that the aircraft may be impaired. Hood should make a formal estimate of
the recoverable amount of its Dash 8 aircraft.
Evidence is available from internal reporting that indicates that the economic
performance of an asset is, or will be, worse than expected Such evidence
that indicates that an asset may be impaired includes the existence of:
o cash flows for acquiring the asset, or subsequent cash needs for
operating or maintaining it, that are significantly higher than those
originally budgeted;
o actual net cash flows or operating profit or loss flowing from the
asset that are significantly worse than those budgeted;
o a significant decline in budgeted net cash flows or operating profit,
or a significant increase in budgeted loss, flowing from the asset; or
o operating losses or net cash outflows for the asset, when current
period figures are aggregated with budgeted figures for the future.
Illustration 7
Armistead is an entity in the professional training sector. It has produced a series of
CD ROM based training products which have been on sale for 8 months. The entity
has capitalised certain development costs associated with this product in accordance
with the rules in lAS 38 Intangible Assets. Early sales have been significantly below
forecast.
The failure of the entity to meet sales targets is an indication that the development asset
may be impaired. Armistead should make a formal estimate of the recoverable amount
of the capitalised development cost.
The above lists are not exhaustive.
Where there is an indication that an asset may be impaired, this may indicate
that the remaining useful life, the depreciation (amortisation) method or the
residual value for the asset needs to be reviewed and adjusted, even if no
impairment loss is recognised for the asset.
3 MEASUREMENT OF RECOVERABLE AMOUNT
3.1 General principles
The recoverable amount is the higher of the asset's fair value less costs to sell and
value in use.
RECOVERABLE
AMOUNT
I
I
Higher of
I
VALUE IN
and
FAIR VALUE
USE LESS COSTS
TO SELL
Recoverable amount is determined for an individual asset, unless the asset
does not generate cash inflows from continuing use that are largely
independent of those from other assets or groups of assets. If this is the case,
recoverable amount is determined for the cash-generating unit to which the
asset belongs (see later).
Illustration 8
Recoverable amount
is the greater of:
Value in Fair
use value less
costs to
sell
Therefore
recoverable
amount is:
Carrying Commentary
amount
900
900
960
1,050
980
925
1,050
980
960
1,000
1,000
1,000
No impairment
An impairment loss of $20 must
be recognised. The carrying
value of the asset is written
down to 980.
An impairment loss of $40 must
be recognised. The carrying
value of the asset is written
down to $960.
It is not always necessary to determine both an asset's fair value less costs to
sell and its value in use to determine the asset's recoverable amount if:
o either of these amounts exceed the asset's carrying amount, the asset is
not impaired, and it is not necessary to estimate the other amount; or
o there is no reason to believe that the asset's value in use materially
exceeds its fair value less selling costs, the asset's recoverable
amount is its fair value less selling costs.
For example when an asset is heldfor imminent disposal the value in use will consist
mainly ofthe net amount to be receivedfor the disposal ofthe asset. Future cash
flows from continuing use ofthe asset until disposal are likely to be negligible.
Where the asset is an intangible asset with an indefinite useful life, the most
recent detailed calculation of the recoverable amount made in a preceding
period may be used in the impairment test in the current period.
3.2 Fair value less costs to sell
Fair value less costs to sell- the amount obtainable from the sale of an asset in an
arm's length transaction between knowledgeable, willing parties, less the costs of
disposal.
o The best evidence of an asset's fair value less costs to sell is a price
in a binding sale agreement in an arm's length transaction, adjusted
for incremental costs that would be directly attributable to the
disposal of the asset.
o Ifthere is no binding sale agreement but the asset is traded in an
active market, the asset's market price (adjusted for costs of
disposal) is the basis for calculating the fair value of the asset less
costs to sell.
The appropriate market price will usually be the current bidprice. Ifcurrent
bidprices are not obtainable, the price ofthe most recent transaction can
provide a basis for the estimation ofthe fair value.
o Ifno binding sale agreement or active market exists for the asset,
fair value less costs to sell is determined based on the best
information available in the circumstances.
An entity should consider the results ofrecent transactions in the same industry.
An active market - is a market in which all the following conditions exist:
o the items traded within the market are homogeneous;
o willing buyers and sellers can normally be found at any time; and
o prices are available to the public.
Costs ofdisposal - are incremental costs directly attributable to the disposal
of an asset, excluding finance costs, income tax expense and any cost which
has already been included as a liability. Examples include:
o Legal costs
o Stamp duty
o Costs of removing the asset
o Other direct incremental costs to bring an asset into condition for its sale.
Examples ofcosts that are not costs ofdisposal include termination benefits
and costs associated with reducing or re-organising a businessfollowing the
disposal ofan asset.
Illustration 9
X operates in leased premises. It owns a bottling plant which is situated in a single
factory unit. Bottling plants are sold periodically as complete assets.
Professional valuers have estimated that the plant might be sold for $100,000. They
have charged a fee of $1,000 for providing this valuation.
X would need to dismantle the asset and ship it to any buyer. Dismantling and
shipping would cost $5,000. Specialist packaging would cost a further $4,000 and
legal fees $1,500.
Fair value less costs to sell:
Sales price
Dismantling and shipping
Packaging
Legal fees
Fair value less costs to sell
$
100,000
(5,000)
(4,000)
(1,500)
89,500
The professional valuers fee of$1,000 would not be included in thefair value
less costs to sell as this is not a directly attributable cost ofselling the asset.
3.3 Value in use
Value in use - is the present value of the future cash flows expected to be
derived from an asset. Estimating it involves:
o estimating the future cash inflows and outflows to be derived from
continuing use of the asset and from its ultimate disposal; and
o applying the appropriate discount rate.
Worked example 1
X holds a patent on a drug. The patent expires in 5 years. During this period the
demand for the drug is forecast to grow at 5% per annum.
Experience shows that competitors flood the market with generic versions of a
profitable drug as soon as it is no longer protected by a patent. As a result X does not
expect the patent to generate significant cash flows after 5 years.
Net revenues from the sale of the drug were $100m last year.
The entity has decided that 15.5% is an appropriate discount rate for the appraisals of
the cash flows associated with this product.
Time Cashflow
$m
1 100 x 1.05 = 105
2 100 x 1.05
2
= 110.3
3 100 x 1.05
3
= 115.8
4 100 x 1.05
4
= 121.6
5 100 x 1.05
5
= 127.6
Value in use
3.3.1 Cashflow projections
Discountfactor
@15.5%
0.86580
0.74961
0.64901
0.56192
0.48651
Present
value ($m)
91
83
75
68
62
379
Projections should be based on reasonable and supportable assumptions that
represent management's best estimate of the set of economic conditions that
will exist over the remaining useful life of the asset.
Greater weight should be given to external evidence.
They should be based on the most recent financial budgets/forecasts that have
been approved by management.
Projections based on these budgets/forecasts should cover a maximum
period of five years, unless a longer period can be justified.
Beyond the period covered by the most recent budgets/forecasts, the cash
flows should be estimated by extrapolating the projections based on the
budgets/forecasts using a steady or declining growth rate for subsequent
years, unless an increasing rate can be justified.
The growth rate should not exceed the long-term average growth rate for the
products, industries, or country or countries in which the entity operates, or
for the market, in which the asset is used, unless a higher rate can be justified.
Estimates of future cash flows should include:
o projected cash inflows including disposal proceeds;
o projected cash outflows that are necessarily incurred to generate the
cash inflows from continuing use of the asset.
Estimates of future cash flows should exclude:
o cash flows relating to the improvement or enhancement of the
asset's performance;
o cash flows that are expected to arise from a future restructuring that
is not yet committed;
Future cash flows are estimated based on the asset in its current condition or
in maintaining its current condition (e.g. maintenance, or the replacement of
components ofan asset, to enable the asset as a whole to achieve its
estimated current economic benefit).
o cash outflows that will be required to settle obligations that have
already been recognised as liabilities;
o cash inflows or outflows from fmancing activities; and
Already taken account ofin discounting.
o income tax receipts or payments.
The discount rate should be a pre-tax market rate (or rates) that reflects current
market assessments of the time value ofmoney and the risks specific to the asset.
When an asset-specific rate is not available from the market, an entity uses
surrogates to estimate the discount rate. As a starting point, the entity may
take into account the following rates:
o the entity's weighted average cost of capital determined using
techniques such as the Capital Asset Pricing Model;
o the entity's incremental borrowing rate; and
o other market borrowing rates.
These rates are adjusted:
o to reflect the way that the market would assess the specific risks
associated with the projected cash flows; and
o to exclude risks that are not relevant to the projected cash flows.
They do not include adjustments for risks that the estimated cash flows have
already taken into account (e.g. bad debts).
Consideration is given to risks such as country risk, currency risk, price risk
and cash flow risk.
Where value-in-use is sensitive to a difference in risks for different future
periods or to the term structure of interest rates, separate discount rates for
each period should be used.
Example 1
Sumter is testing a machine, which makes a product called a union, for impairment It
has compiled the following information in respect of the machine.
Selling price of a union
Variable cost ofproduction
Fixed overhead allocation per unit
Packing cost per unit
All costs and revenues are expected to inflate at 3% per annum.
$
100
70
10
1
Volume growth is expected to be 4% per annum. 1,000 units were sold last year. This
is in excess ofthe long term rate of growth in the industry. The management of Sumter
have valid reasons for projecting this level of growth.
The machine originally cost $400,000 and was supplied on credit terms from a fellow
group entity. Sumter is charged $15,000 per annum for this loan.
Future expenditure:
In 2 years time the machine will be subject to major servicing to maintain its
operating capacity. This will cost $10,000.
In 3 years time the machine will be modified to improve its efficiency. This
improvement will cost $20,000 and will reduce unit variable cost by 15%.
The asset will be sold in 8 years time. Currently the scrap value of machines
of a similar type is $10,000.
All values are given in real terms (to exclude inflation).
Required:
Identify the cash flows that should be included in Sumter's estimate of the value in use
of the machine. Explain the rationale of the inclusion or exclusion of each amount.
Solution
Time Narrative
Net revenue
Per unit Volume
1
2
3
4
5
6
7
8
Other flows
2
8
4 CASH-GENERATING UNITS
Cash flow Comment
A cash-generating unit - is the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from
other assets or groups of assets.
4.1 Basic concept
If there is any indication that an asset may be impaired, the recoverable
amount (the higher of the fair value less costs to sell and value in use of the
asset) must be estimated for the individual asset.
However, it may not be possible to estimate the recoverable amount of an
individual asset because:
o its value in use cannot be estimated to be close to its fair value less
costs to sell (e.g. when the future cash flows from continuing use of
the asset cannot be estimated to be negligible); and
o it does not generate cash inflows that are largely independent of
those from other assets
In this case the recoverable amount ofthe cash-generating unit to which the
asset belongs (the asset's cash-generating unit) must be determined.
Identifying the lowest aggregation of assets that generate largely independent
cash inflows may be a matter of considerable judgement.
Management should considers various factors including how they monitor the
entity's operations (e.g. by product lines, individual locations, regional areas,
etc) or how they make decisions about continuing or disposing ofthe entity's
assets and operations.
Illustration 10
An entity owns a dry dock with a large crane to support its activities. The crane could
only be sold for scrap value and cash inflows from its use cannot be identified
separately from all ofthe operations directly connected with the dry dock.
It is not possible to estimate the recoverable amount of the crane because its value in
use cannot be determined. Therefore, the entity estimates the recoverable amount of
the cash-generating unit to which the crane belongs, i.e., the dry dock as a whole.
Sometimes it is possible to identify cash flows that stem from a specific asset
but these cannot be earned independently from other assets. In such cases the
asset cannot be reviewed independently and must be reviewed as part of the
cash-generating unit.
Illustration 11
An entity operates an airport that provides services under contract with a government
that requires a minimum level of service on domestic routes in return for licence to
operate the international routes. Assets devoted to each route and the cash flows from
each route can be identified separately. The domestic service operates at a significant
loss.
Because the entity does not have the option to curtail the domestic service, the lowest
level of identifiable cash inflows that are largely independent of the cash inflows from
other assets or groups of assets are cash inflows generated by the airport as a whole.
This is therefore the cash-generating unit.
If an active market exists for the output produced by an asset or a group of
assets, this asset or group of assets should be identified as a cash-generating
unit, even if some or all of the output is used internally.
Where the cash flows are affected by internal transfer pricing, management's
best estimate of future market (ie in an arm's length transaction) prices
should be used to estimate cash flows for value in use calculations.
Cash-generating units should be identified consistently from period to period
for the same asset or types of assets, unless a change is justified.
4.2 Allocating shared assets
The carrying amount of a cash-generating unit should include the carrying
amount of only those assets that can be directly attributed, or allocated on a
reasonable and consistent basis, to it.
Goodwill acquired in a business combination and corporate (head office)
assets are examples ofshared assets that will need to be allocated.
4.2.1 Goodwill acquired in a business combination
Goodwill acquired in a business combination must be allocated to each ofthe
acquirer's cash-generating units that are expected to benefit from the
synergies of the combination, irrespective of whether other assets or
liabilities of the acquiree are assigned to those units.
If the initial allocation of goodwill cannot be completed before the end of the
financial year in which the business combination is effected, the allocation
must be completed by the end of the following financial year.
Where an acquirer needs to account for a business combination using
provisional values, adjustments can be made to such values within 12
months of the date of acquisition (IFRS 3). Until such provisional values
have been finalised, it may not be possible to complete the initial allocation
of goodwilL
IFRS 3 allows 12 months from the date of acquisition to finalise goodwill;
lAS 36 allows up to the end of the following financial period (i.e. in most
cases additional time) to allocate goodwill.
Each unit (or group ofunits) to which the goodwill is so allocated must:
o represent the lowest level within the entity at which the goodwill is
monitored for internal management purposes; and
o not be larger than a segment (based on either the entity's primary or
secondary reporting format determined in accordance with lAS 14
"Segment Reporting".
This aims to match the testing ofimpairment ofgoodwill with the monitoring
level ofgoodwill within the entity. As a minimum, this is considered to be
based on segmental reporting requirements such that listed companies will
not be able to "net-off' and shieldgoodwill impairment at the entity level.
Once goodwill has been allocated to a cash-generating unit, that unit must be
tested for impairment:
o at least annually; or
o as soon as there is an indication of impairment of:
goodwill; or
the cash-generating unit.
Worked example 2
Entity Q is a wholly owned subsidiary ofM and has 3 divisions, X, Y and Z.
There are indications that Y is impaired and Q has estimated its recoverable amount to
be $230m. There are no indications that X and Z are impaired.
The value ofQ has been estimated, by M, to be $1,380m.
The management ofM have allocated $450m of the goodwill held in the group
accounts to Q. As X, Y and Z are separately reported to M, they are considered to be
the lowest level within the entity that goodwill is monitored.
Cash-generating unit X Y Z Total
$m $m $m $m
Net assets directly
involved in the
activities of the unit 350 150 250 750
Goodwill 210 90 150 450
Total 560 240 400 1,200
The goodwill has been apportioned in the ratio that the directly attributed assets bear to
each other.
The carrying value that would be compared to the recoverable amount is $240m.
Carrying amount
Recoverable amount
Impairment loss
y
$m
240
(230)
10
Thus an impairment loss of $1Omshould be recognised even though the fair value of Q
as a whole is greater than its carrying value.
Different cash-generating units may be tested for impairment at different
times. However, if some or all ofthe goodwill allocated to a cash-generating
unit was acquired in a business combination during the current annual period,
that unit is tested for impairment before the end ofthe current annual period.
Worked example 3
Facts as above except that Qis reported as a segment and is the level at which
goodwill is monitored by the group, regardless ofthe fact that X, Y and Z are separate
cash-generating units.
Cash-generating unit
Net assets directly
involved in the
activities of the unit
Goodwill
Total
x
$m
350
y
$m
150
z
$m
250
Total
$m
750
450
1,200
Step 1 Test the division (as a separate cash-generating unit)
Carrying amount
Recoverable amount
Impairment loss
Step 2 Test the goodwill (at the reporting level)
Carrying amount
Recoverable amount
Impairment loss
Thus there is no recognised goodwill impairment.
4.2.2 Corporate assets
y
$m
150
(230)
Q
$m
1,200
(1,380)
Corporate assets - are assets, other than goodwill, that contribute to the
future cash flows of both the cash-generating unit under review and other
cash-generating units.
The distinctive characteristics of corporate assets are that they do not
generate cash inflows independently of other assets or groups of assets and
their carrying amount cannot be fully attributed to the cash-generating unit
under review.
Examples could include head office or divisional buildings, central
information system or a research centre.
Because corporate assets do not generate separate cash inflows, the
recoverable amount of an individual corporate asset cannot be determined
unless management has decided to dispose ofthe asset.
If there is an indication that a cash-generating unit may be impaired, then the
appropriate portion of corporate assets must be included within the carrying
amount ofthat unit or group ofunits.
Corporate assets are allocated on a reasonable and consistent basis to each
cash-generating unit.
If a corporate asset cannot be allocated to a specific cash-generating unit, the
smallest group of cash-generating units that includes the unit under review
must be identified.
The carrying amount of the unit or group ofunits (including the portion of
corporate assets) is then compared to its recoverable amount. Any
impairment loss is dealt with in the same way as dealing with an impairment
loss for goodwill.
5 ACCOUNTING FOR IMPAIRMENT LOSS
5.1 Basics
If, and only if, the recoverable amount of an asset is less than its carrying
amount, the carrying amount ofthe asset should be reduced to its recoverable
amount. That reduction is an impairment loss.
An impairment loss should be recognised as an expense in the income
statement immediately, unless the asset is carried at revalued amount under
another lAS.
Any impairment loss of a revalued asset should be treated as a revaluation
decrease under that other lAS.
This will usually mean that the fall in value must be charged to the
revaluation reserve to the extent that the loss is covered by the reserve. Any
amount not so covered is then charged to the income statement.
Illustration 12
Carrying Recoverable Income Directly to
value (1) amount statement equity
Situation 1
Asset carried at historic cost 100 80 20 Dr
Situation 2
Historic cost of asset = 100
but revalued to 150 150 125 25 Dr
Situation 3
Historic cost of asset = 100
but revalued to 150 150 95 5Dr 50Dr
(l) Before recognition of impairment loss.
After impairment the carrying value of the asset less any residual value is
depreciated (amortised) over its remaining expected useful life.
5.2 Allocation within a cash-generating unit
If an impairment loss is recognised for a cash-generating unit, the problem
arises as to where to set the credit entry in the balance sheet.
The impairment loss should be allocated between all assets of the cash-
generating unit in the following order:
o goodwill allocated to the cash-generating unit (if any);
o then, to the other assets of the unit on a pro-rata basis based on the
carrying amount of each asset in the unit.
In allocating an impairment loss the carrying amount of an asset should not
be reduced below the highest of:
o its fair value less costs to sell (if determinable);
o its value in use (if determinable); and
o zero.
The amount of the impairment loss that would otherwise have been allocated
to the asset should be allocated to the other assets of the unit on a pro-rata
Example 2
At 1 January, an entity paid $2,800 for a company whose main activity consists of
refuse collection. The acquired company owns four refuse collection vehicles and a
local government licence without which it could not operate.
At 1 January, the fair value less costs to sell of each lorry and of the licence are $500.
The company has no insurance cover.
At 1 February, one lorry crashed. Because of its reduced capacity, the entity estimates
the value in use of the business at $2,220.
Required:
Show how the impairment loss would be allocated to the assets of the business.
Solution
1
January
Goodwill
Intangible asset
Lorries
Example 3
Following on from Example 2.
Impairment
loss
1
February
At 22 May, the government increased the interest rates. The entity re-determined the
value in use of the business as $1,860. The fair value less costs to sell of the licence
had decreased to $480 (as a result of a market reaction to the increased interest rates).
The demand for lorries was hit hard by the increase in rates and the selling prices were
adversely affected.
Required:
Show how the above information would be reflected in the asset values of the business.
Solution
Goodwill
Intangible asset
Lorries
1 February Impairment
loss
22
May
If an individual asset within the cash-generating unit is impaired, but the
cash-generating unit as a whole is not, no impairment loss is recognised even
if the asset's fair value less costs to sell is less than its carrying amount.
Illustration 13
Two machines within a production line (the cash-generating unit) have suffered
physical damage, but are still able to work albeit at reduced capacities. The fair value
less costs to sell ofboth machines are below their carrying amount. As the machines
do not generate independent cash flows and management intend to keep the machines
in operation, their value in use cannot be estimated. They are considered to be part of
the cash-generating unit, the production line.
Analysis
Assessment ofthe recoverable amount ofthe production line as a whole
shows that there has been no impairment ofthe cash-generating unit.
Therefore no impairment losses are recognised for the machines.
However, because of the damage to the machines, the estimated usefu11ife
and residual values of the machines may need to be reassessed.
If, because of the damage, management decides to replace the machines and
sell them in the near future, their value in use can be estimated as the
expected sale proceeds less costs to sell. Where this is less than their
carrying value, an impairment loss should be recognised for the individual
machines.
No impairment will be recognised for the production line as the machines
have been replaced.
6 SUBSEQUENT REVIEW
6.1 Basic provisions
Once an entity has recognised an impairment loss for an asset other than
goodwill, it should carry out a further review in later years if there is an
indication:
o that the asset may be further impaired;
o that the impairment loss recognised in prior years may have decreased.
An entity should consider, as a minimum, the following indications of both
external and internal sources of information.
6.1.1 External sources ofinformation
o Significant increase in the asset's market value during the period.
o Significant favourable changes during the period, or taking place in the
near future, in the technological, market, economic or legal environment in
which the entity operates or in the market to which the asset is dedicated.
o Decrease in market interest rates or other market rates of return
likely to affect the discount rate used in calculating the asset's value
in use and materially increase the asset's recoverable amount.
6.1.2 Internal sources ofinformation
o Significant favourable changes in the actual or expected extent or
manner ofuse ofthe asset.
For example, ifcapital expenditure incurred enhances the asset.
o Evidence available from internal reporting indicates that the economic
performance of the asset is, or will be, better than expected.
6.2 Reversals of impairment losses
6.2.1 On individual assets, other than goodwill
The carrying amount of an asset, other than goodwill, for which an
impairment loss has been recognised in prior years should be increased to its
recoverable amount only if there has been a change in the estimates used to
determine the asset's recoverable amount since the last impairment loss was
recognised.
The increased carrying amount of the asset should not exceed the carrying
amount that would have been determined (net of amortisation or depreciation)
had no impairment loss been recognised for the asset in prior years.
Any increase in the carrying amount of an asset above the carrying amount
that would have been determined (net of amortisation or depreciation) had no
impairment loss been recognised for the asset in prior years is a revaluation
and should be treated accordingly.
A reversal of an impairment loss for an asset should be recognised as income
immediately in the income statement, unless the asset is carried at revalued
amount under another lAS.
Any reversal of an impairment loss on a revalued asset should be treated as a
revaluation increase under the relevant lAS.
This will usually mean that the increase in value will be credited to the
revaluation reserve unless it reverses an impairment that has been previously
recognised as an expense in income. In this case it is recognised as income in the
income statement to the extent that it was previously recognised as an expense.
6.2.2 Reversal ofan impairment lossfor a cash-generating unit
A reversal of an impairment loss for a cash-generating unit should be
allocated to increase the carrying amount of the assets (but never to
goodwill) pro-rata with the carrying amount of those assets.
Increases in carrying amounts should be treated as reversals of impairment
losses for individual assets.
In allocating a reversal of an impairment loss for a cash-generating unit, the
carrying amount of an asset should not be increased above the lower of:
o its recoverable amount (if determinable); and
o the carrying amount that would have been determined (net of
amortisation or depreciation) had no impairment loss been
recognised for the asset in prior years.
Equivalent to the "ceiling"for the reversal ofan impairment lossfor an individual asset.
6.2.3 Reversal ofan impairment loss on goodwill
An impairment loss recognised for goodwill cannot be reversed in a
subsequent period.
lAS 38 prohibits the recognition of internally-generated goodwill. Any
increase in the recoverable amount of goodwill in the periods following the
recognition of an impairment loss is likely to be an increase in internally
generated goodwill, rather than a reversal of the impairment loss recognised
for the acquired goodwill.
7 DISCLOSURE
Extensive disclosure is required by lAS 36 especially for the key assumptions
and estimates used to measure the recoverable amount of cash-generating
units containing goodwill or intangible assets with indefmite useful lives.
7.1 For each class of assets
Impairment losses recognised during the period and the line item(s) of the
income statement in which those impairment losses are included.
Reversals of impairment losses recognised during the period and the line
item(s) of the income statement in which those impairment losses are
reversed.
The amount of impairment losses recognised directly in equity during the
period.
The amount of reversals of impairment losses recognised directly in equity
during the period.
7.2 Segment reporting
An entity that applies lAS 14 Segment Reporting, should disclose the
following for each reportable segment based on an entity's primary format:
o the amount of impairment losses recognised in the income
statement and directly in equity during the period; and
o the amount of reversals of impairment losses recognised in the
income statement and directly in equity during the period.
7.3 Material impairment losses recognised or reversed
7.3.1 Individual asset or cash-generating unit
The events and circumstances that led to the recognition or reversal of the
impairment loss.
The amount of the impairment loss recognised or reversed.
Whether the recoverable amount of the asset (cash-generating unit) is its fair
value less costs to sell or its value in use:
o if fair value less costs to sell, the basis used (e.g. by reference to an
active market); and
o if value in use, the discount rate(s) used in the current estimate and
previous estimate (if any) ofvalue in use.
7.3.2 Individual asset
The nature ofthe asset.
The reportable segment to which the asset belongs, based on the entity's
primary format (if applicable).
7.3.3 Individual cash-generating unit
A description of the cash-generating unit (e.g. product line, plant, business
operation, geographical area, reportable segment as defined in lAS 14, etc).
The amount of the impairment loss recognised or reversed by class of assets and
by reportable segment based on the entity's primary format (if applicable).
If the aggregation of assets for identifying the cash-generating unit has
changed since the previous estimate ofthe cash-generating unit's recoverable
amount (if any), a description of the current and former way of aggregating
assets and the reasons for change.
7.3.4 Material aggregate
If impairment losses recognised (reversed) during the period are material in
aggregate an entity should disclose a brief description of:
o the main classes of assets affected by impairment losses (reversals
of impairment losses); and
o the main events and circumstances that led to the recognition
(reversal) of these impairment losses.
This is only required to be disclosed ifno information is otherwise disclosed
(i.e. under the provisions for individual assets and CGUs as individually not
material).
Illustration 14
[5] Other operating expenses (extract)
In the previous year, impairment write-downs of intangible assets, property,
plant and equipment of the polyols and fibers operations in the Polymers subgroup
together accounted for expenses of 289 million.
7.3.5 Non-allocation ofgoodwill
If any portion of the goodwill acquired in a business combination during the
period has not been allocated to a cash-generating unit at the reporting date,
the amount of the unallocated goodwill disclosed and the reasons why that
amount remains unallocated.
7.3.6 Cash-generating units containing assets with indefinite lives
If significant disclose:
o the carrying amount of goodwill allocated to the unit;
o the carrying amount of intangible assets with indefinite useful lives
allocated to the unit;
o the basis on which the unit's recoverable amount has been
determined (i.e. value in use or fair value less costs to sell).
If the unit's recoverable amount is based on value in use disclose:
o a description of each key assumption on which management has
based its cash flow projections;
Key assumptions are those to which the unit's recoverable amount is most
sensitive.
o a description ofmanagement's approach to determining the value(s)
assigned to each key assumption;
o the period over which management has projected cash flows based
on fmancial budgets/forecasts approved by management and the
justification for a period longer than five years (if applicable);
o the growth rate used to extrapolate cash flow projections beyond
the period covered by the most recent budgets/forecasts;
o the discount rate(s) applied to the cash flow projections.
If the unit's recoverable amount is based on fair value less costs to sell,
disclose the methodology used to determine fair value less costs to sell.
If fair value less costs to sell is not determined using an observable market
price for the unit, disclose:
o a description of each key assumption on which management has
based its determination; and
o a description ofmanagement's approach to determining the value(s)
assigned to each key assumption.
If a reasonably possible change in a key assumption on which management
has based its determination ofthe unit's recoverable amount would cause the
unit's carrying amount to exceed its recoverable amount, disclose:
o the amount by which the unit's recoverable amount exceeds its
carrying amount; and
o the value assigned to the key assumption; and
o the amount by which the value assigned to the key assumption must
change in order for the unit's recoverable amount to be equal to its
carrying amount.
This means presenting a sensitivity analysis on key assumptions.
For cash-generating units containing assets with indefinite lives which are not
significant the above disclosures are made in aggregate.
FOCUS
define the recoverable amount of an asset;
define impairment losses;
give examples of, and be able to identify, circumstances that may indicate
that an impairment of an asset has occurred;
describe what is meant by a cash-generating unit;
state the basis in lAS 36 on which impairment losses should be allocated, and
allocate a given impairment loss to the assets of a cash-generating unit;
explain the principle of impairment tests in relation to purchased goodwilL
EXAMPLE SOLUTIONS
Solution 1 - Cash flows
Time Narrative
Net revenue
Per unit Volume
Cash flow
Commentary
1 29.87 (WI) 1,040 (WI) 31,065 Net revenue per unit inflates at 3%per
2 30.77 1,082 33,293
annumfor 8 years.
3 31.69 1,125 35,651
Volume inflates at 4%per annumfor 5
years. After this lAS 36prohibits the
4 32.64 1,170 38,189 use ofa growth rate which exceeds the
5 33.62 1,217 40,916
industry average. In the absence of
further information zero growth has
6 34.63 1,217 42,145
been assumed.
7 35.67 1,217 43,410
Efficiency improvements from the future
8 36.74 1,217 44,713
capital improvement are not included.
2 Service (10,000 x 1.03
2
) 10,609 The capital improvement is not included
in the estimate of'future cash flows.
8 Disposal (10,000 x 1.03
8
) 12,668
WORKING
(1) In the first year
Net revenue per unit = (100- (70+1 x (1.03) = 29.87
Volume = 1,000 x 1.04 = 1,040
Commentary
The finance cost of$15,000 is ignored. All cash flows have been inflated to
money terms.
Solution 2 - Impairment loss
1 Impairment 1 February
January loss
Goodwill 300 (80) 220
Intangible asset 500 500
Lorries 2,000 (500) 1,500
2,800 (580) 2,220
An impairment loss of 500 is recognised first for the lorry that crashed because its
recoverable amount can be assessed individually. (It no longer forms part of the cash-
generating unit that was formed by the four lorries and the licence.)
The remaining impairment loss (80) is attributed to goodwill.
Solution 3 - Impairment loss
1 Impairment 22
February loss May
Goodwill 220 (220)
Intangible asset 500 (20) 480 Notel
Lorries 1,500 (120) 1,380 Note 2
2,220 (360) 1,860
Note 1
220 is charged to the goodwill to reduce it to zero. The balance of 140 must be pro
rated between the remaining assets in proportion to their carrying value.
The ratio that the remaining assets bear to each other is 500:1,500. This implies that
25% x 140 = 35 should be allocated to the intangible asset. However this would
reduce its carrying value to below its fair value less costs to sell and this is not allowed.
The maximum that may be allocated is 20 and the remaining 15 must be allocated to
the lorries.
Note 2
The amount that is allocated to the lorries is 75% x 140 = 105 + 15 =120.
IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
OVERVIEW
Objective
To define provisions, contingent liabilities and contingent assets.
To explain the recognition and measurement ofprovisions, contingent liabilities and
contingent assets.
Scope
Issue
Consensus
Transition
s
liabilities
en provisions and
es
ment
nt
ons
Restructuring
Objective
INTRODUCTION
Scope
Definitions
The relationship betwe

contingent liabiliti
Recognition ofprovisi
RECOGNITION
Recognition issues
Contingent assets and
General rules
MEASURMENT
Specific points
I I
CHANGES IN
IFRC 1
PROVISIONS
I I
APPLICATION OF THE

Future operating losse
RULES TO SPECIFIC

Onerous contracts
CIRCUMSTANCES

Specific application -
REPAIRS AND

No Legislative Require
MAINTENANCE

Legislative Requireme
DISCLOSURES
1 INTRODUCTION
1.1 Objective
To ensure that appropriate recognition criteria and measurement bases are applied to
o provisions
o contingent liabilities and
o contingent assets.
To ensure that sufficient information is disclosed in the notes to the financial statements in
respect of each of these items.
1.2 Scope
The rules will apply to all provisions and contingencies except for those covered by more
specific requirements in other IASs. eg those found in
o IAS 11, Construction contracts
o IAS 19, Retirement benefit costs
o IAS 12, Income taxes, and
o IAS 17, Accountingfor leases.
o IFRS 3 Business Combinations
lAS 37 addresses only provisions that are liabilities, ie not provisions for depreciation,
doubtful debts etc.
lAS 37 applies to provisions for restructuring (including discontinuing operations).
1.3 Definitions
Provisions are liabilities of uncertain timing or amount.
A liability is a present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.
An obligating event is an event that creates a legal or constructive obligation that results in an
entity having no realistic alternative to settling that obligation.
This is a key concept in the lAS 37 approach to the recognition ofprovisions.
A legal obligation is an obligation that derives from
o a contract,
o legislation, or
o other operation oflaw.
A constructive obligation is an obligation that derives from an entity's actions where
o by an established pattern ofpast practice, published policies or a sufficiently
specific current statement, the entity has indicated to other parties that it will accept
certain responsibilities, and
o as a result the entity has created a valid expectation on the part of those other parties
that it will discharge those responsibilities.
A contingent liability is
o a possible obligation that arises from past events and whose existence will be
confirmed only on the occurrence or non-occurrence of one or more uncertain future
events that are not wholly within the control of the entity, or
o a present obligation that arises from past events but is not recognised because
it is not probable that an outflow ofbenefits embodying economic
benefits will be required to settle the obligation, or
the amount of the obligation cannot be measured with sufficient
reliability.
JAS 37 stresses that an entity will be unable to measure an obligation with sufficient reliability
only on very rare occasions.
A contingent asset is a possible asset that arises from past events and whose existence will be
confirmed only on the occurrence or non-occurrence of one or more uncertain future events
not wholly within the control of the entity.
An onerous contract is one in which the unavoidable costs of meeting the obligations under
the contract exceed the economic benefits expected to be received from it.
A restructuring is a programme that is planned and controlled by management, and materially
changes either:
o the scope ofa business undertaken by an entity, or
o the manner in which that business is conducted.
1.4 The relationship between provisions and contingent liabilities
In a general sense all provisions are contingent because they are uncertain in timing or
amount.
lAS 37 distinguishes between the two by using the term "contingent" for assets and liabilities
that are not recognised because their existence will be confirmed only on the occurrence or
non-occurrence of one or more uncertain future events not wholly within the control ofthe
entity.
The standard distinguishes between
o provisions - because they are present obligations, and
o contingent liabilities - which are not recognised because they are either
possible obligations, or
present obligations, which cannot be measured with sufficient reliability.
2 RECOGNITION
2.1 Recognition of provisions
A provision should be recognised when:
o an entity has a present legal or constructive obligation to transfer economic benefits
as a result ofpast events, and
o it is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, and
o a reliable estimate of the obligation can be made.
If these conditions are not met a provision should not be recognised.
2.2 Recognition issues
2.2.1 Present obligation
A present obligation exists when the entity has no realistic alternative but to make the transfer
of economic benefits because of a past event, (the "obligating event").
Illustration 1
Scenario
A manufacturer gives warranties at the time of sale to purchasers of its product. Under
the terms of the contract for sale the manufacturer undertakes to make good, by repair
or replacement, manufacturing defects that become apparent within three years from
the date of sale. On past experience, it is probable (i.e, more likely than not) that there
will be some claims under the warranties.
Present obligation as a result of a
past obligating event?
An outflow of resources?
Conclusion
Sale of the product with a warranty gives rise
to a legal obligation
Probable
Provide for the best estimate of the cost of
making good under the warranty of the goods
sold by the balance sheet date
A provision should be made only if the liability exists independent of the entity's future
actions. The mere intention or necessity to undertake expenditure related to the future is not
sufficient to give rise to an obligation.
If the entity retains discretion to avoid making any expenditure, a liability does not exist and
no provision is recognised.
o the mere existence of environmental contamination, eg, even if caused by the
entity's activities, does not in itself give rise to an obligation because the entity
could choose not to clean it up
o a board decision alone is not sufficient for the recognition of a provision because the
board could reverse the decision
o if a decision was made that commits an entity to future expenditure no provision
need be recognised as long as the board have a realistic alternative.
Until the board makes public that offer, or commits itselfin some other way to making the
repairs there is no obligation beyond that ofsatisfying the existing statutory and contractual
rights ofcustomers.
In rare cases it is not clear whether there is a present obligation. In these cases a past event
should be deemed to give rise to a present obligation when it is more likely than not that a
present obligation exists at the balance sheet date.
Clearly this is a matterfor judgement after taking into account all available evidence.
JAS37PROVISIONS,CONTINGENTLIABiliTIES ANDCONTINGENTASSETS
IUustration 2
Scenario
After a wedding in 2003, ten people died, possibly as a result of food poisoning from
products sold by the entity. Legal proceedings are started seeking damages from the
entity but it disputes liability. Up to the date of approval ofthe fmancial statements
for the year to 31 December 2003, the entity's lawyers advise that it is probable that
the entity will not be found liable. However, when the entity prepares the fmancial
statements for the year to 31 December 2004, its lawyers advise that, owing to
developments in the case, it is probable that the entity will be found liable.
At 31 December 2003:
Conclusion
Conclusion
2.2.2 Past event
On the basis ofthe evidence available when the
financial statements were approved, there is no
obligation as a result of past events.
No provision
On the basis ofthe evidence available, there is
a present obligation.
Probable
Provision should be recognised
A past event that leads to a present obligation is called an obligating event.
An obligating event exists when the entity has no realistic alternative but to make the transfer
of economic benefits. This may be due to;
o legal obligations or
o constructive obligations
Examples of constructive obligations include
o a retail store that habitually refunds purchases by dissatisfied customers even though
it is under no legal obligation to do so, but could not change its policy without
incurring unacceptable damage to its reputation, and
o an entity that has identified contamination in land surrounding one of its production
sites. The entity is not legally obliged to clean up, but because of concern for its
long-term reputation and relationship with the local community, and because of its
published policies or past actions, is obliged to do so.
e Accountancy Tuition Centre(InternationalHoldings)Ltd 2005 1706
Illustration 3
Scenario
A retail store has a policy ofrefunding purchases by dissatisfied customers, even
though it is under no legal obligation to do so. Its policy of making refunds is
generally known.
Conclusion
The obligating event is the sale of the product,
which gives rise to a constructive obligation
because the conduct of the store has created a
valid expectation on the part of its customers
that the store will refund purchases.
Probable, a proportion of goods are returned
for refund.
A provision is recognised for the best estimate
of the costs of refunds.
Illustration 4
Scenario
An entity in the oil industry causes contamination and operates in a country where
there is no environmenta11egis1ation. However, the entity has a widely published
environmental policy in which it undertakes to clean up all contamination that it
causes. The entity has a record of honouring this published policy.
Conclusion
The obligating event is the contamination of
the land, which gives rise to a constructive
obligation because the conduct of the entity has
created a valid expectation on the part of those
affected by it that the entity will clean up
contamination
Probable.
of the costs of clean-up.
Provisions are not made for general business risks since they do not give rise to obligations
that exist at the balance sheet date.
It is not necessary to know the identity of the party to whom the obligation is owed in order
for an obligation to exist.
2.2.3 Reliable estimate ofthe obligation
A reasonable estimate can always be made where an entity can determine a reasonable range
of possible outcomes.
Only in extremely rare cases will it be genuinely impossible to make any quantification of the
obligation and therefore impossible to provide for it. (In these circumstances disclosure of the
matter would be necessary).
2.3 Contingent assets and liabilities
These should not be recognised. They are dependent on the occurrence or non-occurrence of
an uncertain future event not wholly within the control of the entity.
It follows that they are not obligations which exists at the balance sheet date.
There is an exception to non-recognition of contingent liabilities. IFRS 3 Business
Combinations requires a subsidiaries contingent liabilities to be recognised and measured at
fair value as part of the acquisition process, this will be considered in more detail in the group
account sessions.
3 MEASUREMENT
3.1 General rules
The amount provided should be the best estimate at the balance sheet date of the expenditure
required to settle the obligation. The amount is often expressed as
o the amount which could be spent to settle the obligation immediately, or
o to pay to a third party to assume it.
The best estimate may derive from the judgement of the management supplemented by
o experience of similar transactions, and
o evidence provided from experts (in some cases).
An entity should take account of the uncertainty surrounding the transaction This may involve
o an expected value calculation (suitable in situations where there is a large
population - eg determining the size ofwarranty provisions)
o the use of the most likely outcome in situations where a single obligation is being
measured (as long as there is no evidence to indicate that the liability will be
materially higher or lower than this amount).
The following factors should be taken into account when deciding on the size of the obligation
o the time value of money (the amount provided should be the present value of the
expected cash flows)
o evidence in respect of expected future events eg
change in legislation
improvements in technology
o prudence.
3.2 Specific points
Reimbursement - If some (or all) of the expected outflow is expected to be reimbursed from a
third party, the reimbursement should be recognised only when it is virtually certain that the
reimbursement will be received ifthe entity settles the obligation.
o The income statement expense in respect of the provision may be presented net of
the amount recognised for a reimbursement.
o The reimbursement should be treated as a separate asset and must not exceed the
provision in terms of its value.
Gains from the expected disposal should not be taken into account when measuring a
provision.
The provision should be measured as a pre tax amount.
4 CHANGES IN PROVISIONS
Provisions may be used only for expenditures that relate to the matter for which they were
originally recognised.
Provisions should be reviewed regularly and if the estimate of the obligation has changed, the
amount recognised as a provision should be revised accordingly.
5 IFRIC 1
5.1 Scope
IFRIC Interpretation 1 "Changes in Existing Decommissioning, Restoration and Similar
Liabilities" applies to changes in the measurement of an existing decommissioning,
restoration or similar liability that is recognised as:
o part of the cost of an item ofproperty, reactor and equipment (lAS 16); and
o a liability (lAS 37).
Examples include liabilities for reactor decommissioning and environmental rehabilitation in
extractive industries where the expectedfuture cost expenditure has been "capitalised" (i.e.
recognised in the cost ofan asset).
5.2 Issue
How to account for the effects of the following events on the measurement of an existing
liability:
o the ''unwinding of the discount" (i.e. the increase that reflects the passage oftime);
o a change in the estimate of the amount required to settle the obligation;
o a change in the current market-based discount rate.
5.3 Consensus
5.3.1 Unwinding ofthe discount
This is recognised in profit or loss as a finance cost as it occurs.
The allowed alternative treatment ofcapitalisation under lAS 23 is prohibited.
5.3.2 Other changes in measurement- Cost model
If the related asset is measured using the cost model, changes in the liability are added to (or
deducted from) the cost of the related asset in the current period.
Ifthere is an indication that an increase carrying amount may not be fully recoverable the
asset is testedfor impairment and any impairment loss accountedfor (lAS 36).
A deduction cannot exceed the carrying amount ofan asset. Any excess must be recognised
immediately in profit or loss.
5.3.3 Other changes in measurement-Revaluation model
If the related asset is measured using the revaluation model, changes in the liability alter the
revaluation surplus or deficit previously recognised:
o a decrease in the liability is credited directly to revaluation surplus in equity;
But is recognised in profit or loss to the extent that it reverses a revaluation deficit previously
recognised in profit or loss.
o an increase in the liability is recognised in profit or loss
But is debited directly to equity to the extent ofany credit balance on the revaluation surplus.
If a decrease in the liability exceeds the carrying amount that would have been recognised had
the asset been carried under the cost model, the excess is recognised immediately in profit or
loss.
Any change in the liability is an indication that the asset may have to be revalued (to ensure
that carrying amount does not differ materially from that which would be determined using
fair value at the balance sheet date).
Ifa revaluation is necessary, all assets ofthat class must be revalued.
Any change in revaluation surplus arising from a change in liability must be separately
identified and disclosed on the face ofthe statement of changes in equity (lAS 1).
5.3.4 Depreciation
The adjusted depreciable amount of an asset is depreciated over its useful life.
Once the related asset has reached the end of its useful life, all subsequent changes in the
liability are recognised in profit or loss as they arise.
This applies under both the cost and revaluation models.
5.4 Transition
IFRIC 1 is effective for annual periods beginning on or after 1 September 2004.
The changes in accounting policies should be accounted for in accordance with lAS 8
"Accounting Policies, Changes in Accounting Estimates and Errors".
Worked example
Alpha has an nuclear reactor and a related decommissioning liability. The reactor
started operating on 1 January 1995 and had an expected useful life of 50 years. Its
initial cost, $150,000, included $14,000 for decommissioning costs (representing
$160,300 estimated cash flows payable in 50 years discounted at 5%). Alpha's
financial year end is 31 December.
On 31 December 2004, the discount rate has not changed. However, Alpha estimates
that the net present value of the decommissioning liability has decreased by $10,000
due to the advances made in environmental clean-up technology.
Required:
Calculate the carrying amount of the reactor at 1 January 2005 and the resulting
charges to the income statement for the year to 31 December 2005.
Solution - Change in existing decommissioning liability
Carrying amount
On 31 December 2004, the reactor is 10 years old. Accumulated depreciation is $30,000 ($150,000..;-
50 = $3,000 per annum).
The decommissioning liability is now $22,800.
$14,000 X 1.05
10
= $22,800 for the unwinding ofthe discount.
Omega makes the following journal entry to reflect the decrease:
Dr Decommissioning liability
Cr Cost of reactor
$
10,000
$
10,000
The carrying amount of the reactor is now ($150,000 - $10,000 - $30,000) $110,000
2005 Income statement
Depreciation expense ($110,000 + 40 years remaining useful life)
Finance cost ((22,800 - $10,000) = $12,800 @ 5%)
$2,750
$640
Ifthe change in the liability had resultedfrom a change in the discount rate, rather than a change
in the estimatedfuture cash flows, the change would be similarly accounted. However, the 2005
finance cost would reflect the new discount rate.
6 APPLICATION OF THE RULES TO SPECIFIC CIRCUMSTANCES
6.1 Future operating losses
Provisions should not be recognised for future operating losses because
o they do not arise out of a past event, and
o they are not unavoidable.
An expectation of future losses is an indication that the assets of the entity may be impaired.
The assets should be tested for impairment according to IAS 36.
6.2 Onerous contracts
If an entity has a contract that is onerous the present obligation under that contract should be
recognised as a provision.
Illustration 5
Scenario
An entity operates profitably from a factory that it has leased under an operating lease.
During December 2004 the entity relocates its operations to a new factory. The lease
on the old factory continues for the next four years, it cannot be cancelled and the
factory cannot be re-let to another user.
Conclusion
Accountancy Tuition Centre (International Holdings) Ltd 2005
The obligating event is the signing of the lease
contract, which gives rise to a legal obligation.
When the lease becomes onerous, an outflow
of resources embodying economic benefits is
probable. (Until the lease becomes onerous,
the entity accounts for the lease under lAS 17,
Leases).
of the unavoidable lease payments.
1712
6.3 Specific application- Restructuring
Examples of restructurings include
o sale or termination of a line ofbusiness
o closure ofbusiness locations in a region
o relocation from one region to another
o changes in management structure
o fundamental reorganisations that have a material effect on the nature and focus of
the entity's operations.
A provision in respect of a liability for restructuring should only be recognised when the
general recognition criteria are met. These are applied as follows.
A constructive obligation to restructure arises only when an entity:
o has a detailed formal plan for the restructuring identifying as a minimum:
the business or part of a business concerned
the principal locations affected
the location, function, and approximate number of employees who will
be compensated for terminating their services
the expenditures that will be undertaken, and
when the plan will be implemented.
Ifthere is a long delay before the plan will be implemented then it is unlikely that the
plan will raise a valid expectation that the entity is committed to the restructuring.
o and has raised a valid expectation that it will carry out the restructuring by starting
to implement the plan or by announcing its main features to those affected by it.
A management decision to restructure does not give rise to constructive obligation unless the
entity has (before the balance sheet date)
o started to implement the restructuring plan eg by the sale of assets, or
o announced the main features of the plan to those effected in a sufficiently specific
manner to raise a valid expectation in them that the restructuring will occur.
No obligation arises for the sale of an operation until there is a binding sales agreement.
IFRS 3 Business Combinations does not allow a provision to be set up in respect of the
restructuring of a subsidiary on initial acquisition. The only restructuring provision that can be
recognised on acquisition will be those of the subsidiary that had met the lAS 37 requirements
and had been provided for before acquisition.
Illustration 6
Scenario
On 12 December 2004 the board of an entity decided to close down a division. Before
the balance sheet date (31 December 2004) the decision was not communicated to any
of those affected and no other steps were taken to implement the decision.
Present obligation as a result of a No
Conclusion
Illustration 7
Scenario
No provision is recognised
On 12 December 2004, the board of an entity decided to close down a division making
a particular product. On 20 December 2004 a detailed plan for closing down the
division was agreed by the board; letters were sent to customers warning them to seek
an alternative source of supply and redundancy notices were sent to the staff of the
division.
Conclusion
The obligating event is the communication of
the decision to the customers and employees,
which gives rise to a constructive obligation
from that date, because it creates a valid
expectation that the division will be closed.
Probable
A provision is recognised at 31 December 2003
for the best estimate of the costs of closing the
division.
Provisions for restructuring should include only those expenditures that are both
o necessarily entailed by a restructuring, and
o not associated with the ongoing activities of the entity.
7 PROVISIONS FOR REPAIRS AND MAINTENANCE
Some assets require, in addition to routine maintenance, substantial expenditure every few
years for major refits or refurbishment and the replacement of major components. lAS 16,
Property, plant and equipment, gives guidance on allocating expenditure on an asset to its
component parts where these components have different useful lives or provide benefits in a
different pattern.
7.1 Refurbishment Costs - No Legislative Requirement
Illustration 8
Scenario
A furnace has a lining that needs to be replaced every five years for technical reasons.
At the balance sheet date, the lining has been in use for three years.
Present obligation as a result of a There is no present obligation.
Conclusion No provision
The cost of replacing the lining is not recognised because, at the balance sheet date, no
obligation to replace the lining exists independently of the company's future actions -
even the intention to incur the expenditure depends on the company deciding to
continue operating the furnace or to replace the lining.
Instead of a provision being recognised, the depreciation of the lining takes account of
its consumption, i.e. it is depreciated over five years. The re-lining costs then incurred
are capitalised with the consumption of each new lining shown by depreciation over
the subsequent five years.
7.2 Refurbishment Costs - Legislative Requirement
Illustration 9
Scenario
An airline is required by law to overhaul its aircraft once every three years.
Present obligation as a result of a There is no present obligation.
Conclusion No provision
The costs of overhauling aircraft are not recognised as a provision for the same
reasons as the cost ofreplacing the lining is not recognised as a provision in the
previous example
Even a legal requirement to overhaul does not make the costs of overhaul a liability,
because no obligation exists to overhaul the aircraft independently ofthe entity's
future actions - the entity could avoid the future expenditure by its future actions, for
example by selling the aircraft.
Instead of a provision being recognised, the depreciation of the aircraft takes account
of the future incidence ofmaintenance costs, i.e. an amount equivalent to the expected
maintenance costs is depreciated over three years.
8 DISCLOSURES
Disclose for each class of provision
D the carrying amount at the beginning and end of the period with movements by type
including
additional provisions in the period including increases to existing
provisions
amounts used
amounts reversed
increase during the period of any discounted amount arising due to the
passage oftime or change in rate.
D a brief description of the nature of the obligation and expected timing of the
expenditure.
D an indication of the nature of the uncertainties about the amount or timing of the
outflows
D the amount of any expected reimbursement with details of asset recognition.
An entity should disclose the following for each class of contingent liability unless the
contingency is remote
D a brief description of the nature of the contingency; and where practicable,
D the uncertainties that are expected to affect the ultimate outcome of the contingency,
D an estimate of the potential financial effect, and
D the possibility of any reimbursement.
An entity should disclose the following for each class of contingent asset when the inflow of
economic benefits is probable
D a brief description of the nature of the contingency, and where practicable,
D an estimate of the potential financial effect.
In extremely rare cases, disclosure of some or all of the information required above might
seriously prejudice the position of the entity in its negotiations with other parties in respect of
the subject matter for which the provision, contingent liability or asset is made. In such cases
the information need not be disclosed, but entitys should
D explain the general nature of the dispute, and
D explain the fact, and reason why, that information has not been disclosed.
FOCUS
discuss the issues relating to the recognition and measurement of provisions, including best
estimates, discounting, future events;
explain the use ofrestructuring provisions and other practical uses ofprovisioning;
discuss the problem with current standards on provisions and contingencies, including
definitional and discounting problems.
IAS 12INCOME TAXES
OVERVIEW
Objective
To describe the rules for recognition and measurement of taxes.
INTRODUCTION
DEFERRED TAX
INTRODUCTION
DEFERRED TAX -THE
CONCEPT
ILLUSTRATED
ACCOUNTING FOR
DEFERRED TAX - THE
BASICS
ACCOUNTING FOR
DEFERRED TAX -
DETAILED RULES
COMPLICATIONS
BUSINESS
COMBINATIONS
PRESENTATION AND
DISCLOSURE
APPENDIX
Overview
Scope
Definitions
Recognition ofcurrent tax liabilities and current tax
assets
Accountingfor withholding tax
Underlyingproblem
Scenario
Analysis - balance sheet approach
After the company has accountedfor deferred tax the
financial statements will be as follows
Introduction
Calculation ofthe balance sheet amounts
Jargon
Recognition ofdeferred tax liabilities
Recognition ofdeferred tax assets
Accountingfor the movement on the deferred tax
balance
Rates
Change in rates
SIC21
SIC25
Introduction
Temporary differences arising on the calculation of
goodwill
Temporary differences arising due to the carrying
amount ofthe investment and the tax base
Inter company transactions
Presentation
Disclosure
IAS 12INCOME TAXES
1 INTRODUCTION
1.1 Overview
In financial reporting, the fmancial statements need to reflect the effects of taxation on a
company. Guidance is provided by the fundamental accounting concepts of accruals and
prudence. Tax rules determine the cash flows; these must be matched to the revenues which
gave rise to the tax and tax liabilities must be recognised as they are incurred, not merely
when they are paid.
The consistency must be applied in the presentation of income and expenditure.
1.2 Scope
lAS 12 should be applied in accounting for income taxes including
o current tax
o tax on distributions
o deferred tax.
1.3 Definitions
Accountingprofit is profit or loss for a period before deducting tax expense.
Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance with the
rules established by the taxation authorities, upon which income taxes are payable
(recoverable).
Tax expense (tax income) is the aggregate amount included in the determination of profit or
loss for the period in respect of current tax and deferred tax.
Current tax is the amount of income taxes payable (recoverable) in respect of the taxable
profit (tax loss) for a period
Deferred tax liabilities are the amounts of income taxes payable in future period in respect of
taxable temporary differences.
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect
of:
o deductible temporary differences,
o the carry forward ofunused tax losses, and
o the carry forward ofunused tax credits.
IAS 12INCOME TAXES
Temporary differences are differences between the carrying amount of an asset or liability in
the balance sheet and its tax base. Temporary differences may be either
o taxable temporary differences which are temporary differences that will result in
taxable amounts in determining taxable profit (tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled, or
o deductible temporary differences which are temporary differences that will result in
amounts that are deductible in determining taxable profit (tax loss) of future periods
when the carrying amount of the asset or liability is recovered or settled.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
1.4 Recognition of current tax liabilities and current tax assets
Current tax for current and prior periods should, to the extent unpaid, be recognised as a
liability. If the amount already paid in respect of current and prior periods exceeds the
amounts due for those periods, the excess should be recognised as an asset.
The benefit relating to a tax loss that can be carried back to recover current tax of a previous
period should be recognised as an asset.
A company is a separate legal entity and is therefore liable to income tax.
The income tax charged in the income statement is an estimate. Any over/under provisions
are cleared in the following period's income statement and do not give rise to a prior period
adjustment.
1.5 Accounting for withholding tax
Companies make payments net of tax, eg dividends. Income tax is deducted at source and
paid to the tax authorities according to specified local rules.
Companies are themselves taxed on their taxable profit. Ifthey have received interest net of a
deduction then they will have already suffered taxation on this piece of income which will
then be taxed again in the tax computation for the year. Therefore they need to account for the
fact that they have been taxed in order to reduce the future liability.
If company has an income tax payable at year end, include in payable.
If company has income tax recoverable, ie company has net income tax suffered for year
o deduct from income tax payable
o include any excess debit balance in receivables.
IAS 12INCOME TAXES
2 DEFERRED TAXATION - INTRODUCTION
2.1 Underlying problem
In most jurisdictions accounting profit and taxable profit differ, meaning that the tax charge
may bear little relation to profits in a period.
Differences arise due to the fact that tax authorities follow rules which differ from lAS rules
in arriving at taxable profit.
Transactions which are recognised in the accounts in a particular period may have their tax
effect deferred until a later period.
Illustration 1
Many non current assets are depreciated.
Most tax authorities will allow companies to deduct the cost ofpurchasing non current
assets from their profit for tax purposes but only according to a set formula. If this differs
from the accounting depreciation then the asset will be written down by the tax authority
and by the company but at different rates.
Thus the tax effect ofthe transaction (which is based on the tax laws) will be felt in a
different period to the accounting effect.
It is convenient to envisage two separate sets of accounts
o one set constructed following lAS rules, and
o a second set following the tax rules of the jurisdiction in which the company
operates. (we will refer to these as the "tax comps").
Ofcourse there is not really afull set oftax accounts but there could be. Tax files in reality
merely note those areas ofdifference between the two systems
The differences between the two sets of rules will result in different numbers in the financial
statements and in the tax comps. These differences may be viewed from
o a balance sheet perspective, or
o an income statement perspective.
The current tax charge for the period will be based on the tax authorities view of the profit,
not the accounting view. This will mean that the relationship between the accounting profit
before tax and the tax charge will be distorted. It will not be the tax rate applied to the
accounting profit figure but the tax rate applied to a tax comp figure.
IAS 12INCOME TAXES
3 DEFERRED TAXATION - THE CONCEPT ILLUSTRATED
3.1 Scenario
Illustration 2
Tom Inc bought a non current asset on 1 January 2004 for $9,000. This asset is to be
depreciated on a straight line basis over 3 years. Accounting depreciation is not allowed
as a taxable deduction in the jurisdiction in which the company operates. Instead tax
allowable depreciation (capital allowances), under the tax regime in the country of
operation is available as follows.
2004
2005
2006
$4,000
$3,000
$2,000
Accountingprofitfor each ofthe years 2004 to 2006 is budgeted to be $20,000 (before
accountingfor depreciation) and income tax is to be charged at the rate of30%.
Differences arising
Difference in the
Carrying Tax base Balance Income
amount sheet statement
Cost at 1 Jan 2004 9,000 9,000
Charge for the year (3,000) (4,000) (1,000)
Cost at 31 Dec 2004 6,000 5,000 1,000
Charge for the year (3,000) (3,000)
Cost at 31 Dec 2005 3,000 2,000 1,000
Charge for the year (3,000) (2,000) 1,000
Cost at 31 Dec 2006
At each balance sheet date the deferred tax liability might be identified from a balance sheet
or an income statement view.
In this example the difference in the balance sheet amounts is the sum of the differences that
have gone through the income statement.
The balance sheet view identifies the deferred taxation balance that is required in the balance
sheet whereas the income statement approach identifies the deferred tax that arises during the
period.
lAS 12 takes the first approach.
IAS 12INCOME TAXES
3.2 Analysis - balance sheet approach
The balance sheet approach calculates the liability (or more rarely the asset) that a company
would need to set up on the face of its balance sheet.
Carrying Tax base Balance sheet view of
amount the differences (known
as the temporary
difference)
At 31 Dec 2004 6,000 5,000 1,000
At 31 Dec 2005 3,000 2,000 1,000
At 31 Dec 2006
Tax@
30%
300
300
Application of the tax. rate to the balance sheet difference will give the deferred tax:balance
that should be recognised in the balance sheet.
In 2004 the company will recognise a deferred tax: liability of $300 in its balance sheet. This
will be released to the income statement in later years.
The $300 is a liability that exists at the balance sheet date and which will be paid in the future.
In years to come (i.e. looking forward from the end of 2004) the company will earn profits
against which it will charge $6,000 depreciation but will only be allowed $5,000 capital
allowances. Therefore taxable profit will be $1,000 bigger than accounting profit in the
future. This means that the current tax: charge in the future will be $300 (30% x $1,000)
bigger than would be expected from looking at the fmancial statements. This is because of
events that have occurred and been recognised at the balance sheet date. This satisfies the
defmition and recognition criteria for a liability as at the balance sheet date.
The charge to the income statement is found by looking at the movement on the liability
Balance sheet liability Income statement entry
required
2004
2005
2006
300
300
NIL
Dr 300
NIL
Cr300
In summary the process involves a comparison of the accounting balance to the tax. authority's
version of the same transaction and applying the tax:rate to the difference.
IAS 12INCOME TAXES
3.3 After the company has accounted for deferred tax the financial statements will be as
follows
Balance sheet - extracts
Deferred taxation liability
2004
$
300
2005
$
300
2006
$
Income statements
2004 2005 2006
$ $ $
Profit before tax 17,000 17,000 17,000
Income tax @ 30% WI
[;]
C:J
5,400
Deferred tax 300 (300)
(5,lDO) (5,lDO) (5,lDO)
Profit after tax 11,900 11,900 11,900
Accounting for the tax on the differences through the income statement restores the
relationship that should exist between the accounting profit and the tax charge. It does this by
taking a debit or a credit to the income statement. This then interacts with the current tax
expense to give an overall figure that is the accounting profit multiplied by the tax rate.
As can be seen from this example, the effect of creating a liability in 2004 and then releasing
it in 2006 is that profit after tax ($11,900 for all three years) is not distorted by temporary
timing differences. As such, a user of the fmancia1 statements now has better information
about the relationship between profit before tax and profit after tax.
Accruals and provisions for taxation will impact on earnings per share, net assets per share
and gearing.
WI Calculations of tax for the periods
2004 2005 2006
$ $ $
Accounting profit (after
depreciation) 17,000 17,000 17,000
Add back depreciation 3,000 3,000 3,000
Deduct capital allowances (4,000) (3,000) (2,000)
(1,000) 1,000
Taxable profit 16,000 17,000 18,000
Tax@30% 4,800 5,lDO 5,400
IAS 12INCOME TAXES
4 ACCOUNTING FOR DEFERRED TAXATION - BASICS
4.1 Introduction
lAS 12 takes a balance sheet perspective. Accounting for deferred taxation involves the
recognition of a liability (or more rarely an asset) in the balance sheet. The difference between
the liability at each year end is taken to the income statement.
Illustration 3
$
Deferred taxation balance at the start of the year 1,000
Transfer to the income statement (as a balancingfigure) 500
Deferred taxation balance at the end of the year 1,500
Most ofthe effort in accountingfor deferred
taxation goes into the calculation ofthis figure
4.2 Calculation of the balance sheet amounts
The calculation of the balance to be put onto the balance sheet is, in essence, very simple. It
involves the comparison of the carrying values of items in the accounts to the tax authority's
view of the amount (known as the tax base ofthe item). The difference generated in each case
is called a temporary difference.
The basic rule in lAS 12 is that deferred taxation should be provided on all taxable temporary
differences. (Note that this is a simplification. Complications will be covered later).
Illustration 4
Carrying Tax base Temporary Deferred tax balance
value in differences required at 30%
financial
statements
s s s s
Non current assets 20,000 14,000 6,000 1,800
Other transactions
A (accrued income) 1,000 1,000 300
B (an accrued expense) (2,000) (2,000) (600)
5,000 1,500
The transactions in respect ofitems A and B are taxed on a cash basis, therefore the tax
authority's balance sheet would not recognised accrued amounts in respect ofthese items.
IAS 12INCOME TAXES
4.3 Jargon
4.3.1 Definitions
Temporary differences are differences between the carrying amount of an asset or liability in
the balance sheet and its tax base.
Temporary differences may be either
o debit balances in the financial statements compared to the tax
computations. These will lead to deferred tax credit balances. These are
known as taxable temporary differences, or
o credit balances in the fmancial statements compared to the tax
computations. These will lead to deferred tax debit balances. These are
known as deductible temporary differences.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
The tax base of an asset is the amount that will be deductible for tax purposes
against any taxable economic benefit that will flow to an entity when it recovers
the carrying amount of the asset.
4.3.2 Commentary
Illustration 5
(Revisiting illustration 2)
Net book value
Tax base of the asset
Temporary difference
Deferred tax balance required (@30%)
2004
$
6,000
(5,000)
1,000
300
The difference between the net book value of the asset and the tax authority's value is
described as a temporary difference because it is temporary in nature - it will disappear in
time.
The lAS 12 justification is that ownership of this asset will lead to income of $6,000 in the
future. The company will only have $5,000 as an expense to charge against this for tax
purposes. The $1,000 that is not covered will be taxed and should be provided for now.
Temporary differences may lead to deferred tax credits or debits, though the standard imposes
a tougher recognition criteria in respect of debit balances.
IAS 12INCOME TAXES
Deferred tax accounting is about accounting for items where the tax effect of items is deferred
to a later period. Circumstances under which temporary differences arise include
o When income or expense is included in accounting profit in one period but included
in the taxable profit in a different period. eg
items which are taxed on a cash basis but which will be accounted for on
an accruals basis.
Illustration 6
The accounts of Bill Inc show interest receivable of $10,000. No cash has yet been
received and interest is taxed on a cash basis. The interest receivable has a tax base ofnil.
Deferred tax will be provided on the temporary difference of$10,000.
situations where the accounting depreciation does not equal tax allowable
depreciation.
Illustration 7
Bill Inc has non current assets at 31 December 2004 with a cost of $4,000,000. Aggregate
depreciation for accounting purposes is $750,000. For tax purposes, depreciation of
$1,000,000 has been deducted to date. The non current assets have a tax base of
$3,000,000. The provision for deferred tax will be provided on the taxable temporary
difference of $250,000.
finance leases recognised in accordance with the provisions ofIAS 17 but
which fall to be treated as operating leases under local tax legislation.
o Revaluation of assets where the tax authorities do not amend the tax base when the
asset is revalued.
Unfortunately the defmition oftemporary difference captures other items which should not
result in deferred taxation accounting. eg accruals for items which are not taxed or do not
attract tax relief.
The standard includes provisions to exclude such items. The wording of one such provision is
as follows
"If those economic benefits will not be taxable, the tax base ofthe asset is equal to its
carrying amount"
The wording seems a little strange but the effect is to exclude such items from the deferred
taxation calculations.
Illustration 8
Bill Inc provided a loan of $250,000 to John Inc. At 31 December 2004 Bill Inc's accounts
show a loan payable of $200,000. The repayment of the loan has no tax consequences.
Therefore the loan payable has a tax base of $200,000. No temporary taxable difference
arises.
IAS 12INCOME TAXES
Example 1
The following information relates to Boniek Sp. z.o.o. as at 31 December 2004.
Note Carrying Tax
value base
Non current assets $ $
Plant and machinery
Receivables:
Trade receivables
Interest receivable
Payables
Fine
Interest payable
Note 1
1
200,000
50,000
1,000
10,000
2,000
175,000
The trade receivables balance in the accounts is made up of the following amounts;
Balances
Doubtful debt provision
$
55,000
(5,000)
50,000
Further information;
1. The deferred tax balance as at 1 January 2004 was $1,200.
2. Interest is taxed on a cash basis.
3. Provisions for doubtful debts are not deductible for tax purposes. Amounts in respect
ofreceivables are only deductible on application of a court order to a specific amount.
4. Fines are not tax deductible.
5. Deferred tax is charged at 30%.
Required:
Calculate the deferred tax provision which is required at 31 December 2004 and the
charge to the income statement for the period.
IAS 12INCOME TAXES
Solution 1
Non current assets
Plant and machinery
Receivables:
Trade receivables
Interest receivable
Payables
Fine
Interest payable
Deferred tax liabilities
Deferred tax assets
Deferred tax as at 1 January 2004
Income statement (balancing figure)
Deferred tax as at 31 December 2004
Carrying
value
$
Tax
base
$
Temporary
difference
Temporary
differences
Deferred
tax@
30%
Deferred
tax@
30%
$
1,200
IAS 12INCOME TAXES
5 ACCOUNTING FOR DEFERRED TAX - DETAILED RULES
5.1 Recognition of deferred tax liabilities
5.1.1 The rule
A deferred tax liability should be recognised for all taxable temporary differences, unless
the deferred tax liability arises from
D the initial recognition of goodwill; or
D goodwill for which amortisation is not deductible for tax purposes; or
D the initial recognition of an asset or liability in a transaction which
is not a business combination and
at the time of the transaction, affects neither accounting profit nor taxable
profit.
If the economic benefits are not taxable the tax base of the asset is equal to its carrying
amount.
5.1.2 Commentary
"all taxable temporary differences"
The definition oftemporary differences includes all differences between accounting rules and
tax rules, not just the temporary ones! The standard contains otherprovisions to correct this
anomaly and excludes items where the tax effect is not deferred, but rather, is permanent in
nature.
"goodwill for which amortisation is not deductible"
In the vast majority ofsituations goodwill is a group accounting concept. In mostjurisdictions
it is the individual companies that are taxed, not the group. Therefore it would be quite rare
for goodwill to be an item which attracted tax relief
The rule here is an application ofthe idea that ifan item is not taxable it should be excluded
from the calculations.
"initial recognition ---- not a business combination"
Ifthe initial recognition is a business combination deferred tax may arise.
"effects neither accounting profit nor loss"
The rule here is an application ofthe idea that ifan item is not taxable it should be excluded
from the calculations.
IAS 12INCOME TAXES
Taxable temporary differences also arise in the following situations:
o Certain lASs permit assets to be carried at a fair value or to be revalued.
if the revaluation of the asset is also reflected in the tax base then no
temporary difference arises.
if the revaluation does not affect the tax base then a temporary difference
does arise and deferred tax. must be provided.
o When the cost of acquiring a business is allocated by reference to fair value of the
assets and liabilities acquired, but no equivalent adjustment has been made for tax.
purposes.
This is basically the same rule as above applied to a group accounting situation
Example 2
The following information relates Lato Sp Z.O.o.
At 1 January 2004
Depreciation
At 31 December 2004
Carrying
value
$
1,000
(100)
900
Tax base
$
800
(150)
650
At the year end the company decided to revalue the asset to $1,250. The tax. base is not affected by
this revaluation.
Required:
Calculate the deferred tax provision required in respect of this asset as at 31 December 2004.
Solution 2
Deferred tax. at 30%
Carrying
value
$
Tax base
$
Temporary
difference
IAS 12INCOME TAXES
5.2 Recognition of deferred tax assets
5.2.1 The rule
A deferred tax asset should be recognised for all deductible temporary differences to the
extent that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised, unless the deferred tax asset arises from
o the initial recognition of an asset or liability in a transaction which:
is not a business combination, and
at the time of transaction, affects neither accounting profit nor taxable
profit (tax loss).
The carrying amount of a deferred tax asset should be reviewed at each balance sheet date.
The carrying value of a deferred tax asset should be reduced to the extent that it is no longer
probable that sufficient taxable profit will be available to utilise the asset.
5.2.2 Commentary
Most of the comments made in respect of deferred tax liabilities also apply to deferred tax
assets.
Major difference between the recognition of deferred tax assets and liabilities is in the use of
the phrase "to the extent that it is probable that taxable profit will be available against which
the deductible temporary difference can be utilised".
This means that lAS 12 brings a different standard to the recognition ofdeferred tax assets
than it does to deferred tax liabilities. In short liabilities will always be provided infull
(subject to the specified exemptions) but assets may not be provided infull or, in some cases
at all.
This is an application ofthe concept ofprudence.
An asset should only be recognised when the company expects to receive a benefit from its
existence. The existence of deferred tax liability (to the same jurisdiction) is strong evidence
that the asset will be recoverable.
IAS 12INCOME TAXES
Illustration 9
Situation 1 Situation 2
$ $
Deferred tax liability 10,000 5,000
Deferred tax asset (8,000) (8,000)
Net position 2,000 (3,000)
In situation 1 the existence of the liability ensures the recoverability of the asset
and the asset should be provided.
In situation 2 the company would provide for $5,000 of the asset but would need
to consider carefully the recoverability of the $3,000 net debit balance.
In short debit balances which are covered by credit balances will be provided (as
long as the tax is payable/recoverable to/from the same jurisdiction), but net debit
balances will be subject to close scrutiny.
IAS 12INCOME TAXES
5.3 Accounting for the movement on the deferred tax balance
Deferred tax should be recognised as income or an expense and included in the profit or loss
for the period, except to the extent that the tax arises from
o a transaction or event which is recognised, in the same or a different period, directly
in equity, or
o a business combination that is an acquisition.
Deferred tax should be charge or credited directly to equity ifthe tax relates to items that are
credited or charged, in the same or different period, directly to equity.
Example 3
Following on from example 2
At 1 January 2004
Depreciation
At 31 December 2004
Carrying
value
$
1,000
(100)
900
Tax base
$
800
(150)
650
At the year end the company revalued the asset to $1,250. The tax base is not affected by this
revaluation.
Deferred tax at 30%
Required:
Carrying
value
$
1,250
Tax base
$
650
Temporary
difference
600
180
Assuming that the only temporary difference that the company has relates to this asset
construct a note showing the movement on the deferred taxation and identify the charge to
the income statement in respect of deferred taxation for the year ended 31 December 2004.
Solution 3
Deferred tax as at 1 January 2004
To equity
Income statement
Deferred tax as at 31 December 2004
Deferred
tax@
30%
$
IAS 12INCOME TAXES
6 COMPLICATIONS
6.1 Rates
The tax rate that should be used is the rate that is expected to apply to the period when the
asset is realised or the liability is settled, based on tax rates that have been enacted by the
balance sheet date.
Example 4
$
320,000
The following information relates to Tomasefski Sp. Z.o.o. at 31 December 2004:
Carrying Tax base
value
$
460,000
90,000
Non-current assets
Tax losses
Further information:
1. Tax rates (enacted by the 2004 year end)
2004 2005
36% 34%
2006
32%
2007
31%
2. The loss above is the tax loss incurred in 2004. The company is very
confident about the trading prospects in 2005.
3. The temporary difference in respect of non-current assets is expected to grow
each year until beyond 2007.
4. Losses may be carried forward for offset, one third into each of the next three
years
Required:
Calculate the deferred tax provision that is required at 31 December 2004.
Proforma solution Temporary
difference
$
Non-current assets (460 - 320)
Losses
Deferred tax liability
Deferred tax asset;
Reversal in 2005
Reversal in 2006
Reversal in 2007
Deferred tax
IAS 12INCOME TAXES
The tax rate used should reflect the tax consequences of the manner in which the entity
expects to recover or settle the carrying amount of its assets and liabilities.
Illustration 10
Bill Inc has an asset with a carrying amount of $5000 and a tax base of $3000. A tax rate of
25% would apply if the asset were sold and a tax rate of33% would apply to other income.
The entity would recognise a deferred tax liability of$500 ($2000 @ 25%) if it expects to sell
the asset without further use and a deferred tax liability of $660 ($2000 @33%) if it expects to
retain the asset and recover its carrying value through use.
6.2 Change in rates
Companies are required to disclose the amount of deferred taxation in the tax expense that
relates to change in the tax rates.
Example 5
$
320,000
Tax base Carrying
value
$
460,000 Non current assets
Accrued interest:
Receivable 18,000
Payable (15,000)
The balance on the deferred tax account on lotJanuary 2004 was $10,000. This was calculated at a
tax rate of 30%. During 2004 the government announced an unexpected increase in the level of
corporate income tax up to 35%.
Required:
Set out the note showing the movement on the deferred tax account showing the charge to the
income statement and clearly identify that part of the charge that is due to an increase in the
rate of taxation.
Solution 5 Deferred
tax
$
Deferred tax as at lotJanuary 2004
Income statement - rate change
Opening balance restated
Income statement- origination of
temporary differences (Balancing figure)
Deferred tax as at 31st December 2004 (WORKING below)
WORKING
Non current assets
Accrued interest:
Receivable
Payable
Deferred tax liability
Deferred tax asset
Deferred tax at 35%
IAS 12INCOME TAXES
Carrying
value
$
Tax base
$
Temporary
difference
6.3 SIC 21 - Income Taxes - Recovery of Revalued Non-Depreciable Assets
Issue
o lAS 12 requires that the measurement of deferred tax liabilities and assets at the
balance sheet date, should reflect the tax consequences that would follow from the
manner in which the entity expects, to recover or settle the carrying amount of those
assets and liabilities that give rise to the temporary differences.
o Revaluation of an asset with no corresponding adjustment to its tax base gives rise
to a temporary difference. If the future recovery of the carrying amount will be
taxable, any difference between the carrying amount of the revalued asset and its tax
base is a temporary difference and gives rise to a deferred tax liability or asset.
o The issue is how to interpret the term "recovery" in relation to a revalued asset that
is not depreciated.
Consensus
o The deferred tax liability or asset that arises from the revaluation of a non-
depreciable asset should be measured based on the tax consequences that would
follow from recovery of the carrying amount of that asset through sale, regardless of
the basis of measuring the carrying amount of that asset.
o Ifthe tax law specifies a tax rate applicable to the sale of an asset that differs from
the tax rate applicable to its use, the former rate is used for the measurement of
deferred tax balances relating to a non-depreciable asset.
Basis for Conclusions
o The Framework indicates that an entity recognises an asset if it is probable that the
future economic benefits associated with the asset will flow to the entity.
o Future economic benefits will be derived (and therefore the carrying amount of an
asset will be recovered):
through sale,
through use, or,
or through use and subsequent sale.
IAS 12INCOME TAXES
o Recognition of depreciation implies that the carrying amount of a depreciable asset
is expected to be recovered through use to the extent of its depreciable amount, and
through sale at its residual value.
o If an asset is not depreciated its, the carrying amount will be recovered only through
sale. If the asset is not depreciated, no part of its carrying amount is expected to be
recovered (that is, consumed) through use. Deferred taxes associated with the non-
depreciable asset reflect the tax consequences of selling the asset.
6.4 SIC 25 - Income Taxes - Changes in the Tax Status of an Entity or its Shareholders
Issue
o A change in the tax status of an entity or of its shareholders may have consequences
for an entity by increasing or decreasing its tax liabilities or assets. (eg upon the
public listing of an entity's equity instruments, the restructuring of an entity's equity
or on relocation to a foreign country).
o An entity may be taxed differently as a result of, eg:
gain or lose tax incentives
becoming subject to a different rate oftax in the future.
o Such changes in tax status may have an immediate effect on the entity's current tax
liabilities or assets. The change may also increase or decrease the deferred tax
liabilities and assets recognised by the entity, depending on the effect the change in
tax status has on the tax consequences that will arise from recovering or settling the
carrying amount of the entity's assets and liabilities.
o The issue is how an entity should account for the tax consequences of a change in its
tax status or that of its shareholders.
Consensus
o The current and deferred tax consequences of a change in tax status should be
included in net profit or loss for the period, unless those consequences relate to
transactions and events that result, in the same or a different period, in a direct credit
or charge to the recognised amount of equity. In those cases the tax consequences
should themselves be recognised directly in equity
Basis for Conclusions
o The treatment is consistent with the lAS 12 guidance on dealing with the tax
consequences of transactions and events and in particular those transactions or
events that are recognised directly in equity.
lAS 12 INCOMETAXES
7 BUSINESS COMBINATIONS
7.1 Introduction
7.1.1 Background
Acquisition accounting, equity accounting and proportionate consolidation share certain
features in common which are relevant to an understanding ofthe deferred taxation
consequences of employing these techniques.
Each involves the replacement of cost with a share ofnet assets and goodwill arising on
acquisition, the subsequent impairment ofthe goodwill and the crediting ofpost acquisition
growth in equity balances to the equivalent equity balances of the group.
lliustration 11
H groupfinancial statements
At the date of
acquisition
At a subsequent
balance sheet
H's own
financial
statements
COST
600
COST
600
SHARE OF NETASSETS
450
SHARE OFNETASSETS
520
Also
+
+
GOODWILL
150
GOODWILL
150
(30)
120
Through the income
statement into equity
~ ~ f l a!lL-__
= a net debit of600
TIlls is effectively what takes place under each ofthe techniques. They differ in the way that
the share of net assets is reflected in the "group" financial statements.
Note that the carrying value of the investment in the illustration above is $640 (520+120).
7.1.2 Sources oftemporary differences
Temporary differences may arise from the above due to the following reasons.
o The calculation of goodwill requires a fair valuation exercise. This exercise may
change the carrying amounts of assets and liabilities but not their tax bases. The
resulting deferred tax amounts will affect the value of goodwill but lAS 12 prohibits
the recognition of deferred tax arising (see session 4.1)
Retained earnings of subsidiaries, branches, associates and joint ventures are
included in consolidated retained earnings, but income taxes will be payable ifthe
profits are distributed to the reporting parent.
Furthermore, lAS 27 requires the elimination ofunrealised profitsllosses resulting from intra-
group transactions. This treatment will generate temporary differences.
e Accountancy Tuition Centre(InternationalHoldings)Ltd 2005 1822
IAS 12INCOME TAXES
7.2 Temporary differences arising on the calculation of goodwill
The cost ofthe acquisition is allocated to the identifiable assets and liabilities acquired by
reference to their fair values at the date of the exchange transaction.
Temporary differences arise when the tax bases of the identifiable assets and liabilities
acquired are not affected by the business combination or are affected differently.
Deferred tax must be recognised in respect ofthe temporary differences. This will affect the
share of net assets and thus the goodwill (one of the identifiable liabilities ofS is the deferred
tax balance).
The goodwill itself is also a temporary difference but IAS 12 prohibits the recognition of
deferred tax on this item.
Illustration 12
Entity H paid $600for 100%ofSon 1'1 January 2004.
S had not accountedfor deferred taxation up to the date ofits acquisition.
The following information is relevant in respect ofS
Property plant and
equipment
Accounts receivable
Inventory
Retirement benefit
obligations
Accounts payable
Fair value at
the date of
acquisition
270
210
174
(30)
(120)
504
Tax base
155
210
124
(120)
Temporary
differences
115
50
(30)
135
504
$
600
(450)
150
(54)
Goodwill arising
Cost ofinvestment
Fair value ofnet assets acquired
Per balance sheet ofS
Deferred tax liability arising in the
fair valuation exercise (40%x 135) _.l.::-:L.-_
GOODWILL
450
150
IAS 12INCOME TAXES
7.3 Temporary differences arising due to the carrying amount of the investment and the tax
base
7.3.1 Background
Temporary differences arise when the carrying amount of investments in subsidiaries,
(branches and associates or interests in joint ventures) becomes different from the tax base
(which is often cost) of the investment or interest.
The carrying amount is the parent or investor's share of the net assets plus the carrying
amount of goodwill. Such differences may arise in a number of different circumstances.
Illustration 13 (followingon from illustration 11)
Entity H paid $600for 100%ofSon r January 2004. At this date the carrying amount in
H's consolidatedfinancial statements, ofits investment in S was made up as follows:
Fair value ofthe identifiable net assets ofS
(including deferred taxation)
Goodwill
Carrying amount 600
Tutorial note
The carrying amount at the date ofacquisition is equal to cost. This must be the
case as the cost figure has been allocated to the net assets to leave goodwill as a
residue
The tax base in H'sjurisdiction is the cost ofthe investment. Therefore there is no
temporary difference at the date ofacquisition.
During the year ended srDecember 2004 S tradedprofitably and accumulated earnings
of$70. This was reflected in the net assets ofthe entity and in its equity.
Since acquisition, goodwill has been impaired by 30.
At srDecember 2004 the carrying amount in H's consolidatedfinancial statements, of
its investment in S was made up as follows:
Fair value ofthe identifiable net assets ofS (450 + 70)
Goodwill (150- 30)
This means that there is a temporary difference of$40. (640-600).
520
120
640
An entity should recognise a deferred tax liability for all taxable temporary differences
associated with investments in subsidiaries, branches and associates, and interests injoint
ventures, except to the extent that both of the following conditions are satisfied:
o the parent, investor or venturer is able to control the timing ofthe reversal of the
temporary difference, and
o it is probable that the temporary difference will not reverse in the foreseeable future.
IAS 12INCOME TAXES
7.3.2 Subsidiaries and branches
A parent controls the dividend policy of its subsidiary (and branches). It is able to control the
timing of the reversal of temporary differences associated with that investment. When the
parent has determined that those profits will not be distributed in the foreseeable future the
parent does not recognise a deferred tax liability.
Illustration 13 continued
IfH has determined that it will not sell the investment in the foreseeable future and that S
will not distribute its retainedprofits in the foreseeable future, no deferred tax liability is
recognised in relation to H's investment in S (Hdiscloses the amount (40) ofthe
temporary difference for which no deferred tax is recognised).
IfH expects to sell the investment in S, or that S will distribute its retainedprofits in the
foreseeable future, H recognises a deferred tax liability to the extent that the temporary
difference is expected to reverse.
The tax rate reflects the manner in which H expects to recover the carrying amount of its
investment.
7.3.3 Associates
An investor in an associate does not control that entity and is usually not in a position to
determine its dividend policy.
Therefore, in the absence of an agreement requiring that the profits of the associate will not be
distributed in the foreseeable future, an investor recognises a deferred tax liability arising
from taxable temporary differences associated with its investment in the associate.
IfS were an associate ofH it would need to providefor deferred tax in respect ofthe $40
unless there was an agreement that the profits ofS would not be distributed in the future.
The tax rate must reflect the manner in which H expects to recover the carrying amount of
its investment.
7.3.4 Joint ventures
The arrangement between the parties to a joint venture usually deals with the sharing of the
profits and identifies whether decisions on such matters require the consent of all the
venturers or a specified majority of the venturers. When the venturer can control the sharing
of profits and it is probable that the profits will not be distributed in the foreseeable future, a
deferred tax liability is not recognised.
IAS 12INCOME TAXES
7.4 Inter company transactions
lAS 27 requires that unrealised profits and losses arising on inter company trading must be
eliminated in full on consolidation. Such adjustments may give rise to temporary differences.
In many tax jurisdictions it is the individual members of the group that are the taxable entities.
As far as the tax authorities are concerned the tax base of an asset purchased from another
member of the group will be the cost that the buying company has paid for it. Furthermore the
selling company will be taxed on the sale of the asset even though it is still held within the
group.
Note that the deferred tax is provided for at the buyers tax rate.
Illustration 14
S has sold inventory to Hfor $700. The inventory cost S $600 originally. S has therefore
made a profit of$100 on the transaction. S will be liable to tax on this amount at say 30%.
Thus S will reflect a profit of$100 and a tax expense of$30 in its own financial statements.
IfH has not sold the inventory at the year-end it will include it in its closing inventory
figure at a cost (to itself) of$700.
On consolidation the unrealisedprofit must be removed by
Dr Income statement $100
Cr Balance sheet inventory $100
In the consolidatedfinancial statements the inventory will be measured at $600 (700-100)
but its tax base is still $700. There is a deductible temporary difference of$100.
This requires the recognition ofa deferred tax asset of $30 (30% x 100).
Note that the other side ofthe entry to set this up will be a credit to the income statement.
This will remove the effect ofthe tax on the transaction. (However ifH operated in a
different tax environment such that it was taxed at 40% the deferred tax asset would be $40
(40% x 100).
IAS 12INCOME TAXES
8 PRESENTATIONAND DISCLOSURE
8.1 Presentation
Tax assets and tax liabilities should be presented separately from other assets and liabilities in
the balance sheet. Deferred tax assets and liabilities should be distinguished from current tax
assets and liabilities.
When an entity makes a distinction between current and non-current assets and liabilities in its
financial statements, it should not classify deferred tax assets (liabilities) as current assets
(liabilities).
An entity should offset current tax assets and current tax liabilities if, and only if, the entity
o Has a legally enforceable right to set off the recognised amounts, and
o Intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously.
An entity should offset deferred tax assets and deferred tax liabilities if, and only if:
o The entity has a legally enforceable right to set off current tax assets against current
tax liabilities, and
o The deferred tax assets and the deferred tax liabilities relate to income taxes levied
by the same taxation authority on either:
the same taxable entity; or
different taxable entities which intend either to settle current tax liabilities
and assets on a net basis, or to realise the assets and settle the liabilities
simultaneously, in each future period in which significant amounts of
deferred tax liabilities or assets are expected to be settled or recovered.
The tax expense (income) related to profit/loss from ordinary activities should be presented on
the face of the income statement.
8.2 Disclosure
The following should be disclosed separately
The major components of tax expense (income) These include
o Current tax expense (income),
o Adjustments in respect of a prior period,
o Deferred tax expense/income,
o Deferred tax expense /income arising due to a change in tax rates,
o Deferred tax consequence of a change in accounting policy or a correction of a
fundamental error.
The aggregate current and deferred tax relating to items that are charged or credited to equity.
Tax expense (income) relating to extraordinary items recognised during the period.
IAS 12INCOME TAXES
An explanation of the relationship between tax expense (income) and accounting profit in
either or both of the following forms:
o A numerical reconciliation between tax expense (income) and the product of
accounting profit multiplied by the applicable tax rate(s) disclosing also the basis on
which the applicable tax rate(s) is (are) computed, or
o A numerical reconciliation between the average effective tax rate and the applicable
tax rate, disclosing also the basis on which the applicable tax rate is computed.
An explanation of changes in the applicable tax rate(s) compared to the previous accounting
period.
The amount (and expiry date, if any) of deductible temporary differences, unused tax losses,
and unused tax credits for which no deferred tax asset is recognised in the balance sheet.
The aggregate amount of temporary differences associated with investments in subsidiaries,
branches and associates and interests in joint ventures.
In respect of each type of temporary difference, and in respect of each type of unused tax
losses and unused tax credits:
o The amount of deferred tax assets and liabilities recognised in the balance sheet for
each period presented,
o The amount of the deferred tax income or expense recognised in the income
statement, if this is not apparent from the changes in the amounts recognised in the
balance sheet, and
In respect of discontinued operations, the tax expense relating to:
o The gain or loss on discontinuance, and
o The profit or loss from the ordinary activities of the discontinued operation for the
period, together with the corresponding amounts for each prior period presented.
An entity should disclose the amount ofa deferred tax asset and the nature of the evidence
supporting its recognition, when:
o The utilisation of the deferred tax asset is dependent on future taxable profits in
excess of the profits arising from the reversal of existing taxable temporary
differences, and
o The entity has suffered a loss in either the current or preceding period in the tax
jurisdiction to which the deferred tax asset relates.
IAS 12INCOME TAXES
9 APPENDIX
Deferred taxation calculations
(a) Debits in the fmancial statements compared to the taxman's view give
rise to deferred tax credits.
Credits in the financial statements compared to the taxman's view give
rise to deferred tax debits.
(b) Full provision accounting is easy!
DT = TAX RATE x TEMPORARY DIFFERENCE =BALANCE SHEET AMOUNT FOR
DEFERRED TAX
(c) Steps
Step 1:
Step 2:
Summarise the accounting carrying amounts and the tax base for every asset
and liability.
Calculate the temporary difference by deducting the tax base from the
carrying amount - see proforma below.
Asset/Liability Carrying
Amount
$
Tax Temporary
Base Difference
$ $
Step 3:
Step 4:
Step 5:
Calculate the deferred tax liability and asset. To calculate the deferred tax
liabilities we sum all positive temporary differences and apply the tax rate.
To calculate the deferred tax asset we sum all negative temporary differences
and apply the tax rate.
Calculate the net deferred tax liability or asset by summing the two amounts
in Step 3. THIS WILL BE THE ASSET OR LIABILITY CARRIED IN
THE BALANCE SHEET.
Deduct the opening deferred tax liability or asset. THE DIFFERENCE
WILL BE THIS YEARS THE CHARGE/CREDIT TO THE INCOME
STATEMENTIEQUITY/GOODWILL.
(d) Where there has been a change in the tax rate it is necessary to calculate the effect of
this change on the opening deferred tax provision. Follow steps 1 to 5 above,
calculating the required closing deferred tax liability or asset and the charge/credit to the
income statement. The charge/credit to the income statement is then analysed into the
amount that relates to the change in the tax rate and the amount that relates to the
temporary differences.
The amount that relates to the change in tax rate will equal the amount of the temporary
difference in the previous period x the change in the tax rate.
IAS 12INCOME TAXES
FOCUS
discuss the different approaches to accounting for deferred tax;
discuss the recognition of deferred tax in the balance sheet and performance statements
including revaluations, unremitted earnings of group companies and deferred tax assets;
explain the nature of the measurement of deferred tax including tax rates and discounting;
calculate deferred tax amounts in the financial statements.
IAS 12INCOME TAXES
EXAMPLE SOLUTIONS
Solution 1
Carrying Tax Temporary
value base difference
Non current assets $ $
Plant and machinery 200,000 175,000 25,000
Receivables:
Trade receivables 50,000 55,000 (5,000)
Interest receivable 1,000 1,000
Payables
Fine 10,000 10,000
Interest payable 2,000 (2,000)
Temporary Deferred
differences tax@
30%
Deferred tax liabilities 26,000 7,800
Deferred tax assets (7,000) (2,100)
5,700
Deferred
tax@
30%
$
1,200
4,500 Balancing figure _----"'--'-'--_
Deferred tax as at 1January 2004
Income statement
Deferred tax as at 31 December 2004 5,700
Solution 2
Carrying
value
$
1,250
Tax base
$
650
Temporary
difference
$
600
Deferred tax at 30% 180
lAS 12INCOME TAXES
Solution 3
Deferred tax as at 1st January 2004
To equity
Income statement
Deferred tax as at 31st December 2004
Solution 4
Non-current assets (460,000 - 320,000)
Losses
Deferred tax liability (31% x 140,000)
Deferred tax asset
Reversal in 2005 (30,000 x 34%)
Reversal in 2006 (30,000 x 32%)
Reversal in 2007 (30,000 x 31%)
Deferred tax
Solution 5
Deferred tax as at 1st January 2004
Income statement - rate change
(1,000 - 800) x 30%
30% x (1,250 - 900)
Balancing figure (or as (150 - 100) x 30%)
Deferred
tax@
30%
$
60
105
15
180
Temporary
difference
$
140,000
(90,000)
43,400
(10,200)
(9,600)
(9,300)
14,300
Deferred
tax
$
10,000
1,667
Opening balance restated 10,000 x 35/30 )
Income statement- origination of
temporary differences (Balancing figure)
Deferred tax as at 31st December 2004 (WORKING)
11,667
38,383
50,050
WORKING
Fixed assets
Accrued interest:
Receivable
Payable
Deferred tax liability (35% x 158,000)
Deferred tax asset (35% x 15,000)
Deferred tax at 35%
IAS 12INCOME TAXES
Carrying
value
$
460,000
18,000
(15,000)
Tax base
$
320,000
Temporary
difference
140,000
18,000
(15,000)
55,300
(5,250)
50,050
IAS 12INCOME TAXES
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
OVERVIEW
Objective
To explain the rules on measurement, recognition, presentation and disclosure
of financial instruments.
lAS 32 &39
BACKGROUND
I
APPLICATION
AND SCOPE
I
DEFINITIONS
Traditional accounting
Financial instruments
History
lAS 32
lAS 39
lAS 32
lAS 39
PRESENTATION RECOGNITION I-- DERECOGNITION
Initial recognition
Examples
Liabilities and equity
Own equity instruments
Offset
Interest, dividends, losses and
gains
Compound instruments
Contingent settlement provisions
Treasury shares
DISCWSURE
Rules
Illustrative notes - Nokia
ED7
MEASUREMENT
HEDGING
HEDGE
ACCOUNTING
Financial asset
Financialliability
Initial
Fair value considerations
Subsequent measurement
lAS 39 definitions
Hedging instruments
Hedged items
Background
Fair value hedges
Cashflow hedges
1 BACKGROUND
1.1 Traditional accounting
Traditional accounting practices are based on serving the needs of manufacturing
companies. Accounting for such entities is concerned with accruing costs to be
matched with revenues. A key concept in such a process is revenue and cost
recognition.
The global market for financial instruments has expended rapidly over the last twenty
years, not only in the sheer volume of such instruments but also in their complexity.
Entities have moved from using "traditional" instruments (e.g. cash, trade debtors, long-
term debt and investments) to highly sophisticated risk management strategies based
around derivatives and complex combinations of instruments.
The traditional cost-based concepts are not adequate to deal with the recognition and
measurement of fmancial assets and liabilities. Specifically:
o Traditional accounting bases recognition on the transfer of risks and rewards.
It is not designed to deal with transactions that divide up the risks and rewards
associated with a particular asset (or liability) and allocate them to different parties.
o Some fmancial instruments have no or little initial cost (e.g. options) and are not
adequately accounted for (if at all) under traditional historical cost based systems.
If a transaction has no cost, traditional accounting cannot Dr and CR. In
addition, the historical cost of fmancial assets and liabilities has little
relevance to risk management activities.
1.2 Financial instruments
Afinancial instrument is any contract that gives rise to both a financial asset
of one entity and a financial liability or equity instrument of another entity.
Instruments include:
o primary instruments (e.g. receivables, payables and equity securities); and
o derivative instruments (e.g. financial options, futures and forwards,
interest rate swaps and currency swaps).
1.3 History
lAS 32 "Financial Instruments: Disclosure and Presentation" was first issued in June
1995.
lAS 39 "Financial Instruments: Recognition and Measurement" was first issued in
December 1998.
Both standards have been revised and updated since they were first issued.
This time difference of the initial issue ofIAS 32 and lAS 39, reflects the
complexity of the recognition and measurement issues. The first exposure
draft on fmancial instruments (issued in 1991) had sought to address
disclosure, presentation, recognition and measurement in one standard. The
subsequent revisions reflect the "learning process" of dealing with the
complexities of financial instruments and new issues that have been raised
since the standards were first issued.
2 APPLICATION AND SCOPE
2.1 lAS 32
2.1.1 Application
Classification of financial instruments between:
D financial assets;
D financial liabilities; and
D equity instruments.
Presentation, disclosure and offset of financial instruments and the related
interest, dividends, losses and gains.
Disclosure of:
D factors affecting the amount, timing and certainty of cash flows;
D the use of financial instruments and the business purpose they
serve; and
D the associated risks and management's policies for controlling those
risks.
2.1.2 Scope
This Standard should be applied in presenting and disclosing information
about all types of financial instruments, both recognised and unrecognised,
except for financial instruments that are dealt with by other standards, i.e:
D interests in subsidiaries, associates, and joint ventures accounted for
under lAS 27, lAS 28 and lAS 31 respectively,;
D contracts for contingent consideration in a business combination
under IFRS 3 (only applies to the acquirer);
D employers' rights and obligations under employee benefit plans, to
which lAS 19 applies;
D certain insurancecontractsaccountedfor under IFRS4; and
D fmancial instruments, contracts and obligations under share-based
payment transactions to which IFRS 2 applies (unless relating to
treasury shares).
2.2 lAS 39
2.2.1 Application
Recognition and derecognition of fmancia1 assets and financia11iabi1ities.
Classification of financial assets and financia11iabi1ities.
Initial measurement and subsequent measurement of financial assets and
financial liabilities.
Defmition ofhedge accounting, and criteria and rules for hedge accounting.
2.2.2 Scope
This Standard should be applied by all entities to the recognition and
measurement of all fmancial instruments exceptfor financial instruments that
are dealt with by other standards, i.e:
o interests in subsidiaries, associates, and joint ventures that are
accounted for under lAS 27, lAS 28 and lAS 31 respectively,.
The Standard does not change the requirements relating to accounting by a
parentfor investments in subsidiaries, associates or joint ventures in the
parent's separatefinancial statements as set out in lAS 27, 28 and 31.
o rights and obligations under leases, to which lAS 17 applies;
o employers' assets and liabilities under employee benefit plans, to
which lAS 19 applies;
o fmancial instruments issued by the entity that meet the definition of
an equity instrument (lAS 32) including options and warrants;
However, the holder ofsuch equity instruments applies lAS 39 to those instruments,
unless they meet the exception relating to lAS 27, lAS 28 or lAS 31.
o contracts for contingent consideration in a business combination
under IFRS 3 (only applies to the acquirer);
o contracts between an acquirer and a vendor in a business
combination to buy or sell an acquiree at a future date; and
o fmancial instruments, contracts and obligations under share-based
payment transactions to which IFRS 2 applies.
3 DEFINITIONS
3.1 From lAS 32
Afinancial asset is any asset that is:
o cash;
o a contractual right to receive cash or another fmancial asset from
another entity;
o a contractual right to exchange financial instruments with another
entity under conditions that are potentially favourable;
o an equity instrument of another entity; or
o certain contracts that will (or may) be settled in the entity's own
equity instruments.
For this purpose the entity's own equity instruments do not include
instruments that are themselves contractsfor the future receipt or delivery of
the entity's own equity instruments.
Afinancialliability is any liability that is a contractual obligation:
o to deliver cash or another financial asset to another entity;
o to exchange financial instruments with another entity under
conditions that are potentially unfavourable; or
o certain contracts that will (or may) be settled in the entity's own
equity instruments.
Physical assets (e.g. prepayments), liabilities that are not contractual in
nature (e.g. taxes), operating leases, and contractual rights and obligations
relating to non-financial assets that are not settled in the same manor as a
financial instrument) are not financial instruments.
Preferred shares that providefor mandatory redemption by the issuer, or that
give the holder the right to redeem the share, meet the definition ofliabilities
and are classified as such even though, legally, they may be equity.
An equity instrument is any contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities.
Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm's length transaction.
3.2 From lAS 39
3.2.1 Derivatives
A derivative is a financial instrument:
o whose value changes in response to the change in a specified
interest rate, fmancial instrument price, commodity price, foreign
exchange rate, index ofprices or rates, credit rating or credit index,
or other variable (sometimes called the "underlying");
o that requires little or no initial net investment relative to other types
of contracts that would be expected to have a similar response to
changes in market conditions; and
o that is settled at a future date.
3.2.2 Categories offinancial assets
lAS 39 currently identifies four categories offmancial assets.
A financial asset or financial liability at fair value through profit or loss is a
financial asset or financial liability that is either:
o classified as held for trading; or
o designated initially at fair value through profit or loss.
Except for investments in equity instruments that do not have a quoted market
price in an active market and whosefair value cannot be reliably measured,
anyfinancial asset or financial liability within the scope oflAS 39 may be
designated when initially recognised at fair value through profit or loss.
Once afinancial asset has been designated as at fair value through profit or
loss, it must remain in that category until de-recognition.
Held-to-maturity investments are non-derivative financial assets with fixed or
determinable payments and fixed maturity that an entity has the positive
intent and ability to hold to maturity other than those:
o designated as at fair value through profit or loss on initial recognition;
o designated as available for sale; or
o meeting the definition of loans and receivables.
Fixed or determinable payments andfixed maturity means a contractual
arrangement that defines the amounts and dates ofpayments to the holder,
such as interest andprincipal payments on debt.
Loans and receivables are non-derivative financial assets with fixed or
determinable payments that are not quoted in an active market, other than
those:
o intended for immediate sale (classified as held for trading);
o designated initially as at fair value through profit or loss or
available for sale; or
o se loans where repayment of the initial loan is in doubt (other than
where there is a fall in credit rating), in which case they will be
classed as available for sale.
Available-for-salefinancial assets are those non-derivative financial assets
that are designated available-for-sale or are not classified as:
o loans and receivables;
o held-to-maturity investments; or
o fmancial assets at fair value through profit or loss.
This category captures all financial assets which do not fit into the other categories.
3.2.3 Recognition and measurement
Amortised cost of a financial asset or financial liability is:
o the amount at which it was measured at initial recognition;
minus
o principal repayments;
plus or minus
o the cumulative amortisation of any difference between that initial
amount and the maturity amount; and
minus
o any write-down (directly or through the use of an allowance
account) for impairment or uncollectability.
The effective interest method is a method of calculating the amortised cost of
a financial asset or a financial liability, using the effective interest rate and of
allocating the interest.
The effective interest rate is the rate that exactly discounts estimated future
cash payments or receipts through the expected useful life of the financial
instrument to the net carrying amount of the financial asset (or financial
liability). The computation includes all cash flows (e.g. fees, transaction
costs, premiums or discounts) between the parties to the contract.
The effective interest rate is sometimes termed the "level yield-to-maturity"
(or to the next repricing date), and is the internal rate of return of the fmancial
asset (or liability) for that period.
Transaction costs are incremental costs that are directly attributable to the
acquisition, issue or disposal of a financial asset (or fmancialliability).
An incremental cost is one that would not have been incurred ifthe entity had
not acquired, issued or disposed ofthe financial instrument. Examples
include fees and commissions paid to agents.
Transaction costs do not include debt premiums or discounts, financing costs
or internal administrative or holding costs.
Illustration 1 - Amortised cost using the effective interest rate method
A company issues a $100,000 zero coupon bond redeemable in 5 years at $150,000.
The internal rate ofretum (the yield) on these flows is 8.45%. This should be used to
allocate the expense.
Period Opening balance Interest@ Closing
8.45% balance
1 100,000 8,450 108,450
2 108,450 9,164 117,614
3 117,614 9,938 127,552
4 127,552 10,778 138,330
5 138,330 11,689 150,019
This should be 150,000.
The difference of19 is due
to rounding
3.2.4 lledging
Defmitions relating to hedging are given later in this session.
4 PRESENTATION (lAS 32)
4.1 Liabilities and equity
On issue, fmancial instruments should be classified as liabilities or equity in
accordance with the substance of the contractual arrangement on initial
recognition.
Some financial instruments may take the legal form of equity, but are in
substance liabilities.
An equity instrument is any contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities.
Illustration 2 - Preference shares
Redeemable preference shares are not classified as equity under lAS 32 as there is a
contractual obligation to transfer fmancial assets (e.g. cash) to the holder ofthe shares.
They are therefore a financial liability.
If such shares are redeemable at the option of the issuer, they would not meet the
defmition of a fmancialliability as there is no present obligation to transfer a financial
asset to the holder of the shares. When the issuer becomes obliged to redeem the
shares, they become a financial liability and will then be transferred out of equity.
For non-redeemable preference shares, the substance of the contract would need to be
studied. For example, if distributions to the holders of the instrument are at the
discretion of the issuer, the shares are equity instruments.
4.2 Settlement in own equity instruments
A contract is not an equity instrument solely because it may result in the
receipt or delivery of the entity's own equity instruments.
A financial liability will arise when:
o there is a contractual obligation to deliver cash or another financial
asset, to exchange financial assets or financial liabilities, under
conditions that are potentially unfavourable to the issuer;
o there is a non-derivative contract to deliver, or be required to
deliver, a variable number of own equity instruments;
o there is a derivative that will or may be settled other than by issuing
a fixed number of own equity instruments.
An equity instrument will arise when:
o there is a non-derivative contract to deliver, or be required to
deliver a fixed number of own equity instruments;
o there is a derivative that will or may be settled by issuing efixed
number of own equity instruments.
Illustration 3 - Settlement in the entity's own equity instruments
(a) A company enters into a contract to deliver 1,000 of its own common shares
to a third party in settlement of an obligation.
As the number of shares are fixed within the contract to meet the obligation,
it is an equity instrument. There is no obligation to transfer cash, another
financial asset or an equivalent value.
(b) The same company enters into another contract that requires it to settle a
contractual obligation using its own shares in an amount that equals the
contractual obligation.
In this case the number of shares to be issued will vary depending on, for
example, the market price of the shares at the date of the contract or
settlement. If the contract was agreed at a different date, a different number
of shares may be issued. Whilst cash has not been paid, the equivalent value
in shares will be transferred. The contract is a financial liability.
(c) Company G has an option contract to buy gold that if exercised, would be
settled net in the company's shares based on the share price at the date of
settlement.
As the company will deliver as many shares (i.e, variable) as are equal to the
value of the option contract, the contract is a financial asset or a financial
liability.
This will be so even if the amount to be paid was fixed or based on the value
of the gold at the date of exercising the option. In both cases the number of
shares issued would be variable.
4.3 ()ffset
Financial assets and liabilities must be offset where the entity:
D has a legal right of offset; and
D intends to settle on a net basis or to realise the asset and settle the
liability simultaneously.
Offset might be oftrade receivables and payables, or ofaccounts in debit and
credit at a bank.
4.4 Interest, dividends, losses and gains
Interest, dividends, losses and gains relating to a fmancia1 instrument (or a
component) that is classified as a liability, shall be recognised in the profit or
loss as income or expense.
Dividends on preferred shares classified as a financia11iabi1ity are accounted
for as expenses, rather than as distributions ofprofit.
Distributions to holders of equity instruments should be debited directly to equity.
Gains or losses on refmancing or redemption of a financial instrument are classified
as income/expense or equity according to the classification ofthe instrument.
Transaction costs relating to the issue of a compound financial instrument are allocated
to the liability and equity components in proportion to the allocation ofproceeds.
Basically, such itemsfollow the classification ofthe underlying component.
4.5 Compoundinstruments
4.5.1 Presentation
Financial instruments that contain both a liability and an equity element are
classified into separate component parts.
As an example, convertible bonds are primary fmancialliabilities of the
issuer which grant an option to the holder to convert them into equity
instruments in the future. Such bonds consist of:
o the obligation to repay the bonds, which should be presented as a
liability; and
o the option to convert, which should be presented in equity.
The economic effect ofissuing such an instrument is substantially the same as
issuing simultaneously a debt instrument with an early settlement provision
and warrants to purchase ordinary shares.
4.5.2 Carrying amounts
The equity component is the residual amount after deduction of the more
easily measurable debt component from the value of the instrument as a
whole.
The liability is measured by discounting the stream of future payments at the
prevailing market rate for a similar liability without the associated equity
component.
Example 1
An entity issues 2,000 convertible, $1,000 bonds at par on 1 January 2004.
Interest is payable annually in arrears at a nominal interest rate of 6%.
The prevailing market rates of interest at the date of issue of the bond was 9%.
The bond is redeemable 31 December 2006.
Required:
Calculate the values at which the bond will be included in the fmancial statements of
the entity at initial recognition.
Solution
4.6 Contingent settlement provisions
An entity may issue a fmancial instrument where the rights and obligations
regarding the manner of settlement (in cash or in equity) depend on the
outcome of uncertain future events that are beyond the control of both the
issuer and the holder of the instrument.
Examples include:
o bonds that require the issuer to settle in shares if a market price
exceeds a certain mark; and
o issuing potential shares that will be issued as shares ifrevenues
exceed a certain amount or as bonds if the revenues do not.
As the issuer of the instrument does not have the unconditional right to avoid
delivering cash or another financial asset, the instrument shall be classified as
a financial liability.
4.7 Treasury shares
If an entity acquires its own equity instruments, those instruments ('treasury
shares') are deducted from equity.
No gain or loss is recognised in profit or loss on the purchase, sale, issue or
cancellation of an entity's own equity instruments.
Such treasury shares may be acquired and held by the entity or by other
members of the consolidated group.
Consideration paid or received is recognised directly in equity.
The amount of treasury shares held is disclosed separately either on the face
of the balance sheet or in the notes, in accordance with lAS 1.
If own equity instruments are acquired from related parties lAS 24 disclosure
requirements apply.
5 DISCLOSURE (lAS 32)
5.1 Rules
5.1.1 Introduction
The purpose of disclosure is to:
o enhance understanding of the significance of fmancial instruments
to an entity's fmancial position, performance and cash flows;
o assist in assessing the factors affecting the amount, timing and
certainty of future cash flows associated with those instruments;
and
o provide information to assist users of financial statements in
assessing the extent ofrelated risks.
Transactions in financial instruments may result in an entity assuming or
transferring to another party one or more ofthe following financial risks:
o currency risk (related to changes in foreign exchange rates);
o fair value interest rate risk (related to changes in interest rates);
o price risk (related to changes in market prices);
o credit risk (the risk of "bad debts");
o liquidity/funding risk (the risk of an inability to meet
commitments); and
o cash flow interest rate risk (the risk that future cash flows will
fluctuate because of changes in marker interest rates, for example,
those relating to floating rate debt instruments).
5.1.2 Risk management and hedging activities
An entity must describe its fmancia1risk management objectives and policies
including its policy for hedging forecasted transactions.
The level ofdetail to be given needs to strike a balance between excessive
detail and over aggregation.
For each type of hedge:
o a description of the hedge;
o a description of the financial instruments designated as hedging
instruments and their fair values at the balance sheet date; and
o the nature of the risks being hedged.
When a gain or loss on a hedging instrument in a cash flow hedge has been
recognised directly in equity (through the statement of changes in equity)
disclose:
o the amount recognised in equity during the current period;
o the amount removed from equity and reported in profit or loss for
the period; and
o the amount transferred from equity into the acquisition cost of a
non-fmancia1 asset or liability.
Sometimes referred to as the "basis adjustment".
5.1.3 Terms, conditions and accounting policies
For each class of asset, liability and equity instrument, both recognised and
unrecognised, information should be disclosed covering:
o the extent and nature of fmancial instruments;
o significant terms and conditions affecting the amount, timing and
certainty of future cash flows;
o the accounting policies and methods adopted, including the criteria
for recognition and the basis of measurement applied (usually cost
or fair value).
When financial instruments held or issued by an entity create a potentially
significant exposure to financial risks, the terms and conditions that warrant
disclosure include:
o details of the principal or nominal amounts on which future
payments are based;
o dates of maturity, expiry or execution;
o early settlement options;
o options to convert, the amount and timing of future cash receipts
and payments, interest or dividend rates;
o collateral held or pledged;
o the amount and timing of scheduled future cash receipts or payments
ofthe principal amount ofthe instrument;
o stated rate or amount of interest, dividend or other periodic return on
principal and the timing of payments;
o any condition of the instrument or an associated covenant that, if
contravened, would significantly alter any of the other terms.
Where the balance sheet presentation differs from legal form, this should be
explained as should hedging relationships.
5.1.4 Interest rate risk
An entity must disclose information about its exposure to interest rate risk.
Such information includes:
o contractual repricing or maturity dates;
o effective interest rates; and
o which fmancial assets and liabilities are exposed to fair value or
cash flow interest rate risk and those that are not directly exposed to
interest rate risk.
5.1.5 C7reditrisk
An entity must disclose information about its exposure to credit. Such
information includes:
o the maximum credit exposure risk; and
o significant concentrations of credit risk.
5.1.6 Fair value risk
An entity must disclose information about the fair value of each class of
financial asset and financial liability.
It must disclose the methods and significant assumptions applied in
estimating fair values of financial assets and financial liabilities that are
carried at fair value, separately for each significant class of fmancial assets.
In applying the above, an entity will disclose prepayment rates, rates of
estimated credit losses, and interest or discount rates.
Whether fair values are determined directly by reference to published price
quotations in an active market or are estimated using a valuation technique.
Whether the financial statements include financial instruments measured at
fair values that are determined using a valuation technique based on
assumptions that are not supported by market prices or rates.
The total amount ofthe change in fair value that was estimated using a valuation
technique.
If fair value cannot be reliably measured for financial assets, disclose:
D that fact;
D a description of them;
D carrying amount;
D an explanation of why fair value cannot be reliably measured; and
D ifpossible, the range of estimates within which fair value is highly
likely to lie.
5.1.7 Other disclosures
Disclose material items of income, expense, and gains and losses resulting
from fmancial assets and financial liabilities, whether included in net profit or
loss or as a separate component of equity. For this purpose:
D total interest income and total interest expense should be disclosed
separately;
D for available-for-sale financial assets, the amount of any gain or
loss recognised directly in equity during the period and the amount
that was removed from equity and recognised in profit or loss for
the period; and.
Disclose the carrying amount of financial assets pledged as collateral and any
material terms and conditions relating to such pledged assets.
Disclose the carrying amounts of financial assets and financial liabilities that:
o are classified as held for trading; and
o were, upon initial recognition, designated by the entity as financial
assets and financial liabilities at fair value through profit or loss
(i.e. those that are not financial instruments classified as held for
trading).
For a financial liability designated as at fair value through profit or loss,
disclose:
o the amount of change in its fair value that is not attributable to
changes in a benchmark interest rate (e.g. LIBOR); and
o the difference between its carrying amount and the amount the
entity would be contractually required to pay at maturity to the
holder of the obligation
If the entity has reclassified a financial asset as one required to be reported at
amortised cost rather than at fair value, disclose the reason for that
reclassification.
Disclose the nature and amount of any impairment loss or reversal of an
impairment loss recognised for a fmancial asset, separately for each
significant class of financial asset.
5.2 Illustrative notes - Nokia
A very good example ofhow the requirements oflAS 32 may be fulfilled.
34. Risk management
~ n r l risk management principles
Nokia's overall risk management concept is based on visibility
of the key risks preventing Nokia from reaching its business
objectives. This covers all risk areas; strategic, operational
financial and hazard risks. Risk management at Nokia is a
systematic and pro-active way to analyze, review and manage 011
opportunities, threats and risks related to Nokia's objectives
rather than to solely eliminate risks.
The principles documented in Nokia's Risk Policy and
accepted by the Audit Committee of the Roan! of Directors
require risk management and its clements to beintegrated into
business processes. One of the main principles is that the
business or function owner is also the risk owner, however, it is
everyone's responsibility at Nokia to idcntify risks preventing us
from reaching our objectives.
Key risks are reported to the business and Group level
management to create assurance on business risks and to enable
prioritization of risk management implementation at Nokia. In
addition to general principles there arc specific risk management
polieics covering, for example, treasury and customer finance
risks.
Financial rl.b
The key financial targets for Nokia are growth, profitability,
operational cffieicney and a strong balance sbeet, The objective
for the Treasury function is lwofold: to guarantee cost-effic ient
funding for the Group at all times, andto identify, evaluate and
hedge financial risks in close co-operation with the business
groups. There is a strong focus in Nokia on creating sbarcbolder
value. The Treasury functioo supports this aim by minimizing
the adverse effects caused by fluctuations in the financial
markets on the profitability of the underlying businesses andby
managing the balance sheet structure of the Group.
Nokia has Treasury Centers in Geneva, Singapore/Beijing
andDallas ISao Paolo, and a Corporate Treasury unit in Espoo.
This international organization enables Nokia to provide the
Group companies with financial services according to local
needs and requirements,
The Treasury function is governed by policies approved by
top management. Treasury Policy provides principles for overall
financial risk management and determines the allocation of
responsibilities for financial risk management in Nokia.
Operating Policies cover specific areas such as foreign exchange
risk, interest rate risk, usc of derivative financial instruments, as
well as liquidity and credit risk, Nokia is risk averse in its
Treasury activities. Business Groups have detailed Standard
Operating Procedures supplementing the Treasury Policy in
financial risk management related issues.
Market ris k
Foreign exchange risk
Nokia operates globally and is thus exposed to foreign exchange
risk arising from various currency combinations. Foreign
currency denominated assets and liabilities together with
expected cash flows from highly probable purchases and sales
give rise to foreign exchange exposures, These tmnsaction
exposures arc managed against various local currencies because
of Nokia's substantial production and sales outside the
Eurozonc.
lAS 32 AND lAS 39 FINANCfAL fNSTRUMBNTS
2002
2002
5' .4
5.1
3.1-a.7
6.5
B.ll
55-19.0
9.8
6.7
4.7-11.9
At December 31
Avemgefor the year
Range fur theyear
GBP3I)%
Olherl7%
JPV28%
88<5%
AUC7%
U8C15%
IDtereit rate risk
The Groql is exposedto interest ratI: risk cilberthroughmaUd
value fluctuations of balance sheet itemlJ (i.e. price ri8k) aDd
tbroush changes in interest or apen8C8 (i.e. re-
investment ri8k). Interest ratI: risk mainly ariJea through
interest-bearing liabilities and aseets. Estimated future changes
in cuh f1awJ andbs!JInce sheet strIIcCUre alto exposetheGroup
to interest nde risk.
Trees1Iry is responsible for monitoring and the
interest ratI: expolRRof die Group . Due to the balance
sheet stnlctureof Nokia, emphasis is placed OIl IDlIDlIging the
interest nde risk of ilrvestmen1s.
Nokia uses the VaR methodologyto assess andmeasure the
intere3t nde riskin inYestmem portfolio, whkh is benchmarked
spinst a 0IlJ: year investmellt horizon. The VaR fipe
repn:sentB the potential &it' value 10SBelI for a portfolio
Due to the chllnges in 1be businessenviromnent, currency resulting ftom lIllvel'lle changes in market factors using a
combinations may alto chlmgewithin the :tinaDl:iaI year. The specified time period andconfidencelevel based on historkaI
most signi:lkam nOll-Qll'O sales CQlI'CItCies durina the year data . For inIBest nde risk Va&, Nokia1I8es
U.S. dollar (USD), UK pound Sterling (OBP) and methodology. Volatilities 8Ddc:orreIItions are Q\cuIIted. ftom
AII8traIilIn dollar (AUD). Ill. g=u:raI, the depreciation of a Olle-year set of daily data. The VaR-based intmcst IlllI: risk
another currencyrelative to the euro has an lIlIverIIe c:ffe<:t OIl fi8ures for an investment portfolio with a one-week hori7.on
Nokia', sales and openll:ina profit, while appreciation of and 9S% confidencelevel are shownbelow.
anothercum=y hu a positive effect, with the r.'!ltCeption of
bema lhe only signifieaBt foreign in TreanIry Investment portfolio Valae-at-RIsIt
whichNokia has more purehasethan sales.
The dlert above shOWll 1be breakdownby eurteIlCY of lhe (EURm)
underlying net furei&n exchange tr\IIISllCtion exposure as of
December31.2003 (in some of the espr:cidly the VaR
US dollar. Nokia has both sub8bmtia1 sales as well 88 eost,
whichIulvebeen nettedin the chart).
Aceording to the forei&n exchange policy gnideIme8 of lhe
Group. material tJlU1saction foreign exchange exponres are
hedged. Exposures are mainly hedged with derivative
fillancial instrumentB such 88 forward foreign exdumge
and foreign exchange optiOI18. The majority of Eqllfty price risk
finml:i8I instruments hedging foreign exclumge risk have. Nokia 1uls stIablgic invostmmrts in .publicly
duratiOll of less tIum a year. The Group does not hedae eompsmes. invMtIntm1s classified as
fon:o:utedforeigncurrency cash flows beyond twoyears. avaiIable-for-ule. The fm value eqwty
Nolda uses the Value-at-Risk ("YaR") metbodology to Deeember 31, 2003 was BUR8 million (EUR 137 million m
assess 1be foreign exchange risk related. to the TreaslllY 2002).
lIIllIUlpDlent of 1be Group exposures. The VaR figure Then are l:WRIlI1y no ouIIrtlmding derivative financial.
representB die potcmiaIlosses for a portfolio resulting from instrumfmsdesignafed. as hedges of dlese equity investmellts.
adverse chanses in marlret filctors using specified time The VaR figures for equity investments, shown in the table
period and confidence level based on historical data. To have }-n cak:uIated using the IllD1e principleI as for
correctly 1lIkeinto account the non-lillear price fimction of mblmlt IlllI: riaL
c;ertain derivative lnstrumentB, Nokia uses Monte Carlo
simIIlation. Volatilities andcondatiOl18 are cakuIated ftom. Equity InYeltmeDti Vlllne-at-Rbk (EURm)
one-year set of daily data. The VaR :fis1lres assume 1hat the
forecamd cash flows IOlIterialize llll expected. The VaR
figures for the Group lrlms8ction foreign exchange expowre, VaR 2003
iw:hId.ing bedging 1ranI1lCti0l18 and Treasary exposures for At:December 31 CU
nettins and risk management purposes, with a one-week
horizon and 9S%eonfidenee kveI, are shown below. Avenge for theyear 3.5
Ranse for theyear 0.2-,9."
Ai December31
Avenge for the
year
Range for the year
16.7
9.3
5.8-16.7
5.9
14.3
4,9-27 .6
In addition to 1he listed equity holdings, Nokia investll in
privale equity throoghNokiaVeatvreFunds. The fair Y8lu.e of
these availablo-for..sllle equity inve"8tmenI8 at December 31,
2003 wasusn85million (USD S4 million in 2002). Nokia is
exposedto equity price risk on socialseeurity costB relatingto
,tock compensation plans. Nokia hedge8 fhis risk by entering
into cash settled eqgitylIWap and optionc:ontr1lctll.
Sinee Nolda has sobsidiaries outaidetheHurozone, the eoro-
denominated value of the shareholder's equity of Nokia is aim Credit risk
exposed to flnrtuatiOl18 in c:xcha:nge rates. Eqalty changes
caused by in foreignexchange IlllI:s are shownas
a IrImsIation diffilrence in !be Group c:onsolidation. Nokia eu.tomer l'fJIp.ee Credtt Rtak
uses, ftom time to time, foreign exchange con1racts and Networkopcntors sometimes their supplierB te lIIIlUIge
foreign currency denominated loans to hedge its equity or provide teIm financing in relation to inftaItrnetureprojects.
exposurearisingfromforeignnet inveslmcms. Nokia b;as a financing policy aimed at c10le
OOllJleration withbanks, financialioItitutiOI18 and Export Credit
Agencies to support selected custlmlerTl in their financing of
inftaItrneture investments. Nokia ac:tively mitigales, msIket
c:onditions permitting, this expollUnl by ammgements with
these institutiOl18 8Ddinvestcm.
@ AccOUlltanc:y Tuition. Cc:ntre (lldemational Holding8)Ltd 2005 1919
The term custome r flnanelng portrollo at December 31,
2003 was:
The term customer financing portfolio at December 31, 2003
mninly consists of outstanding and eommitted customer financing
to wireless operators Hutchison 30 UK Lid in the United
Kingdom and to TNL PCS SA (Tclcmar) in Brazil. Total
committed customer financing to Hutchison 30 UK Lid
amounted to EUR 653 million, of which outstanding financing
was EUR 354 million, while total committed customer financing
to Telcmark amounted to EUR 191 million, of which none was
outstanding .
Credit risk
Customer FinanceCredit Risk
Network operators in some markets sometimes require their
suppliers to arrange or provide term financing in relation to
infrastructure projects. Nokia has maintained a financing policy
aimed at close cooperation with banks, financial institutions and
Export Credit Agencies to support selected customers in thcir
financing of infrastructure investments. Nokia actively mitigates,
market conditions permitting, this exposure by arrangements with
these institutions and investors.
Credit risks related to customer financing are systematically
analyzcd, monitored and managed by Nokia's Customer Finanee
organization, reporting to the Chief Financial Officer. Credit risks
are approved and monitored by Nokia's Credit Committee along
principles defined in the Company' s credit policy and according
to the credit approval process. The Credit Committee consists of
the CFO, Group Controller , Head of Group Treasury and Head of
Nokia Customer Finance.
Credit risks related to customer financ ing are systematically
analyzed, monitored and managed by Nokia's Customer Finance
organization, reporting to the Chief Financial Officer. Credit risks
arc approved and monitored by Nokia' s Credit Committee along
principles dcfined in the Company's credit policy IUId according
to the credit approval process. The Credit Committee consists of
the CFO, Group Controller, Head of Group Treasury and Head of
Nokia
At thc cnd of December 31, 2002 our long-term loans to
customers, net of allowances and write-offs, totaled EUR 354
million (EUR I 056 million in 2002), while financial guarantees
given on behalf of third parties totalled BUR33 million (EUR 91
million in 2002). In addition, we bad financing commitments
totaling EUR 490 million (EUR 857 million in 2002). Total
customer financing (outstanding and committed) stood at EUR 877
million (EUR2 004 million in 2002).
4
3
18
8
10
7
18
5
7
1
2
1
4
30
7
6
128
141
137
6
4
128
Unrea
lIed
gains
Unrea
lied
golns
-3
-2
-3
- 1
-1
-I
-3
- I
-1
- 1
-5
Unrea
ned
losses
1484
692
314
478
264
4012
2075
2538
1 109
264
1 165
1058
5206
2 165
6371
2 167
5470
3330
976
4326
2553
8430
fair
value
10967
2002, EURm
Governmenls
Ban l.:s
Corporales
2002, EURm
Govemments
Banl.:s
Corporales
2003, EURm
Govemmenls
Banl.:s
Corporales
Tolal
2002, EURm
Governments
Bonks
Corporales
2003, EURm
Govemmenls
Banks
Corporales
Tolal
2003, EURm
Govemmenls
Banks
Corporales
Maturity dale 12
month or more
Maturity dale 12
month or more
Maturlty dale less
than 12 monlh
Maturlty dale less
than 12 month
Current Avallable- for- sale investments I ~
fair Unr a
value -Iled
losses
490 877
Financing
Commit-
ments Total
387
Outstanding EURm
Total Portfolio
7855 -1 37
Financial credi t ri sk
Financial instruments contain an element of risk of the
counterparties being unable to meet their obligations. This risk is
measured and monitored by the Treasury function. The Group
minimizes financial credit risk by limiting its countcrpartics to a
sufficient number of major banks and financial institutions, as
well as through entering into netting arrangcments, which gives
the Company the right to offset in the case that the counterparty
would not be able to fulfill the obligations.
EURm
Fixed rate investmcnts
Floating rate investments
Total
2003
10541
426
10 967
2002
7 433
4n
7855
Direct credit risk represents the risk of loss resulting from
counterparty default in relation to on-balance sheet products. The
fixed income and money market investment decisions are based
on strict creditworthiness criteria. The outstanding investments are
also constantly monitored by the Treasury, Nokia does not expect
the counterparties to default given their credit quality.
1 Includes thegrossamount of all notiooat values forcontracts
thathave notyetbeen settled nrcancelled. The amount of
ncrionel valueoutstanding is Dot necessarily a IDCa5lU1:or
indication of market risk. as theexposure of certain contracts
maybeolUet bythat of other contracts.
, M. 01December 31, 2003ootional amounlI includecontracts
amounting to EUR3 billion usedto hedge lb. shareholders'
equity of foreign subsidiaries (December 31, 2002 EUR2
billion).
c..h settledequity IWlIp!I and option. can beusedto hedge risk
relating toincentive programsandinvestmernactivities.
Fair values of derivatives
The net fair values or derivative financial instruments at
the baIance sheet date were:
I Available-for-we iavestroentsere carried at fair value in 2003 and
2002.
, Welghlcd average Inlerest rateforCurrent available-for-..le
investments was 3.08% in2003 and 3.54% in2002.
J Included withinCUJ'Tt'ot investments is EUR
3ImJIIlon and EUR44 million ofrc.slriclcd cssh at December 31, 2003
and 2002, respectively,
UquldJty rIsk
Nokia guarantees a suffieient liquidity at all times by efficient
cash management and by investing in liquid interest bearing
securities. Due to the dynamic nature of the underlying business
Treasury also aims at maintaining flexibility in funding by
keeping committed and uncommitted credit IinC8 available.
During the year Nokia refinanced all its Revolving Credit
Facilities. At the end of December 31, 2003 the ncw committed
facility totalled USD 2.0 billion. The committed credit facility is
intended to be used for U.S. and Euro Commereinl Paper
Programs back up purposes. The commitment fee on the facility
is 0.10"10 per anum.
The most significant existing fundingprograms include:
RevolvingCredit Facilityof USD2 000 million, matures in
200g
Local commercial papcr program in Finland, totalling EUR
750 million
Euro Commercial Paper (BCP)program, totalling USD500
million
US Commercial Paper (USCP) program, totalling USD500
million
Derivatives withpositive fair valueI ,
Forward foreign exchange contracts '
Currency optionsbought
Cashsettled equityoptions
Interest rate swaps
Embedded derivatives'
Derivatives withnegative fair value' :
Forwardforeign exchange contracts '
Currency optionswritten
Embcddodderivates '
2003
EVRm
358
59
13
I
25
- 108
- 35
-8
2002
EURm
235
21
28
14
-98
- 7
None of the above programs have been used to a significant
degree in 2003.
Nokia's international creditworthiness facilitates the efficient
use of international capital and loan markets. The ratings of
Nokia from credit rating agencies have not changed during the
year. The ratings nt December 31, 2003 were:
Short-term Standard & Poor's A-I
Moody's P-I
Long-term Standard & Poor's A
Moody's Al
Hazard risk
Nokia strives to ensure that all financial, reputation and other
losses to the Group and our customers are minimized through
preventive risk management measures or purchase of insurance.
Insurance is purchased for risks which cannot be internally
managed. Nokia's Insurance & Risk Finance function's objective
is to ensure that Group's hazard risks, whether related to physical
assets (e.g. buildings) or intellectual assets (e.g. Nokia brand) or
potential liabilities (e.g, product liability) arc optimally insured.
Nokia purchases both annual insurance policies for specific
risks and multi-line multi-year insurance policies, where
available. Nokia has concluded a Multi-Line Multi-Year
Insurance covering a variety of the above mentioned risks in
order to decreasethe likelihood of non-anticipatedsudden losses.
Notional amounts of derivative flnanciallnstruments I
2003 2002
EVRm EVRm
Outof !beforward foreign exchange contracts and currency
optio"" fairvalue EUR90 millinn wasdesignated forhedges of
net investmenl inforeign subsidiaries8J at December 31,2003
(BUR36 million at December 31, 2(02) and reported In
tranatation dffcrcnces.
, Outof!beforeign exchange forwardcontracts, fair value EUR
33 million waa dcoignatcd forcash flow hedge, as al December
31, 2003 (BUR31 mJUion at December 31, 2(02) and reporlcd
in falr value and other reserves,
] Embedded derivative. arecomponents of contracts havingthe
charactcri5lics ofderivatives, and thus rcquirinll fairvaluing of
suchcompoocnts. Thechange in thefairvalue iarcporlcdIn
other financial income and expenses,
Foreign exchange forward contracts ,
Currencyoptions bought 2
Currency options sold '
Interest rate swaps
Cash settled equity options
Cash settled equity swap
10271
2924
2478
1 500
228
11 118
1408
1206
209
12
5.3 ED7 Financial Instruments: Disclosures
In July 2004 the IASB issued ED7 which if and when it becomes standard
will require additional disclosures.
Main features of the draft are as follows:
o Applies to all risks from most financial instruments. The main
exceptions being interests in subsidiaries, associates and joint
ventures.
o Disclosure of the significance of financial instruments for an
entity's financial position and performance.
o Adds to the requirements ofIAS 32 in that it requires:
Enhanced balance sheet and income statement
disclosures;
Disclosures relating to any allowances used to reduce the
carrying amount of impaired financial assets.
o Requires qualitative and quantitative disclosures about risks arising
from financial instruments, including describing management's
objectives, policies and processes for managing risk.
o Specific minimum disclosures relating to liquidity and market risk
are required.
o Disclosure is required relating to an entity's objectives, policies and
processes of managing capital including the compliance with any
capital targets that have been set.
o The draft when it becomes standard will replace lAS 30
Disclosures in the Financial Statements ofBanks and Similar
Financial Institutions.
6 RECOGNITION (lAS 39)
6.1 Initial recognition
An entity should recognise a fmancial asset (or liability) on its balance sheet
when, and only when, it becomes a party to the contractual provisions of the
instrument.
As a consequence of this rule, an entity must recognises all of its contractual
rights or obligations under derivatives in its balance sheet as assets or
liabilities.
6.2 Examples
A forward contract (i.e. a commitment to purchase or sell a specified
financial instrument or commodity on a future date at a specified price) is
recognised as an asset or a liability on the commitment date, rather than
waiting until the closing date on which the exchange actually takes place.
Financial options are recognised as assets or liabilities when the holder or
writer becomes a party to the contract.
Plannedfuture transactions, no matter how likely, are not assets and
liabilities of an entity since the entity, as of the financial reporting date, has
not become a party to a contract requiring future receipt or delivery of assets
arising out ofthe future transactions.
6.3 Embedded derivatives
An embedded derivative is a component of a combined instrument that
includes a non-derivative host contract.
The effect will be that some of the cash flows of the combined instrument
will vary in a manner that is similar to that of a stand alone derivative.
A derivative that is attached to a financial instrument but can be transferred
separately from that instrument, such as a warrant, is not an embedded
derivative, but a separate financial instrument.
An embedded derivative will be separated from the host contract and
accounted for as a separate derivative if:
o the economic characteristics and risks of the embedded derivative
are unrelated to those of the host contract;
o a separate instrument with the same terms of the embedded would
meet the defmition of a derivative in its own right; and
o the combined instrument is not measured at fair value with changes
in fair value being recognised in profit and loss.
A derivative that is embedded in afinancial instrument measured at fair
value through profit or loss will not be separated.
If the embedded is separated, the host contract will be accounted for under
lAS 39 if it is a financial instrument or under another appropriate standard if
the host is not a financial instrument.
lAS 39 does not require the host and its embedded derivative to be presented
separately in the fmancia1 statements.
If an entity is unable to value the embedded derivative separately, either at
acquisition or at a later date, it shall treat the combined contract as a financial
asset or liability that is held for trading.
7 DERECOGNITION
7.1 Derecognition of a financial asset
7.1.1 Basic derecognition criteria
An entity should derecognise a financial asset (or a part of it) when, and only
when:
o the contractual rights to the cash flows from the financial asset
expire; or
o it transfers the financial asset and the transfer qualifies for
derecognition.
In many cases derecognition of a financial asset is straight forward - if there
are no longer any contractual rights, the asset is derecognised. If contractual
rights remain, the Standard requires three further steps to be considered, i.e.
transfer, risks and rewards, control.
7.1.2 Transfer ofafinancial asset
An entity transfers a financial asset if, and only if, it either:
o gives the contractual rights to receive the cash flows to a third
party; or
o retains the contractual rights to receive the cash flows, but assumes
a contractual obligation to pay the cash to a third party.
7.1.3 Transfer ofrisks and rewards ofownership
When the entity establishes that a transfer has taken place, it must then
consider risks and rewards of ownership.
If substantially all the risks and rewards of ownership of the fmancial asset
have been transferred, the financial asset is derecognised.
However, if the entity neither transfers nor retains substantially all the risks
and rewards of ownership, the entity determines whether it has retained
control.
7.1.4 Control
If control has not been retained, the financial asset shall be derecognised.
Ifthe third party is able to use the asset as ifit owned it (e.g. sell the asset
without attaching conditions such as a repurchase option) the entity has not
retained control.
In all other cases, the entity has retained control.
Illustration 4 - Control
(a) As part of a contract, Enigma is required to transfer to Brevity a fmancial
asset comprising 5,000 shares in a listed entity. Under the terms of the
contract, Brevity is required to return the same number of shares to Enigma
on demand.
As the shares are listed and are therefore freely traded in an active market,
Brevity can sell the shares when received and repurchase 5,000 shares when
required to return them to Enigma.
Enigma should derecognise the shares when transferred to Brevity as they
have lost control.
(b) The same situation, except that the "shares" transferred are rare collector's
items of shares issued by a Russian railroad entity in the late l800s.
In this situation, the shares are not freely available on an active market and if
sold, could not be re-purchased (without attaching a repurchase option).
Control has not been passed and the financial asset would not be
derecognised.
Where a financial asset is transferred to another entity but control has not
been lost, the transferor accounts for the transaction as a collateralised
borrowing.
If control passes the asset may be treated as sold.
Dr Cash
Cr Disposals
If control does not pass then the asset has not been sold but rather it has been used as
collateral (security) for borrowing.
Dr Cash
CrLoan
7.1.5 Profit or loss on derecognition
On derecognition, the difference between:
D the carrying amount of an asset (or portion of an asset) transferred
to another party; and
D the sum of:
the proceeds received or receivable; and
any prior adjustment to reflect the fair value of that asset
that had been reported in equity,
should be included in net profit or loss for the period.
7.2 Derecognition of a financial liability
An entity should remove a fmancialliability from its balance sheet when, and
only when, it is extinguished - that is, when the obligation specified in the
contract is discharged, cancelled, or expires.
This condition is met when either:
D the debtor discharges the liability by paying the creditor, normally
with cash, other financial assets, goods, or services; or
D the debtor is legally released from primary responsibility for the
liability (or part thereof) either by process of law or by the creditor.
Thefact that the debtor may have given a guarantee does not necessarily
mean that this condition is not met.
The difference between:
D the carrying amount of a liability (or portion) extinguished or
transferred to another party (including related unamortised costs);
and
D the amount paid for it,
should be included in profit or loss for the period.
8 MEASUREMENT (lAS 39)
8.1 Initial measurement of financial assets and financial liabilities
When a financial asset (or liability) is initially recognised, it is measured at its
fair value (usually the fair value of the consideration given or received for it).
Transaction costs that are directly attributable to the purchase of a fmancial
asset or the issue of a financial liability are included in the initial
measurement of all fmancial assets and liabilities, except those for a fmancial
asset or fmancialliability at fair value through profit or loss.
Costs ofan equity transaction are only those incremental external costs directly
attributable to the equity transaction that would otherwise have been avoided. .
The costs of a transaction which fails to be completed should be expensed.
Transaction costs that relate to the issuance of a compound instrument that
contains both a liability and an equity element should be allocated to the
component parts in proportion to the allocation ofproceeds.
Transaction costs that relate jointly to more than one transaction should be
allocated to those transactions using a basis of allocation which is rational
and consistent with similar transactions.
8.2 Fair value considerations
The fair value is reliably measurable if:
o the variability in the range of reasonable fair value estimates is not
significant; or
o the probabilities of the estimates can be reasonably assessed and
used in the estimates of fair value.
Fair value exists in the following circumstances:
o there is a published price in an active market;
o a debt instrument has been rated by an independent rating agency;
o an appropriate valuation model exists for which the inputs come
from active markets (i.e. Black-Scholes);
o a generally accepted method (e.g. use ofprice/earnings ratios and
discounted cash flow techniques).
8.3 Subsequent measurement of financial liabilities
After initial recognition all fmancia11iabi1ities, except for financia11iabi1ities
at fair value through profit or loss, are measured at amortised cost using the
effective interest method.
8.4 Subsequent measurement of financial assets
8.4.1 Classificationoffinancial assets
For the purpose of subsequent measurement lAS 39 uses the four categories:
o loans and receivables;
o he1d-to-maturity investments;
o avai1ab1e-for-sa1e financial assets; and
o fmancia1 assets at fair value through profit or loss.
8.4.2 The rules
Loans and Fair value
receivables
Held-to-maturity Available-for-sale
through profit and
loss
Subsequent AMORTISED AMORTISED FAIR FAIR
measurement COST COST VALUE VALUE
Accounting
Recognised gain
DIRECTLY TO PROFTOR
or loss on the fair Not applicable Not applicable
EQUITY LOSS
value exercise
Amortisation PROFTOR PROFTOR Not applicable Not applicable
LOSS LOSS
Impairment PROFTOR PROFTOR PROFTOR Not applicable
LOSS LOSS LOSS
However, investments in equity instruments that do not have a market price
and whose fair value cannot be reliably measured, will be measured at cost.
AFS financial assets are only impaired if there is objective evidence that the
asset has become impaired. On the rare occasions when impairment has
occurred the some or all of the cumulative loss on the asset, that is included
in equity, will be recognised in profit and loss for the period.
For financial instruments designated as hedging instrument, the above
measurement rules are set aside and different treatments followed.
For financial assets and financial liabilities carried at amortised cost, a gain or
loss is recognised in profit or loss when the financial asset or financial
liability is derecognised or impaired, and through the amortisation process.
9 HEDGING
9.1 lAS 39 definitions
Hedging, for accounting purposes, means designating one or more hedging
instruments so that their change in fair value is an offset, in whole or in part,
to the change in fair value or cash flows of a hedged item.
A hedged item is an asset, liability, firm commitment, or highly probable
forecast transaction that:
o exposes the entity to the risk of changes in fair value or changes in
future cash flows; and
o is designated as being hedged.
A hedging instrument is a designated derivative (or, in limited circumstances,
another financial asset or liability) whose fair value or cash flows are
expected to offset changes in the fair value or cash flows of a designated
hedged item.
Hedge effectiveness is the degree to which changes in the fair value or cash flows
of the hedge item that are attributable to a hedged risk are offset by changes in the
fair value or cash flows of the hedging instrument.
9.2 Hedging instruments
All derivatives (except written options, since the writer has accepted risk rather than
reducing risk) may be designated as a hedging instruments.
To "write" is to sell an option. The investor who sells is called the writer.
Non-derivative financial instruments (e.g. foreign currency loans) may only
be designated as a hedging instrument to hedge a foreign currency risk.
9.3 Hedged items
A hedged item can be:
D a recognised asset or liability;
D an unrecognised firm commitment; or
D a highly probable forecast transaction.
The hedged item can be:
D a single asset, liability, firm commitment, or forecasted transaction; or
D a group of assets, liabilities, firm commitments, or forecasted
transactions with similar risk characteristics.
10 HEDGE ACCOUNTING
10.1 Background
Hedge accounting recognises symmetrically the offsetting effects on net profit
or loss of changes in the fair values of the hedging instrument and the related
item being hedged.
The hedge accounting rules do not relate to the offset ofany asset and liability.
10.1.1 Hedging relationships - three types
(1) Fair value hedge: a hedge of the exposure to changes in the fair value ofa
recognised asset (or liability or an identified portion of such an asset or
liability) that:
D is attributable to a particular risk; and
D will affect reported net profit or loss.
(2) Cashflow hedge: a hedge of the exposure to variability in cash flows that:
o is attributable to a particular risk associated with a recognised asset or
liability (e.g. all or some future interest payments on variable rate debt) or
a highly probable forecast transaction (e.g. an anticipated purchase or
sale); and
o will affect reported net profit or loss.
(3) Hedge ofa net investment in aforeign operation as defmed in lAS 21.
These are accountedfor similarly to cashflow hedge.
10.1.2 Hedge accounting
A hedging relationship qualifies for hedge accounting if, and only if, ALL of
the following conditions are met:
o at the inception of the hedge there is detailed formal documentation
of the hedging relationship and the entity's risk management
objective and strategy for undertaking the hedge;
o the hedge is expected to be highly effective (between 80% and 125%)
in hedging the risk and this effectiveness can be reliably measured;
o for cash flow hedges, a forecasted transaction (that is the subject of
the hedge) must:
be highly probable; and
present an exposure to variations in cash flows that could
ultimately affect reported net profit or loss;
o the hedge was assessed on an ongoing basis and determined
actually to have been highly effective throughout the financial
reporting period.
10.2 Fair value hedges
The gain or loss from remeasuring the hedging instrument at fair value should
be recognised immediately in net profit or loss.
The gain or loss on the hedged item attributable to the hedged risk should
adjust the carrying amount of the hedged item and be recognised immediately
in net profit or loss.
Worked example 1
On 30 June 2004 entity X issues $10 million fixed interest debt at 7.5% (6
month rate).
It is worried about changes in the value of the liability so on the same day it
enters into a SWAP (fixed to floating).
1 July to 31 December LIBOR is 6%
Fair value of the liability
Fair value of the SWAP (an asset)
$10,125,000
$(125,000)
X is now exposed to variable rates. As the required rate of return on the market
changes the value of the fixed rate debt and the SWAP will change in tandem. If
we think of it as a synthetic instrument (i.e. borrowing + SWAP) the company's
cash flows change as does the market's view of them. The overall value remains
constant.
Lender
Pay fixed
@7.5%t
Company X
+--- Receive fixed @7.5% +---
Pay variable
SWAP
The value of the liability has increased because it is now in demand.
The fair value of the SWAP is an asset because it gives X the right to pay 6% for
7.5%.
Cash flows
X pays 7.5% to the lender
X receives 7.5% from the counterparty
to the SWAP
X pays 6% to the counterparty to the
SWAP
Outflow
Gross
$
375,000
(375,000)
300,000
300,000
Net
$
375,000
(75,000)
300,000
Worked solution
Double entries Cash Liability SWAP
$000 $000 $000 $000 $000 $000
Initial 10,000 10,000 0
recognition
Fair value 125
adjustment
Fair value 125
adjustment
.. ----- ---- - -- - --- - - - - ,
Cash 75
..... ~ ; ?
Balance clf 10,125 125
Balance blf 10,125 125
Net off to 10,000
10.3 Cash flow hedges
The portion of the gain or loss on the hedging instrument that is determined
to be an effective hedge should be recognised directly in equity through the
statement of changes in equity.
Income
statement
$000 $000
125
125
300
The ineffective portion should be reported immediately in net profit or loss if
the hedging instrument is a derivative.
There is no guidance on how effectiveness and ineffectiveness should be
measured. That is up to the entity to decide. The methodology must be
explained in the formal hedge documentation. The methodologies can be
quite complicated in practice.
Ifthe hedge transaction results in the recognition of a financial asset or
liability, the amount previously recognised in equity will be recycle to profit
and loss to match the interest income or expense from the financial asset or
liability.
Ifthe hedge transaction results in the recognition of a non-financial asset or
liability, there are two options:
o to recycle the amount recognised in equity into profit or loss in the
same period or periods during which the asset or liability affects
profit or loss; or
i.e to match the depreciation charge.
o to transfer the amount recognised in equity into the initial cost of
the asset or liability.
The "basis adjustment".
e Accountancy TuitionCentre(InternationalHoldings)Ltd 2005 1932
Worked example 2
30 September
X contracted to buy a plane for Swiss Francs (SwFr)l,OOO,OOO (a future
transaction). The spot rate at this date was 2.5 SwFr = $1.
It is worried about changes in the rate so on the same day it enters into a
forward exchange contract to buy SwFr/ sell $ at a rate of2.5 SwFr = $1.
Year end 31 December
The spot rate is 2.4 SwFr = 1$.
The fair value of the forward is given as:
1,000,000 @ 2.4 =
1,000,000 @ 2.5 =
31 March
$
416,667
400,000
16,667
The plane is purchased. The rate is 2.3SwFr = $1.
The fair value of the forward is given as:
1,000,000 @ 2.3 =
1,000,000 @ 2.5 =
$
434,783
400,000
34,783
Worked solution 2
Note Forward Reserve
30 September (1)
31 December (2) 16,667 16,667
31 March (3) 18,116 18,116
(5) 34,783
(6) 34,783
Cash
30 September
31 December
31 March (4)
434,783
(5) 34,783
(6)
Bal clf
Bal blf
Notes
Plane - Asset
434,783
434,783
400,000
34,783
400,000
434,783
(l) Spot rate is 2.5 which is the same as the forward therefore the fair value of
the of forward is zero.
(2) Fair value of forward (based on the difference between the spot rate and
contracted rate) at the year end.
(3) Increase in fair value of the forward to the date of purchase of the asset.
(4) Purchase of asset at spot rate.
(5) Recognising the amount by which the forward reduces the cash flow.
(6) "Basis adjustment". Recognises that the asset's real cost was just $400,000.
FOCUS
account for:
D debt instruments;
D equity instruments;
D the allocation of the fmance cost; and
D fixed interest rate and convertible bonds;
discuss the defmition, classification and measurement issues relating to a
financial instrument;
explain the current measurement proposals for financial instruments
including the use of current values, hedging and the treatment of gains and
losses;
describe the nature ofthe disclosure requirements for financial instruments.
discuss the key areas where consensus is required on the accounting
treatment of fmancia1 instruments.
EXAMPLE SOLUTION
Solution 1
$
Present value of the principle repayable in 3 years time
$2,000,000 x 0.772 (3 year, 9% discount factor)
Present value of the interest stream
$120,000 x 2.531 (3 year, cumulative,9% discount factor)
Totalliability component
Equity component (taken as a balancing figure)
Proceeds of the issue
Commentary
1,544,000
303,720
1,847,720
152,280
2,000,000
1
A simple discount factor is - where r is the discount rate.
r
A cumulative discountfactor is the sum ofsimple discountfactors. You will
not have to calculate discount factors in the examination.
lAS 19 EMPLOYEE BENEFITS
OVERVIEW
Objectives
To prescribe the accounting treatment in respect of employee benefits.
To prescribe the disclosures which should be made in respect of employee
benefits.
INTRODUCTION
I
SHORT TERM
BENEFITS
I
POST RETIREMENT
BENEFITS
I
DEFINED
CONTRIBUTION
SCHEMES
I
DEFINED BENEFIT
SCHEMES
I
SUNDRY GUIDANCE
I
PAST SERVICE COSTS
I
DISCLOSURES
Key problem
Objective
Scope
Definitions
Types
Accountingfor short-term employee benefits
Introduction
Accountingfordefinedcontributionschemes
Recognition and Measurement
Disclosure
Introduction
Accountingfor defined benefit schemes
Amendment to lAS 19
Actuarial Valuation Method
Discount Rate
Regularity
1 INTRODUCTION
1.1 Key problem
Companies remunerate their staff by means ofa wide range ofbenefits.
These include wages and salaries, retirement benefits.
Cost to employer needs to be matched with benefits derived from employees'
services.
1.2 Objective
The objective ofIAS 19 is to prescribe the accounting and disclosure for
employee benefits.
An entity must recognise:
o a liability when an employee has provided service in exchange for
employee benefits to be paid in the future, and
o an expense when the entity consumes the economic benefit arising
from service provided by an employee in exchange for employee
benefits.
1.3 Scope
The standard applies to all employee benefits.
Employee benefits include:
o short-term employee benefits,(eg wages, salaries and social security
contributions, paid annua11eave and paid sick leave etc),
o post-employment benefits (eg pensions, other retirement benefits,
post-employment life insurance and post-employment medical
care),
o other long-term employee benefits, (eg long-service leave or
sabbatica11eave),
o termination benefits, and
1.4 Definitions
Employee benefits are all forms of consideration given by an entity in
exchange for service rendered by employees.
Short-term employee benefits are employee benefits (other than termination
benefits) which fall due wholly within twelve months after the end ofthe
period in which the employees render the related service.
Post-employment benefits are employee benefits (other than termination
benefits) which are payable after the completion of employment.
Post-employment benefit plans are formal or informal arrangements under
which an entity provides post-employment benefits for one or more
employees.
Defined contribution plans are post-employment benefit plans under which
an entity pays fixed contributions into a separate entity (a fund) and will have
no legal or constructive obligation to pay further contributions if the fund
does not hold sufficient assets to pay all employee benefits relating to
employee service in the current and prior periods.
Defined benefit plans are post-employment benefit plans other than defined
contribution plans.
The present value ofa defined benefit obligation is the present value, without
deducting any plan assets, of expected future payments required to settle the
obligation resulting from employee service in the current and prior periods.
Current service cost is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period.
Interest cost is the increase during a period in the present value of a defined
benefit obligation which arises because the benefits are one period closer to
settlement.
Plan assets are assets held by an entity (a fund) that satisfies all of the
following conditions
o the entity is legally separate from the reporting entity,
o the assets ofthe fund are to be used only to settle the employee
benefit obligations, are not available to the entity's own creditors
and cannot be returned to the entity (or can be returned to the entity
only if the remaining assets of the fund are sufficient to meet the
plans obligations), and
o to the extent that sufficient assets are in the fund, the entity will
have no legal or constructive obligation to pay the related employee
benefits directly.
Actuarial gains and losses comprise:
o experience adjustments (the effects of differences between the
previous actuarial assumptions and what has actually occurred), and
o the effects of changes in actuarial assumptions.
2 SHORT TERM EMPLOYEE BENEFITS
2.1 Types
Wages, salaries and social security contributions,
Short-term compensated absences (such as paid annual leave and paid sick
leave) where the absences are expected to occur within twelve months after
the end of the period in which the employees render the related employee
service,
Profit sharing and bonuses payable within twelve months after the end of the
period in which the employees render the related service, and
Non-monetary benefits (such as medical care, housing, cars and free or
subsidised goods or services) for current employees.
2.2 Accounting for short-term employee benefits
When an employee has rendered service to an entity during an accounting
period, the entity should recognise the amount of short-term employee
benefits expected to be paid in exchange for that service:
o as a liability (accrued expense), after deducting any amount already
paid, and
o as an expense, (unless another lAS requires or permits the inclusion
of the benefits in the cost of an asset).
In short, the entity must account for the expense on an accruals basis.
3 POST RETIREMENT BENEFITS
Arrangements whereby an entity provides post-employment benefits are post-
employment benefit plans.
An entity mayor may not establish a separate entity to receive contributions
and to pay benefits, though it is convenient to think of the plan as a separate
entity.
tofpost
ent benefits
THE ENTITY
Transfer of
cash (tundine):
THE PLAN
Paymen
retirem
I EMPLOYEE
Post-employment benefit plans are classified as either defined contribution
plans or defmed benefit plans, according to the economic substance of the
plan.
4 DEFINEDCONTRIBUTIONSCHEMES
4.1 Introduction
The entity's obligation is limited to the amount that it agrees to contribute to
the fund.
Thus, the amount of the post-employment benefits received by the employee
is determined by the amount of contributions paid to the plan, together with
investment returns arising from the contributions.
In consequence any risks with regard to the size of the pension paid fall on
the employee.
4.2 Accounting for defined contribution schemes
Accounting for defined contribution plans is straightforward because the
reporting entity's obligation for each period is determined by the amounts to
be contributed for that period.
4.3 Recognition and Measurement
The accruals concept is applied.
o Charge contributions payable in respect of period to the income
statement.
o The balance sheet will reflect any outstanding or prepaid
contributions.
4.4 Disclosure
An entity should disclose the amount recognised as an expense for defined
contribution plans.
5 ACCOUNTINGFORDEFINEDBENEFIT SCHEMES
5.1 Introduction
The entity's obligation is to provide the agreed benefits to current employees.
There is a risk that the fund will be insufficient to pay the agreed pension fall
on the entity who will have to provide for any shortfall. (eg plans where an
employee is guaranteed a specified return).
The entity will set cash aside which is then invested to earn a return and this
will then grow and hopefully enable the entity to meet its future obligations.
Clearly the estimation ofthe amount to set aside is very difficult. Usually
companies will use the services of an actuary (an expert in post retirement
benefits). The actuary will perform a calculation in which he includes
estimates of all the variables which will effect the growth of assets and
liabilities. These include:
o Required post retirement benefit;
o Rate ofreturn on the stock market;
o Interest rate;
o Inflation;
o Rate ofleavers;
o Death in service probability.
The actuary will then tell the company how much it needs to set aside in
order to meet the obligation. This is usually stated as a percentage of salary
and is usually paid to the plan on a monthly basis.
The actuary will never be absolutely accurate in respect of his estimates. This
means that the value of the plan assets and liabilities at each year end will be
different to that forecast at the last actuarial valuation. The standard gives
rules on how (or whether) to account for such differences.
5.2 Accounting for defined benefit schemes
5.2.1 Basics
An entity makes payments to a fund (a separate legal entity). This cash is
invested and used to pay retirement benefits when they fall due for payment.
The fund is an entity with assets and liabilities (to the pensioners).
At each balance sheet date the assets and liabilities of the fund are valued and
the entity recognises the net liability (or more rarely the net asset on the face
of its balance sheet).
This seems a little strange at first. The entity is recognising a net liability of a separate
legal entity. But remember that the ultimate obligation to the employees is owed by the
entity. The fund is merely a vehicle which allows the entity to meet this obligation. In
substance the assets and liabilities of the fund are a special area of the entity's own
balance sheet even though they are held by a separate entity.
Illustration 1
The following information relates to the assets and liabilities of the retirement benefit plan
of entity X. (NB this is not a summary ofX's balance sheet but that of the plan).
Market value ofplan assets
Present value ofplan obligations
Net liability of the plan
2003
$m
100
(120)
(20)
2004
$m
110
(135)
(25)
The basic rule (it is a little more complicated than this - see later) is that:
In 2003 X must recognise a liability of $20m
In 2004 X must recognise a liability of $25m
If X had made a payment of$lmto the fund in 2004 the full journal would be:
Dr income statement
Cr liability (25 - 20)
Crcash
6
5
I
125
80
130
1,000
(1,000)
5.2.2 Complication
Firstly we must understand what causes the movement in the values of the
plan assets and liabilities.
At the year end the entity knows the following:
o value of the plan assets and liabilities at the start of the year,
o the amount of cash paid to the plan during the period,
o the amount of cash paid by the plan to pensioners during the period,
o the current service cost for the period (information supplied by the
actuary),
o the actuarial assumptions made for the period.
An entity can calculate the values of the assets and liabilities that it would
expect to exist at the end of the period if all of the information was accurate.
Illustration 2
The following information relates to the assets and liabilities of the retirement benefit plan
of entity Q. (NB this is not a summary ofQ's balance sheet but that of the plan).
Start of the period:
Market value of plan assets
Present value ofplan obligations
During the period:
Current service cost
Contributions paid to the fund
Benefits paid
Actuarial assumptions
Interest rate payable
Return on investments
Analysis
At start of the year
Interest expense (9% x 1,000)
Benefits paid
Interest earned (12% x 1,000)
Contributions
"Expected value" (This is what the valuation at the year
end would show ifall ofthe actuarial assumptions made at
the start ofthe period had been 100% correct)
Suppose the actual values at the year end were:
The difference is called the actuarial gain or loss:
Actuarial loss
9%
12%
Liability
1,000
125
90
(130)
1,085
1,215
130
Asset
1,000
(130)
120
80
1,070
1,147
Actuarial gain 77
In the above illustration:

Liability Asset Net
liability
Expected value 1,085 1,070 15
Actual value 1,215 1,147 68
Actuarial difference (130) 77 53
lAS 19 requires that an entity recognises a liability based on the year end
values of the fund assets and liabilities.
If the entity recognised a liability of$68 then this would mean that it would
recognise the actuarial loss of $53. The double entry would be:
Dr income statement (balancing figure)
Cr liability (68-0)
Crcash
148
68
80
Actuarial differences arise every year. Some years they will be a loss and in
others they will be a gain.
The lASH believes that if they are always taken to the income statement this
would lead to misleading fluctuations in profits.
To avoid this lAS 19 contains a materiality test. Only that part of the gain or
loss which falls outside a test figure ("the corridor") is taken to income. Even
then this amount is not expensed immediately but recognised over the
average remaining service lives of the employees starting next year.
The corridor is the higher of:
o 10% of the market value of the plan assets at the end of the
previous period, or
o 10% of the present value of the plan obligations at the end of the
previous period.
Illustration 3
10% ofplan assets (10% x 1,000)
10% ofplan liabilities (10% x 1,000)
:. The corridor is
Actuarial difference
Amount recognised
Recognition at the year end:
Net liability at the end of the period
Less the unrecognised actuarial difference
Net liability actually recognised
Dr income statement (balancing figure)
Cr liability (15-0)
Crcash
5.2.3 Expense
$
100
100
$
68
(53)
15
95
100
53
15
80
The expense can be analysed into its component parts (ie the plan incomes
and expenses).
The expense will be made up of:
Interest cost
Expected return on plan assets
Actuarial gains and losses
125
90
(120)
95
Example 1
(This continues the illustration above into the next 2 years)
2004 2005 2006
$ $ $
Current service cost 125 140 155
Benefits paid 130 150 170
Contributions paid 80 90 100
Present value of the obligation at 31 December 1,215 1,413 1,600
Fair value of the plan assets at 31 December 1,147 1,137 1,200
Discount rate at the start of the year 9% 8% 8%
Expected return on plan assets 12% 11% 11%
The present value of the obligation and the fair value of the plan assets were both
$1,000 at 1 January 2004 and there were no actuarial gains or losses at this date.
The average remaining working lives ofthe employees was estimated to be 10 years.
Required:
In respect each ofthe three years ending 2004, 2005, 2006:
(a) Calculate the actuarial gain/loss arising in the period.
(b) Calculate how much of the gain or loss should be recognised and in which
period.
(c) Calculate the liability to be included in the balance sheet at each year end.
(d) Construct the necessary journal to record the above transactions.
(e) Explain the composition of the income statement figure.
Proforma solution
Acmarialwss/(gam)
Present valuelFair value at 1 January
Interest cost (9%)
Expected return (12%)
Benefits paid
Contributions
2004
Liabilities Assets
$ $
1,000 1,000
90
120
125
(130) (130)
80
Expected value'
Actuarial loss/gain - a balancing figure
Present valuelFair value at 31 December
The activity has been completedfor the first year.
1,085
130
1,215
1,070
77
1,147
53 Net loss
Interest cost (8%)
Benefits paid
Contributions
Expected value'
2005
Liabilities Assets
$ $
1,215 1,147
Net loss/(gain)
1 If all estimates made at the start of the period had been 100% accurate.
2006
Liabilities Assets
$ $
Interest cost (8%)
Benefits paid
Contributions
Expected value'
Net loss/(gain)
(b) Amount ofactuarial difference recognised
2004
$
b/f
2005
$
53
2006
$
2007
$
Gain /(loss) in the year (see (a) above)
Recognised in the period (W)
Net loss unrecognised at the year end
Net cumulative unrecognised loss/(gain) at the previous
yearend
WORKING
Corridor limits:
10% ofplan obligations at previous year end
10% ofplan assets at previous year end
Limit is the greater of the above
Net cumulative unrecognised loss/(gain) at previous year
end
Amount which falls outside the corridor
Amount recognised (+ 10)
(c) Figures for the balance sheet at 31 December
53
53
2004
$
100
100
100
2005
$
2006
$
2007
$
Present value of the obligation
Fair value of the plan assets
Unrecognised actuarial (loss)
Recognised in the balance sheet
2004 2005 2006
$ $ $
1,215
1,147
68
(53)
15
(d) Journal
Dr to the income statement (balancing figure)
Cr liability (W)
Cr cash (contributions paid)
WORKING
Movements on the liability:
Opening liability
Net movement
Closing liability
(e) Income statements
Current service costs
Interest cost
Expected return on plan assets
Net actuarial gain or loss recognised in the year
Income statement expense
5.3 Amendment to lAS 19
2004
95
15
80
2004
$
15
15
2004
$
125
90
(120)
95
2005
2005
$
2005
$
2006
2006
$
2006
$
The lASH currently has reservations about lAS 19 regarding the deferral of
actuarial gains and losses. It believes that deferred recognition is inconsistent
with its Framework document. The lASH intends to carry out a major project
in the area of accounting for retirement benefits.
In the meantime the board has issued an amendment to lAS 19 which will
allow, in addition to the current recognition criteria, full recognition of all
actuarial gains and losses in the period they occur and through the statement
of total recognised gains and losses.
An entity wishing to adopt this policy must do so for all defmed benefit plans
and all actuarial gains and losses.
6 SUNDRYGUIDANCE
6.1 Actuarial Valuation Method
An entity should use the projected unit credit method to determine the present
value of its defmed benefit obligations and the related current service cost
(and, where applicable, past service cost).
o This method sees each period of service as giving rise to an
additional unit ofbenefit entitlement and measures each unit
separately to build up the final obligation
o The method requires an entity to attribute benefit to the current
period (in order to determine current service cost) and the current
and prior periods (in order to determine the present value of defined
benefit obligations).
6.2 Discount Rate
The discount rate should be determined by reference to market yields on high
quality corporate bonds at the balance sheet date.
6.3 Regularity
Valuations should be carried out with sufficient regularity that the amounts
recognised in the financial statements do not differ materially from the
amounts that would be determined at the balance sheet date.
An entity is encouraged to use a qualified actuary in the measurement of all
material post-employment benefit obligations.
7 PAST SERVICECOST
Past service cost should be recognised as an expense on a straight-line basis
over the average period until the benefits become vested.
If the benefits are already vested immediately following the introduction of,
or changes to, a defined benefit plan, the past service cost must be recognised
immediately.
Illustration
An entity operates a pension plan that provides a pension of 2% of final salary for
each year of service. The benefits become vested after five years of service. On 1
January 2005 the entity improves the pension to 2.5% of final salary for each year
of service starting from 1 January 2001. At the date of the improvement, the
present value ofthe additional benefits for service from 1 January 2001 to 1
January 2005 is as follows:
Employees with more than five years' service at 1 Jan 2005 150
Employees with less than five years' service
at 1 Jan 2005 (average period until vesting: three years) 120
270
The entity recognises 150 immediately because those benefits are already vested.
The entity recognises 120 on a straight-line basis over three years from 1 January
2005.
8 DISCLOSURE
The following information about defined benefit plans:
o the entity's accounting policy for recognising actuarial gains and
losses,
o a general description of the type ofplan,
o a reconciliation of the assets and liabilities recognised in the
balance sheet, showing at least:
the present value at the balance sheet date of defined
benefit obligations that are wholly unfounded,
the present value at the balance sheet date of defined
benefit obligations that are wholly or partly funded,
the fair value of any plan assets at the balance sheet date,
the net actuarial gains or losses not recognised in the
balance sheet,
the past service cost not yet recognised in the balance
sheet,
any amount not recognised as an asset, because of the
materiality limit, and
the amounts recognised in the balance sheet,
o a reconciliation showing the movements during the period in the net
liability (or asset) recognised in the balance sheet,
o the total expense recognised in the income statement for each of the
following, and the line item(s) ofthe income statement in which
they are included:
current service cost,
interest cost,
expected return on plan assets,
actuarial gains and losses,
past service cost, and
the effect of any curtailment or settlement,
o the actual return on plan assets,
o the principal actuarial assumptions used as at the balance sheet date,
including, where applicable:
the discount rates,
the expected rates of return on any plan assets for the
periods presented in the financial statements,
the expected rates of salary increases
medical cost trend rates, and
any other material actuarial assumptions used.
FOCUS
describe the nature of defined contribution, multi employers and defined
benefit schemes;
explain the recognition of defined benefit schemes under the current
proposals;
discuss the measurement of defined benefit schemes under current proposals;
account for defined benefit schemes including amounts shown in the balance
sheet and the income statement and notes to the accounts;
discuss perceived problems with current proposals on accounting for
retirement benefit schemes.
EXAMPLE SOLUTION
Solution 1
(a) Actuarialloss/(gain)
Interest cost (9%)
Benefits paid
Contributions
Expected value/
Interest cost (8%)
Benefits paid
Contributions
Expected value
Actuarial loss/gain
Interest cost (8%)
Benefits paid
Contributions
Expected value
Actuarial loss/gain
2004
Liabilities Assets
$ $
1,000 1,000
90
120
125
(130) (130)
80
1,085 1,070
130 77 53 Net loss
1,215 1,147
2005
Liabilities Assets
$ $
1,215 1,147
97
126
140
(150) (150)
90
1,302 1,213
111 (76) 187 Net loss
1,413 1,137
2006
Liabilities Assets
$ $
1,413 1,137
113
125
155
(170) (170)
100
1,511 1,192
89 8 81 Net loss
1,600 1,200
2 If all estimates made at the start of the period had been 100% accurate.
(b) Amount ofactuarial difference recognised
2004 2005 2006 2007
$ $ $ $
b/f 53 240 311
Loss/(gain) in the year (see (a) above) 53 187 81 X
Recognised in the period (W) (10) (15)
Net cumulative unrecognised at the year end 53 240 311 X
Net cumulative unrecognised loss/(gain) at the previous
53 240 311
yearend
WORKING
2004 2005 2006 2007
Corridor limits: $ $ $ $
10% ofplan obligations at previous year end 100 122 141 160
10% ofplan assets at previous year end 100 115 113 120
Limit is the greater of the above 100 122 141 160
Net cumulative unrecognised loss/(gain) at the previous 53 240 311
yearend
Amount which falls outside the corridor 99 151
Amount recognised (+ 10) 10 15
(c) Figures for the balance sheet at 31 December
2004 2005 2006
$ $ $
Present value of the obligation 1,215 1,413 1,600
Fair value ofthe plan assets 1,147 1,137 1,200
68 276 400
Unrecognised actuarial (loss) (53) (240) (311)
Recognised in the balance sheet 15 36 89
(d) Journal
2004 2005 2006
$ $ $
Dr to the income statement (balancing figure) 95 111 153
Cr liability (W) 15 21 53
Cr cash (contributions paid) 80 90 100
WORKING
2004 2005 2006
Movements on the liability: $ $ $
Opening liability 15 36
Net movement 15 21 53
Closing liability 15 36 89
(e) Income statements
2004 2005 2006
$ $ $
Current service costs 125 140 155
Interest cost 90 97 113
Expected return on plan assets (120) (126) (125)
Net actuarial gain or loss recognised in the year 10
Income statement expense 95 111 153
IFRS 2 SHARE-BASED PAYMENTS
OVERVIEW
Objective
To explain how to account for the granting of shares and share options to
executives, employees and other parties.
Needfor a standard
Key issues
Objective ofIFRS 2
Scope
Effective date
RECOGNITION
SHARE-BASED
PAYMENTS
DEFINITIONS
Share-basedpayment
transaction arrangement
Types oftransactions
MEASUREMENT
DISCLOSURES
Fair value
Equity-settled transactions
Granting ofequity instruments
Indirect measurement
Valuation technique
Cash-settled transactions
Purpose
Nature and extent ofschemes in place
How fair value was determined
Effect ofexpenses arising
1 SHARE-BASED PAYMENTS
1.1 Need for a standard
Share plans and share option plans have become a common feature of
remuneration packages for directors, senior executives and other employees
in many countries.
Shares and share options may also be used to pay suppliers (e.g. for
professional services).
IFRS 2 "Share-based Payments" fills a gap in accounting for the recognition
and measurement of such transactions under IFRS.
lAS 19 "Employee Benefits" prescribed certain disclosures to enable users of
financial statements to assess the effect of equity compensation benefits (i.e.
shares, share options and cash payments linked to future share prices) on an
entity's financial performance and cash flows. However, it did not seek to
address the recognition and measurement issues.
1.2 Key issues
Recognition: When to recognise the charge for share-based payments?
Recognition must reflect accrual accounting in keeping with "The Framework".
Measurement How much expense to recognise?
IFRS 2 limits the measurement possibilities. In principle share-basedpayment
transactions are accountedfor to reflect the "value" ofgoods or services
received. However, the measurement method depends on the type of
transactions and who it is made with.
1.3 Objective of IFRS 2
To specify the financial reporting of share-based payment transactions.
In particular, to show the effects of such transactions (including associated
expenses) on profit or loss and fmancial position.
In summary, IFRS 2 requires the recognition ofall share-basedpayment
transactions measured at fair value.
1.4 Scope
All share-based payment transactions. Transactions may be:
o settled in cash, other assets, or equity instruments of the entity; and
o with employees or other parties.
There are no exceptions, other than for transactions to which more specific
standards apply, for example:
o shares issued as consideration in a business combination (IFRS 3
"Business Combinations"; and
o certain contract transactions falling within IAS 32 "Financial
Instruments: Disclosure and Presentation" or IAS 39 "Financial
Instruments: Recognition and Measurement".
There are no exception for employee share purchase plans.
1.5 Effective date
Annual periods beginning on or after I January 2005.
Earlier application is encouraged.
Ifapplied early thatfact must be disclosed.
2 DEFINITIONS
2.1 Share-based payment transaction arrangement
An agreement between the entity and an employee (or other party) to enter
into a share-basedpayment transaction which entitles the employee to
receive:
o equity instruments (including shares) of the entity; or
o cash (or other assets) for amounts based on the price of the entity's
instruments,
Provided any specified vesting conditions are met.
"Vest" means to become an entitlement. A party's right to shares of an entity
may be free or at a pre-arranged exercise price.
Share-basedpayment transaction: A transaction in which the entity:
o receives goods or services as consideration for equity instruments
of the entity (including shares or share options); or
o acquires goods or services by incurring liabilities (to the supplier of
those goods or services) for amounts based on the price of the
entity's equity instrument(s).
As many entities mostly receive services (e.g. from their executives and
employees) references to "goods or services" are simplified to "services" in
this session.
Equity instrument: A contract that gives a residual interest in the assets of an
entity after deducting all of its liabilities.
Share option: A contract that gives the holder the right, but not the
obligation, to subscribe to the entity's shares at a fixed (or determinable)
price for a specified period of time.
Vesting conditions: The conditions that must be satisfied for a person to
become entitled to receive cash, other assets or equity instruments under a
share-based payment arrangement.
Examples ofvesting conditions include completion ofa specified service
period and meetingperformance targets (e.g. a specified increase in revenue
over a specifiedperiod oftime).
2.2 Types of transactions
The Standard identifies three types of share-based payment transactions:
o equity-settled share-based payment transactions;
o cash-settled share-based payment transactions; and
o share-based payment transactions with cash alternatives.
2.2.1 Equity-settled
The entity receives services as consideration for equity instruments of the
entity (including shares or share options).
2.2.2 C7ash-settled
The entity acquires goods or services by incurring liabilities for amounts that
are based on the price (or value) ofthe entity's equity instrument(s).
3 RECOGNITION
3.1 On receipt or acquisition
Normal recognition rules apply in respect of the goods or services received:
Dr Expense (e.g. purchases, labour)
Or debit an asset account.
If settlement by equity settled share-based payment then increase equity:
Cr Equity
If settlement by cash settled share-based payment then recognise a liability:
Cr Trade (or other) payables
4 MEASUREMENT
4.1 Fair value
Goods or services are measured at fair value.
That is, the amountfor which an asset could be exchanged, a liability settled,
or an equity instrument granted, between knowledgeable, willingparties in
an arm's length transaction.
4.2 Equity-settled transactions
The fair value of the services received (and the corresponding increase in
equity) is measured either:
o directly, at the fair value of the services received; or
o indirectly, by reference to the fair value of the equity instruments
granted.
Direct measurement is at the date the entity receives the services (or obtains
the goods).
Indirect measurement, as a surrogate, is at the grant date.
The grant date is the date when the parties to the arrangement have a shared
understanding of its terms and conditions. The right to cash, other assets, or
equity instruments is conferred at grant date (provided any vesting
conditions). If an agreement is subject to approval (e.g. by shareholders),
grant date when that approval is obtained.
4.2.1 Employee's remuneration
Direct measurement of services received for particular components of an
employee's remuneration package (e.g. cash, shares and other employee
benefits) may not be possible.
Also, it may not be possible to measure the fair value of a total remuneration
package, without measuring directly the fair value ofthe equity instruments
granted.
Measurement will be further complicated where equity instruments are
granted as part of a bonus arrangement (e.g. a loyalty bonus to stay with the
entity) rather than as a part ofbasic remuneration.
Granting equity instruments is paying additional remuneration to obtain
additional benefits. Estimating the fair value of the additional benefits is
likely to be more difficult than measuring the fair value of the equity
instruments granted.
4.2.2 Transactions with others
For transactions with parties other than employees, there is a rebuttable
presumption that the fair value of the goods or services received can be
estimated reliably.
That fair value is measured at the date the goods are obtained or the supplier
renders the service.
In rare cases, ifthe presumption is rebutted, measurement will be indirect, at
the date the entity obtains the goods or service (rather than at the grant date).
4.3 Granting of equity instruments
4.3.1 Without vesting conditions
When equity instruments granted vest immediately, employees (executives or
other suppliers) are not required to complete a specified period of service
before becoming unconditionally entitled to those equity instruments.
Unless there is evidence to the contrary, the entity presumes that services
rendered by the employee have been received. So, on grant date the entity
recognises:
D the services received in full; and
D a corresponding increase in equity.
Recognition is immediate when equity instruments are granted for past
performance.
4.3.2 With vesting conditions
If the equity instruments granted do not vest until a specified period of
service has been completed, it is presumed that the services to be rendered as
consideration will be received over the future vesting period.
Services must then be accounted for as they are rendered by the employee
during the vesting period, with a corresponding increase in equity.
Illustration 1
An employee is granted share options conditional upon completing three years of
service.
The entity presumes that the services to be rendered by the employee as consideration
for the share options will be received in the future, over that three-year vesting period.
Illustration 2
An employee is granted share options conditional upon:
the achievement of a performance condition; and
remaining in the entity's employ until that performance condition is satisfied.
Thus the length of the vesting period varies depending on when that performance
condition is satisfied. The entity therefore presumes that the services to be rendered for
the share options will be received over an expected vesting period.
4.3.3 Expected vesting period
The expected vesting period at grant date is estimated based on the most
likely outcome ofthe performance condition.
A performance condition may be a market condition (i.e. a condition upon
which the exercise price, vesting or exercisability of an equity instrument is
related to the market price ofthe entity's equity instruments).
For example, achieving a specified share price.
If the performance condition is a market condition, the estimate oflength of
vesting period must be consistent with the assumptions used in estimating the
fair value of the options granted.
Such an estimated length ofvestingperiod is not subsequently revised.
If the performance condition is not a market condition, the entity revises its
estimate of the length ofthe vesting period, if necessary.
Ifsubsequent information indicates that the length ofthe vesting period
differs from previous estimates.
Worked example 1
Omega grants 120 share options to each of its 460 employees. Each grant is
conditional on the employee working for Omega over the next three years. Omega has
estimated that the fair value of each share option is $12.
Omega estimates that 25% of employees wi11leave during the three-year period and so
forfeit their rights to the share options.
Everything turns out exactly as expected.
Required:
Calculate the amounts to be recognised for services received as consideration for the
share options during the vesting period.
Estimates ofleavers could be made on the basis ofa weighted average
probability applied to a historic pattern ofleavers as adjustedfor expected
changes in that pattern.
Worked solution 1
Year Calculation
1 55,200 options x 75% x $12 x 1/
3
years
2 (55,200 options x 75% x $12 x 2/
3
years)
- $165,600
3 (55,200 options x 75% x $12 x %years)
- $331,200
Remuneration Cumulative
expensefor remuneration
period expense
$ $
165,600 165,600
165,600 331,200
165,600 496,800
Example 1
As for Worked Example 1 except that everything does not turn out as expected.
Year 1: 25 employees leave. Omega revises its estimate of totalleavers over the three-
year period from 25% (115 employees) to 20% (92 employees).
Year 2: Another 22 employees leave. Omega revises its estimate of totalleavers over
the three-year period from 20% to 15% (69 employees).
Year 3: A further 13 employees leave.
Required:
Calculate the amounts to be recognised for services received as consideration for the
share options during the vesting period.
Proforma solution
Year
1
2
3
Calculation Remuneration
expense/or
period
$
Cumulative
remuneration
expense
$
Worked example 2
On 1 January 2004, Kappa granted 1,000 options to an executive, conditional on his
remaining in Kappa's employment for three years. The exercise price is $35, but falls
to $25 if earnings increase by 12% on average over the three-year period.
On grant date the estimated fair value of an option is:
$12 for an exercise price of $25;
$9 ifthe exercise price is $35.
2004 earnings increase by 14%. This increase is expected over the next two years,
giving expected exercise price of $25.
2005 earnings increase by 13%. The earnings target is still expected to be achieved.
2006 earnings increase by only 7%. The earnings target is not achieved.
On 31 December 2006 the executive completes three year's service. Rights to the
1,000 options are now vested at an exercise price of$35.
Required:
Calculate the remuneration expense arising from the share options over the three year
period.
The exercise price is the price at which the executive can buy the shares
under the option contract.
Worked solution 2
Year Calculation Remuneration expense
Period Cumulative
$ $
1
2
3
1,000 options x $12 x 1/
3
years
(1,000 options x $12 x %years) - $4,000
(1,000 options x $9) - $8,000
4,000
4,000
1,000
4,000
8,000
9,000
The performance condition is not a market condition.
4.4 Indirect measurement
Fair value of equity instruments granted is based on:
D market prices, if available; otherwise
D a valuation technique.
The measurement date is the grant date for employees and other providing
similar services. For transactions with parties other than employees it is the
date the goods are received (or the services rendered).
Vesting conditions other than market conditions are not taken into account
when estimating fair value.
Instead, they are reflected in the estimate ofthe likely outcome ofthese
conditions and hence the number ofequity instruments expected to vest.
Services received measured at the grant date fair value of equity instruments
granted is the minimum amount recognised (unless the equity instruments do
not vest due to forfeiture).
This is irrespective ofany modifications to the terms and conditions on which
the equity instruments were granted, including cancellations and settlement.
4.5 Valuationtechnique
It is highly unlikely that market prices will be available for employee share
options because the terms and conditions under which they are granted do not
apply to options that are actively traded.
Where similar traded options do not exist the fair value of options granted is
estimated by applying an options pricing model.
As a minimum, an option-pricing model should reflect:
D Exercise price of option;
D Life of option;
D Current price ofunderlying;
D Expected volatility of share price;
D Expected dividends;
D Risk free interest rate over life of option.
4.6 Cash-settled transactions
For cash-settled transactions, the goods or services acquired and the liability
incurred are measured at the fair value of the liability.
The liability is remeasured to fair value at each reporting date, with any
changes in value recognised in profit or loss, until it is settled.
In contrast with equity-settled where there is no remeasurement.
Where either the entity or the supplier may choose whether the entity settles
the transaction in cash or by issuing equity instruments, it is accounted for as:
D cash-settled if the entity has a liability to settle in cash; or
D equity-settled if no such liability has been incurred.
5 DISCLOSURES
5.1 Purpose
To enable users of financial statements to understand:
D the nature and extent of share-based payment arrangements that
existed during the period;
D how the fair value of the goods or services received, or the fair value of
the equity instruments granted, during the period was determined; and
D the effect of expenses arising from share-based payment
transactions on the entity's profit or loss and financial position.
If the following disclosures do not satisfy these principles an entity is
required to disclose such additional information as is necessary to satisfy
them.
5.2 Nature and extent of schemes in place
The following are minimum disclosure requirements.
A description of each type of scheme that existed at any time during the
period, including:
D general terms and conditions (e.g. vesting requirements);
D the maximum term of options granted; and
D the settlement method (i.e. cash or equity).
This information may be aggregatedfor substantially similar types ofscheme.
The number and weighted average exercise prices of share options:
D outstanding at the beginning of the period;
D granted during the period;
D forfeited during the period;
D exercised during the period;
D expired during the period;
D outstanding at the end of the period; and
D exercisable at the end of the period.
For share options exercised during the period, the weighted average share
price at the date of exercise.
Ifoptions were exercised on a regular basis throughout the period, the
weighted average share price during the period may be disclosed instead.
For share options outstanding at the end of the period, the range of exercise
prices and weighted average remaining contractua11ife.
A wide range ofexercise prices should be sub-divided meaningfullyfor
assessing the number and timing ofadditional shares that may be issued and
the cash that may be received infuture.
5.3 Howfair value was determined
Where fair value has been determined indirectly, by reference to the fair value ofthe
equity instruments granted, the following extensive disclosure is required, as a
minimum.
5.3.1 Share options
The weighted average fair value of share options granted during the period at
the measurement date and information on how that fair value was measured,
including:
D the option pricing model used and the inputs to that model;
Some information such as dividendyield could be quite sensitive.
D how expected volatility was determined, including an explanation
of the extent to which it is based on historical volatility; and
D whether and how any other features of the option grant (e.g. market
condition) were taken account of.
5.3.2 Other equity instruments
The number and weighted average fair value of other equity instruments at
the measurement date, and information on how that fair value was measured,
including:
D how fair value determined if not measured on the basis of an
observable market price;
D whether and how expected dividends (and any other features) were
incorporated into the fair value.
5.3.3 Modifications
For schemes that were modified during the period:
D an explanation of the modifications;
D the incremental fair value granted (as a result of the modifications); and
D information on how the incremental fair value granted was measured.
5.3.4 Direct measurement
Where the fair value of goods or services received during the period has been
measured directly, disclose how that fair value was determined (e.g. whether
at a market price).
In rare cases, where the presumption that direct measurement can be made is
rebutted, that fact is disclosed with an explanation why the presumption was rebutted.
5.4 Effect of expenses arising
The total expense recognised for the period where the goods or services
received did not qualify for recognition as assets.
Separate disclosure of that portion ofthe total expense that arises from
equity-settled transactions.
For liabilities arising from cash-based transactions:
D the total carrying amount at the end of the period; and
D any vested share appreciation rights.
That is where another party's right to cash or other assets has vested by the
end ofthe period.
FOCUS
You should now be able to
understand the term 'share-based payment' (IFRS 2);
discuss the fair value measurement issue;
explain the difference between:
o cash-settled share-based payment transactions; and
o equity-settled share-based payment transactions
understand the principles applied to measuring both cash and equity-settled
share-based payment transactions
compute the amounts to be recorded in the fmancia1 statements to reflect
share-based payment transactions
discuss the problems of applying IFRS 2.
EXAMPLE SOLUTIONS
Solution 1 - Description
Year Calculation
1 55,200 options x 80% x $12 x 1/
3
years
2 (55,200 options x 85% x $12 x 2/
3
years)
- $176,640
3 (48,000 options x $12) - 576,000
Remuneration Cumulative
expensefor remuneration
period expense
$ $
176,640 176,640
198,720 375,360
$375,360 200,640
A total of60 employees (25 + 22 + 13) forfeited their rights to the share
options during the three-year period. Therefore a total of48,000 share
options (400 employees x 120 options per employee) vested at the end of
year 3.
REGULATORY FRAMEWORK
OVERVIEW
Objectives
To describe the provisions ofIAS 27 Consolidated and Separate Financial
Statements.
To list the disclosure requirements ofIAS 27 and IFRS 3 Business Combinations.
TRANSITION
INCLUSIONS
INTRODUCTION
SUNDRY
PROVISIONSOF
IAS27
Definitions
Accountingfor subsidiaries in
separatefinancial statement
Truth andfairness
EXEMPTION
Parent and control
SIC-12: Consolidation-
Special Purpose Entities
Potential voting rights
Purchase method
Results ofintra-group trading
Accounting year ends
Accountingpolicies
Date ofacquisition or disposal
DISCLOSURE
lAS 27 disclosures
IFRS 3 disclosures
Rule
Rationale
Accountancy Tuition Centre (International Holdings) Ltd 2005 220 I
1 INTRODUCTION
1.1 Definitions
A business combination - the bringing together of separate entities into one
reporting entity.
Date ofacquisition - the date on the acquirer effectively obtains control of the
acquiree.
Control - the power to govern the financial and operating policies of an entity
so as to obtain benefits from its activities.
A subsidiary - an entity that is controlled by another entity (known as the parent).
A parent - an entity that has one or more subsidiaries.
A group - a parent and all its subsidiaries.
Consolidatedfinancial statements - are the financial statements of a group
presented as those of a single entity.
Minority interest - that part ofthe profit and loss and net assets of a subsidiary
attributable to interests which are not owned, directly or indirectly through
subsidiaries, by the parent.
1.2 Accounting for subsidiaries in separate financial statements
In a parent's separate financial statements, investments in subsidiaries that are
included in the consolidated fmancia1 statements should be either:
o Carried at cost;
o Accounted for as described in lAS 39 Financial Instruments:
Recognition and Measurement (i.e. at fair value).
If an investment is classified as held for sale then it is accounted for under
IFRS 5 "Non-current Assets Heldfor Sale andDiscontinued Operations".
1.3 Truth and fairness
Group accounts aim to give a true and fair view to the owners of the parent
company ofwhat their investments represents (i.e. control and ownership of
the net assets of subsidiary companies).
Rules are needed to ensure that the consolidation includes all entities
controlled by the parent company - the definition of subsidiaries attempts to
do this (see next section).
On occasion no useful purpose is served by a parent company producing
group accounts. Thus in certain circumstances parent companies are exempt
from the general requirement.
2 INCLUSIONS
2.1 Parent and control
A parent which issues consolidated financial statements should consolidate all
subsidiaries, foreign and domestic, other than those excluded for the reasons specified
in lAS 27 (see later).
Control is presumed to exist when the parent owns, directly or indirectly
through subsidiaries, more than one half of the voting power of an entity
unless, it can be clearly demonstrated that such ownership does not
constitute control.
If on acquisition a subsidiary meets the criteria to be classified as held for sale,
in accordance with IFRS 5, it is accounted for at fair value less costs to sell.
Ifa large group ofsubsidiaries are acquired, the parent may intend to
dispose ofunwanted subsidiaries. These may fall within the definition ofheld
for sale.
Control also exists even when the parent owns one half or less of the
voting power of an entity when there is power:
D over more than one half of the voting rights by virtue of an
agreement with other investors;
D to govern the financial and operating policies ofthe entity
under a statute or an agreement;
D to appoint or remove the majority of the members of the board
of directors or equivalent governing body; or
D to cast the majority of votes at meetings of the board of
directors or equivalent governing body.
When assessing whether control exists, the existence and effect of currently
exercisable potential ordinary shares (i.e. options) should be considered.
Illustration 1
Scope of consolidation (extract)
The financial statements of the Bayer Group as of December 31, 2003 include Bayer AG
and 65 German and 260 foreign consolidated subsidiaries in which Bayer AG, directly or
indirectly, has a majority of the voting rights, over which it exercises uniform control, or
from which it is able to derive benefit by virtue of its power to govern corporate financial
and operating policies. There was virtually no change in the total number of consolidated
companies compared with the previous year (2002: 59 German and 268 foreign
consolidated subsidiaries). Excluded from consolidation are 142 subsidiaries that in
aggregate are immaterial to the net worth, financial position and earnings of the Bayer
Group; they account for less than 1 percent of Group sales.
2.2 SIC-12: Consolidation- Special Purpose Entities
2.2.1 Issue
A "special purpose entity" is one created to accomplish a narrow and well-defined
objective. Examples of special purpose entities include entities set up to:
D effect a lease;
D securitise fmancial assets; or
D undertake research and development activities.
The question is when or whether a special purpose entity should be
consolidated by a reporting entity.
2.2.2 (7onsensus
The SIC agrees that a reporting entity should consolidate a special purpose
entity when, in substance, it controls the special purpose entity.
The concept of control used in lAS 27 requires having the ability to direct or
dominate decision-making accompanied by the objective of obtaining benefits
from the special purpose entity's activities.
2.2.3 Example indications ofcontrol
The special purpose entity enters into activities on behalf of the reporting entity.
The reporting entity has decision-making powers over the special purpose entity.
The reporting entity has rights to the majority ofbenefits and exposure to
significant risks of the special purpose entity.
The reporting entity retains the majority of the residual or ownership risks
related to the special purpose entity or its assets in order to obtain benefits
from its activities.
2.3 Potential voting rights
When assessing whether one entity has control over another account should be
taken of any potential voting rights, that are presently exercisable or
convertible, that the parent may have.
An entity may own share options or convertible instruments that if exercised
or converted will give the entity voting power over the fmancial and operating
policies of the other entity.
Potential voting rights that are not presently exercisable or convertible are
ignored in assessing control.
Example 1
Identify the entities to be included in the group as defined by IAS 27, in each ofthe
following situations:
(d)
Shareholders in common
.. ------ --- .. ------- ------- ---- ----------- ------------ ----------r--- -------
. ,
: 100% : 100%
. ,
. ~
A B
2.4 Purchase method
IFRS 3 requires that all business combinations be accounted for using the
purchase method of accounting.
This involves:
o identifying an acquirer;
o measuring the cost of the business combination; and
o allocating the cost of the business combination to the assets acquired
and liabilities and contingent liabilities assumed.
Prior to IFRS 3 a second method of accounting for business combinations,
"uniting of interest", was used if certain criteria were met. This method is no
longer allowed.
3 SUNDRY PROVISIONS OF lAS 27
3.1 Results of intra-group trading
Intra-group balances and intra-group transactions and resulting
unrealised profits should be eliminated in full.
3.2 Accounting year ends
3.2.1 Co-terminous year ends
The financial statements of the parent and its subsidiaries used in the preparation of
the consolidated financial statements are usually drawn up to the same date.
3.2.2 Different reporting dates
Either the subsidiary must prepare special statements as at the same date as the group.
Or, if it is impracticable to do this, fmancial statements drawn up to different
reporting dates may be used if:
o the difference is no greater than three months; and
o adjustments are made for the effects of significant transactions or
other events that occur between those dates and the date of the
parent's financial statements.
Consolidated financial statements should be prepared using uniform
accounting policies for similar transactions and events.
If a group member uses different accounting policies, maybe it is a
foreign subsidiary and following its local GAAP, then appropriate
adjustments must be made at the consolidation stage.
3.4 Date of acquisition or disposal
The results of operations of a subsidiary are included in the consolidated
fmancial statements as from the date of acquisition.
The date of acquisition is the date on which control of the acquired subsidiary
is effectively transferred to the buyer (IFRS 3 Business Combinations).
The date of acquisition and the date of disposal are based on when control
passes not necessarily the legal date of acquisition or date of disposal.
The results of operations of a subsidiary disposed of are included in the
consolidated income statement until the date of disposal, which is the
date on which the parent ceases to have control of the subsidiary.
4 EXEMPTION FROM PREPARING GROUP ACCOUNTS
4.1 Rule
A parent need not present consolidated financial statements if:
o it is a wholly-owned or partially-owned subsidiary;
Minority shareholders must give their consent.
o the parent's debt or equity instruments are not traded on a public
market;
o the parent has not filed its financial statements with a recognised
stock market;
o the ultimate (or intermediate) parent presents consolidated fmancial
statements in accordance with IFRSs.
"Partially owned" is usually taken to mean 90% in many countries.
Illustration 2 - Example ofspecific national rules
(UKfollowing the EU1
h
Directive)
An intermediate parent company is exempt if .....
it is unlisted
and
its immediate parent is established under EC law
and
it is wholly owned or the minority interest have not asked for group accounts
and
the parent company must prepare and have audited group accounts
under EU law.
4.2 Rationale
Users of the fmancial statements of a parent are usually concerned with, and
need to be informed about, the financial position, results of operations and
changes in financial position of the group as a whole.
This need is served by consolidated financial statements, which present
fmancial information about the group as that of a single entity without
regard for the legal boundaries ofthe separate legal entities.
A parent that is itself wholly owned by another entity may not always
present consolidated fmancial statements since such statements may not
be required by its parent and the needs of other users may be best
served by the consolidated financial statements of its parent.
5 DISCLOSURE
5.1 lAS 27 disclosures
5.1.1 Consolidatedfinancial statements
The nature of the relationship if ownership ofvoting power is less than 50%.
Why control does not exist if ownership of voting rights is greater than 50%.
The reporting date of the subsidiary if different to the parent.
Any significant restrictions on the subsidiaries' ability to transfer funds to the
parent.
5.1.2 Parent's separate financial statements
If a parent does not present consolidated fmancial statements it shall disclose:
o the fact they are separate financial statement;
o that the exemption has been used;
o the name and country of incorporation ofthe ultimate parent
presenting in accordance with IFRS;
o a list of significant subsidiaries, jointly controlled entities and
associates with:
proportion of ownership and voting rights; and
the method of accounting for the investments.
5.2 IFRS 3 disclosures
5.2.1 Information needed
To allow users to evaluate the nature and fmancial effect of business
combinations that occurred:
o during the period;
o after the balance sheet date but before the fmancial statements are
authorised for issue.
5.2.2 Business combinations effected during the period
The names and descriptions of the combining entities.
Acquisition date.
Percentage of voting instruments acquired.
The cost ofthe combination and a description of the components of that cost
(including any directly attributable costs).
When equity instruments are issued or issuable as part of the cost:
o the number of equity instruments issued or issuable; and
o their and the basis for determining that fair value.
Details of any operations the entity has decided to dispose of as a result of the
combination.
The amounts recognised at the acquisition date for each class of the acquiree's
assets, liabilities and contingent liabilities, and their carrying values under
IFRS, ifpracticable.
The amount of any excess of net assets acquired over cost recognised in profit
or loss, and the line item in the income statement where it is recognised.
A description of:
o the factors contributing to a cost that results in the recognition of goodwill;
o each intangible asset that was not recognised separately from
goodwill and an explanation of why the intangible asset's fair value
could not be measured reliably; or
o the nature of any excess recognised in profit or loss.
The amount of the acquiree's profit or loss since the acquisition date included
in the acquirer's profit or loss for the period.
If provisional figures have been used that fact shall be disclosed.
Subsequent adjustments to such provisional fair values should be disclosed
and explained in the financial statements of the period concerned.
5.2.3 Goodwill reconciliation
To enable users to evaluate changes in the carrying amount of goodwill during
the period, an entity reconciles the carrying amount of goodwill at the
beginning and end of the period, disclosing separately:
o the gross amount and accumulated impairment losses at the
beginning of the period;
o additional goodwill recognised in the period (except goodwill
included in a disposal group);
o adjustments resulting from the subsequent recognition of deferred
tax assets in the period;
o goodwill in respect of disposal groups;
o impairment losses recognised in the period;
o net exchange differences arising in the period;
o any other changes in the carrying amount in the period; and
o the gross amount and accumulated impairment losses at the end of the period.
Information about the recoverable amount and impairment of goodwill is
disclosed in accordance with lAS 36 "Impairment ofAssets".
Illustration 3
Acquisitions are accounted for by the purchase method. Accordingly, the results
of operations of the acquired businesses are included in the consolidated financial
statements as from the respective dates of acquisition. The purchase prices of acquisitions
outside the euro zone are translated at the exchange rates in effect at the respective dates
of acquisition.
Illustration 4
GVCCI GROUP N.V.
Notes to the consolidated fmancial statements
(3) Summary of significant accounting policies - extract
Principles ofconsolidation
Theassets, liabilities andequityof consolidated companies areadded together ona line-by-line basis,
eliminatingthebookvalue oftherelated investment against theGroup's share of equity.
In the caseofsubsidiaries not l000!o owned, the Group recognizes aminority interest consisting ofthe
portionofnet income andnet assets attributable totheinterest ownedbythirdparties.
Allsignificant inter-companybalances, transactions andunrealizedprofitsandlosses areeliminated.
Thebalance sheets ofsubsidiaries denominated inforeign currencies aretranslated intoEumusingyear-
end exchange rates, whileaverage exchange ratesfortheyearareusedfurthetranslationofthestatements
of income andcash flows. Significant individual transactions aretranslated at the rateof exchange
prevailing onthe dateofthetransaction. Translationgains andlosses, includingthe differences arising asa
result oftranslatingopening shareholders' equity using exchange ratesat theclose oftheperiod or onthe
dateofacquisition furforeign companies acquireddwingtheyearrather than exchange ratesat the
beginning oftheperiod, arereportedasa separate component ofshareholders' equity.
5.2.4 Business combinations effected after the balance sheet date
Business combinations effected after the balance sheet date but before the date
on which the financial statements of one ofthe combining entities are
authorised for issue are disclosed if they are of such importance that non-
disclosure would affect the ability of the users of the financial statements to
make proper evaluations and decisions.
In accordance with lAS 10 "Events After the Balance Sheet Date".
In this case IFRS 3 disclosures should be made.
If it is impracticable to disclose any of this information, this fact should be
disclosed.
6 TRANSITIONAL PROVISIONS
6.1 Previously recognised goodwill
Any remaining goodwill arising from business combinations occuring before
31 March 2004, shall no longer be amortised.
This goodwill will now be tested annually for impairment in accordance with
lAS 36.
6.2 Previously recognised negative goodwill
Any remaining negative goodwill arising from business combinations
occurring before 31 March 2004 shall be derecognised with the credit entry
being taken to the opening retained earnings position.
6.3 Previously recognised intangible assets
Any intangible assets arising from a business combination or jointly
controlled entity, where proportional consolidation is used, that occurred prior
to 31 March 2004 will be reclassed as goodwill if the recognition criteria of
lAS 38 are not satisfied.
FOCUS
explain the concept of a group and the purpose of preparing consolidated
fmancia1 statements;
explain and apply the defmition of subsidiary companies;
identify the circumstances and reasoning when subsidiaries should be
excluded from consolidated financial statements;
explain the need for using co-terminous year-ends and uniform accounting
policies when preparing consolidated financial statements and describe how it
is achieved in practice.
EXAMPLE SOLUTION
Solution 1 - Entities in the group
(a) A is the parent of C. Even though it owns no shares it has the power of control.
(b) A is the parent ofB. A is also the parent ofC as it has control of75% of the
voting rights of C.
(c) A is the parent ofB and D. A may therefore appear to control C through a
60% indirect shareholding. In which case A would be the parent. However,
A effectively owns only a 36% interest in C. The substance of this
relationship would therefore require scrutiny.
(d) There is no group in this situation as A and B fall within the ownership of
shareholders in common which are scoped out of consolidated accounts. A
and B however may be related parties and would have make necessary
disclosures in accordance with lAS 24 (see later session).
GROUPACCOUNTS- REVISIONOF BASICS
OVERVIEW
Background
THE ISSUE
Definitions
Rule
Types ofconsolidation
--- -- - -------- - - -- -- - -- - ---- ------------------------------------ - - - ------ -- - - - - - - - - - - -
BALANCESHEETS
I
CONCEPTUAL OVERVIEW OF CONSOLIDATION CONSOLIDATION
BACKGROUND THE TECHNIQUE ADJUSTMENTS 1 ADJUSTMENTS 1
COMPLICATIONS
CBS WORKINGS
INCOME STATEMENTS
CONTROL AND
OWNERSHIP
I
DIVIDENDS
I
INTER COMPANY
TRADING
I
UNREALISED
PROFITS ON
TRADING
I
FIXED ASSET
TRANSFERS
I
MIDYEAR
ACQUISITION
e Accountancy TuitionCentre(InternationalHoldings)Ltd 2005 2301
GROUP ACCOUNTS - REVISION OF BASICS
1 THE ISSUE
1.1 Background
Many companies carry on part of their business through the ownership of
other companies which they control. Such companies are known as
subsidiaries.
Controlling interests in such companies would appear at cost in the balance
sheet of the investing company. Such interests may result in the control of
assets of a very different value to the cost of investment. In other words the
accounts will not provide the shareholders of the parent (or holding) company
with a true and fair view of what their investment actually represents.
The substance ofthe relationship is not reflected.
1.2 Definitions
Consolidatedfinancial statements are the fmancial statements of a group
presented as those of a single entity.
Group is a parent and all its subsidiaries.
The definition of a group does not include associates or jointly controlled
entities.
Subsidiary is an entity that is controlled by another entity (known as the
parent).
Parent is an entity that has one or more subsidiaries.
Minority interest is that part of the net results of operations and ofnet assets
of a subsidiary attributable to interests which are not owned, directly or
indirectly through subsidiaries, by the parent.
1.3 Rule
A company which has a subsidiary on the last day of its accounting period
must prepare consolidated financial statements in addition to its own
individual accounts. In practice a holding company will usually prepare (and
publish) the following:
o Its own balance sheet with relevant notes and
o Consolidated versions of its balance sheet, income statement, and
cash flow statement, all with relevant notes.
1.4 Types of consolidation
IFRS 3 Business Combinations only allows the acquisition method of
consolidation.
Prior to IFRS 3 being issued the IASB also allowed the use of the Uniting of
Interest method of consolidation if certain criteria were met.
This session is only concerned with acquisition accounting.
GROUP ACCOUNTS - REVISION OFBASICS
2 CONCEPTUAL BACKGROUND
Replace cost of investment with what it represents - ie
r--- . . _-_ -_ --_.. --- _. ----- . . _- _- -_ -_ _-_ ----- --
: Share ofnet assets at the balance sheet date andgoodwill at the date of
: acquisition
,
AND
Credit reserves with pts share of the post acquisition growth in S's
: reserves
3 THE TECHNIQUE - CONSOLIDATED BALANCE SHEETS
2 steps
[J Process individual company adjustments
[J Consolidate
Step 1 - Individual company adjustments
[J Items not accounted for
[J Group accountingpolicy adjustments
[J Fair valuation adjustments
[J Translation ofthe subsidiary's accounts into the presentation currency in
accordancewith lAS 21
[J Unrealisedprofit
._ __ r 1 _.-
Net assets
P S
X + X
CBS
X
_____ ___ __ __ J _X
Share capital
Reserves
x
X
X
X
X
X
Step :z - coDlloHdatlon
adJultments
[J Goodwill
[J Minority Interest
[J Consolidatedreserves
And
[J Cancellation ofinter
company balances
x
X
AcclJUIl!Bncy Tuiticm Centre (Intmnafumal Holdings) Ltd 2005 2303
4 QUESTION APPROACH
4.1 Specific steps
1 Establish group structure
2 Proforma the answer - fill in easy figures eg share capital
3 Process individual company adjustments
do double entry on face of question as far as possible
tick off points on paper as they are dealt with
4 Prepare a net assets summary for each subsidiary
I Aim: to give the corrected figures I

At BS date At date of acquisition
Share Capital
Accumulated profits:
perQ X
Adjustments (X)
X X
X
\ (y
I ToGRE
To MI ITo Goodwill
5 Consolidation schedules
Goodwill
X
Share of net assets at acquisition (X)
X
Remainig portion - to the BS X
Impaired portion to the IS (and then RE) X
Minority interest
x% x Net assets at consolidation
Consolidated retained earnings
Notes:
All ofP
as perQ
Adjustments made
Share of Ss post
acquisition profit
x%(X-X)
Less impaired goodwill
X
(X)
X
X
(X)
X
At P3.6 be prepared to calculate Ss net assets from either the equity or net
asset position, both have been examined.
IFRS 3 now only allows the minority interest calculation to be based on fair
value of S net assets.
Theoption previously allowed underlAS 22, tovalue Ml based on book
values is nolonger permitted.
5 UNREALISED PROFIT
5.1 Background
lAS 27 says that unrealised profit on inter company trading and sale of assets
must be removed in full. This will result in the restatement of the asset to the
cost to the group.
There are two common ways of reflecting the write downs:
o Charge the whole amount to consolidated reserves, and
o Charge the minority interest with their share of any adjustment
where appropriate.
lAS 27 gives no guidance on which treatment to adopt.
5.2 The group suffers the whole charge
Process the following entry in the consolidated accounts
Dr Closing inventory in the consolidated income statement
Cr Closing inventory in the consolidated balance sheet
5.3 The group shares the charge with the minority interest where
appropriate.
It is appropriate where S has made the sale to P.
The double entry required is:
Dr Closing inventory in the consolidated income statement
AND
Dr Balance sheet - minority interest
Cr Income statement - minority interest
With the minority share.
The effect in the balance sheet is:
Dr Accumulated profits
Dr Balance sheet - minority interest
In most balance sheet questions this is easily carried out by treating the write
down as an individual company adjustment in the books of the selling
company The minority interest will then automatically share in the
adjustment when necessary.
5.4 Exception
This will usually work but there is a rare circumstance where this would not
give the correct answer.
This is where there is a piecemeal acquisition and P's percentage holding in S
has changed after the date of the inter company transfer of the inventory in
question.
Illustration
As at 31 December 2004 P owned 80% of S. This holding consisted of 75% which was
acquired many years ago and 5% which was acquired on 31st December 2004. S has made
sales to P and P holds inventory at the year end which S had sold to it at a mark up of
$1,000.
If the adjustment is processed in the accounts of S and the year end minority interest
percentage (20%) is applied to the resultant net assets figure this would mean that the group
had been charged with 80% ofthe adjustment.
There is no need to charge the group with unrealised profit on transfers before S became a
subsidiary. By extension there is no need to charge the group with that part of the
unrealised profit which relates to the latest acquisition.
The solution to this problem is to carry out the consolidation without the adjustment and
then to process the following double entry in the consolidated accounts.
Dr Accumulated profits 750
Dr Minority interest 250
Cr Inventory (balance sheet) 1,000
Example
Balance sheets as at 31.12.2004
P S
$ $
Non current assets
Cost of investment in S
Tangible assets
Current assets
10,000
8,000
5,000
2,000
7,000
23,000 9,000
Share capital
Accumulated profits
Payables
1,000
21,000
1,000
500
5,500
3,000
Further information
23,000 9,000
1 P acquired 80%of S 2 years ago when the balance on S' s accumulated profits was
$4,000.
2 At acquisition S's assets included one with a book value of $1,200 and a fair value of
$1,500. This asset was being written off over 10years.
3 During the year S had sold goods to P. At the year end P retained goods at a value of
$450 above the cost to S. It is group policy to charge the minority interest with their share
of any adjustments in respect of unrealised profit.
4 Before the year end P proposed a dividend of $200 and S proposed a dividend of $100.
Neither company has yet reflected the proposed dividend in their accounts.
5 Goodwill had been impaired by $2,464 since the acquisition occurred.
Required:
Produce the consolidated balance sheet as at 31.12.2004.
Solution 1
Consolidated balance sheet as at 31.12.2004
$
Tangible assets
Current assets
Share capital
Accumulated profits
Minority interest
Proposed dividend
Other Payables
5.5 Deferred tax
Unrealised profit in the group accounts will give rise to a deductible
temporary difference. The tax base of the inventory will reflect the cost to the
buying company whereas the carrying value in the consolidated accounts will
be based on cost.
lAS 12 requires the buyer's tax rate to be applied to the deductible temporary
difference. This requirement is different to other tax regimes, such as UK,
which tax the difference at the seller's tax rate.
6 CONSOLIDATED INCOME STATEMENTS
6.1 Control and ownership
Principles
o Group accounts reflect control and ownership.
o Prepare the consolidated income statement on basis consistent with
the consolidated balance sheet.
Preparation overview
o Show income generated from net assets under P's control.
o Reflect ownership by deducting the minority interest's share ofS's
profit after tax in the consolidated income statement.
o Eliminate effect of intra-group transactions.
6.2 Unrealised profits on trading
Adjustment
o Inventory needs reducing to lower of cost or NRV to group.
Dr Income statement - closing inventory X
Cr Balance sheet - closing inventory X
o This should be done either in the consolidated accounts or in the
accounts of the selling company depending on whether the minority
interest is to share in the adjustment where appropriate
6.3 Non current asset transfers
Adjustments
o Again need to be consistent with treatment in the consolidated
balance sheet.
o Eliminate profit or loss on transfer and adjust depreciation in full.
o This may either be done in the consolidated financial statements or
in the books of seller (unrealised profit) and buyer (depreciation)
Again this depends on whether the minority interest is to share as
appropriate or not.
6.4 Mid-year acquisitions
Inclusion of S's results
o Consolidate S from date of acquisition.
o Assume revenue and expenses accrue evenly over time unless
contrary indicated.
FOCUS
apply the basic principles of group accounts.
EXAMPLE SOLUTION
Solution I
CBS as at 31 December 2004
Intangibles
Tangible assets (8,000 +2,000 +300 - 60)
Current assets (5,000 +7,000 - 450)
Share capital
Accumulated Profits (W5)
Minority interest (W3)
Proposed dividend (200 + 20)
Other payables
$
3,696
10,240
11,550
25,486
1,000
19,128
1,138
220
4,000
25,486
WORKINGS
(WI) Adjustments made on face of question
Balance sheets as at 31.1.2.2004
H S
$ $
Cost of investment in S 10,000
300
Tangible assets 8,000 2,000
(60)
Dividends receivable 80
Current assets 5,000 7,000
(450)
22,000 6,000
Share capital 1,000 500
Accumulated profits 21,000 5,500 (60)
(200) (100)
80 (450)
Revaluation reserve 300
Proposed dividend (200) (100)
Payables (1,000) (3,000)
22,000 6,000
Explanation:
H's books $200
$80
dividend payable
dividend receivable
S's books
$100 -
$300 -
$60 -
$450 -
dividend payable
asset revaluation
extra depreciation on revaluedasset (1
20
X 300)
unrealised profit adjustment
(W2) Net assets summary
At date of At date of
consolidation acquisition
Share capital 500 500
Accumulated profits
perQ 5,500 4,000
dividend
payable (100)
extra dep" (60)
UP (450) 4,890
Revaluation reserve 300 300
5,690 4,800
(W3) Minority interest
(W4) Goodwill
Cost
SNA
80% x 4,800 (W2)
To the BS
To the IS
20% x 5,690 (W2) = 1,138
$
10,000
(3,840)
6,160
3,696
2,464
(W5) Consolidate accumulated profits
All ofP
perQ
dividend payable
dividend receivable
Share of S 80% (4,890 - 4,000) (W2)
Goodwill (W4)
21,000
(200)
80
20,880
712
(2,464)
19,128
lAS 22 GOODWILL
OVERVIEW
Objective
To describe GAAP applied to the measurement and recognition of goodwill.
To describe the proposed revision to the rules on measurement and
recognition of goodwill.
To examine the rationale behind GAAP and the recent revisions to GAAP.
GOODWILL
I
FAIR VALUE OF
PURCHASE
CONSIDERATION
I
IDENTIFIABLE ASSETS
AND LIABILITIES
I
FAIR VALUE OF THE
IDENTIFIABLE ASSETS
AND LIABILITIES
I
ACCOUNTING FOR THE
REVALUATIONS IN THE
ACCOUNTS OF THE
SUBSIDIARY
I
ACCOUNTING FOR
GOODWILL
I
DISCUSSION TOPICS
Purchase method
Definition
Features ofgoodwill
Introduction
Provisions
Contingent liabilities
General guidelines

Subsequent adjustment
Exam complication
How is the revaluation accountedfor?
Positive goodwill
Excess
Should an asset be recognised at all?
Impairment review vs amortisation
lAS 22 GOODWILL
1 GOODWILL
1.1 Purchase method
A combination that is an acquisition should be accounted for in the
consolidated accounts using the purchase method (the acquisition method).
As at the date of the acquisition the acquirer should:
o incorporate the results ofthe acquiree into the income statement,
o recognise the identifiable assets and liabilities of the acquiree and
any goodwill arising (positive or negative) into the balance sheet.
1.2 Definition
IFRS 3 defines goodwill as "future economic benefits arising from assets that
are not capable of being individually identified and separately recognised".
In essence it is the difference between the cost of the acquisition and the
acquirer's interest in the fair value of its identifiable assets, liabilities and
contingent liabilities as at the date of the exchange transaction.
This is reflected in consolidation workings as:
Cost (the value of the part of the business owned)
Acquirer's share of the fair value of the identifiable assets,
liabilities and contingent liabilities of the subsidiary as
at the date of acquisition
Therefore there are several issues to address:
$
X
(X)
X
o Calculation of cost - the fair value of the purchase consideration.
o Identifiability of assets and liabilities on acquisition
o Calculation of the fair value of the identifiable assets and liabilities
o Accounting for the revaluations in the accounts of the subsidiary
o Accounting for the goodwill which is generated.
1.3 Features of goodwill
It is incapable of separate realisation.
Its value has no reliable relationship to cost.
Its value may fluctuate widely over time.
Valuation can be highly subjective.
It exists because of factors which are difficult to identify with precision.
Goodwill may be internally generated or it may arise on acquisition
!AS 22 GOODWILL
2 FAIRVALUE OF PURCHASE CONSIDERATION
An acquisition should be accounted for at its cost. Cost is:
D Amount of cash or cash equivalents paid, or
D The fair value ofthe other purchase consideration given,
o Costs directly attributable to the acquisition.
Deferred consideration - cost of the acquisition is the present value of the
consideration, taking into account any premium or discount likely to be
incurred in settlement.
Cost of acquisition
I
I I I
Cash paid
Fair value ofother Acquisition
purchase consideration expenses
. .
. .
... --- -.. ---.. - - - - ----- . -- - -----.. -----"
Discount deferred consideration
to present value.
Contingent consideration: When
the acquisition agreement provides
for an adjustment to the purchase
consideration contingent on one or
more future events, the amount
should be included in the cost of
acquisition as at the date of
acquisition ifthe adjustment is
probable and can be measured
reliably.
The cost of acquisition should be
adjusted when a contingency is
resolved subsequent to the date of
acquisition. This will have a
consequential effect on the
goodwill balance.
Accountancy TuitionCentre(International Holdingt) Ltd 2005 2403
Include:
fees and similar incremental
costs directly related to the
acquisition
Exclude:
General administrative
expenses and other costs not
directly attributable to the
acquisition.
Note that where an issue of
shares funds an acquisition the
costs associated with the issue
are transaction costs as de:fmed
in IAS 39. They should be
treated as IAS 39 specifies and
not capitalised as part of the
cost of acquisition
lAS 22 GOODWILL
Example 1
Klingon Inc acquired 75% of Entity Inc on 1 July 2004. The consideration comprised the
following.
5 million 25c ordinary shares of Klingon Inc (market value 60c) to be issued on 1 July 2004
(issue costs of$lO,OOO were paid to a merchant bank).
$1 million cash payable on 1 July 2004.
A further 1 million 25c ordinary shares of Klingon Inc to be issued on 1 July 2005,
provided that Entity Inc achieves a profit for the year ended 31 March 2005 of $10 million
(assume market value remains unchanged).
Professional fees to bankers and advisers relating to the acquisition totalled $20,000 (excluding
the issue costs stated above). The directors of Klingon Inc estimate that the value of their time
spent working on the acquisition was $25,000.
The fair value of Entity Inc's identifiable assets and liabilities at 1 July 2004 is $3,628,000
which includes $200,000 of capitalised development costs. These costs do not meet the
recognition criteria for intangible assets.
Klingon Inc intends restructuring Entity Inc at an estimated cost of $250,000.
Current forecasts indicate that Entity Inc will probably make profits of at least $12 million for
the year to 31 March 2005.
Required:
Show the entries in Klingon Inc's books to record the investment in Entity Inc and calculate
goodwill on acquisition.
Solution 1
lAS 22 GOODWILL
3 IDENTIFIABLE ASSETS ANDLIABILITIES
3.1 Introduction
The identifiable assets, liabilities and contingent liabilities acquired are recognised
separately as at the date of acquisition (and therefore feature in the calculation of
goodwill) when:
o for an asset other than an intangible, it is probable that future
economic benefits will flow to the acquirer, and its fair value can be
measured reliably;
o for a liability other than a contingent liability, it is probable that an
outflow ofresources will be required to settle the obligation, and its
fair value can be measured reliably;
o for an intangible asset or a contingent liability, its fair value can be
measured reliably.
Identifiable assets, liabilities and contingent liabilities may include elements
that were not recognised in the accounts ofthe acquired entity.
3.2 Provisions
Liabilities are not to be recognised at the date of acquisition when:
o they result from the acquirer's intentions or actions; or
o they are to provide for future losses or costs expected to be incurred as a
result of the acquisition (whether they relate to the acquirer or the acquiree).
Such liabilities are not liabilities of the acquiree at the date of acquisition.
Therefore they are not relevant in allocating the cost of acquisition.
3.3 Contingent liabilities
An acquirer recognises contingent liabilities of the acquiree only if their fair
value can be measured reliably.
If the contingent liabilities fair value cannot be measured then this will affect
the amount of goodwill or excess recognised on acquisition. The acquirer is
required to disclose information about the contingency.
After initial recognition the contingent liability is measured at the higher of:
o the amount required under lAS 37 Provisions, Contingent
Liabilities and Contingent Assets, and
o the amount on initial recognition less any cumulative amortisation
recognised under lAS 18 Revenue.
lAS 22 GOODWILL
4 FAIR VALUE OF THE IDENTIFIABLE ASSETS AND LIABILITIES
4.1 General guidelines
Marketable securities - current market values.
Non-marketable securities - estimated values that take account ofprice
earnings ratios, dividend yields and expected growth rates of comparable
securities of entities with similar characteristics.
Receivables - at the present values of the amounts to be received, determined
at appropriate current interest rates, less allowances for uncollectibility and
collection costs, if necessary.
Discounting is not requiredfor short-term receivables when the difference between
the nominal amount ofthe receivable and the discounted amount is not material.
Inventories:
o finished goods and merchandise at selling price less:
costs of disposal; and
a reasonable profit allowance for the acquirer's selling
effort (based on profit for similar items);
o work in progress at selling price of finished goods less:
costs to complete;
costs of disposal; and
a reasonable profit allowance for the completing and selling
effort (based on profit for similar fmished goods; and
o raw materials at current replacement costs.
Land and buildings - at their current market value.
Plant and equipment - at market value normally determined by appraisal.
Depreciated replacement cost may be used as a substitute where there is no
evidence ofmarket value (see lAS 16).
Intangible assets - at fair value determined:
o by reference to an active market;
o if no active market exists at an amount that the entity would have
paid for the asset in an arm's length transaction between
knowledgeable and willing parties based on the best information
available.
Ifthe fair value cannot be measured by reference to an active market, the
amount recognisedfor the intangible at the date ofacquisition is limited to an
amount that does not create or increase any "excess" ofthe acquirer',s
interest over cost (see later).
lAS 22 GOODWILL
Defined benefit plans assets or liabilities at present value of the defmed benefit
obligation less the fair value of the plans assets.
An asset will only be recognised ifit is available to the acquirer in the form
ofrefunds from the plan or a reduction of'future contributions.
Tax assets and liabilities - at the amount of the tax benefit arising from tax
losses or the taxes payable in respect ofthe profit or loss, assessed from the
perspective of the combined entity or group resulting from the acquisition. The
tax recognised will be after allowing for the effects of fair valuing the assets,
liabilities and contingent liabilities of the acquiree. The amount recognised is
not discounted.
Accounts and notes payable - long-term debt, liabilities, accruals and other
claims payable at the present values of amounts to be disbursed in meeting
the liability determined at appropriate current interest rates.
Discounting is not requiredfor short-term liabilities when the difference between
the nominal amount ofthe liability and the discounted amount is not material.
Onerous contracts and other identifiable liabilities of the acquiree - at the
present values of amounts to be disbursed in meeting the obligation
determined at appropriate current interest rates.
Contingent Liabilities of the acquiree will be valued at the amounts third
parties would charge to take them over. The amount reflects all expectations
about future cash flows.
4.2 Provisional accounting
If accurate figures cannot be assigned to elements of the business
combination then provisional values are assigned to those elements at the
date of acquisition.
Subsequent to that date, the acquirer recognises any changes in the
provisional values made within twelve months of the acquisition date as if
those values had been available at the date of acquisition.
Goodwill is adjusted to reflect the changes in provisional values initially
made and comparative information is restated as if those values were
available on acquisition.
lAS 22 GOODWILL
4.3 Subsequent adjustments
Ifa conditional component of the cost of acquisition was not initially
included as part of the cost, due to the condition being improbable or not
capable of measurement, and subsequently the condition is satisfied, then the
cost of acquisition will be adjusted.
If a deferred tax asset was not recognised as part of the acquisition process
but is subsequently realised, the tax benefit is recognised in income. The
carrying amount of goodwill is reduced to an amount that would have been
recognised if the deferred tax asset had been recognised on initial acquisition.
The reduction in goodwill is expensed to income in the period.
Any other adjustments are treated in accordance with lAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors.
o An error in acquisition values is treated retrospectively.
o A change in estimate is treated prospectively.
lAS 22 GOODWILL
Illustration 1
Parent acquires 80% of Subsidiary for $60,000. The subsidiary's net assets at date of
acquisition were $62,500. At the end of the fITSt year goodwill has been impaired by
$1,000.
In the year following acquisition, but within 12 months ofthe acquisition date, it was
identified that the value of land was $2,500 greater than that recognised on acquisition.
The value of goodwill at the end ofyear 2 was valued at $7,400.
Year 1:
Year 2:
Cost of investment
Net assets on acquisition (62,500 x 80%)
Goodwill
Goodwill charge to income statement
Cost of investment
Net assets on acquisition (65,000 x 80%)
Goodwill at year end
Goodwill charge to income statement
Journal
60,000
50,000
10,000
1,000
60,000
52,000
8,000
7,400
600
Dr Land 2,500
Dr Income statement (goodwill) 600
Cr Goodwill (9,000 -7,400) 1,600
Cr Minority interest (2,500 x 20%) 500
Cr Opening retained earnings 1,000
(prior year charge for goodwill reversed)
lAS 22 GOODWILL
5 ACCOUNTING FOR THE REVALUATION IN THE ACCOUNTS OF
SUBSIDIARY ENTITYS
5.1 Exam complication
The revaluations mayor may not have been reflected in the financial
statements of 8 at the date of acquisition. In the exam they will not have
been.
If 8 has not reflected fair values in its accounts, this must be done before
consolidating.
o For a revaluation upwards create a revaluation reserve in net assets
working (fair value less book value ofnet assets at acquisition) at
acquisition and the balance sheet date.
May need to adjust post-acquisition depreciation to base it on
revalued amount.
o For a revaluation downwards create a provision against retained
earnings in net assets working (book value less fair value of net
assets at acquisition) at acquisition and balance sheet date.
Goodwill in 8' s balance sheet is not part of identifiable assets and liabilities
acquired. If 8' s own balance sheet at acquisition includes goodwill, this must
be written off:
o reduce retained earnings at acquisition and the balance sheet date
by goodwill in S's balance sheet at acquisition. Do this in the net
assets working.
5.2 How is the revaluation accounted for?
IFR8 3 requires the whole revaluation to be reflected in the consolidated
group accounts. The minority interest balance will reflect their share of the
revaluation.
The minority interest shares in both the revaluation and any consequential
depreciation adjustment.
Results:
Goodwill calculation is based on fair value
Minority interest at the date of acquisition is based on fair
value
Minority interest subsequent to acquisition is based on
fair value at the date of acquisition plus the minority
interest's share in the post acquisition growth in the assets
(reserves).
lAS 22 GOODWILL
Example 2
As at 31 December 2004
Parent Subsidiary
$ $
Non-current assets:
Tangibles 1,800 1,000
Cost of investment in Subsidiary 1,000
Current assets 400 300
3,200 1,300
Issued capital 100 100
Retained earnings 2,900 1,000
Current liabilities 200 200
3,200 1,300
Parent bought 80% of Subsidiary on the 31 December 2002.
At the date of acquisition Subsidiary's retained earnings stood at $600 and the fair
value of its net assets were 1,000. The revaluation was due to an asset that had a
remaining useful economic life of 10 years as at the date of acquisition.
Goodwill has been impaired by $40 since acquisition.
Required:
Prepare the consolidated balance sheet of Parent as at 31 December 2004.
lAS 22 GOODWILL
Solution 2
lAS 22 GOODWILL
6 ACCOUNTING FOR GOODWILL
6.1 Positive goodwill
Goodwill reflects the future economic benefits arising from assets that are not
capable ofbeing identified individually or recognised separately.
It is initially measured at cost, being the excess of the cost of the acquisition
over the acquirer's interest in the fair value of the identifiable assets,
liabilities and contingent liabilities acquired as at the date of the acquisition.
It is recognised as an asset.
Subsequent to initial recognition goodwill is carried at cost less any
accumulated impairment losses.
Goodwill is tested annually for impairment, any loss is expensed to profit and
loss.
Prior to the issue ofIFRS 3, goodwill was capitalised and amortised over its
useful life.
6.2 Excess of acquirer's interest over cost
If on initial measurement the fair value of the acquiree' s assets, liabilities and
contingent liabilities exceeds the cost of acquisition (excess), then the
acquirer reassesses:
o the value of net assets acquired;
o that all relevant assets, liabilities and contingent liabilities have
been identified; and
o that the cost of the combination has been correctly measured.
If there still remains an excess after the reassessment then that excess is
recognised immediately in profit and loss. This excess (gain) could have
arisen due to:
o future costs not being reflected in the acquisition process;
o measurement of items not at fair value, if required by another
standard, such as deferred tax being undiscounted;
o bargain purchase.
lAS 22 GOODWILL
7 DISCUSSION TOPICS
Over the years there has been a great deal of debate about the accounting
treatment of goodwill. This section summarises the arguments in respect of
some of these issues
7.1 Should an asset be recognised at all?
The alternative to recognising goodwill as an asset is to write it off
immediately to equity. This was preferred practice in the UK until recently
and, was up until 1997, an allowed alternative under lAS 22.
There are three groups of commentators:
o those who do not believe that goodwill should be recognised as an
asset,
o those who believe that goodwill meets the definition of, and
recognition criteria for, an asset, and
o those who are not convinced by the conceptual arguments for the
recognition of goodwill as an asset but believe that this treatment is
pragmatic and a widely accepted convention.
lAS 22 GOODWILL
Arguments for non recognition (and therefore in favour ofimmediate write oft)
Non recognition is a treatment that is consistent with the treatment ofnon-purchased goodwill
Some believe that goodwill does not meet the lASH's "Framework" definition of an asset. ie
"a resource controlled by the entity as a result ofpast events and from which future economic
benefits are expected to flow to the entity".
D It is not a resource in the true sense of the word. It is not itself capable of generating
cash flow. It is a residue within a cost, and a cost of itself is not an asset.
D It is not controlled by the entity (note that certain items, (eg staff skills), which may
lead to future economic benefits, cannot be controlled and thus fail to meet the
recognition criteria as separate intangible assets). It can be argued that it is illogical to
argue that individually these items cannot be controlled yet when included in the
measurement of goodwill they somehow can be controlled.
The balance sheet should include only assets that are separable from other assets ofthe entity
without adversely affecting the value of those of other assets. (Goodwill is not separately
realisable therefore it is imprudent to carry it as an asset).
Arguments for recognition as an asset
Goodwill has a value which, has been established. It is over-prudent to write off immediately
an asset that has been paid for
Ensures consistency of accounting for non current assets
Goodwill will not be worthless while entity is a going concern.
Goodwill is a resource. Goodwill gives an entity rights and opportunities to future cash
inflows (eg the right to use a particular business name; the opportunity to deal with existing
customers). The fact that such items do not usually appear on the balance sheet of companies
is because their cost of creation cannot be identified. When they contribute to the value of
purchased goodwill this is not the case.;
The cost of goodwill is incurred because the access to future cash flows from the mix of the
various rights and opportunities mentioned above is effectively controlled by the acquirer.
Separability is not a recognition criteria in lASH's "Framework". Sometimes, assets need to
work together to generate economic benefits.
Immediate write off would not represent the economic reality of goodwill and therefore
would not be useful to users of the financial statements.
Many argue that whether or not goodwill meets the definition of an asset is
not important. The recognition of goodwill as an asset is a pragmatic and
acceptable solution that settles a debate that has continued over many recent
years.
The view that goodwill should be recognised as an asset was supported by a
majority of commentators. The treatment is applied in most countries around
the world.
lAS 22 GOODWILL
7.2 Impairment review vs amortisation
If goodwill is recognised as an asset, should it be amortised, or should it be
carried as a permanent item and subject to a periodic impairment review?
Arguments in favour of carrying the goodwill as a permanent asset and subjecting it to an
annual impairment review
Goodwill does not "depreciate" in value in normal course ofbusiness (as do tangible assets).
It is inappropriate to reflect the consumption of the service potential as amortisation.
Write-off is only necessary if net realisable value falls to less than cost.
Expenditure incurred in generating and maintaining goodwill (eg staff training) is expensed,
:. to write-off goodwill results in a "double charge" against profits.
Amortisation could mislead users of financial statements because the charge can only be
determined on an arbitrary basis. Information about value is more relevant;
Goodwill is a portion of a larger asset, the underlying investment. Since investments are not
amortised, goodwill should not be amortised.
Rigorous impairment reviews ensure that an asset is not overvalued in the financial
statements and they provide users with a genuine economic signal about the financial state of
the underlying investment.
Arguments against carrying goodwill as a permanent asset and in favour of amortisation
Goodwill has a fmite (albeit unknown) life which can be estimated.
Purchased goodwill will deteriorate over time as the factors (eg personnel) which generated it
are replaced.
There may be no physical limit to the useful life of some intangible assets and goodwill if
properly maintained, but infinite lives do not exist.
The depreciable amount of all non current assets should be allocated on a systematic basis to
reflect the consumption of these assets over their useful lives, even ifthey are long. The
future economic benefits embodied in an intangible asset and goodwill are always consumed.
Amortisation matches cost of asset with the revenue which it helps to generate.
Ifthe value of an intangible asset or goodwill is maintained, it is because the potential
economic benefit that was purchased initially has been replaced by new potential economic
benefit purchased by post acquisition enhancements. Unless the costs ofthese enhancements
meet the recognition criteria set out in lAS 38 they contribute to the internally generated
goodwill of the entity.
An impairment approach is a valuation concept rather than one of allocation of cost. Its
purpose is not to reflect the consumption ofthe economic benefits embodied in an asset.
lAS 22 GOODWILL
FOCUS
describe and apply the provisions of IFRS 3 in so far as they relate to
goodwill;
discuss the issues surrounding the measurement and recognition of goodwill;
explain the principle ofmeasurement relating to the fair value of the
consideration and the net assets acquired;
account for goodwill.
lAS 22 GOODWILL
EXAMPLE SOLUTIONS
Solution 1
Recording investment in Entity Inc
Shares issued 1 July 2004
Dr Investment in Entity Inc [(5m x 60c)] 3,000
Cr Cash (issue costs)
Cr Share capital (5m x 25c)
Cr Share premium (3,000 - 1,250 - 10)
Cash
Dr Investment in Entity Inc
Cr Cash
Professional fees
Dr Investment in Entity Inc (fees)
CrCash
Shares to be issued 1 July 2004
Dr Investment in Entity Inc (lm x 60c)
Cr Shares not yet issued
(heading in capital and reserves)
$000 $000
10
1,250
1,740
1,000
1,000
20
20
600
600
Note The directors' time is not a direct cost of the acquisition and
hence cannot be included in the cost of investment.
Goodwill on consolidation ofEntity Inc
Cost of investment
Shares
Cash
Fees
Shares to be issued
Identifiable assets and liabilities acquired
Entity Inc
Accounting policy adjustment
Group share (75%)
$000 $000
3,000
1,000
20
600
4,620
3,628
(200)
3,428
(2,571)
2,049
lAS 22 GOODWILL
Solution2
As at 31.12.2004
Non current assets:
Goodwill
Tangibles:
(1,800 + (1,000 + 300 - [2/10 x 300] ))
Current assets (400 + 300)
Share capital
Retained earnings
Minority Interest
Current liabilities( 200+200)
WORKINGS-
WI Net assets summary
$
160
3,040
700
3,900
100
3,132
268
400
3,900
Share capital
Retained earnings
As per the question
Extra depreciation
$
1,000
(60)
At consolidation
$
100
940
At acquisition
$
100
600
FAIR VALUEADWSTMENTS
NET ASSETS
GOODWILL
COST
SNA acquired
80% x 1,000
Balance sheet
Income statement
NUNORITYINTEREST
20% x 1,340
300
1,340
$
1,000
(800)
200
160
40
$268
300
1,000
$272
(40)
IAS 22 GOODWILL
CONSOLIDATED RETAINED EARNINGS
P 2,900
Share ofS
80% (940 - 600)
Goodwill
3,132
GROUP ACCOUNTS - MORE COMPLEX GROUPS
OVERVIEW
Objective
To consolidate more complicated group structures.
TYPES
I
STATUS OF
INVESTMENT
I
TECHNIQUE
Status is always based on control
In the above illustration P effectively owns
There are 2 possible approaches to
consolidations involving sub subsidiaries.
Direct technique
Sub subsidiary
Sub associate
Timing ofacquisitions
D shaped groups
Income statement consolidations
1 TYPES OFSTRUCTURE
A subsidiary is a company controlled by another.
In practice this control might be achieved through complicated chains
of control.
Example
Similarly, significant influence may be exercised over an associate indirectly.
p
80%
S
30%
A
2 STATUS OF THE INVESTMENT
2.1 Status is always based on control
p
P owns 70% of S and
therefore controls it.
70%
S
T
60%
S owns 60% of T and
therefore controls it.
P controls T by controlling
S
:. T is a subsidiary
2.2 In the above illustration P effectively owns
70% x 60% = 42% ofT.
This is a useful tool to bring to the consolidation
but it is irrelevant in deciding the status of the investment.
3 TECHNIQUE
3.1 There are 2 possible approaches to consolidations involving sub
subsidiaries.
Indirect approach (2 stages)
o
o
1.
2.
Consolidate T into S to give the S group accounts.
Consolidate the S group into P.
This technique is too slow for exam purposes when it
comes to dealing with subsidiaries. Always use the direct
method.
But it must be used to consolidate sub associates.
Direct approach
o Carry out the consolidation using the effective rate.
P P
,
70% 70% x 60%
S =42%
I:MI 58% I
60%
,
T T
In effect we have changed to
P
70%
s
60%
T
3.2 Direct technique
Step 1 Calculate the effective holding.
P
7;1\ 42%
S \T
(as a subsidiary)
Step 2 Consolidate as normal subject to 2 important points
o Dividends are paid to real shareholders not effective shareholders.
o Cost of investment in the sub subsidiary [ie that appears in the main
subsidiary's accounts] is split:
P's share is used to calculate goodwill
the rest is charged to the minority interest.
Step 3 Proceed with the consolidation as normal.(note that there may be a
need to apply 'piecemeal acquisition' approach (see later session.
3.3 Sub subsidiary
Example 1
Balance sheets as at 31 December 2004
P S T
$ $ $
Cost of investment
in S 700
in T 450
Other assets 1,100 900 600
1,800 1,350 600
Share capital
Retained earnings
Further information
200
1,600
1,800
100
1,250
1,350
100
500
600
(a) P bought 70% of S two years ago when S's retained earnings stood at $500
Later (1 year ago) 8 bought 60% ofT when T's retained earnings were $200
(b) Goodwill to the extent of$112 has been impaired in respect of the holding in 8
and by $37.8 in respect ofthe holding in T.
(c) The companies declared the following dividends before the year end but have not
yet accounted for them
P proposed a dividend of $150
8 proposed a dividend of $100
T proposed a dividend of $80
Required:
Prepare the consolidated balance sheet of the P group as at 31 December 2004.
Solution 1
3.4 Sub associate
Example 2
P S A
$ $ $
Cost of investment
in S 700
inA 450
1,800 1,350 600
Share capital
Retained earnings
200
1,600
1,800
100
1,250
1,350
100
500
600
(a) P bought 70% ofS two years ago when S's retained earnings stood at $500
Later ( 1 year ago) S bought 25% ofA when A's retained earnings were $200
(b) Goodwill to the extent of $112 has been impaired in respect of the holding in S.
There is no impairment in the investment in the associate.
(c) The companies declared the following dividends before the year end but have not
yet accounted for them
P proposed a dividend of $150
S proposed a dividend of $100
A proposed a dividend of $80
Required:
Prepare the consolidated balance sheet of the P group as at 31 December 2004.
3.5 Timing of acquisitions
Issue
o What is the date of acquisition of the sub - subsidiary?
o This is important for deciding reserves of the date of acquisition.
Illustration
P bought 80% of S at 31 March 2001. S bought 60% of T on 14 July 2004
Date of acquisition ofT = 14 July 2004.
Illustration
P bought 80% ofS at 31 March 2003. S already owned 60% ofT.
Date of acquisition ofT = 31 March 2003.
3.6 D shaped groups
P
70%
S
60%
T
5%
P
T
Indirect
70% x 60%
Direct
42%
5%
47%
I MI=53% I
3.7 Income statement consolidations
These present no real problem. Calculate the effective rate and consolidate as
normal.
There is one complication.
o If the sub subsidiary has declared a dividend and the main
subsidiary has accounted for its share through the income statement
this will be part of the subsidiary's profit before tax.
o It must be eliminated (as a consolidation adjustment) during the
minority interest calculation.
Illustration
p
S T CIS
Operating profit 1,200 600 500 2,300
Dividend receivable
fromT 120*
1,200 720 500 2,300
Taxation (400) (250) (100) (750)
PAT 800 470 400 1,550
Minority interest (W) (278)
Dividends (300) (200) *(200) (300)
500 270 200 972
P P
80%
S 48%
60%
MI=52%
T T
Minority interest
InS
InT
20% x (470 -120)
This is not consolidated
52% x400
70
208
278
FOCUS
account for complex group structures.
EXAMPLE SOLUTIONS
Solution 1
CBS as at 31 December 2004
Assets
Intangibles (168 + 151.2)
(1,100 + 900 + 600)
Share capital
Retained earnings

Dividend payable
(150 + 100 +80)
(70) (48)
$
319.2
2,600.0
2,919.2
200
1,951.2
556
212
2,919.2
(WI) Balance sheets as at 31 December 2004
p
S T
$ $ $
Cost of investment
in S 700
in T 450
Dividend receivable 70 48
X X X
Share capital 200 100 100
70 48
Retained earnings 1,600 1,250 500
(150) (100) (80)
Current liabilities
Dividendpayable 150 100 80
X X X
(W2) Group structure
p p
1
70
%
S 42%
1
60
%
I MI58%
I
T T
SIne
At At
Retained earnings
perQ 1,250
dividend payable (100)
dividend receivable 48 1198 500
1,298 600
TIne
At At
consolidation consolidation
Share capital
Retained earnings
perQ
dividend payable
500
(80)
100
420
520
100
200
300
(W4) Goodwill
Cost $ $
Investment in S 700
Investment in T (70% x 450) 315
Share of net assets
70% x 600 (W3) (420)
42% x 300 (W3) (126)
280 189
BS (balance) 168 151.2
IS (given) 112 37.8
$
In S 30% x 1,298 (W3) 389.4
In T 58% x 520 (W3) 301.6
S Inc's minority's share of cost of
investment in T (30% x 450) (135)
556
(W6) Consolidated retained earnings
All ofP
per question
dividend payable
dividend receivable
Share ofS
70% (1,198 - 500) (W3)
Share ofT
42% (420 - 200) (W3)
Goodwill (112 +37.8 W4)
Solution 2
CBS as at 31.12.2004
Intangibles
Investment in associate
Dividend receivable
Other assets
Share capital
Retained earnings
1,600
(150)
70
1,520
488.6
92.4
(149.8)
1,951.2
168
505
20
2,000
2,693
200
1,916
Minority interest
Dividend payable (150 + 100)
(70)
397
180
2,693
p
S A
$ $ $
Cost of investment
inS 700
inA 450
Dividend receivable 70 20
Other net assets 1,100 900 600
Dividendpayable (150) (100) (80)
Share capital
Retained earnings
200
70
1,600
(150)
100
20
1,250
(100)
100
500
(80)
(W2) Then replace 'cost of investment' in A (450) with S's share
of A's net assets plus remaining goodwill and take a
balancing figure to the retained earnings
Strictly speaking goodwill and CPL balance should be calculated but this
takes too long
Investment in S
Investment in
Associate
Dividend receivable
Other assets
Dividend payable
Share capital
Retained earnings
p
S
700
505
As far as possible
70 20
(WI) and (W2)
should be performed
1,100 900
on face of the
question
(150) (100)
1,720 1,325
200 100
1,520 1,225
1,720 1,325
SIne
Share capital
Retained earnings
perQ
dividend payable
dividend receivable
At
consolidation
100
1,250
(100)
20
At
acquisition
100
500
Share of A
(25% x 220)
1,170
55 1,225
1,325 600
AIne
At At
consolidation consolidation
Retained earnings
perQ 500
dividend payable (80) 420 200
520 300
30% x 1,325= 397
(W5) Goodwill
$ $
Cost 700 450
Share of net assets
70% x 600 (420)
25% x 300 (75)
280 375
BS (balance) 168 375
IS (given) 112
(W6) Investment in associate
$
Share of net assets
25% x 520 130
Remaining goodwill (W5) 375
505
(W7) Consolidatedretained earnings
All ofP
per question
dividend receivable
dividend payable
Share ofS
70% (1,225 - 500)
Goodwill (W5)
1,600
70
(150)
1,520
508
(112)
1,916
GROUP ACCOUNTS - DISPOSALS
OVERVIEW
Objectives
To describe the accounting for disposal of subsidiaries.
Profit / loss on disposal
ACCOUNTING
ISSUES
I
DEEMED DISPOSALS
DISPOSAL
DEMERGERS
POSSIBILITIES
Background
I

Accounting issues
Accounting treatment - Income
Treatment by P Inc
statement
Treatment by R Inc
Accounting treatment - Balance

TREATMENT IN
sheet THE PARENTS
OWN ACCOUNTS
I
Summary
TREATMENT IN
Consolidated income statement -

THE GROUP
"pattern ofownership"
ACCOUNTS
Consolidated income statement -

1 INTRODUCTION
When a group disposes of all or part of its interest in a subsidiary
undertaking, this needs to be reflected in the parent's books as an individual
company and, more importantly, in group accounts.
In group accounts, need to deal with
o inclusion of results and cash flows of entity disposed of
o calculation and presentation of profit or loss on disposal
o inclusion in group accounts of any remaining interest in the
company after a part-disposal.
In dealing with these matters in group accounts, the single entity concept
needs to be applied and the effect on the group as a whole considered.
2 DISPOSAL POSSIBILITIES
Disposal may be
o full disposal, ie sell entire holding, or
o part disposal, retaining some interest in the undertaking.
Part disposal possibilities are
o retention of control, ie undertaking remains a subsidiary
o retention of significant influence, ie undertaking becomes an
associate
Deemed disposals also need to be dealt with, ie where the group's interest is
reduced other than by selling shares, and demergers, ie where an existing
group divides into two separate groups.
3 TREATMENT IN PARENT'S OWN ACCOUNTS
Parent will carry its investment in a subsidiary in its own balance sheet as a
non current asset investment, usually at cost.
When all or part of the investment is sold, this is recorded as a disposal in the
parent's own accounts, and will usually give rise to a profit or loss on
disposal (proceeds - cost of investment sold). An accrual may also be
necessary for tax on any profit on disposal.
To record disposal
$ $
Dr Cash/receivables (proceeds) X
Cr Investment in S (cost of investment sold) X
Dr IS loss on disposal or Cr IS profit on disposal X X
Ifrequired
$ $
Dr IS tax charge (tax on gain on disposal) X
Cr Tax payable X
4 TREATMENT IN GROUP ACCOUNTS
4.1 Summary
Consolidated balance sheet
o Simply reflect the closing position.
o There is one potential problem area. This is when the parent has not
yet accounted for the disposal in its own accounts. In this case
profit or loss on disposal must be calculated from the parent's
viewpoint and processed into the parent's accounts as an individual
company adjustment.
$
Proceeds X
Cost of investment disposed of K
Profit / loss K
o Also note that in most jurisdictions it is this view ofprofit that will
be taxed and you may also need to provide for the tax liability.
Consolidated income statement
o The consolidated income statement must reflect the pattern of
ownership in the period.
o Must calculate group view ofprofit/loss on disposal. (Note that this
will be a different figure from that discussed above).
4.2 Consolidated income statement - "pattern of ownership"
Status ofinvestment Treatment in CIS Treatment in CBS
Before After
Disposal disposal
Sub

Consolidate up until
No action needed zero
the date of disposal
Eg90% 0%
Sub ~ Sub
Consolidate for the Consolidate as normal with

Eg90% eg60% whole year Closing MI based on year end
Holding
Calculate MI in two
pieces
eg 'IT profit x 10%
+
l ~ profit x 40%
Sub ~ Assoc.
Pro-rata S's results and Equity account as at the year

Eg90% eg40% consolidate up to the end based on year end holding
date of disposal
After disposal equity

account
4.3 Consolidatedincome statement - Profit floss on disposal
Profit or loss on disposal is calculated as follows.
Proceeds
Less Share of S's net assets at date of disposal attaching
To stake disposed of (note 1)
Remaining goodwill
Profit or (loss) on disposal
Notes
(1) Net assets of S at disposal
$
X
(X)
(X)
X/(X)
Net assets bff
$
X
Add
Less
Profit before dividends x
12
Dividends paid prior to disposal
X ie from bff date
disposal
(X)
X
Example 1
The draft accounts of two companies at 31 March 2005 were as follows.
Balance sheets
Investment in Jemima at cost
Sundry assets
Share capital ($1 ordinary shares)
Retained earnings
Sale proceeds of disposal (suspense ale)
Income statements
Profit before tax
Tax
Profit after tax
Retained earnings bid
Retained earnings elf
Hamble Group Jemima
$ $
3,440
36,450 6,500
39,890 6,500
20,000 3,000
11,000 3,500
31,000 6,500
8,890
39,890 6,500
Hamble Group Jemima
$ $
12,950 3,800
(5,400) (2,150)
7,550 1,650
3,450 1,850
11,000 3,500
Ramble and Jemima are both incorporated enterprises.
Ramble had acquired 90% of Jemima when the reserves of Jemima were $700. Goodwill
of $110 arose on the acquisition. This had been fully impaired by 31 March 2004.
On 31 December 2004, Ramble sold shares in Jemima.
Required:
Prepare extracts from the Ramble Group balance sheet and Ramble Group income
statement on the basis that Ramble sold the following shares in Jemima.
(a) Its entire holding
(b) A 15% holding (75% remaining)
(c) A 50% holding (40% remaining with significant influence)
Note Ignore tax on the disposal
Solution 1
WORKINGS
(1) Net assets
Share capital
Retained earnings
(2) Retained earnings at date of disposal
(3) Retained earnings bid
Hamble Group
Jemima 90% (1,850 - 700)
Less Goodwill wlo
BSdate
$
$
$
3,450
1,035
(110)
4,375
Disposal
$
Acquisition
$
(4) Profit on disposal of Jemima (individual company view)
(a)
$
Sale proceeds
Less Cost ofinv. disposed of;
Profit on disposal
(b)
$
(c)
$
(5) Consolidated retained earnings
(a)
$
Retained earnings ofHamble
Per the question
Profit on disposal (W4)
Share of Jemima
Goodwill
(6) Profit on disposal of Jemima (group view)
(b)
$
(c)
$
Sale proceeds
Less Net assets at disposal (WI)
Profit on disposal
(a)
$
8,890
(b)
$
8,890
(c)
$
8,890
(a) Ramble Group
Consolidated balance sheet as at 31 March 2005
HGroup
$
Sundry assets
Share capital
Retained earnings
Adjustments
$
CBS
$
Consolidated income statement for the year ended 31 March 2005
HGroup
$
Operating profit
Profit on disposal of operations (W6)
Profit before taxation
Taxation
Profit after taxation
Minority interests
Profit for the financial year
Retained earnings blf (W3)
J9/12
$
CIS
$
(b) Ramble Group
HGroup
$
Sundry assets
Share capital
Retained earnings
Minority interests
HGroup
$
Operating profit
Taxation
Minority interests
10% * 9/12
25% * 3/12
Retained earnings blf (W3)
Retained earnings clf
J
$
J
$
CBS
$
CIS
$
(c) Ramble Group
HGroup
$
Interest in associate
Sundry assets
Share capital
Retained earnings
CBS
$
HGroup
$
Operating profit
Income from interests in associate
Taxation
Minority interests
Retained earnings bid (W3)
J9/12
$
CIS
$
5 DEEMED DISPOSALS
5.1 Background
A group may reduce its interest by means of a deemed disposal; ie where the
group's interest is reduced other than by selling shares.
Deemed disposals may arise where:
o A subsidiary makes a rights issue and the group does not take up its
full allocation of shares,
o Another party exercises options which give it an increased stake in
the subsidiary (and hence reduce the group's interest),
o A subsidiary issues shares to a third party.
5.2 Accounting treatment - Income statement
A deemed disposal is treated in the same way as a direct disposal.
o Consolidate so as to reflect the pattern of ownership in the period.
o Calculate the consolidated profit on disposal.
The calculation of the consolidated profit or loss on disposal is carried out by
comparing the share of net assets and any remaining goodwill before the
deemed disposal to the share of net assets and any remaining goodwill after
the deemed disposal.
Example 2
P has owned 100% of S since the incorporation of S.
31 December 2004 are as follows.
Share capital - $1 ordinary shares
Retained earnings
The capital and reserves of S at
$000
3,000
7,000
10,000
S then issues 1,000,000 shares to a third party for $3,000,000. S Inc's share capital
and reserves will now be as follows.
Share capital - $1 ordinary shares
Share premium account
Retained earnings
$000
4,000
2,000
7,000
13,000
Required:
Calculate the profit or loss on disposal in the consolidated income statement ofP.
5.3 Accounting treatment - Balance sheet
The consolidated balance sheet is compiled in the usual way using the
relevant percentage holding at the year end. However there is one
complication. That part of the cost of the original holding that relates to the
percentage of the assets that P is no longer entitled to consolidate must be
written off.
Illustration
Following on from example 2 suppose that P had paid $10,000 for its original holding in S.
This gave it the right to consolidate 100% ofthe assets of S at the date of acquisition (and
subsequently) and also paid for 100% of the goodwill.
After the deemed disposal P has the right to consolidate only 75% of the assets (including
those held at acquisition) and only owns 75% of the goodwill held at acquisition.
The share of net assets at acquisition and goodwill equal the cost of the investment ( by
defmition). Therefore part of the cost represents that part of the share ofnet assets at
acquisition and goodwill can no longer be consolidated. This must be written off.
In this example 25% of 10,000 must be written off:
Dr Reserves
Cr Cost of investment
2,500
2,500
Example 3
p
S
$ $
Cost of investment in S 1,000
Net assets 1,500 1,100
2,500 1,100
Accumulated profits 2,000 1,000
2,500 1,100
Income statements for the y.e.31
st
December 2004
P S
$ $
Retained profit 500 240
Cost of investment in S
Net assets
Share capital
Share premium
Accumulated profits
P S
$ $
1,000
2,000 1,385
3,000 1,385
500 125
20
2,500 1,240
3,000 1,385
1 P acquired lOO% of S 2 years ago when the balance on S' S accumulated profits was
$700.
2 On the 31
st
December 2004 S made a new issue of 25,000 1$ ords at a premium of 80c
per share to a third party.
3 The value of goodwill at 31 December 2003 was $160, and immediately after the issue of
new shares it had fallen to $96.
Required:
a) Prepare the consolidated balance sheet as at 31.12.2003
b) Prepare the consolidated balance sheet as at 31.12.2004
c) Prepare the consolidated income statement for the year ended 31.12.2004
Solution 3
(a) Consolidated balance sheet as at 31
st
December 2003
$000
Goodwill
Net assets
W2
$000
Share capital
Accumulated profits W3
(WI) Net assets summary
At date of
consolidation
$000
Share capital
Retained earnings;
(W2) Goodwill
$000
Cost
Share of net assets
WI
IS
BS lW
$000
All ofR
Share ofS
WI
Goodwill W2
At date of
acquisition
$000
(b) Consolidated balance sheet as at 31
st
December 2004
$000
Goodwill
Net assets
W3
$000
Share capital
Accumulated profits W4
Capital reserve W5
Minority interest W2
At date of
consolidation
$000
Share capital
Share premium
Retained earnings;
(W3) Goodwill
$000
Cost
Write off of cost of 20%
Share ofnet assets
W1
IS
BS 96
$000
All ofP
Write off ofpart of cost of inv
Share ofS
W1
Goodwill W3
At date of
acquisition
$000
(W5) Capital reserve
(c) Consolidated income statement for the year ended 31
1t
December 2004
$000
Operating profit
Loss on deemed disposal WI
Consolidated profit for the year
(WI) _
: Amounts that would have been consolidated
.
Share ofnet assets
Goodwill (from part a):
LESS:
Amounts that would have been consolidated
_
Share ofnet assets
Goodwill (from part b):
Loss on disposal
160
96
6 DEMERGERS
A demerger occurs where an existing group divides into two or more separate
groups. This is illustrated in the following diagram.
Demerger illustration
Before
Shareholders
l
P Inc
llOO%
QInc
After
Same shareholders
l
P Inc has owned Q since incorporation. P Inc incorporates a new company, R Inc,
which issues shares to P Inc's shareholders in exchange for P Inc's shares in Q. P
Inc then retains no significant interest in R Inc.
(P Inc also has other subsidiary undertakings.)
The key accounting issues are
o How should the transaction be reflected in the individual company
and group accounts ofP Inc
o How should R Inc
record the shares issued to the shareholders ofP Inc and
its investment in Q in its own accounts, and
consolidate Q in its group accounts?
(Note that as an alternative to setting up a new company, P Inc could distribute
the shares in Q to its own shareholders directly.)
6.2 Treatment by P Inc
The substance ofthe transaction is that P Inc has made a distribution (ie a
dividend) to its shareholders.
o In P Inc's individual accounts, this represents a distribution ofthe
investment in Q, ie value of distribution = carrying value of
investment in Q in P Inc's balance sheet.
o The value of the distribution from the perspective of P group =net
assets of Q at date of demerger.
These amounts should be shown as movements on the retained earnings in
reserves.
Another possibility is to show the transaction as a disposal for nil
consideration of the investment in Q. However, this would show a loss to P
Inc and the group whereas the substance is that there has been a distribution
to the owners ofP Inc. Hence, this approach is not normally adopted.
6.3 Treatment by R Inc
R Inc has issued shares in exchange for 100% ofQ. In most jurisdictions R
Inc would be allowed to record the issue of shares at nominal value using
merger relief provisions and need not record its investment in Q at fair value.
This transaction would seem to be classed as a business combination
involving entities under common control and is scoped out ofIFRS 3. This is
an area that the IASB are looking into and will be covered under Phase 2 of
the business combinations project.
Under lAS 22 this transaction may well have qualified for the use of the
Uniting of Interest method of consolidation.
7 SUMMARY
The key steps in dealing with a disposal are as follows.
o Check that disposal has been properly dealt with in parent's own
accounts.
o Prepare consolidated balance sheet at required date subsequent to
disposal, based on group structure at that time.
o Prepare CIS for period including disposal, consolidating subsidiary
up to date of disposal (or for whole year if control is retained).
o Calculate profit or loss on disposal from group perspective,
including any related goodwill.
FOCUS
explain the basic principles relating to the disposals of group companies;
discuss the treatment of goodwill on disposal;
apply the principles of accounting for partial and deemed disposals;
discuss the creation of a new holding company;
explain changes in the ownership of companies within a group;
discuss the nature of demergers and divisionalisation;
prepare group financial statements after reorganisation and restructuring.
EXAMPLE SOLUTIONS
Solution 1
(a) (b) (c)
Ramble Group $ $ $
Investment in associate (6,500 x 40%) 2,600
Sundry assets 36,450 42,950 36,450
36,450 42,950 39,050
Share capital 20,000 20,000 20,000
Retained earnings 16,450 21,325 19,050
36,450 41,325 39,050
Minority interests (6,500 x 25%) 1,625
36,450 42,950 39,050
Consolidated Income statement for the year ended 31 March 2005
(a) (b) (c)
$ $ $
Operating profit (W7) 15,800 16,750 15,800
Income from interests in associate
(40% x 3/12 x 1,650) 165
Profit on disposal of operations (W6) 3,411 7,977 5,846
Profit before taxation 19,211 24,727 21,811
Taxation - Group (W8) (7,012) (7,550) (7,012)
Profit after taxation 12,199 17,177 14,799
Minority interests (W9) (124) (227) (124)
Profit for the fmancial year 12,075 16,950 14,675
Retained earnings blf (W3) 4,375 4,375 4,375
Retained earnings elf 16,450 21,325 19,050
WORKINGS
(1) Net assets
BSdate Disposal Acquisition
$ $ $
Share capital 3,000 3,000 3,000
Retained earnings 3,500 3,088 700
6,500 6,088 3,700
(2) Retained earnings at date of disposal
$
REb/f 1,850
Profit for year to disposal (1,650 x 9/
12)
1,238
3,088
(3) Retained earnings b/f
$
Hamble Group 3,450
Jemima 90% (1,850 -700) 1,035
Less Goodwill wlo (110)
4,375
(c)
$
8,890
(1,911)
(573)
(b)
$
8,890
(3,440)
Profit on disposal of Jemima (individual company view)
(a)
$
8,890 Sale proceeds
Less Cost ofinv. disposed of;
3,440
3,440 x 15/90
3,440 x 50/90
(4)
Profit on disposal 5,450 8,317 6,979
(5) Consolidated retained earnings
(a) (b) (c)
$ $ $
Retained earnings of Ramble
Per the question 11,000 11,000 11,000
Profit on disposal (W4) 5,450 8,317 6,979
16,450 19,317 17,979
Share of Jemima
75% x (3,500 - 700) 2,100
40% x (3,500 -700) 1,120
Goodwill;
110 x 75/90 (92)
110 x 40/90 (49)
16,450 21,325 19,050
(6) Profit on disposal of Jemima (group view)
(a) (b) (c)
$ $ $
Sale proceeds 8,890 8,890 8,890
Less Net assets at disposal (WI)
6,088 x 90% (5,479)
6,088 x 15% (913)
6,088 x 50% (3,044)
Profit on disposal 3,411 7,977 5,846
(7) Operating profit
Ramble Group 12,950 12,950 12,950
Jemima 2,850 3,800 2,850
15,800 16,750 15,800
(8) Group tax
(a) (b) (c)
$ $ $
Ramble Group 5,400 5,400 5,400
Jemima 1,612 2,150 1,612
7,012 7,550 7,012
(9) Minority interests in Jemima
Operating profit (W7)
Tax(W8)
2,850
(1,612)
1,238
x 10%
3,800
(2,150)
1,650
2,850
(1,612)
1,238
9
x - x 10%= 124
12
x 10%
3
x - x 25%= 103
12
Solution2
Before After
PIne PIne
100%

3,000 = 75%
4,000 0
SIne SIne
124 227
$000 $000
124
Proceeds
Less Share of net assets disposed of
Share of net assets after disposal
(75% x 13,000)
Share of net assets before disposal (100%)
Loss on disposal
9,750
(10,000)
(250)
(250)
S Inc's net assets change at disposal because shares are being issued.
Solution 3
(a) Consolidated balance sheet as at 31
st
December 2003
Goodwill
Net assets
Share capital
Accumulated profits
W2
W3
$000
160
2,600
2,760
$000
500
2,260
2,760
$000 $000
Retained earnings; 1,000 700
1,100 800
(W2) Goodwill
$000
Cost 1,000
Share of net assets
100% x 800 WI (800)
200
IS (balance) 40
BS (given) 160
$000
All ofR 2,000
Share ofS
100% x (1,000 - 700) WI 300
Goodwill W2 (40)
2,260
(b) Consolidated balance sheet as at 31
st
December 2003
$000
Goodwill W3 96
Net assets 3,385
3,481
$000
Share capital 500
Accumulated profits W4 2,668
Capital reserve W5
80% x 45 36
Minority interest W2 277
3,481
$000 $000
Share premium 20
Retained earnings; 1,240 700
1,385 800
20% x 1,385 WI = 277
(W3) Goodwill
$000
Cost 1,000
Write off of cost of 20% (200)
800
Share ofnet assets
80% x 800 WI (640)
160
IS (balance) 64
BS (given) 96
$000
All ofR 2,500
Write off ofpart of cost of inv (200)
2,300
Share ofS
80% x (1,240 - 700) WI 432
Goodwill W3 (64)
2,668
(W5) Capital reserve
H has the right to share in all post acquisition movement ofthe reserves of S. WI
shows that there is a movement of 25 on share capital and of 20 on share premium.
The total is of course the proceeds of the share issue.
Hs share ofthis is 80% x 45 = 36
This is debited to the retained earnings and credited to a capital reserve.
(c) Consolidated income statement for the year ended 31
st
December 2004
$000
Operating profit
(H) 500 +(S) 240)
Loss on deemed disposal WI
Consolidated profit for the year
Statement of changes in equity
Opening eRE (part a)
Profit for year (part c)
Transfer to capital reserve (W5)
(WI) _
: Amounts that would have been consolidated
:_ _ _ _
Share ofnet assets 100% x (1,385 - 45)
Goodwill (from part a):
LESS:
Amounts that would have been consolidated
.. .....
Share ofnet assets 80% x 1,385
Goodwill (from part b):
Loss on disposal
AccountancyTuitionCentre(InternationalHoldings)Ltd 2005 2627
740
(296)
444
$000
2,260
444
(36)
2,668
1,340
160
1,108
96
1,500
(1,204)
296
GROUP ACCOUNTS - PIECEMEAL ACQUISITION
OVERVIEW
Objective
To explain how to account for the acquisition of an associate or subsidiary
over a period oftime.
INTRODUCTION
I I
CASES WHERE THE CASES WHERE THE
ACQUISITION CAUSES ACQUISITION DOES NOT
CARRYING VALUE TO CAUSE CARRYING VALUE
CHANGE FROM COST TO TO CHANGE FROM COST
SHARE OF NET ASSETS + TO SHARE OF NET ASSETS
GOODWILL + GOODWILL
I I I I
TRADE TRADE INCREASE IN ASSOCIATE
INVESTMENT INVESTMENT STAKE IN BECOMES A
BECOMES A BECOMES AN SUBSIDIARY SUBSIDIARY
SUBSIDIARY ASSOCIATE.
Introduction
Consolidated balance sheet
Consolidated income statement
1 PIECEMEAL ACQUISITIONS
1.1 Introduction
A piecemeal acquisition occurs where the investment in a subsidiary (or an
associate) is acquired in several stages, rather than in one go.
Investments may be carried at cost or this may be replaced by a share ofnet
assets and goodwill when appropriate. This is when the investing company
has a holding which gives it,
o Control - when consolidation is used, or
o Significant influence - when equity accounting is used.
In order to calculate goodwill and reserves at acquisition, net assets acquired
need to be established. Hence, the date on which to identify the net assets of
the subsidiary at acquisition is needed. This depends on how the earlier
holdings were carried in the group accounts.
When a holding is built piecemeal, IFRS 3 requires the calculation of
goodwill (and therefore the fair valuation of assets) for each significant
transaction
In practice, the term "significant" is taken to mean a purchase that will cause
a change in status (eg the investing company needs to replace cost with its
share of the net assets and goodwill) or an increase in a holding of an
associate or a subsidiary.
In the case ofpiecemeal acquisitions, whenever a purchase causes the
investing company to replace cost with its share of the net assets and
goodwill, the calculations are based on the balance sheet of the investee
company at the date at which the status ofthe investment changed. Ie,
o Trade investment Associate,
o Trade investment Subsidiary.
Whenever a new acquisition does not itself cause such a change but simply
increases a stake in a subsidiary or an associate, the consolidation is based on
the balance sheet positions of the investee company at the date of each
acquisition since the carrying method changed from cost. ie,
o Subsidiary Subsidiary (bigger holding)
o Associate Subsidiary
Thus there are several piecemeal acquisition possibilities, depending on the
size of the stake purchased at each stage. Those relevant to this session are
summarised below, with example percentages
First acquisition Second acquisition
Percentage Status ofinvestment Percentage Status ofinvestment
acquired acquired
15% Trade investment 45% Subsidiary (total: 60%)
15% Trade investment 20% Associate (total: 35%)
60% Subsidiary 20% Subsidiary (total: 80%)
20% Associate 40% Subsidiary (total: 60%)
2 TRADE INVESTMENT BECOMING A SUBSIDIARY
Use subsidiary's net assets at date on which control is gained in consolidation
workings.
o For goodwill, cancel total cost of investment, including earlier
purchase of a trade investment, against share ofnet assets acquired
on the date on which control is gained.
o All of the subsidiary's reserves up to the date on which control is
gained are treated as pre-acquisition.
In effect, the entire investment is treated as though it was purchased on the
date on which control is gained.
3 TRADE INVESTMENT BECOMING AN ASSOCIATE
Equity account for the associate from the date on which significant influence
is gained.
Calculate goodwill on acquisition as difference between total cost of
investment and share of net assets of A on date on which significant influence
is gained. All reserves of A prior to this date are pre-acquisition.
In effect, the entire investment is treated as though it was purchased on the
date on which control is gained.
4 INCREASEIN STAKEIN SUBSIDIARY
Consolidate subsidiary from date on which control is first gained, and
identify S' s net assets at fair value on this date for goodwill and reserves at
acquisition.
If stake in S is then increased, need to cancel out the extra investment on
consolidation and include a larger share of S' s reserves in group reserves.
Hence, need fair value of S' s net assets on date on which stake is increased to
calculate goodwill on the increased stake and to identify reserves at this
acquisition.
For consolidation workings, need S's net assets at three dates
o Date on which control is first gained
o Date on which stake is increased
o Balance sheet date.
Minority interest in consolidated balance sheet is calculated based on their
share of net assets at the balance sheet date.
Example 1
Portion and Slice are both incorporated entitys. The balance sheets of Portion and
its subsidiary Slice at 31 December 2004 are as follows.
Investment in Slice
Sundry assets
Share capital: $1 ordinary shares
Retained earnings
Portion acquired its holding in Slice as follows.
Portion Slice
$000 $000
400
600 550
1,000 550
200 100
800 450
1,000 550
Date
30 September 2003
1 July 2004
Proportion Cost of Slice
acquired investment Retained
earnings
% $000 $000
60 250 300
20 150 400
At 31 December 2004 goodwill is valued at 80% of the original combined totals
arising on acquisition.
Required:
Prepare the consolidated balance sheet of Portion at 31 December 2004.
Solution 1
Portion: Consolidated balance sheet as at 31 December 2004
$000
Goodwill
Sundry assets
Retained earnings
Minority interests
WORKINGS
(1) Group structure
(2) Net assets working
Share capital
Retained earnings
Balance
sheet date
$000
31.07.2004
Acq Postacq
$000 $000
30.092003
Acq Postacq
$000 $000
(3) Goodwill
Cost of investment
Share ofnet assets acquired
(4) Minority interests
(5) Retained earnings
Portion
Share of Slice
Goodwill
$000 $000
$000
$000
5 ASSOCIATE BECOMING A SUBSIDIARY
5.1 Introduction
If an investment had previously been an associate, the group accounts would
already include a share ofprofits, and goodwill will already have been
accounted for. Hence, at the date on which control is gained, the investment
would not be stated at cost in the group accounts.
Once control is gained, consolidation is used instead of using equity
accounting. To consolidate, the net assets at acquisition need to be
established for goodwill and pre-acquisition reserves.
5.2 Consolidated balance sheet
Use the same calculation for goodwill and post-acquisition reserves as for
increase in stake in subsidiary ie identify net assets when significant
influence is gained and when control is gained.
5.3 Consolidated income statement
For the consolidated income statement in year of change (under either
method)
o equity account up to date control is gained, then
o consolidate from date control is gained.
Unless P acquires lOO%, a minority interest will arise from the date on which
control is gained.
FOCUS
Discuss the nature of acquisitions achieved in stages;
Prepare consolidated financial statements where control is established by an
acquisition in stages.
EXAMPLE SOLUTIONS
Solution 1
Portion: Consolidated balance sheet as at 31 December 2003
Goodwill
Sundry net assets (600 + 550)
Retained earnings (W5)
Minority interests (W4)
WORKINGS
$000
48
1,150
1,198
200
888
1,088
110
1,198
Share capital
Retained earnings
Balance
sheet date
$000
100
450
550
31.07.2004
Acq Postacq
$000 $000
100
400 50
500
Acq
$000
100
300
400
30.9.2003
Postacq
$000
150
(2) Goodwill
$000 $000
Cost of investment 150 250
Share ofnet assets acquired
20% x 500 (100)
60% x 400 (240)
50 10
BS
IS
50 + 10) x 80%)
(balance)
48
12
20% x 550
Portion
Share of Slice
Goodwill
60% x 150
20% x 50
90
10
$000
110
$000
800
100
(12)
888
IAS 28 INVESTMENTS IN ASSOCIATES
OVERVIEW
Objectives
To explain what an associate is.
To explain the accounting treatment for associates.
EQUITY
ACCOUNTING
ACCOUNTING
TREATMENT
Background
Scope
Definitions
Significant influence
Separate financial statements
INTER-COMPANY
ITEMS WITH AN
ASSOCIATE
Relationship to a group
Basic rule
Equity accounting
Treatment in a consolidated
balance sheet
Treatment in a consolidated
income statement
Recognition oflosses
Accountingpolicies and year ends
Impairment
Exemptions to equity accounting
DISCWSURE
Inter-company trading
Dividends
Unrealised profit
Investments in associates
Using the equity method
1 EQUITY ACCOUNTING
1.1 Background
Where one company has a controlling investment in another company, a
parent-subsidiary relationship is formed and accounted for as a group.
Companies may also have substantial investments in other entities without
actually having control. Thus, a parent-subsidiary relationship does not exist
between the two.
If the investing company can exert significant influence over the financial
and operating policies of the investee company, it will have an active
interest in its net assets and results.
The nature ofthe relationship differs from that ofa simple investment, i.e. it
is not a passive interest.
Including the investment at cost in the company's accounts would not fairly
present the investing interest.
So that the investing entity (which may be a single company or a group) fairly
reflects the nature of the interest in its accounts, the entity's interest in the net assets
and results of the company, the associate, needs to be reflected in the entity's
accounts. This is achieved through the use of equity accounting.
1.2 Scope
lAS 28 is applied in accounting for investments in associates.
However, it does not apply to investments in associates held by:
o venture capital organisations, or
o mutual funds, unit trusts and similar entities including investment-
linked insurance funds
that upon initial recognition are designated as at fair value through profit or
loss or are classified as held for trading and accounted for in accordance with
lAS 39 Financial Instruments: Recognition and Measurement.
Such investments are measured atfair value in accordance with lAS 39, with
changes infair value recognised in profit or loss in the period ofthe change.
1.3 Definitions
An associate is an entity over which an investor has significant influence and
which is neither a subsidiary nor a joint venture (i.e. an economic activity
undertaken by two or more parties with joint control).
Significant influence is the power to participate in the financial and operating policy
decisions of the investee but is not control or joint control over those policies.
Control is the power to govern the financial and operating policies of an
entity so as to obtain benefits from its activities.
The equity method is a method of accounting whereby the investment is initially
recognised at cost and adjusted thereafter for the post acquisition change in the
investor's share ofnet assets ofthe investee. The profit or loss of the investor
includes the investor's share of the profit or loss of the investee.
1.4 Significant influence
The term significant influence means that an investor is involved, or has the right
to be involved, in the financial and operating policy decisions of the investee.
The existence of significant influence by an investor is usually evidenced in
one or more of the following ways:
o Representation on the board of directors or equivalent governing body;
o Participation in policy making processes;
o Material transactions between the investor and the investee;
o Interchange of managerial personnel; or
o Provision of essential technical information.
A holding of 20% or more of the voting rights of the investee indicates
significant influence, unless it can be demonstrated otherwise.
Conversely, a holding ofless than 20% presumes that the holder does not
have significant influence, unless such influence can be clearly demonstrated
(e.g. representation on the board).
The existence and effect ofpotential voting rights that are currently exercisable
or convertible by the investor should be considered.
Such potential voting rights may occur through holding share warrants,
share call options, debt or equity instruments (or other similar instruments)
that are convertible into ordinary shares.
When significant influence is lost, the carrying amount of the investment at
that date is regarded as its cost on initial measurement thereafter (and will be
accounted for as a fmancial asset in accordance with lAS 39).
1.5 Separate financial statements
Investors that are exempt from the requirement to equity account may present
separate financial statements as their only fmancial statements.
In the separate fmancial statements, the investment in the associate should be
accounted for:
o Under IFRS 5 if classified as held for sale;
o At cost or in accordance with lAS 39.
The emphasis in the separate financial statements will be upon the
performance of the assets as investments.
2 ACCOUNTING TREATMENT
2.1 Relationship to a group
A group is defmed as being a parent and all of its subsidiaries. An associate
is not part of a group as it is not a subsidiary, i.e. it is not controlled by the
group.
As such, the accounting treatment of the associate is different to that of
subsidiaries.
2.2 Basic rule
An investment in an associate should be accounted for using the equity
method.
Associates must be accounted for using the equity method regardless of the
fact that the investor may not have investments in subsidiaries and does not
therefore prepare consolidated financial statements.
2.3 Equity accounting
The investment in an associate is initially recognised at cost and the carrying
amount is increased or decreased to recognise the investor's share ofthe profit
or loss ofthe investee after the date of acquisition.
This is equivalent to taking the investor's share of the net assets of the
associate at the date of the fmancial statements plus goodwill.
Distributions received from the associate reduce the carrying amount of the
investment.
Adjustments to the carrying amount may also be necessary for changes in the
investor's proportionate interest in the associate arising from changes in the
associate's equity that have not been recognised in the profit or loss.
Such changes include those arising from the revaluation ofproperty, plant
and equipment and from foreign exchange translation differences.
The logical way ofrecognising these changes in equity would be to show the
investor's share ofthe changes through the statement ofchanges in equity.
The investor's share of the current year's profit or loss of the associate is
recognised in the investor's profit or loss.
The associate is not consolidated line-by-line. Instead, the group share of the
associate's net assets is included in the consolidated balance sheet in one line,
and share of profits (after tax) in the consolidated income statement in one line.
2.4 Treatment in a consolidated balance sheet
The methods described below apply equally to the fmancial statements of a non-
group company that has an investment in an associate as they do to group
accounts.
In group investments, replace the investment as shown in the individual company
balance sheet with:
o the group's share of the associate's net assets at the balance sheet
date, plus
o the goodwill arising on acquisition, less any impairment losses.
As for business combinations under IFRS 3, lAS 28 does not permit the
amortisation of goodwill.
Do not consolidate line-by-line the associate's net assets. The associate is not a
subsidiary, therefore the net assets are not controlled as they are for a subsidiary.
In group reserves, include the parent's share of the associate's post-acquisition
reserves (the same as for subsidiary).
Cancel the investment in associate in the individual company's books
against the share of the associate's net assets and contingent liabilities
acquired at fair value. The difference is goodwill.
The fair values of the associate's assets and liabilities must be used in
calculating goodwill. Any change in reserves, depreciation charges etc due to
fair value revaluations must be taken into account (as they are when dealing
with subsidiaries).
Where the share of the associate's net assets and contingent liabilities
acquired at fair value are in excess of the cost of investment, the difference is
included as income in determining the investor's share of the associate's
profits or losses.
To calculate amounts for net assets and post-acquisition reserves, use a
net assets working for the associate (the same as for the subsidiary).
The amount to be placed in the balance sheet at the balance sheet date
will be:
$
Share ofnet assets
(Group % x Associate's net assets at balance sheet date)
x
X
X
This is not how lAS 28 phrases it. lAS 28 says that the carrying value of the
investment should be:
Cost + share of associate's post acquisition profit or loss
But Cost = share of associates net assets at acquisition + goodwill
Hence Carrying value = share of net assets at acquisition + goodwill
+ share ofpost acquisition profit or loss
Which = Share of net assets at balance sheet date +Goodwill
Therefore the carrying value can easily be calculated with reference to the share of net assets
at the balance sheet date.
Example 1
P owns 80% of 8 and 40% of A. Balance sheets of the three companies at 31
December 2004 are:
Investment: shares in 8
Investment: shares in A
Other non-current assets
Current assets
Issued capital - $1 ordinary shares
Retained earnings
Liabilities
p
S A
$ $ $
800
600
1,600 800 1,400
2,200 3,300 3,250
5,200 4,100 4,650
1,000 400 800
4,000 3,400 3,600
200 300 250
5,200 4,100 4,650
P acquired its shares in 8 seven years ago when S's retained earnings were $520 and
P acquired its shares in A on the 1 January 2004 when A's retained earnings were
$400.
The goodwill in 8 was fully written off after five years.
There were no indications during the year that the investments in 8 or A were
impaired.
Required:
Prepare the consolidated balance sheet at 31 December 2004.
Proforma solution
P: Consolidated balance sheet as at 31 December 2004
$
Non-current assets
Current assets
Issued capital
Retained earnings
Minority interests
Liabilities
WORKINGS
(1) Group structure
S
Issued capital
Retained earnings
A
Issued capital
Retained earnings
Balance
sheet date
$
Balance
sheet date
$
Acquisition
$
Acquisition
$
(3) Goodwill
S
Cost of investment
Net assets acquired
A
Cost of investment
Net assets acquired
S only
P - from question
Share ofS
Share ofA
Less Goodwill
(6) Investment in associate
Share of net assets
Remaining goodwill
$
$
$
$
$
2.5 Treatment in a consolidatedincome statement
Treatment is consistent with consolidated balance sheet and applies equally to
a non-group company with an associate:
o Include group share ofthe associate's profits after tax in the
consolidated income statement. This replaces dividend income
shown in the investing company's own income statement.
o Do not add in the associate's revenue and expenses line-by-line as
this is not a consolidation and the associate is not a subsidiary.
o Time-apportion the associate's results if acquired mid-year.
Note that the associate balance sheet is NOT time apportioned as the balance
sheet reflects the net assets at the date ofthe balance sheet to be equity
accounted.
Example 2
P has owned 80% of S and 40% ofA for several years. Income statements for the
year ended 31 December 2004 are:
p
S A
$ $ $
Revenue 14,000 12,000 10,000
Cost of sales (9,000) (4,000) (3,000)
Gross profit 5,000 8,000 7,000
Administrative expenses (2,000) (6,000) (3,000)
3,000 2,000 4,000
Dividend from associate 400
Profit from ordinary activities before taxation 3,400 2,000 4,000
Income taxes (1,000) (1,200) (2,000)
Profit from ordinary activities after taxation 2,400 800 2,000
Dividends (paid) (1,000) (1,000)
Retained earnings for the period 1,400 800 1,000
Goodwill was fully written off three years ago.
Required:
Prepare the consolidated income statement for the year ended 31 December 2004.
Proforma solution
P: Consolidated income statementfor the year ending 31 December 2004
$
Revenue
Cost of sales
Gross profit
Administrative expenses
Operating profit
Income from associate
Profit from ordinary activities before taxation
Income taxes
Profit from ordinary activities after taxation
Minority interests
Dividends (paid)
Retained earnings for the fmancia1year
(1) Group structure
(2) Consolidation schedule
Revenue
Cost of sales
Administration expenses
Income from assocociate
Tax
Profit after tax
(3) Minority interest
S only
P
$
s
$
40%
A
$
Adjustment Consolidation
$ $
2.6 Recognitionof losses
If an investor's share of losses of an associate equals or exceeds its interest in
the associate, the investor discontinues recognising its share of further losses.
The interest in the associate is its value under the equity method plus any
long-term interest that forms part of the investor's net investment.
Such interests may include preference shares and long-term receivables or
loans but do not include trade receivables, trade payables or any long-term
receivables for which adequate collateral exists, such as secured loans.
After the investor's interest is reduced to zero, additional losses are provided
for, and a liability is recognised, only to the extent that the investor has incurred
legal or constructive obligations or made payments on behalf ofthe associate.
If the associate subsequently reports profits, the investor resumes recognising
its share of those profits only after its share of the profits equals the share of
losses not recognised.
The investment in the associate can be reduced to nil but no further( i.e. the
investment in associate will not be negative, even if there are post acquisition
losses of the associate).
Illustration 1
A parent company has a 40% associate, which was acquired a number ofyears ago for
$lm. A long-term loan was also made to the associate of $250,000
Since the acquisition the associate has made losses totalling $5m.
The parent's share of those losses would be $2m.
The parent would only be required to recognise the losses to the extent of the
investment of $lmplus $250,000, the remaining share of losses ($750,000) would not
be recognised unless the parent had a present obligation to make good those losses.
Ifthe associate then became profitable, the parent would not be able to recognise those
profits until its share ofunrecognised losses had been eliminated.
However the investor should continue to recognise losses to the extent of any
guarantees made to satisfy the obligation of the associate (or joint venture).
This may require recognition of a provision in accordance with lAS 37.
Continuing losses of an associate (or a joint venture) is objective evidence
that fmancial interests in the associate (or joint venture) other than those
included in the carrying amount may be impaired.
2.7 Accounting policies and year ends
2.7.1 Accountingpolicies
If an associate uses accounting policies other than those of the investor,
adjustments must be made to conform the associate's accounting policies to
those of the investor in applying the equity method.
2.7.2 Year ends
The most recent available financial statements of the associate are used by the
investor.
When the reporting dates of the investor and the associate are different, the
associate prepares, for the use of the investor, financial statements as of the
same date as the financial statements of the investor.
When it is not practicable to produce statements as at the same date, adjustments
must be made for the effects of significant transactions or events that occur
between that date and the date of the investor's fmancial statements.
In any case, the difference between the reporting date ofthe associate and that
of the investor must not be more than three months.
The length of the reporting periods and any difference in the reporting dates
must be the same from period to period.
2.8 Impairment
After application ofthe equity method, including recognising the associate's
losses, the investor applies the requirements of lAS 39 to determine whether
it is necessary to recognise any additional impairment loss.
Because goodwill included in the carrying amount of an investment in an associate
is not separately recognised, it is not tested for impairment separately.
Instead, the entire carrying amount of the investment is tested for impairment,
by comparing its recoverable amount with its carrying amount.
In determining the value in use ofthe investment, an entity estimates:
D its share of the present value of the estimated future cash flows
expected to be generated by the associate, including the cash flows
from the operations ofthe associate and the proceeds on the ultimate
disposal ofthe investment; or
D the present value of the estimated future cash flows expected to
arise from dividends to be received from the investment and from its
ultimate disposal.
Under basic assumptions, both methods will give the same result.
If the Associate is profitable it is unlikely that there will be any impairment in
its value
2.9 Exemptions to equity accounting
An associate that is classified as held for sale is accounted for under IFRS 5
"Non-currentAssetsHeldfor Sale andDiscontinuedOperations".
Under IFRS 5, if an associate is acquired and held with a view to disposal
within twelve months, it will be measured at the lower of its carrying value
(e.g cost) and fair value less costs to sell.
If the investor is also a parent company that has elected not to present
consolidated financial statements the investment in the associate will be
measured at cost or in accordance with IAS 39.
The investment in the associate will be measured at cost or in accordance with
IAS 39 if all of the following apply:
o the investor is a wholly-owned subsidiary (or partially-owned and
other owners do not object); and
o the investor's debt or equity instruments are not traded in a public
market; and
o the investor does not file its financial statements with a securities
regulator; and
o the ultimate (or any intermediate) parent of the investor produces
consolidated financial statements available for public use under IFRS.
This allows investors who do not have investments in a subsidiary, but only
have an investment in an associate, to be exempt from the requirement to
equity account on the same basis as parents under IAS 27.
3 INTER-COMPANYITEMS WITHAN ASSOCIATE
3.1 Inter-company trading
Members of the group can sell to or make purchases from the associate.
This trading will result in the recognition ofreceivables and payables in the
individual company accounts.
Do not cancel inter-company balances on the balance sheet and do not adjust
sales and cost of sales for trading with associate.
In consolidated balance sheet, show balances with associate separately from
other receivables and payables.
The associate is not part of the group. It is therefore appropriate to show
amounts owed to the group by the associate as assets and amounts owed to
the associate by the group as liabilities.
3.2 Dividends
Consolidated balance sheet:
o Ensure dividends payable/receivable are fully accounted for in
individual companies' books.
o Include receivable in the consolidated balance sheet for dividends
due to group from associates.
o Do not cancel inter-company balance for dividends.
Consolidated income statement:
o Do not include dividends from the associate in the consolidated
income statement. Parent's share ofthe associate's profit after tax
(hence before dividends) is included under equity accounting in the
income from associate.
It would be double-counting to include dividend in the consolidated income
statement as well in addition to this.
3.3 Unrealised profit
If parent sells goods to associate and associate still has these goods in stock at
the year end, their balance sheet value will include the profit made by parent
and recorded in its books. Hence, profit is included in inventory value in
associate's net assets (profit is unrealised); and parent's income statement.
If associate sells to parent, a similar situation arises, with the profit being
included in associate's income statement and parent's inventory.
To avoid double counting when equity accounting for associate, this
unrealised profit needs to be eliminated.
Unrealised profits should be eliminated to the extent of the investor's interest
in the associate.
Unrealised losses should not be eliminated if the transaction provides
evidence of an impairment in value of the asset that has been transferred.
The above treatment is similar to that prescribed by lAS 31 in respect of
jointly controlled entities accounted for under the equity method.
To eliminate unrealised profit, deduct the profit from associate's profit before
tax and retained earnings in the net assets working before equity accounting
for associate, irrespective ofwhether sale is from associate to parent or vice
versa.
Worked example 1
Parent has a 40% associate.
Parent sells goods to associate for $IS0 which originally cost parent $100. The goods
are still in associate's inventory at the year end.
Required:
State how the unrealised profit will be dealt with in the consolidated accounts.
Worked solution 1
To eliminate unrealised profit.
Deduct $SO from associate's profit before tax in income statement, thus
dealing with the profit or loss impact.
Deduct $SO from retained earnings at balance sheet date in net assets working
for associate, thus dealing with the balance sheet impact.
Share of net assets and post acquisition profits included under equity accounting will
then be $20 (SO x 40%) lower.
4 DISCLOSURE
4.1 Investments in associates
The fair value of investments in associates for which there are published price
quotations.
Summarised financial information of associates (including aggregated
amounts of assets, liabilities, revenues and profit or loss).
Whether accountedfor using the equity method or not.
Ifrelevant, the reason(s) why:
o there is significant influence if the voting power is less than 20 per cent;
o there is not significant influence if the voting power is more than 20
per cent.
Ifrelevant, the associate's reporting date if different from that of the investor,
and the reason for using a different reporting date (or different period).
The nature and extent of any significant restrictions on the ability of associates
to transfer funds to the investor (e.g. cash dividends or loan repayments).
The unrecognised share of losses of an associate for the period and cumulatively.
The fact that an associate is not accounted for using the equity method when
exempt from doing so.
4.2 Using the equity method
Classification as non-current assets.
The investor's share of:
o profit or loss ofsuchassociates;
o discontinued operations (lFRS 5);
o changes recognised directly in the associate's equity (lAS 1); and
o contingent liabilities incurred through joint and several liability (lAS 37).
FOCUS
define associates;
describe and prepare accounts using equity accounting;
prepare consolidated financial statements to include a single subsidiary and
an associate.
EXAMPLE SOLUTIONS
Solution 1
P Consolidated balance sheet as at 31 December 2004
Non-current assets (1,600 + 800)
Current assets (2,200 + 3,300)
Issued capital
Retained earnings (W5)
Liabilities
WORKINGS
(1) Group structure
$
1,880
2,400
5,500
9,780
1,000
7,520
8,520
760
500
9,780
A
S Balance Acquisition
sheet date
$ $
Retained earnings 3,400 520
3,800 920
A Balance Acquisition
sheet date
$ $
Retained earnings 3,600 400
4,400 1,200
(3) Goodwill
S $
Cost of investment 800
Net assets acquired (80% x 920 (W2 (736)
64
A $
Cost of investment 600
Net assets acquired (40% x 1,200 (W2 (480)
120
S only - (20% x 3,800)
P - from question
Share of S [80% x (3,400 - 520) (W2)]
Share of A [40% x (3,600 - 400) (W2)]
Less Goodwill impaired (W3 per Activity)
$
760
$
4,000
2,304
1,280
(64)
7,520
Share of net assets (40% x 4,400)
Goodwill
Proof
Cost
Share ofpost acquisition profits
Solution 2
$
1,760
120
1,880
600
1,280
1,880
P Consolidated profit and loss account for the year ending 31 December 2004
Turnover
Cost of sales
Gross profit
Administrative expenses
Operating profit
Profit from ordinary activities before taxation
Income taxes
Profit on ordinary activities after taxation
Profit for the fmancial year
Dividends (paid)
Retained profit for the fmancial year
$ $
26,000
(13,000)
13,000
(8,000)
5,000
800
5,800
(2,200)
3,600
(160)
3,440
(1,000)
2,440
lAS 28 INVESTMENTS IN ASSOCIATES
WORKINGS
(1) Group structure
(2) Consolidation schedule
40%
p
S A Adjustment Consolidation
$ $ $ $ $
Revenue 14,000 12,000 26,000
Cost of sales (9,000) (4,000) (13,000)
Administration expenses (2,000) (6,000) (8,000)
40% x 2,000 800 800
Tax- group (1,000) (1,200) (2,200)
Profit after tax 800
(3) Minority interest
S only 20% x 800 $160
lAS 31 INTERESTS IN JOINT VENTURES
OVERVIEW
Objectives
To define joint ventures.
To describe the accounting treatment for joint ventures.
lAS 31
Definitions
JOINT VENTURES Forms ofjoint venture
Characteristics
JOINTLY
CONTROLLED
OPERATIONS
Description
Presentation and
accounting
JOINTLY
CONTROLLED
ASSETS
Description
Presentation and accounting
DISCLOSURE
Contingencies
Interests
JOINTLY
CONTROLLED
ENTITIES
Description
Presentation and accounting
Transactions between venturer
and ajoint venture
SIC-13: Jointly Controlled
Entities - Non-Monetary
Contributions by Venturers
Exemptions
Separate financial statements
Investors
Ceasing to be a venturer
1 lAS 31
1.1 Scope
lAS 31 should be applied in accounting for interests in joint ventures and the
reporting ofjoint venture assets, liabilities, income and expenses in the
financial statements of venturers and investors, regardless ofthe structures or
forms under which the joint venture activities take place.
However, it does not apply to venturers' interests in jointly controlled entities
held by:
o venture capital organisations; or
o mutual funds, unit trusts and similar entities,
accounted for in accordance with lAS 39 "Financial Instruments:
Recognition and Measurement".
Such investments are measured atfair value in accordance with lAS 39, with
changes infair value recognised in profit or loss in the period ofthe change.
2 JOINT VENTURES
2.1 Definitions
Ajoint venture is a contractual arrangement whereby two or more parties
undertake an economic activity, which is subject to joint control.
Control is the power to govern the financial and operating policies of an
economic activity so as to obtain benefits from it.
Joint control is the contractually agreed sharing of control over an economic
activity
It exists only when the strategicfinancial and operating decisions relating to
the activity require the unanimous consent ofthe joint venturers.
Significant influence is the power to participate in the financial and operating
policy decisions of an economic activity but is not control or joint control
over those policies.
A venturer is a party to a joint venture and has joint control over that joint
venture.
An investor in ajoint venture is a party to a joint venture and does not have
joint control over that joint venture.
Proportionate consolidation is a method of accounting and reporting
whereby a venturer's share of each ofthe assets, liabilities, income and
expenses of a jointly controlled entity is:
(1) combined on a line by line basis with similar items in the venturer's
fmancial statements; or
(2) reported as separate line items in the venturer's financial
statements.
The equity method is a method of accounting and reporting whereby an
interest in a jointly controlled entity is initially recorded at cost and adjusted
thereafter for the post acquisition change in the venturer's share of net assets
ofthe jointly controlled entity. The profit or loss of the venturer includes the
venturer's share of the profit or loss of the jointly controlled entity.
2.2 Forms of joint venture
Joint ventures take many different forms and structures. lAS 31 identifies
three broad types:
o Jointly controlled operations;
o Jointly controlled assets; and
o Jointly controlled entities.
2.3 Characteristics
The following characteristics are common to all joint ventures:
o two or more venturers are bound by a contractual arrangement; and
o the contractual arrangement establishes joint control.
No single venturer can be in a position to control the activity unilaterally.
The contractual arrangement will usually be in writing and cover:
o the activity, duration and reporting obligations of the joint venture;
o the appointment ofthe board of directors or equivalent governing
body of the joint venture and the voting rights of the venturers;
o capital contributions by the venturers; and
o the sharing by the venturers of the output, income, expenses or
results of the j oint venture.
One venturer may be the operator or manager under the terms ofthe
agreement. They will carry out the policy ofthe joint venture as agent for,
and as agreed by, the venturers. Ifthey are able to govern the financial and
operatingpolicies ofthe economic activity, they control the venture. Ifso,
the venture is a subsidiary ofthe operator and not a joint venture.
3 JOINTLY CONTROLLED OPERATIONS
3.1 Description
The operation of some joint ventures involves the use ofthe assets and other
resources of the venturers rather than the establishment of a corporation,
partnership or other entity, or a fmancial structure that is separate from the
venturers themselves.
Each venturer uses its own property, plant and equipment and carries its own
inventories. It also incurs its own expenses and liabilities and raises its own
finance, which represent its own obligations.
The joint venture activities may be carried out by the venturer's employees
alongside the venturer's similar activities.
The joint venture agreement usually provides a means by which the revenue
from the sale of the joint product and any expenses incurred in common are
shared among the venturers.
Illustration 1 - Jointly controlled operations
Two or more venturers combine their operations, resources and expertise in order to
manufacture, market and distribute jointly a particular product, such as an aircraft.
Different parts of the manufacturing process are carried out by each of the venturers.
Each venturer bears its own costs and takes a share of the revenue from the sale of the
aircraft, as determined in the contractual arrangement.
A venturer should recognise in its separate fmancial statements:
o the assets that it controls and the liabilities that it incurs; and
o the expenses that it incurs and its share of the income that it earns
from the sale of goods or services by the joint venture.
As the assets, liabilities, income and expenses are recognised in the financial
statements of the individual venturers, no separate fmancial statements for
external use are required for the venture. No adjustments or consolidation
procedures are required in respect of those items in any consolidated accounts
produced by the venturers.
Each venturer will usually maintain a joint venture account (as part of its
management accounts) in which all transactions they enter into on behalf of
the venture are recorded.
At end of each period a memorandumjoint venture account is prepared which
combines all expenses and income from individual joint venture accounts, in
order to calculate the profit/loss to date. The profit/loss arising is then split in
the agreed profit sharing ratios.
Points for consideration
o Transfer of goods between ventures should be ignored (since it does
not change who paid for the goods).
o Expenses borne by one venturer only:
(1) Record expense as normal
Dr Joint venture
Cr Cash
x
x
(2) Remove expense from memorandum account.
(3) Adjust joint venture account of venturer who will bear
expense:
Dr Expense
Cr Joint venture
x
x
Worked example 1
Q, a sound engineer, and R, a lighting engineer, entered into a joint venture to stage a
concert. They agreed to purchase certain items of equipment needed to convert their
local hall into a suitable venue, book the performers and sell tickets. Both are self-
employed and decided to record all transactions in joint venture accounts within their
own business books.
Qpurchased a number of radio microphones for $400. He also paid $150 for the
printing oftickets and programmes.
R purchased a computerised lighting deck for $600 and paid a total of $2,000 to the
performers. She also paid $800 for the rental of the hall.
Q sold 200 tickets at $12 each. R sold 500.
After the concert, Qand R prepared a pint venture account. They agreed that they
would each retain the equipment they had purchased at a valuation of $150 for the
microphones and $350 for the lighting deck. Q and R also agreed to share profits in
the ratio 2 to 3.
Rather than liquidate the venture, they decided to form a limited company (QR). Each
would contribute the equipment purchased for the concert, valued at the amounts
agreed earlier. They would also leave a total of $800 of the cash raised from the
concert in the company, allocated to each in such a way that their investment was
equal. Q and R would be the sole shareholders and each would receive a number of $1
shares equal in value to hislher investment.
Required:
(a) Prepare a memorandum joint venture account for the concert and the
subsequent appropriation ofprofit.
(b) Prepare joint venture accounts for Q and R which show the amounts invested
by each in QR.
(c) Prepare the balance sheet of QR as would have appeared immediately after
the company's incorporation.
Worked solution 1
(a) Memorandum Joint Venture Account - Q and R
$ $
Sales 200 + 500) x $12) 8,400
Expenses:
Cost of equipment (600 +400) 1,000
Less: Retained (150 + 350) (500)
Net cost of equipment 500
Tickets and programmes 150
Rental 800
Performers 2,000 3,450
Net profit 4,950
Allocated:
Q (2/5) 1,980
R (3/5) 2,970 4,950
(b)
Bank - equipment
-printing
-rents
- performers
Profit
Balance cld
Balance bid
Equipment
Bank
Joint Venture accounts
Q
R
Q
R
400 600 Bank - tickets 2,400 6,000
150
800 Equipment 150 350
2,000
1,980 2,970
20 Balance cld 20
2,550 6,370 2,550 6,370
20 Balance bid 20
150 350 Shares in QR 650 650
520 280
670 650 670 650
Q will invest equipment of $750 and cash of $520
R will invest equipment of $350 and cash of $280
(c) QR- Balance sheet on incorporation
Non-current assets (150 + 350)
Bank
$
500
800
1,300
Share capital (650 + 650) 1,300
4 JOINTLY CONTROLLEDASSETS
4.1 Description
This type ofjoint venture involves the joint control, and often the joint
ownership, by the venturers of one or more assets contributed to, or acquired
for the purpose of, the joint venture and dedicated to the purposes of the joint
venture.
The assets are used to obtain benefits for the venturers.
Each venturer may take a share of the output from the assets and each bears
an agreed share ofthe expenses incurred.
These joint ventures do not involve the establishment of a corporation,
partnership or other entity, or a fmancial structure that is separate from the
venturers themselves. Each venturer has control over its share of future
economic benefits through its share in the jointly controlled asset.
Illustration 2 - Jointly controlled assets
Many activities in the oil, gas and mineral extraction industries involve jointly
controlled assets. For example, a number of oil production companies may jointly
control and operate an oil pipeline. Each venturer uses the pipeline to transport its own
product in return for which it bears an agreed proportion ofthe expenses of operating
the pipeline.
Each venturer should include the following items in its accounting records
and recognise them in its separate financial statements (and consequently in
its consolidated financial statements ifthe venturer is part ofa group):
o its share of the jointly controlled assets, classified according to the
nature of the assets rather than as an investment;
o any liabilities which it has incurred on behalf of the joint venture,
(e.g. in fmancing its share of the assets);
o its share of any joint liabilities incurred in relation to the joint
venture;
o its share of income the joint venture, together with its share of any
expenses incurred by the joint venture; and
o any expenses that it has incurred in respect of its interest in the joint
venture.
As with jointly controlled operations, no separate financial statements for
external use are required for the venture. No adjustments or consolidation
procedures are required in respect of the jointly controlled asset in any
consolidated accounts produced by the venturers.
Again, management accounts will usually be used to assess the performance
ofthe joint venture.
5 JOINTLY CONTROLLED ENTITIES
5.1 Description
This is a joint venture, which involves the establishment of a corporation,
partnership or other entity in which each venturer has an interest.
The entity operates in the same way as other entities, except that a contractual
arrangement between the venturers establishes joint control over the
economic activity of the entity.
A jointly controlled entity controls the assets of the joint venture, incurs
liabilities and expenses and earns income. It may enter into contracts in its
own name and raise fmance for the purposes of the joint venture activity.
Each venturer is entitled to a share ofthe results of the jointly controlled
entity, although some jointly controlled entities also involve a sharing of the
output ofthe joint venture.
Illustration 3 - Jointly controlled entities
An entity may commence a business in a foreign country in conjunction with the
government or other agency in that country, by establishing a separate entity which is
jointly controlled by the entity and the government or agency.
A jointly controlled entity maintains its own accounting records and prepares
and presents fmancial statements (e.g. under IFRS) in the same way as other
entities.
5.2 Presentationand accounting
Each venturer usually contributes cash or other resources to the jointly
controlled entity. These contributions are included in the accounting records
ofthe venturer and recognised in its fmancial statements as an investment in
the jointly controlled entity.
A venturer shall recognise its interest in a jointly controlled entity using
either proportionate consolidation or the equity method.
5.2.1 Proportionate consolidation
The application ofproportionate consolidation means that the balance sheet
ofthe venturer includes its share of the assets that it controls jointly and its
share of the liabilities for which it is jointly responsible.
The income statement of the venturer includes its share of the income and
expenses of the jointly controlled entity.
Note that the venturer may be a single entity or a group (in which case the
balance sheet and income statement will be the consolidated balance sheet
and consolidated income statement).
Different reporting formats may be used:
o The venturer may combine its share of each of the assets, liabilities,
income and expenses of the jointly controlled entity with similar
items in its financial statements on a line-by-line basis.
For example, it may combine its share ofthejointly controlled entity's
inventory with the inventory ofthe consolidated group and its share ofthe
jointly controlled entity's property, plant and equipment with the same items
ofthe consolidated group.
o Alternatively, the venturer may include separate line items for its
share ofthe assets, liabilities, income and expenses ofthe jointly
controlled entity in its consolidated financial statements.
Worked example 2
Purple Inc owns 80% of Sepia and 40% of Jade. Jade is a jointly controlled entity.
Balance sheets ofthe three companies at 31 December 2004 are:
Investment: shares in Sepia
Investment: shares in Jade
Other non-current assets
Current assets
Share capital- $1 ordinary shares
Retained earnings
Liabilities
Purple Sepia Jade
$ $ $
800
600
1,600 800 1,400
2,200 3,300 3,250
5,200 4,100 4,650
1,000 400 800
4,000 3,400 3,600
200 300 250
5,200 4,100 4,650
Purple acquired its shares in Sepia many years ago when Sepia's retained earnings
were $520. Purple acquired its shares in Jade at the beginning of the year when Jade's
retained earnings were $400.
The balance of goodwill relating to Serpia had been written off as impaired three years
ago.The value of goodwill in respect of Jade remains unchanged at 31 December 2004.
Required:
Prepare the consolidated balance sheet at 31 December 2004 incorporating the interest
in Jade using proportionate consolidation.
Worked solution 2
Purple Inc: Consolidated balance sheet as at 31 December 2004
Goodwill (WI)
Non-current assets (1,600 + 800 + (40% x 1,400
Current assets (2,200 +3,300 +(40% x 3,250)
Share capital
Retained earnings (Balancing figure)
Minority interests (20% x (400 + 3,400
Liabilities (200 +300 +(40% x 250
$
120
2,960
6,800
9,880
1,000
7,520
8,520
760
600
9,880
WORKINGS
(1) Goodwill
In joint venture (W3)
In subsidiary (W2)
In subsidiary amortised or written off as impaired
On balance sheet
(2) Goodwill in subsidiary
Cost of investment in subsidiary
Net assets of subsidiary on acquisition
(400 + 520) x 80%
Goodwill
(3) Goodwill in joint venture
Cost of investment in joint venture
Net assets ofjoint venture on acquisition
(800 + 420) x 40%
Goodwill
$
120
64
(64)
120
$
800
(736)
64
$
600
(480)
120
The amount ofthe group retained earnings can be reconciled as follows:
All ofparent - per question
Subsidiary post-acquisition (3,400 - 520) x 80%
Joint venture post-acquisition (3,600 - 400) x 40%
Less goodwill written offas impaired
Group retained earnings
$
4,000
2,304
1,280
(64)
7,520
5.2.2 Equity method
In its consolidated financial statements, a venturer should report its interest in
a jointly controlled entity using the equity method as described by lAS 28
(see previous session).
The use of the equity method is supported by those:
o who argue that it is inappropriate to combine controlled items with
jointly controlled items; and
o who believe that venturers have significant influence, rather than
joint control, in a jointly controlled entity.
However, lAS 31 does not recommend the use ofthe equity method because
proportionate consolidation better reflects the substance and economic reality of
a venturer's interest in a jointly controlled entity (i.e. control over the
venturer's share ofthe future economic benefits.
Nevertheless, it permits the use ofthe equity method when recognising
interests injointly controlled entities.
A venturer should discontinue the use ofproportionate consolidation or the
equity method from the date on which it ceases to have joint control over, or
(for the equity method) have significant influence in, a jointly controlled
entity.
5.3 Transactions between venturer and a joint venture
When a venturer contributes or sells assets to a joint venture, recognition of
any portion of a gain or loss from the transaction reflects the substance of the
transaction.
While the assets are retained by the joint venture, and provided the venturer
has transferred the significant risks and rewards of ownership, the venturer
recognises only that portion ofthe gain or loss that is attributable to the
interests of the other venturers.
The venturer recognises the full amount of any loss when the contribution or
sale provides evidence of a reduction in the net realisable value of current
assets or an impairment loss.
When a venturer purchases assets from a joint venture, the venturer does not
recognise its share of the profits ofthe joint venture from the transaction until
it resells the assets to an independent party.
A venturer recognise its share of the losses resulting from these transactions
in the same way as profits except that losses are recognised immediately
when they represent a reduction in the net realisable value of current assets or
an impairment loss.
Worked example 3
Alpha Group and Beta Group set up a joint venture, Gamma. Alpha owns 60% of Gamma whilst Beta
owns the remaining 40%.
Alpha sells to the joint venture a piece ofland for $2m making a profit of $500,000 on the asset's
carrying value. At the year end, the land remains in the books of the Gamma.
Required:
Show the entries that would be made in the consolidated accounts of Alpha Group to reflect the sale of
the land.
Worked solution 3
Portion of gain realised by Alpha group = 40% x $500,000 = $200,000
Therefore the remaining 60% ofthe gain ($300,000) has not yet been realised by the
Alpha group and should be eliminated on consolidation.
On consolidation the following adjustment will be made:
Dr Profit or loss (retained earnings)
Cr Land
300,000
300,000
This eliminates Alpha's unrealised share of the profit and reduces the land to $900,000, in effect
Alpha's share of the carrying value after the sale to Gamma ($1,500,000 x 60%).
5.4 SIC-13: Jointly Controlled Entities - Non-Monetary Contributions by
Venturers
Issue
A joint venturer may contribute non-monetary assets to a jointly-controlled
entity in exchange for an equity interest in the jointly-controlled entity.
The issue is when should a joint venturer recognise the appropriate portion of
any gains or losses resulting from a contribution in its income statement.
Consensus
The joint venturer should recognise the portion of gains or losses attributable
to the other venturers on contributions ofnon-monetary assets unless:
o the significant risks and rewards related to the non-monetary asset
are not transferred to the jointly controlled entity;
o the gain or loss cannot be measured reliably; or
o the contribution lacks commercial substance, as that term is
described in lAS 16.
Non-monetary assets contributed by venturers are similar when they have:
D a similar nature;
D a similar use in the same line ofbusiness; and
D a similar fair value.
A contribution meets the similarity test only if all significant component
assets included in the contribution are similar to each ofthe significant
component assets contributed by the other venturers.
A gain should also be recognised if, in addition to the equity interest in the jointly
controlled entity, the venturer receives consideration in the form of either cash or
other assets, which are dissimilar to the non-monetary assets contributed.
5.5 Exemptions to proportionate consolidation and equity methods
The exemptions are basically the same as for interests in associates under IAS
28 and subsidiaries under IAS 27
If the investment in a jointly controlled entity is classified as held for sale
account for as requiredby IFRS 5 "Non-current Assets Heldfor Sale and
Discontinued Operations",
If the investor is also a parent company within a group that has elected not to
present consolidated financial statements measure the investment at cost or in
accordance with IAS 39.
The investment in the associate will be measured at cost or in accordance with
IAS 39 if all ofthe following apply:
D the venturer is a wholly-owned subsidiary (or partially-owned and
other owners do not object); and
D the venturer's debt or equity instruments are not traded in a public
market; and
D the venturer does not file its financial statements with a securities
regulator; and
D the ultimate (or any intermediate) parent of the venturer produces
consolidated financial statements available for public use under
IFRS.
This allows investors who do not have investments in a subsidiary, but only
have an investment in ajointly controlled entity, to be exemptfrom the
requirement to use proportionate consolidation or the equity method on the
same basis as parents under IAS 27.
5.6 Separate financial statements of a venturer
An interest in a jointly controlled entity is accounted for:
o Under IFRS 5 if classified as held for sale; or
o At cost or in accordance with lAS 39.
5.7 Reporting the interests of an investor
An investor in a joint venture that does not have joint control accounts for
that investment in accordance with lAS 39 or, if it has significant influence in
the joint venture, in accordance with lAS 28.
5.8 Ceasing to be a venturer in a joint venture
From the date on which a jointly controlled entity becomes a subsidiary of a
venturer, the venturer accounts for its interest in accordance with lAS 27.
From the date on which a jointly controlled entity becomes an associate of a
venturer, the venturer accounts for its interest in accordance with lAS 28.
6 DISCLOSURE
A venturer shall disclose the method it uses to recognise its interests in jointly
controlled entities.
6.1 Contingencies
A venturer should disclose the aggregate amount of the following contingent
liabilities, unless the probability ofloss is remote, separately from the amount
of other contingent liabilities:
o any contingent liabilities hat the venturer has incurred in relation to
its interests in joint ventures and its share in each ofthe contingent
liabilities which have been incurred jointly with other venturers;
o its share of the contingent liabilities ofthe joint ventures themselves
for which it is contingently liable; and
o those contingencies that arise because the venturer is contingently
liable for the liabilities of the other venturers of a joint venture.
A venturer discloses the aggregate amount of any capital commitments in
respect of its interests in joint ventures separately from other commitments.
6.2 Interests
A venturer should list and describe interests in significant joint ventures and
the proportion of ownership interest held in jointly controlled entities.
A venturer which reports its interests in jointly controlled entities using the
line by line reporting format for proportionate consolidation or the equity
method should disclose the aggregate amounts of each of:
o current assets
o long-term assets
o current liabilities
o long-term liabilities
o income and expenses related to its interests in joint ventures.
Illustration 4
We have included eight joint ventures - three fewer than in the previous year-
by proportionate consolidation in compliance with lAS 31 (Financial Reporting of Interests
in Joint Ventures). The effect of joint ventures on the Group balance sheet and income
statement is as follows:
mi/lion
Noncurrent assets
Current assets
Pension provisions
Other rovisions
Financial liability
Remaining liabilities
2003
135
85
(45)
(59)
million
Income
E enses
2003
330
306
Net assets 111 Income after taxes 24
7 CONSOLIDATION METHODS - SUMMARY
The three consolidation methods give the same "results" as is shown by the following:
Worked example 4
Entity M has acquired 50% of Entity X.
Entity X Summary balance sheet at year end
Non-current assets
Net current assets
Capital
Retained earnings
Income statement for year
Revenue
Costs
Profit
Required:
$
600
400
1,000
200
800
1,000
$
600
(400)
200
Calculate the net assets and profit of Entity X which will be included in the
consolidated fmancial statements of Entity M if Entity X is:
(a) a subsidiary;
(b) an associate;
(c) a jointly-controlled entity (using proportional consolidation).
Worked solution 4
Non current
Net current
Investment in "A"
Minority Interest
(a) Subsidiary
$
600
400
(500)
500
(b) Associate
$
500
500
(c) Joint venture
$
300
200
500
Included in
consolidated retained earnings 500 500 500
(a) Subsidiary (b) Associate (c) Joint venture
$ $ $
Revenue 600 300
Costs (400) (200)
Income from "A" 100
Minority interest (100)
Profit for year 100 100 100
FOCUS
define joint ventures (i.e. jointly controlled operations, assets and entities);
distinguish between equity accounting and proportional consolidation;
describe and prepare accounts under the two formats ofproportional
consolidation;
prepare consolidated financial statements to include a single subsidiary and a
joint venture (under both methods).
ACCOUNTING ISSUES
lAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
OVERVIEW
Objectives
To prescribe translation rules for transactions in a currency different to the
reporting currency.
To prescribe the accounting treatment for exchange differences.
Introduction
Key issues
Scope
L...-,------------,..--J. Definitions
Effective date
INDIVIDUAL
COMPANY STAGE
Accounting treatment -
basic transactions
EXCEPTIONS TO
THE BASIC RULES
Net investment in aforeign entity
Hedging
Severe devaluation ofcurrency
SIC- 7
CONSOLIDATED
FINANCIAL
STATEMENTS
Nature ofexchange difference
Classification ofForeign
Operations
FOREIGN ENTITY
lAS 21 Foreign currency
translation
Calculation ofexchange difference
Goodwill
INTEGRATED
FOREIGN
OPERATIONS
lAS 21 Foreign currency
translation
Calculation ofexchange difference
EXCHANGE
DIFFERENCES - A
SUMMARY
FOREIGN
ASSOCIATES
DISPOSAL OF A
FOREIGN ENTITY
DISCLOSURES
1 ACCOUNTING ISSUES
1.1 Introduction
A company may engage in foreign currency operations in two ways.
o It may enter directly into transactions which are denominated in
foreign currencies.
o Foreign operations may be conducted through a foreign enterprise
(subsidiary or associate)
Resultant transactions and balances must be translated into the presentation
currency of the entity for inclusion in fmancia1 statements.
1.2 Key issues
Exchange rate to be used for translation.
Treatment of exchange differences (which arise because exchange rates vary
overtime).
1.3 Scope
lAS 21 should be applied:
o In accounting for transactions in foreign currencies, and
o In translating the financial statements of foreign operations that are included
in the fmancia1 statements of the enterprise by consolidation, proportionate
consolidation or by the equity method.
This standard does not deal with hedge accounting for foreign currency.
1.4 Definitions
Functional currency is the currency of the primary economic environment in
which the entity operates.
Presentation currency is the currency in which the fmancia1 statements are
presented.
Foreign currency is a currency other than the functional currency of the
entity.
Closing rate is the spot exchange rate at the balance sheet date.
Net investment in aforeign entity is the amount of the reporting entity's
interest in the net assets of that operation.
Monetary items are money held and assets and liabilities to be received or
paid in fixed or determinable number ofunits of currency.
Foreign operation is a subsidiary, associate, j oint venture or branch of the
reporting entity, the activities of which are based or conducted in a country or
currency other than the country of the reporting entity.
2 INDIVIDUAL COMPANY STAGE
2.1 Accounting treatment - basic transactions
2.1.1 Initial recognition
Initially a foreign currency transaction shall be recorded in an entity's
functional currency using the spot exchange rate on the date of the
transaction.
Exchange differences arising on settlement of a foreign currency transaction
in the same reporting period shall be recognised in profit and loss for the
period.
2.1.2 Subsequent recognition
At each balance sheet date any foreign currency monetary item shall be re-
translated using the closing exchange rate.
Exchange differences arising on re-trans1ation of a foreign currency balance
shall be recognised in profit and loss for the period.
Non-monetary items measured at historical cost shall be translated at the
exchange rate at the date ofthe transaction.
Non-monetary items measured at fair value shall be translated using the
exchange rate when the fair value was determined.
IAS21 THEEFFECTSOF CHANGES INFOREIGNEXCHANGE RATES
Transactions
during the year
Actual rate at date the transaction took place (= historic rate (HR.) )
Or average rate (AR) for the period (ifno significant fluctuations)
I
Transactions
Balances at the year end settled during the
year
Monetary items
Non monetary
items
Retranslate at the No retranslation
year end using the (:. no exchange
closing rate difference arises)
.. . .. . . . . . . 1. . .. . . .. . . . . -_. --_. ---
-----------
Exchange
differences will
arise at the year
end
---- --- ----1-----------
Exchange
differences will
arise during the
year
---- --- ---l---- -------
All exchange differences(on settled and unsettled transactions) go
through the IS (note the exceptions at paragraph 3)
Accountancy Tuition Centre (Interna tional Holdings) Ltd 2005 3004
Example 1
Aston has a year end of 31 December 2004. On 25 October 2004 Aston buys goods
from a Mexican supplier for Peso 286,000.
On 16 November 2004 Aston pays the Mexican supplier in full. The goods remain in
inventory at the year end.
Exchange rates
25 October 2004
16 November 2004
31 December 2003
Required:
$1:Peso 11.16
$l:Peso 10.87
$1:Peso 11.02
Show the accounting entries for the transactions in each of the following situations:
(a) on 16 November 2004 Aston pays the Mexican supplier in full;
(b) the supplier remains unpaid at the year end.
Solution 1 - Purchase of goods on credit
(a) Supplier paid
(b) Year-end trade payable
Example 2
Warrior has a year end of 31 December 2004. On 29 November 2004 Warrior received
a loan from an Australian bank of AUD 1,520,000.
The proceeds are used to finance in part the purchase of a new office block. The loan
remains unsettled at the year end.
Exchange rates
29 November 2004 USD 1 =ADD 1.52
31 December 2004 USD 1 = ADD 1.66
Required:
Show the accounting entries for these transactions.
Solution 2 - Loan
3 EXCEPTIONS TO THE BASIC RULES
3.1 Net investment in a foreign operation
An entity may have a monetary item that is receivable from or payable to a
foreign operation.
Such monetary items where settlement is neither planned nor likely to occur
in the foreseeable future is in substance part of a " net investment in the
operation" ( note that these items do not include trade receivables and trade
payables)
Exchange differences on such items shall be included in profit and loss in the
separate financial statements of the reporting entity or foreign operation.
In the consolidated financial statements these exchange differences shall be
included in a separate component of equity and recycled through profit and
loss on disposal of the investment.
4 CONSOLIDATEDFINANCIALSTATEMENTS
4.1 Nature of exchange difference
Illustration
Net assets at start of the year
Retained profit
Net assets at year end
Rate s
1,000 2 500
500 1.9 263
1,500 1.85 811
This
column
does not
add up
The closing net assets figure comes from 2 sources
D last years balance sheet,
D profit for the period.
The closing figure has been translated at a different rate to its component figures
Exchange difference on consolidation comes from two sources
D Restatement of opening net assets
o Translating retained profit at one rate and the net assets (the other side of
the IS double entry) at another rate
4.2 Identifying the functional currency
The functional currency of an entity will be dictated by the primary economic
environment in which the entity operates.
An entity should consider the following in determining its functional
currency;
o the currency that mainly influences the selling price of goods or
services and the currency of the country whose regulations mainly
determine the selling price of goods and services.
o the currency that impacts labour, material and other costs of
providing goods and services.
Secondary factors to consider in determining the functional currency are;
o the currency in which funds from financing activities are generated.
o the currency in which monies from operating activities are kept.
The following factors are also to be considered in determining the functional
currency of a foreign operation, and whether that currency is the same as the
reporting entity.
o are they carried out as an extension of the reporting entity or does
the foreign operation carry out its activities with a significant
degree of autonomy.
o are transactions between the reporting entity and foreign operation a
high percentage of total transactions.
o do cash flows ofthe foreign operation impact directly on the cash
flows of the reporting entity and is cash available for remittance to
the reporting entity.
o is the foreign operation dependant upon the reporting entity to help
service debt obligations, both existing and those of the future.
If the functional currency is not obvious management must use their
judgement in identifying the currency that most faithfully represents the
economic effects of the underlying transactions.
Once a functional currency has been identified it should only be changed if
there is a change to the economic climate in which it was initially identified.
5 FOREIGN OPERATION - (CLOSING RATE METHOD)
5.1 Presentation currency
The financial statements of a foreign operation shall be translated into the
presentation currency ofthe parent entity.
Assets and liabilities shall be translated, at each balance sheet date, at the
closing exchange rate.
Income and expenses shall be translated using exchange rates when the
transaction occurred. An average exchange rate that approximates to actual
exchange rates may be used.
The parent's share of any exchange difference will be included as a separate
component of equity, and recycled through profit and loss when the foreign
operation is disposed. The minority share will be included within minority
interest in the consolidated balance sheet.
5.2 Supplementary information
The standard does not prohibit an entity providing additional supplementary
information translated using a different currency, prepared in a manner other
than that required by the standard.
If an entity does present additional information they should be clearly
identified as supplementary and the fact that translation is not in accordance
with the standard.
5.3 lAS 21 Foreign currency translation
Translation rules
o Balance sheet
Non current assets
Inventory
Monetary items
Share capital
Pre acquisition
reserves
Post acquisition
reserves
$
X 1 X
X I Closing Rate X
X r (CR) X
I $ total is the basis of
X J X
-
MI calculation
X Historical Rate X
-
$ basis of Goodwill
(HR) calculation
X
X Bal Fig X
-
basis ofGRE
calculation
X X
o Income statement
All items at the rate ruling at the date of the transaction. For
practical reasons a rate that approximates to the rate ruling (Eg an
average rate (AR).)may be used.
Ifthe foreign entity operates in a hyper inflationary economy the
closing rate should be used.
Exchange difference - Take P's share directly to reserves where they remain
until the disposal ofthe asset when the cumulative exchange difference will
be recycled through the income statement.
5.4 Calculation of exchange difference
Either
Closing net assets of S
Opening net assets of S
Retained profit
Exchange difference
or
$
X
(X)
X
(X)
X --- Take P's share
Opening net assets @ OR = X
Opening net assets @ CR = X
X
Retained profit
as per the IS (AR)
as per the BS (CR)
X
(X) X
X --- Take P's share
Accountancy Tuition Centre (International Holdings) Ltd 2005 30I0
lAS 21 THBEFFECTSOF CHANGES INFOREIGNEXCHANGERATES
5.5 Goodwill
Goodwill arising on the acquisition of a foreign entity and any fair value
adjustments to the carrying amounts ofassets and liabilities arising on the
acquisition ofthat foreign entity are treated as assets and liabilities ofthe
foreign operation and translated at the closing rate. This would require the
recognition of goodwill in the investee'sown accounts. This may mean that
the level to which goodwill is allocated for foreign currency purposes is
different to that at which it is annually tested at for impairment purposes.
Illustration
P acquired 100% of S on 30
th
September 2004 at a cost of4m. The fair value of
the net assets of S at that date were 3m. 'The exchange rate at the date of
acquisition was 2 =$1. At the 31
11
December (P's accounting year end) the
exchange rate was 2.1=$1.
Goodwill
1.000,000
lm@2.1
s
476.190
----------- ---- ------- ---- ~ ~ ~ ~ ------- ---- --- ------ -- ~ ~ ~ _ --------
Views goodwill as the excess of
the amount paid over the fair
value ofthe net assets expressed
in the currency ofS as at the date
of acquisition. It is deemed to be
a foreign currency asset and
subject to retranslation,
@ Accountancy Tuition Centre (International Holding,) Ltd 2005 3011
The amount paid for the holding
would have been based onthe
expected future earnings stream
expressed in . The goodwill
relates to a business which
operates in the economic
environment ofanother country.
It should bematched as a cost
against revenues.
Example 3 Translation of Sly Gmbh
Gobbo Inc bought 80% of Sly Gmbh on 31 December 2001 for 6,000 when the exchange rate was 4 = $1. The reserves
of Sly Gmbh at that date were 2,000. Goodwill was fully impaired by 31 December 2003.
On 31 December 2004 the balance sheets were as follows.
Closing rate
method CBS
GInc SGmbh Rate SGmbh
$ $ $
Non current assets
Tangible 9,000 12,000
Investment in Sly 1,500
Current assets
Inventory 1,000 1,914
Other 500 4,986
12,000 18,900
Long term loans (6,000)
12,000 12,900
Share capital 2,000 4,000
Retained earnings 10,000 8,900
Minority interest
12,000 12,900
The rate of exchange on 31 December 2004 was 3 = $1.
The income statement for the year ended 31 December 2004 were as follows.
Revenue
Cost of sales and other expenses
Depreciation
Profit before tax
Tax
Profit after tax
Minority interest
GInc
$
35,250
(28,200)
(1,350)
5,700
(2,700)
3,000
SGmbh
28,215
(19,515)
(1,500)
7,200
(3,600)
3,600
Closing rate
method
Rate SGmbh
$
CIS
$
The average rate of exchange for the year was 2.85 = $1. The closing rate used in last years accounts was 2.5 = $1
WORKINGS
Either
Exchange difference
$
Closing net assets of S
Opening net assets of S
Retained profit
Exchange difference
or
Retranslation of opening net assets
@CR
@OR
Retranslation of retained profit
@CR
@AR
$ $
6 FOREIGNASSOCIATES
Foreign associates should be translated using the closing rate method
and the standard workings.
7 DISPOSAL OF FOREIGNOPERATION
On the disposal of a foreign operation, the cumulative amount of the
exchange differences which have been deferred and which relate to
that foreign entity should be recognised as income or as expenses in
the same period in which the gain or loss on disposal is recognised.
In the case ofa partial disposal, only the proportionate share of the
related accumulated exchange differences is included in the gain or
loss.
Example 4
P bought a 100% interest in S on 1st January 2003 ( 2 years) ago for a purchase
consideration of$5,000.
P disposed ofthe holding for $10,000 on 31st December 2004.
S is a German enterprise.
Goodwill has been impaired by 600 since acquisition
Net assets at 01/01/03 (the date of acquisition)
Net assets at 31/12/04 (the date of disposal)
Retained profit for the years ending:
31st December 2003
31st December 2004
7,000
10,000
1,400
1,600
Rate
/$
1.8
2.1
1.85
2
Required:
Calculate the income statement impact of the disposal of the interest in S.
8 DISCLOSURE
The amount of exchange differences included in profit or loss for the
period.
Net exchange differences classified in equity as a separate component
of equity, and a reconciliation of the amount of such exchange
differences at the beginning and end of the period.
When presentation currency is different to the functional currency,
that fact shall be stated along with the what the functional currency is
and the reason for using a different reporting currency.
Any changes in functional currency, and the reasons for the change.
9 SIC - 7; INTRODUCTION OF THE EURO
Consensus
o The requirements ofIAS21 should be strictly applied as the Euro is
introduced.
Foreign currency assets and liabilities should be translated
into the reporting currency at the closing rate with
differences being taken to the income statement.
Exchange differences relating to the translation of the
financial statements of foreign entities should continue to
be classified as equity until disposal of the net investment
in the entity.
o The changeover does not justify the inclusion of exchange
differences resulting from severe devaluations of currencies in the
carrying amount of related assets.
FOCUS
discuss the recording of transactions and retrans1ation of monetary and non
monetary items at the balance sheet date for individual entries;
account for the treatment of exchange differences arising on individual
entries;
discuss the nature of accounting fro foreign entities and foreign operations
that are integral to the operations of the entity;
account for a net investment in a foreign entity;
prepare group fmancia1 statements incorporating a foreign subsidiary or
associate;
discuss problem areas in foreign currency transactions for individual and
group companies.
EXAMPLE SOLUTIONS
Solution 1 - Purchase of goods on credit
(a) Supplier paid
25 October 2004
16 November 2004
$ $
Dr Purchases (WI) 25,627
Cr Trade payables 25,627
Dr Trade payables 25,627
Dr Income statement-
other operating expense 684
CrCash (W2) 26,311
The goods will remain in inventory at the year end at $25,627.
WORKINGS
(1) Peso 286,000 -;- 11.16 = $25,627
(2) Peso 286,000 -;- 10.87 = $26,311
(b) Year-end tradepayable
$ $
25,627 25 October 2004
31 December 2004
Dr Purchases (WI)
Cr Trade payables
Dr Income statement
- other operating expense 326
25,627
Cr Trade payables (W2)
The goods will remain in stock at the year end at $25,627.
WORKINGS
$
326
(1)
(2)
Peso 286,000 -i- 11.16
Peso 286,000 -i- 11.02
25,627
25,953
326
Solution 2 - Loan
29 November 2004
31 December 2004
Dr Cash
CrLoan
Dr Loan
us $000 US $000
1,000
1,000
84
WORKINGS
Cr Income statement-
other operating income 84
(1)
(2)
AUD 1,520,000 -:- 1.52
AUD 1,520,000 -:- 1.66
US $000
1,000
916
84
Solution 3 Closing rate method
Balance sheets at 31 December 2004
Closing rate
method
Glnc SGmbh Rate SGmbh CBS
$ $ $
Non current assets
Tangible 9,000 12,000 3.0 4,000 13,000
Investment in Sly 1,500
Current assets
Inventories 1,000 1,914 3.0 638 1,638
Other 500 4,986 3.0 1,662 2,162
18,900 6,300 16,800
Long-term loans (6,000) 3.0 (2,000) (2,000)
12,900 4,300 14,800
Share capital 4,000 1 2,000
Retained earnings r 4.0 1,500 11,940
Pre-acquisition 2,000 2,000 J
Post-acquisition 10,000 6,900

2,800
Minority Interest 860
12,900 4,300 14,800
Income statement for the year ended 31 December 2004
Revenue
Cost of sales and other expenses
Depreciation
Profit before tax
Tax
Profit after tax
Minority interest
Retained profit
WORKINGS
(1) Exchange difference
Closing net assets
Opening net assets
(12,900 - 3,600) @2.5
Retained profit
Retrans1ation of opening net assets
9,300 @ CR (3.00)
@ OR (2.50)
Retrans1ation of retained profit
3,600 @ CR (3.00)
@ AR(2.85)
Closing rate
method
GLtd SGmbh Rate SGmbh
$ $
35,250 28,215 2.85 9,900 45,150
(28,200) (19,515) 2.85 (6,847) (35,047)
(1,350) (1,500) 2.85 (526) (1,876)
5,700 7,200 2,527 8,227
(2,700) (3,600) 2.85 (1,263) (3,963)
3,000 3,600 1,264 4,264
(253)
4,011
$
4,300
(3,720)
580
(1,264)
684
$ $
3,100
(3,720)
(620)
1,200
(1,263)
(63)
(683)
Solution 4
Goodwill
Cost of acquisition
Net assets on acquisition
(7,000 @ 1.8) X 100%
Impaired
Unimpaired on disposal
Proceeds
Share of net assets disposed of:
10,000 @ 2.1
Unimpaired goodwill
$
@1.8
@2.1
$
5,000
(3,889)
1,111
2,000
(600)
1,400
$667
$
10,000
(4,762)
(667)
Profit on disposal 4,571
Rate $
Net assets at 31/12/04 (the date of disposal) 10,000 2.1 4,762
Net assets at 01/01/03 (the date of acquisition) 7,000 1.8 (3,889)
873
Retained profit for the years ending:
31
0t
December 2003 1,400 1.85 (757)
31
0t
December 2004 1,600 2 (800)
Exchange loss (684)
CHANGES IN ORGANISATIONAL STRUCTURE
OVERVIEW
Objective
To describe the techniques of executing and appraising schemes of
reconstruction.
To describe and illustrate the general concepts underlying purchase of own
shares and the calculation of distributable profit.
SCHEMES OF
RECONSTRUCTION
Background
Protection ofthe stakeholders
'-- ---'. Questions
Appraisal ofthe scheme
Order in which interestedparties are ranked
on a winding up
PURCHASE OF OWN
SHARES
Legalbackground
Creditors buffer
'-- ----'. Why do it?
Accounting rules
DISTRIBUTABLE
PROFIT
What is a distribution?
Meaning ofrealised
L-- --l. Revaluations can have a number ofimpacts on
distributable profits.
1 CORPORATERECONSTRUCTION
1.1 Background
An entity is in financial difficulties (maybe cash flow problems which have
culminated in the bank asking for a plan whereby the entity's overdraft might
be repaid).
Often the entity's balance sheet will be characterised by:
o a debit balance on retained earnings
o low net assets per share
A scheme is suggested by the directors (or maybe another stakeholder).
Under the scheme the balance sheet is restructured. Typically the scheme will
involve:
o an injection of cash
o a reorganisation of the capital of the entity
o revaluation of assets
The aim of the scheme is to allow the entity to proceed to the future on a
strong financial footing. NB this presupposes that the entity has good
prospects. There is no point in executing a scheme if the entity is going to
trade unprofitably in the future.
1.2 Protection of the stakeholders
The scheme will effect the rights of the various stakeholders in the entity. In
most jurisdictions the regulatory environment within which the entity
operates will have mechanisms to protect the rights of each class of interested
party.
In short they are often given a right of veto. As a result each party has to be
persuaded into acceptance of the scheme.
Typically the protective mechanisms will include some or all of the
following:
o court approval,
o the scheme must be approved by a specified majority (eg 75%) of
each stakeholder group,
o the scheme must be authorised within the constitution ofthe entity.
1.3 Questions
There are two types of scheme that may be examined
o Internal reorganisation
a restructuring of the balance sheet
o External reorganisation
winding up of company
setting up of new company to take over trade/assets
like a purchase and sale ofbusiness
You may be required to:
o Prepare the fmancial statements after the reorganisation has taken
place
this may involve a book keeping exercise
i.e. process the scheme of reorganisation
o Appraise the scheme, either in general or for a specified
stakeholder.
No single correct answer
Apply principles
Example 1
$000 $000
Non current assets
Tangibles 1,000
Goodwill 500
1,500
Current assets
Cash
Receivables 300
Inventory 400
2,200
Share capital
Ordinary shares ($1 ords) 1,500
Reserves
Retained earnings (300)
Liabilities
10% debenture (secured on the
tangible non current assets) 500
4% Preference shares 200
Bank overdraft 300
2,200
The following scheme has been proposed
1. Assets are to be revalued:
Tangibles
Goodwill
Receivables
Inventory
980
290
350
2. Ordinary share capital to be surrendered and reissued as 25c ords on a 1 for 1 basis
3. The existing ordinary shareholders are to subscribe for 1,000 25c ords @75c.
4. The preference share capital is to be reduced by 25% through surrender and reissue.
5. The debenture holders are to exchange debs with a value of $250 for 500 25c ords.
Required:
Execute the scheme of reconstruction.
Reconstruction account
1.4 Appraisal of the scheme
Scheme must be approved by each group of stakeholders. In performing the
appraisal you will need to look at things as they would. Compare
E
A
C C
H L
A
S
S
Position on
wind up*
X
x
x
Position with
scheme
x
x
x
o in terms of their capital and income positions
*Note that the alternative to the scheme is usually taken as being to wind up the
business
As a general point in the appraisal of the scheme remember that parties with
the most to lose on winding up (and therefore to gain on the scheme) should
contribute most to its success
1.5 Order in which interested parties are ranked on a winding up
The capital position without the scheme is established by calculating the
amount of cash that would be available and then distributing it on the basis
specified in the regulatory environment within which the entity operates.
Typically stakeholders would share in the following order.
o Holders of fixed charge
o Preferential creditors
Tax authorities
Employees salaries
o Holders of floating charge
o Unsecured creditors
o Preference share holders
o Ordinary share holders
Example 2
Following on from the previous example
Asset values on a forced sale basis are as
follows:
Tangibles
Receivables
Inventory
$000
460
200
200
860
Required:
Appraise the scheme from the point of view ofthe ordinary shareholders, the
preference shareholders and the debenture holders.
2 PURCHASE OF OWN SHARES
An entity may purchase their own shares during a scheme of reconstruction. This
section is a reminder of the principles underlying purchase of own shares.
2.1 Legal background
The situation will vary from country to country.
Basic rule: not allowed because owners could use it to take cash out of a
business that was in fmancial difficulties to the detriment of creditors.
However there are certain circumstances where purchase of own shares is
desirable. For example:
o To return surplus funds to shareholders
o To buyout dissenting minorities
o To allow retirement from family companies
IASB uses the term treasury shares when discussing the accounting treatment
relating to the purchase of own shares.
Allowed subject to certain controls. eg
o authorised by articles
o must fund the purchase out of distributable profit and/or the
proceeds of a new issue
2.2 Creditors buffer
What is it?
o Sum of share capital and non-distributable reserves
o Legal rules normally made to protect it.
2.3 Accounting rules
2.3.1 Basic rules
These will vary from country to country but typically they include the
following.
Replace the nominal value of shares purchased with:
o proceeds ofnew issue
or
o transfer from distributable reserve into capital redemption reserve
or
o a combination
this maintains the creditors buffer fund and ensures distributions are
not made to shareholders using funds that they are not entitled to.
2.3.2 lAS 32 requirements
If an entity acquires its own equity instruments, it is required to deduct those
instruments directly from equity.
No gain or loss will be recognised in profit or loss in respect of the purchase,
sale, issue or cancellation ofthe equity shares.
Any consideration paid or received will be recognised directly in equity.
The amount of treasury shares held will be disclosed separately on the face of
the balance sheet or within the notes.
3 DISTRIBUTABLE PROFIT
Sometimes schemes of reorganisation require a distribution to be made (eg see
demergers in session 25). This section is a reminder of the principles underlying
dividend distributions.
3.1 What is a distribution?
Not just the cash payment of a dividend (but it always has been in exams).
A distribution may only be made out of "profits available for the purpose" as
determined by local legislation.
Typically companies may only distribute accumulated realised profits. This
means that a company may pay a dividend in periods in which it has made a
loss as long as it has made sufficient profit in earlier periods to absorb this
loss and leave a credit balance of retained earnings.
3.2 Meaning of realised
There is no single defmition of realised. Usually a transaction is deemed to be
realised when it results in a transfer of economic benefit ( usually cash) or is
reasonably certain to result in such a transfer.
Normally, ifIAS instructs profit to be taken to the income statement it is
realised eg profit under construction contracts as per lAS 11.
There can be exceptions:
o Net unsettled gains on long term monetary items taken to the
income statement as per lAS 21. These must be treated as
unrealised when calculating distributable profits.
Illustration
The profit of Colette Inc is $150,000, including a $15,000 gain on
the re-translation of a long term foreign currency loan.
What are the realised profits for the year for the purpose of
calculating distributable profits?
Profit per the accounts
Less: unrealised gain
$
150,000
(15,000)
135,000
3.3 Revaluations can have a number of impacts on distributable profits.
(i) Add back to distributable profits any "excess" depreciation charged
because an asset was revalued upwards.
(ii) If an asset is sold, any remaining balance in the revaluation reserve
relating to that asset becomes realised.
Example 3
On 1 January 2005 Robling Inc revalued to $175,000 an asset which had a net book
value of$110,000. The asset is to be written off in equal instalments over 10 years.
Retained profit for the year was $900,000.
Required:
Calculate the distributable profit for the year?
FOCUS
prepare group fmancial statements after reorganisation and reconstruction;
appraise the benefits ofreorganisations and restructurings.
EXAMPLE SOLUTIONS
Solution 1
$000 $000
Non current assets
Tangibles 1,000 980
Goodwill 500
1,500
Current assets
Cash 450
Receivables 300 290
Inventory 400 350
2,200 2,070
Share capital
Ordinary shares ($1 ords) 1,500 (1,500) + 375 + 250 750
+125
Reserves
Share premium 500
Capital reserve 420
Retained earnings (300)
Liabilities
10% debenture 500 250
4% Preference shares 200 150
Bank overdraft 300
2,200 2,070
Reconstruction account
Write offs of;
Tangibles
Goodwill
Receivables
Inventory
Retained earnings
Issue of
Newords
Newprefs
Ords to deb holders
Ba1c/d as capital reserve
20
500
10
50
300
375
150
125
420
Surrender of old ords
Surrender of old prefs
Surrender of debentures
1,500
200
250
1,950 1,950
Solution 2
Distribution of cash on a wind up
$000
860 Cash available
Paid out to;
Debenture holders (500)
360
Bank (300)
60
A . 1
morarsa s
Ordinary With scheme Without scheme
Capital 625/750 = 83% of the zero
company
Income 83% of profit stream (after zero
other distributions)
Preference With scheme Without scheme
Capital 150 60
Income 4% x 150 return on 60
Debentures With scheme Without scheme
Capital 375 500
Income 17% Of dividend stream; return on 500
10% x 250 interest
Solution 3
Retained profit
Add back excess depreciation
175,000
10
110,000
10
Distributable profit
$
17,500
(11,000)
$
900,000
6,500
$906,500
Note This could be reflected in the accounts by making
an annual transfer between reserves
Revaluation reserve Retained earnings
$ $ $ $
Annual Revaluation
TIF 6,500 excess 65,000 elf 906,500 Profit 900,000
TIF 6,500
SHARE VALUATION
OVERVIEW
Objective
To describe the methods available to value shares.
REASONS
I
METHODS
I
REGULATORY
ENVIRONMENT
Introduction
Asset based methods
Earnings based methods
Dividends based
City code on takeovers and mergers
Monopolies & Mergers Commission
Note: be prepared to use knowledge from paper 3.7 in a
question on business valuation
SHARE VALUATION
1 REASONS
A question may require you to value:
o a small holding,
o a majority holding.
The size of holding to be valued influences the choice of technique.
Note: there is considerable overlap with paper 3.7 in this area. This chapter
will provide an overview only.
2 METHODS
2.1 Introduction
2.1.1 General comments
Remember the value of a business is whatever a 3rd party will pay for it.
There are a series of methods available to allow for the estimate of a
valuation.
2.1.2 METHODS
____________ I ____________
ASSET
BASED
DIVIDEND
BASED
EARNINGS
BASED
These are not mutually exclusive and may be used:
o to provide a range ofprices as the basis for negotiation,
o to value different parts of a group under bid.
2.2 Asset based methods
Two issues must be addressed:
o which assets?
will all the assets on a balance sheet be valued?
eg Intangibles?
will only the assets on a balance sheet be valued?
eg Operating leases or other rights not
accounted for (eg airline landing slots;
distribution channels)
o what basis of valuation should be used?
Historic CostlMarket Value/Current Cost
SHARE VALUATION
2.3 Earnings based methods
2.3.1 PE Ratio
Value
Earnings
Earnings x PE Ratio
o need a figure to represent the future sustainable earnings
o this may be calculated by adjusting fmancial statements to take
account of future intentions post acquisition
PE Ratio
o We will use the PE of a proxy company ie one which is of:
similar size
similar industry
similar capital structure
o The PE ratio is often that of a quoted company. If it is being used
to value an unquoted company (as is usual) it should be reduced to
reflect the lower value of an unquoted entity.
2.3.2
Value
2.4
2.4.1
MY
ROCE
Earnings
ROCE
Earnings and ROCE - comments as above
Dividends based
Dividend yield
Future sustainable dividend stream
dividend yield
Dividends
o use the future forecast dividends
Dividend yield
o use the PE ratio of a proxy company adjusted if the proxy is
unquoted and the target is not.
2.4.2 Dividend valuation model
MY PV of future cash flows at the investors required rate ofreturn.
If cash flows are assumed to be constant dividends in perpetuity
MY
di
Ke
di = dividend at ti
Ke = investors required rate of return
SHARE VALUATION
If dividends are forecast to grow at a constant rate in perpetuity
MY
di
-- g = growth rate
Ke-g
3 REGULATORY ENVIRONMENT (USING THE UK AS AN
EXAMPLE)
3.1 City code on takeovers and mergers
Background
D Quoted companies must follow the rules of the stock exchange.
D The rules exist to ensure the fairness of the market thus maintaining
investor confidence.
D Business combinations are governed by the City code on takeovers
and mergers
Content
D It is a code ofbehaviour which companies must follow.
D It includes principles and detailed rules which must be followed.
D Aim is to ensure that takeover bids proceed smoothly with all
information being fairly available to all parties and without
distorting the market.
D Examples of rules:
Bidding companies directors must issue offer document
within 28 days of announcing intention.
Target companies' directors must not hinder the offer and
must give shareholders their assessment of it.
3.2 Monopolies & Mergers Commission
Decides on whether certain proposed business combinations are within the
public interest. Ifnot it can block the bid. It examines cases referred to it by
the Office of Fair Trading.
FOCUS
calculate and appraise a range of acceptable values for shares in an unquoted
company;
advise a client on the purchase of a business entity;
analyse the impact of accounting policy changes on the value and
performance of an entity.
ANALYSIS AND INTERPRETATION
OVERVIEW
Objective
To describe the need for analysis offmancial statements.
To describe the approach to interpreting financial information.
ACCOUNTING
ISSUES
TREND ANALYSIS
-
Introduction
Specific cost and price
indices
General price indices
USER AND USER
FOCUS
INTERPRETATION
I-- OF FINANCIAL
STATEMENTS
Introduction
Investors
Employees
Lenders
Suppliers and other creditors
Customers
Government and their agencies
Public
CREATIVE
ACCOUNTING
CORPORATE
FAILURE
PREDICTION
MODELS
--.- Altman
Argenti
Problems
Use ofratios Introduction
Limitations ofratios
Influences on ratios
Accountingpolicies
Business factors
Other indicators
PERFORMANCE
-
ACCOUNTING RATIOS
I--
EFFICIENCY
Significance
Key ratios
Commentar.f-v '----,
SHORT TERM
LIQUIDITY
Significance
Key ratios
Commentary
LONG TERM
SOLVENCY
Significance
Key ratios
Commentary
Significance
Keyratios
Commentary
INVESTORS
RATIOS
Significance
Key ratios
Commentary
1 ACCOUNTING ISSUES
Every issue addressed by all the other sessions has its roots in its effect on the
view shown by the accounts. This is therefore the issue which underlies
detailed studies of financial reporting.
The objective of financial reporting is to provide information about an entity
to external users of its financial statements. The needs ofusers are the key
issue in fmancial reporting.
2 USERS AND USER FOCUS
2.1 Introduction
Purpose of interpretation depends on users
I I I
Management Lenders
Shareholders &
Analysts
I I I
Cost control
Lending
Buy I hold
Isell shares
Profitability
Credit
analysis worthiness
Investment
decisions
I I I
Comparison required with:

0 Previous years
0 Other companies I industry data
0 Budget
2.2 Investors
The providers ofrisk capital and their advisers are concerned with risk inherent in, and
return provided by, their investment. They need information
o To help them determine whether they should buy, hold or sell.
o That enables them to assess the performance of management.
The aspect of the performance that will be of interest to the investor, and the type of
analysis performed to provide the basis for decision making depends on the nature of
the investor and/or the size of the holding (potential holding)
2.2.1 Potential takeover bidder
Aspect ofbusiness performance that is ofconcern;
Value of business on basis of earnings and assets.
Disposable value of assets in contrast with book value.
Financial and dividend policy and availability of cash.
Analysis will look at;
Several years' accounts with particular reference to
o profits including any exceptional items
o return on capital with reference to separate divisions where possible
o indications oftrue asset values
o liquid assets
2.2.2 Potential small investor
Possible enrichment by capital gain and/or dividends.
May wish for "safe" investment or be prepared to accept "risk" for higher returns.
Several years' accounts with particular reference to
o trend of sales, costs and earnings
o dividend record
o dividend cover.
2.2.3 Potential institutional investor
Good growth prospects coupled with fmancial stability.
Analysis of several years' accounts, paying particular attention to trends exhibited in
o sales, costs and profits
o dividend record
o dividend cover.
Attention will also be paid to
o maintenance of adequate liquid funds
o general control over net current assets
o gearing.
This analysis will be carried out by experienced investment analysts
2.3 Employees
Employees and their representative groups are interested in information about
o the stability and profitability of their employers.
o that enables them to assess the ability of the entity to provide remuneration,
retirement benefits and employment opportunities.
Relative movements in wage levels, profits and dividends.
Where there is a profit sharing scheme, the level ofprofits. Interest is probably limited
fairly largely to the income statement, although this may not give enough information.
Controversy exists as to the extent to which employees and/or their representatives should
receive financial information above and beyond the fmancial statements.
2.4 Lenders
Lenders are interested in information that enables them to determine whether their
loans, and the interest attaching to them, will be paid when due.
Aspect ofbusiness performance that is ofconcern:
Sufficiency of cash flow to: repay and adequacy of security.
Analysis will be:
More concerned with management accounts and budgeted cash flows.
Published accounts will indicate
o adequacy ofprofit levels,
o creation of other charges.
Despite the fact that published accounts may be a year or more out of date, debenture
holders will look at
o extent to which interest is covered by profits,
o priority of repayment and likely adequacy of security in event of liquidation.
2.5 Suppliers and other creditors
Suppliers and other creditors are interested in information that enables them to
determine whether amounts owing to them will be paid when due.
Trade creditors are likely to be interested in an entity over a shorter period than
lenders unless they are dependent upon the continuation of the entity as a major
customer.
Ability to pay for credit purchases on due date.
net current assets
make-up of net current assets
priority ofpayment on possible liquidation
earnings and growth record
The financial statements may be used by specialist credit agencies on behalfof
suppliers at large.
2.6 Customers
Customers have an interest in information about the continuation of an entity,
especially when they have a long term involvement with, or are dependent on, the
entity.
2.7 Government and their agencies
Governments and their agencies are interested in the allocation of resources and,
therefore, the activities of entity.
They also require information in order to regulate the activities of entity's, determine
taxation policies and provide a basis for national income and similar statistics.
2.8 Public
Entities affect members of the public in a variety of ways. For example, an entity
may make a substantial contribution to the local economy in many ways including
the number of people they employ and their patronage of the suppliers. Financial
statements may assist the public by providing information about the trends and recent
developments in the prosperity of the entity and the range of its activities.
3 INTERPRETATION OF FINANCIAL STATEMENTS
3.1 Use of ratios
Ratios are a tool to assist analysis. They focus attention on trends and
weaknesses and facilitate comparison over time and between companies.
Ratios are of no use in isolation. To be useful, a basis is needed for
comparison, eg
o previous years
o other companies
o industry averages
o budgeted v actual (for management use).
3.2 Limitations of ratios
Comparisons of ratios between entity's can be very difficult:
o Ratios may be distorted by differences in accounting policies and
also by the use of creative accounting techniques. (these issues are
covered more fully in paragraph 3.3 and section 10 below)
o Comparisons between different types of business are difficult
because of differing structures and market characteristics.
Ratios use historic data which may not be predictive as this ignores future
actions by management and changes in the business environment
The environment within which the business is operating may change. If the
business environment or the rate of inflation changes, then performance over
time using ratio analysis may be distorted
The ratios are based on an information set (ie fmancial statements) which
itself might be flawed or incomplete:
o Creative accounting can hide the true situation.
o Entity's may still leave assets and liabilities off the balance sheet.
(eg internally generated brands that fail the recognition tests of lAS
38; operating leases).
3.3 Influences on ratios
The story of the performance and position told by a set offmancial
statements is a function of
o Business factors (including the results ofmanagement actions) and
o Accounting policies
Users will be interested in the business factors ie the underlying performance
of the entity.
Users need to understand the effects that accounting policy can have on
reported figures. This understanding will then allow the user of the accounts
to adjust or rebase figures, as necessary, onto a basis which is consistent for
the comparison being undertaken.
In analysing sets of financial statements the following are important in this
context;
o changes of accounting policy
o creative accounting technique
Note that the project which produced a core set of standards for adoption by
IOSCO has in part removed areas of choice in financial reporting. This will
enhance comparability and make the use of creative accounting a little more
difficult.
The improvements project, whereby the IASB revised a large number of
standards in December 2003, also removed areas of choice in financial
reporting.
Choice of accounting policies can significantly affect the view presented by
the accounts, and the ratios computed, without affecting the business's core
ability to generate profits and cash. E.g..
o Revaluations v historic cost
If a business revalues its assets rather than carrying them at historic
cost, this will usually increase capital employed and reduce profit
before tax (due to higher depreciation). Thus, ROCE, profit
margins and gearing are all likely to be lower if a business revalues
its assets.
3.5 Business factors
Ratios may change over time or differ between companies because of the
nature of the business, or management actions in running the business. Such
factors include:
o Type of business eg retailer v manufacturer
This affects the nature of the assets employed and the returns
earned, eg a retailer may have higher asset turnover but lower
margins than a manufacturer.
o Quality of management
Better managed businesses are likely to be more profitable and have
better working capital management than businesses where
management is weak.
o State of economy and market conditions
If a market or the economy in general is depressed, this is likely to
adversely affect companies and make most or all oftheir ratios
appear worse.
o Management actions
These will be reflected in changes in ratios, eg price discounting to
increase market share is likely to reduce margins but increase asset
turnover; withdrawing from unprofitable market sectors is likely to
reduce turnover but increase profit margins.
o Changes in the business
Ifthe business diversifies into wholly new areas, this is likely to
change the resource structure and thus impact on key ratios. A new
acquisition near the year-end will mean that capital employed will
include all the assets acquired but profits of the new acquisition will
only be included in the IS for a small part of the year, thus tending
to depress ROCE.
3.6 Other indicators
Ratios are a key tool of analysis but other sources of information are also
available.
o Absolute comparisons can provide information without computing
ratios, eg comparing the balance sheet between this year and last
may show that new shares have been issued to repay borrowings or
fmance new investment, which may in turn impact on gearing and
ROCE.
o Background information supplied about the nature of the business
may help to explain changes or trends, eg you may be told that the
business has made an acquisition.
o The cash flow statement provides information as to how a business
has generated and used cash so that users can obtain a fuller picture
ofliquidity and financial adaptability.
4 ACCOUNTING RATIOS
Accounting ratios help to summarise and present financial information in a
more understandable form. They assist in assessing a business's
performance by identifying significant relationships between different
figures.
Ratios do not provide answers but focus attention on important areas.
Ratios divide into five main areas:
o Performance
o Short term liquidity
o Long term solvency
o Efficiency
o Investors' (or stock market) ratios
5 P R F O ~
5.1 Significance
Performance ratios measure rate of return earned on capital employed, and
analyse this into profit margins and use of assets. These ratios are frequently
used as the basis for assessing management effectiveness in utilising the
resources under their control.
5.2 Key ratios
Return on (total) capital employed (ROCE) (NB: alternative definitions)
Profit before interest and tax x 100
Share capital +reserves +debt
Measures overall efficiency of company in employing resources available to
it.
Return on shareholders' funds (ROSF)
Profit before tax
Share capital +reserves
Measures how efficiently company is employing funds that shareholders
have provided.
Considerations 1 - ROCEIROSF
When drawing conclusions from ROCEIROSF consider
o target return on capital (company or shareholder)
o real interest rates
o age of plant
o leased/owned assets
o revaluation of assets
Gross profit percentage
Gross profit x 100
Sales
Measures margin earned by company on sales.
Considerations 2 - GP %
Variations between years may be attributable to
o change in sales prices
o change in sales mix
o change in purchase/production costs
o inventory obsolescence
Overheads/sales percentage
Overheads x 100
Sales
Measures margin of overheads (fixed and variable - usually = distribution
costs + administrative expenses) to sales.
Ideally should be broken into variable overheads (expected to change with
sales) and fixed overheads (likely to move in more "lumpy" fashion).
Considerations 3 - Overheads/sales
May change because of
o change in the value of sales - investigate whether due to price or
volume changes
o company relocation to new premises
5.3 Commentary
RaCE measures return achieved by management from assets which they
control, before payments to providers of fmancing for those assets, ie lenders
and shareholders. Usually year end capital employed is used to compute this
ratio.
RaCE can be further sub-divided into profit margin and asset turnover (use of assets).
Profit margin
PBIT
Turnover
x
x
Asset turnover
Turnover
Capital employed
RaCE
PBIT
Capital employed
Profit margin is often seen as a measure of quality ofprofits. A high profit margin
indicates a high profit on each unit sold. Asset turnover is often seen as a quantitative
measure, indicating how intensively the management is using the assets.
A trade-off often exists between margin and asset turnover. Low margin businesses, eg
food retailers, usually have high asset turnover. Conversely, capital-intensive
manufacturing industries usually have relatively low asset turnover but higher margins,
eg electrical equipment manufacturers.
6 SHORT TERM LIQUIDITY
6.1 Significance
Short term liquidity ratios are used to assess a company's ability to raise cash
to meet payments when due. In practice, information contained in the cash
flow statement is often more useful when analysing liquidity.
6.2 Key ratios
Current ratio
o
Current assets
(usually expressed as X :1)
Current liabilities
Measures adequacy of current assets to cover current
liabilities.
Quick ratio (acid test)
o
Debtors +investments +cash
(usually expressed as X :1)
Current liabilities
Eliminates the slower moving item - inventory - from the calculation, thus
measuring real short-term liquidity.
Considerations 4 - Current and quick ratios
o Low ratio may indicate - liquidity problems
o High ratio may indicate - poor use of shareholder/company funds
o Consider constituent components ofratio - inventory
obsolescence (in case of current ratio), recoverability of
Receivables (in case ofboth ratios).
o Consider manipulation - if company has positive cash balances
and a ratio greater than 1:1, payment ofpayables just prior to the
year end will improve ratio.
6.3 Commentary
The current ratio is oflimited use as some current assets, eg inventory, may
not be readily convertible into cash, other than at a large discount. Hence,
this ratio may not indicate whether or not the company can pay its debts as
they fall due.
As the quick ratio omits inventory, this is a better indicator ofliquidity but is
subject to distortions, eg retailers have few receivables and utilise cash from
sales quickly, but finance their inventory from trade payables. Hence, their
quick ratios are usually low.
7 LONG TERM SOLVENCY
7.1 Significance
Gearing ratios examine the fmancing structure of a business. They indicate
to shareholders the degree ofrisk attached to the company and the sensitivity
of profits and dividends to changes in profitability and activity level.
7.2 Key ratios
Gearing ratio
o
debentures,
Fixed return capital preference shares,
loan stock
Equity capital +reserves
Debt
Equity
or
Debt
Debt +Equity
Measures relationship between company's borrowings and its share capital
and reserves.
A company is highly geared if it has a substantial proportion of its capital in
the form ofpreference shares, debentures or loan stock.
Interest on fixed return capital (and dividends on preference shares)
generally have to be paid irrespective of whether profits are earned - this
may cause a liquidity crisis if a company is unable to meet its fixed return
capital obligations. High gearing should therefore be accompanied by stable
profits.
Asset backing - generally loan capital is secured on assets - these should be
suitable for the purpose (not fast depreciating or subject to rapid changes in
demand and price).
Interest cover
Profit before interest
Interest
Measures the security of the interest payments
Consider accounting policies which affect profit before interest and interest
payable
Considerations 5 - Gearing
When drawing conclusions from gearing ratios consider
o assets in the balance sheet at historic cost or revalued amount -
revaluation offixed assets increases shareholders' funds and thus
decreases gearing
o use of off balance sheet finance to reduce gearing
7.3 Commentary
As many measures of gearing are used in practice, it is especially important
with gearing ratios that the ratios calculated are defmed.
If a business is highly geared, this usually indicates increased risk for
shareholders as, ifprofits fall, debts will still need to be financed, leaving
much smaller profits available to shareholders.
Highly geared businesses are usually more exposed to insolvency if there is
an economic downturn. However, returns to shareholders will grow
proportionately more in highly geared businesses where profits are growing.
Illustration: impact of gearing on earnings
Consider three situations for the same geared company, ignoring tax.
(1) (2) (3)
$ $ $
Profit before interest 200 100 300
Interest on fixed debt (100) (100) (100)
Profit available to shareholders (earnings) 100 200
Compared to situation (1)
Change in profits before interest -50% +50%
Change in earnings -100% + 100%
Low gearing provides scope to increase borrowings when potentially
profitable projects are available. Companies with low gearing are likely to
find it easier to borrow and should be able to borrow more cheaply than if
gearing is already high.
Gearing is also significant to lenders as they are likely to charge higher
interest, and be less willing to lend, to companies which are already highly
geared as such companies are more likely to default on the interest or debt
repayments
Interest cover indicates the ability of a company to pay interest out ofprofits
generated. Interest cover of less than two is usually considered
unsatisfactory. This indicates that the company may have difficulty financing
its debts if its profits fall and also indicates to shareholders that their
dividends are at risk as interest must be paid first, even ifprofits fall.
8 EFFICIENCY
8.1 Significance
Working capital ratios are an important indicator ofmanagement's
effectiveness in running the business efficiently, as for a given level of
activity, it is most profitable to minimise the level of working capital
employed in the business.
8.2 Key ratios
Inventory turnover
Cost of sales
Average stock
(= number of times inventory is turned over each year - the higher the
better)
Average stock x 365
Cost of sales
(= number of days it takes to turn inventory over once - the lower the better)
Ideally consider 3 components of inventory
o Raw material to volume ofpurchases
o WIP to cost of production
o Finished goods to cost of sales.
Considerations 6 - Inventory turnover
o High inventory turnover rate - may be efficient but risk of stock
outs increased
o Low inventory turnover rate - inefficient use ofresources and
potential obsolescence problems
o Accurate reflection?
Does position represent real inventory turnover rate for the year or does
year end inventory holding distort the true picture?
Debtor days
Averagetradedebtors x 365
Credit sales
Measures period of credit taken by company's
customers.
Ideal approximately 30 - 40 days, depending on the
industry.
Considerations 7 - Debtor days
A change in the ratio may indicate
o bad debt/collection problems
o change in nature of customer base (big new debtor - slow payer)
o change in settlement terms
o accurate reflection?
Do year end Receivables give reasonable indication of debtor profile for
the year as a whole?
Creditor days
Average trade creditors
x 365
Credit purchases
Measures number of days credit taken by company from suppliers.
Should be broadly consistent with debtor days.
Considerations 8 - Creditor days
A change in the ratio may indicate
o High figure may indicate liquidity problems with company
o Potential appointment of receiver by aggrieved creditors
o Accurate reflection?
Do year end payables give reasonable indication of creditor profile for year
as a whole?
8.3 Commentary
Inventory turnover, debtor days and creditor days give an indication of
whether a business is able to generate cash as fast as it uses it. They also
provide useful comparisons between businesses, eg on effectiveness in
collecting debts and controlling inventory levels. The average of opening and
closing inventories, Receivables and payables is often used to compute these
ratios.
9 INVESTORS'RATIOS
9.1 Significance
Investors' ratios help to establish characteristics of ordinary shares in
different companies eg
o Earnings per share will be important to those investors looking for
capital growth
o Dividend yield, dividend cover and dividends per share will be
important to those investors seeking income
9.2 Key ratios
D
" id d ield Net dividend per share +tax credit
IVI en Yle =
Current market price per share
Measures
o the dividend per share relative to price
o dividend policy rather than performance
o useful to income seekers
Considerations 9 - Dividend yield
Compare with the yield from other types of investment
o A high yield based on recent dividends and current share price
may arise because share price has fallen in anticipation of future
dividend cut
o Rapidly growing companies may have low yields based on
historic dividends, especially if current share price reflects
anticipated future growth in earnings and dividends
EPS
Dividend cover = --------
Net dividend per share
Considerations 10 - Dividend cover
Measures the security of the dividend payment
o Useful to income seekers
o Compare with industry
P
/ . (PE) . current market price per share
nce earnmgs ratio = ---------------------
EPS
Measures the number of years earnings which pay back the price of the share
Considerations 11 - PE ratio
Factors affecting the market
o Factors affecting EPS
o If calculated on historic earnings, a high PIEratio indicates
expectations of significant future earnings growth prepared to
pay large multiple of historic earnings
o Low PIEratio indicates expectations ofpoor growth prospects
Net assets per share (NAPS)
Measures equivalent of PIEratio for asset-based businesses where assets
revalued frequently
Considerations 12 - NAPS
NAPS usually less significant than other investors' ratios because investors cannot
realise assets
o IfNAPS > share price company should be broken up eg
through demerger
o Of little relevance in a "people" business eg public relations or
advertising as tangible asset base negligible, and company should
be considered from point of view of earnings generated by its
staffwho are not reported as assets on BS
EPS is also a very important ratio but it is not covered in this session.
9.3 Commentary
Ideally investors should use forecast information when making investment
decisions. In practice only historic figures are usually available.
Dividend yield measures dividend policy rather than performance. A high
yield based on recent dividends and current share price may arise because the
share price has fallen in anticipation of a future dividend cut. Rapidly
growing companies may exhibit low yields based on historic dividends,
especially if the current share price reflects anticipated future growth.
The dividend cover ratio shows how many times a company could have paid
its current dividend from available earnings ie an indication of how secure
dividends are.
The PE ratio is used to indicate whether shares appear expensive or cheap in
terms ofhow many years of current earnings investors are prepared to pay
for.
10 CREATIVE ACCOUNTING
10.1 Introduction
Creative accounting means choosing an accounting treatment to allow the
accounts to show a desired picture.
Accounting policies can significantly affect the view presented by accounts,
and ratios computed, without affecting the core ability of a business to
generate profits and cash.
Examples
Effect on EPS ROCE Gearing
Revaluation of fixed assets v inclusion Reduced Reduced Reduced
at historical cost
Apply foreign currency hedging Increased Reduced Reduced
provisions (where presentation
currency depreciates against foreign
currency)
Potential impact is especially important where
o accounting standards permit a choice
o judgement is needed in making accounting estimates
o there is no accounting standard
Examples
Accounting Choice Judgement
standard
lAS 11 Method of revenue recognition Contract profitability.
lAS 2 Method of inventory valuation
lAS 16 Method of depreciation
lAS 38 Development criteria
met?
11 CORPORATEFAILURE PREDICTIONMODELS
It is important for users of fmancial statements to be able to predict corporate
failure especially at times of recession.
11.1 Altman
Altman researched into the simultaneous analysis of groups of ratios. He
carried out an empirical study on historical data. He analysed combinations of
ratios of two groups of companies. One group was of companies that had
gone bust and the second group was of entities that had stayed in business.
Altman developed a model that linked together several ratios and weighted
them according to the results of his study. He found that by applying the
model to entities selected at random from those in the study he was able to
identify which group they came from with greater than 90% accuracy. The
model was not as useful in a predictive capacity when applied to entities
outside the groups.
The model emerged as below:
Z = 1.2X(l) + 1.4X(2) + 3.3X(3) + O.6X(4) +l.OX(5)
Where:
XCI) = Working capital/total assets
X(2) = retained earnings/total assets
X(3) = earnings before interest and tax/total assets
X(4) =market value of equity/book value of total debt
X(5) = sales/total assets
11.2 Argenti
This model is also based on empirical study. The model calculates scores
based on:
o Defects of the entity
o Management mistakes
o Symptoms of failure
Examples
Defects
Autocratic chief executive
Passive board
Lack of budgetary control

Mistakes
Over trading
High level of gearing
Failure oflarge project

Symptoms
Deteriorating ratios
Creative accounting
Declining morale
Declining quality
11.3 Problems associated with using the models
An underlying weakness is the lack of comparability of fmancia1 statements.
The ratios are based on historical data and this might not be a good indicator
of what will happen in the future. Prospective information would be a lot
more useful but this is generally unavailable to parties outside the
management of the company.
The underlying theory behind the models is suspect and little attempt has
been made to explain the logic of the models.
The models were developed in the 1960s - 1980s. The business environment
has changed since then.
The models fail to account for the impact of inflation.
12 TREND ANALYSIS
12.1 Introduction
Financial statements provide information, which can be used to assess the
performance of an entity over time. The picture given may be affected by
inflation.
There are two possible methods of dealing with this problem.
o Use specific cost and price indices
o Use a general price index
12.2 Specific cost and price indices
This is difficult to apply in practice as it involves the generation of a
completely new set of accounts for past periods at each year end.
This may lead to fluctuations in profits that could be difficult to interpret.
12.3 General price indices
This method focuses on fmancial changes.
It is easier to apply because the information is readily available and involves
a single inflation index rather than a combination of specific rates.
13 INTERPRETATION TECHNIQUE
If asked to interpret accounts
o make comments pertinent to user of accounts identify audience
from requirement
o only compute ratios if you can make use of them (and always
define ratios calculated)make comparisons and suggest reasons
o also compare absolute numbers in accounts to identify differences,
eg changes year-on-year
o look for influence of business factors and accounting policies
o be able to link different pieces of information and see what they
point towards
o indicate need for further information ifnecessary, and
o be aware of limitations of ratios.
Most marks in the exam are likely to be for specific, relevant comments
rather than solely for computations.
If asked to write a report, put a table ofratios in an appendix and refer to
them in the text as appropriate.
Use the requirement to structure your report/answer. Eg if the requirement
asks for a report on the profitability and liquidity of two entities your
headings should include:
PROFITABILITY LIQUIDITY
Entity A Entity A
EntityB
AND
Entity B
Use short punchy sentences.
FOCUS
discuss the financial and non-financial measures ofperformance;
describe the procedures in designing an accounting based performance
measurement system;
appraise different performance measures including return on investment,
residual income and economic value added;
evaluate the potential for corporate failure;
compare target levels ofperformance with actual performance.
SCOPE
IAS 7 CASH FLOW STATEMENTS
OVERVIEW
Objective
To provide information about historical changes in cash and cash equivalents
by means of a cash flow statement (CFS) which classifies cash flows during
the period from operating, investing and fmancing activities.
Applies to all enterprises
Importance ofcash flow
Benefits ofcash flow information
Definitions
L...-----r----....I
Classification
PRESENTATION
OPERATING
ACTIVITIES
Direct method
Indirect method
Techniques
INVESTING AND
FINANCING
ACTIVITIES
Separate reporting
Investing activities
Financing
PROFORMA
Direct method
Indirect method
Notes to the cash flow statement
COMPONENTS OF
CASH & CASH
EQUNALENTS
Reconciliation
1 SCOPE
1.1 Applies to all entities
Users of financial statements are interested in cash generation regardless of
the nature ofthe entity's activities.
Entities need cash for essentially the same reasons
o to conduct operations,
o to pay obligations,
o to provide returns to investors.
1.2 Importance of cash flow
To show that profits are being realised (eg that trade receivables are being
recovered).
To pay dividends.
To finance further investment.
1.3 Benefits of cash flow information
Provides information that enables users to evaluate changes in
o net assets,
o fmancial structure (including its liquidity and solvency),
o ability to affect amounts and timing of cash flows (to adapt to
changing circumstances and opportunities).
Useful in assessing ability to generate cash and cash equivalents.
Users can develop models to assess and compare the present value of future
cash flows of different entities.
Enhances comparability of reporting operating performance by different
entities (by eliminating effects of alternative accounting treatments).
Historical cash flow information may provide an indicator of the amount,
timing and certainty of future cash flows.
1.4 Definitions
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible
to known amounts of cash subject to an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the
entity and other activities that are not investing or fmancing activities.
Investing activities are the acquisition and disposal oflong-term assets and
other investments not included in cash equivalents.
Financing activities are activities that result in changes in the size and
composition of equity capital and borrowings.
2 PRESENTATION OF A CASH FLOW STATEMENT
2.1 Classification
OPERATING
Key indicator of sufficiency of
cash flows to
repay loans
maintain operating
capability
pay dividends
make new investments
without recourse to external
sources of fmance
Useful in forecasting future
operating cash flows
Primarily derived from principal
revenue-producing activities :.
generally result from transactions
and events net profit or loss.
INVESTING
Separate disclosure is
important - cash flows
represent extent to which
expenditures have been
made for resources
intended to generate
future income and cash
flows
Examples
Payments to acquire/
receipts from sales of
property, plant and
equipment,
intangibles
FINANCING
Separate disclosure is
useful in predicting
claims on future cash
flows by providers of
capital
Examples
Cash proceeds from
issuing
shares/equity
instruments
Examples
Cash receipts from
sale of goods/rendering
services
royalties, fees, commissions
Cash payments to
equity or debt
instruments of other
entitys and interests
in joint ventures
Cash advances and loans
made to other parties and
repayments thereof

debentures, loans,
notes, bonds,
mortgages, other
short or long-term
borrowings
Cash payments to
owners to acquire or
redeem own shares
suppliers for goods/services
and on behalf of employees
Cash repayments of
borrowings
3 REPORTING CASH FLOWS FROM OPERATING ACTIVITIES
Either 1
3
.1 Direct method
ENCOURAGED - provides info useful in
estimatingfuture cash flows which is not
available under indirect method
Discloses major classes of gross
cash receipts and gross cash
payments
Information obtained either
From accounting records, or
By adjusting sales, cost of sales for
changes during period in
inventories and operating
receivables and payables
other non-cash items
other items for which cash
effects are investing/fmancing
cash flows.
3.3 Techniques
Direct method
Or
13.2 Indirect method
Adjusts profit or loss for
effects of
non-cash transactions
(eg depreciation)
any deferrals or
accruals of past or
future operating cash
receipts or payments
items of income or
expense associated
with investing or
financing cash flows.
Steps 1 Cash receipts from customers
Less cash paid to suppliers and employees
::::) Cash generated from operations
Step 2 Payments for interest and income taxes.
::::) Net cash from operating activities
Indirect method
Step 1(a) Start with profit before tax.
Step 1(b)Adjust for non-cash items and investing and financing items
accounted for on the accruals basis.
=> Operating profit before working capital changes
Step 1(c) Making working capital changes.
=> Cash generated from operations
Workings - examples
Interest payable ale
$
Bal blf
$
x
Cash paid
Bal elf
x B
x
x
Interest charge for year x
x
Tax payable ale
$
Bal blf
$
x
Tax paid
Bal elf
x B
x
x
Tax charge for year x
x
Thiswill include any deferred tax balances.
4 REPORTING CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES
4.1 Separate reporting
Major classes of gross cash receipts and gross cash payments arising from
investing and financing activities should be reported separately.
4.2 Investing activities
Purchase ofproperty plant and equipment - this must represent actual
amounts paid.
Proceeds from sales of tangible assets.
Illustration
A new car is acquired at full list price of $50,000. $10,000 is allowed by way ofpart-
exchange against the cost of the car, when an old car is traded-in.
Solution
Payment to acquire tangible asset
Receipts from sale of tangible asset
WORKINGS
$40,000
Nil
Tangible asset - Cost ale
$ $
Bal blf
Additions
Revaluations
x
x
x
x
Disposals
Balance clf
x
x
x
Tangible asset - Accumulated depreciation ale
$
Balance blf
$
x
Disposals
Revaluations
Balance clf
x
x
x
x
Charge for the year x
x
Tangible asset - Disposal ale
$ $
Cost
Profit on sale
x
x
Accumulated depreciation
Proceeds
Loss on sale
x
x
x
x x
4.3 Financing
Proceeds from issuance of share capital
Illustration
Issue 100,000 $1 ordinary shares at $1.50 per share.
Solution
Dr Cash $150,000 (figure in cash flow)
Cr Share capital $100,000
Cr Share premium $50,000
Proceeds from long-term borrowings
Dividends paid
Dividends payable ale
$ $
Cash paid
Bal elf
x B
x
x
Bal blf
Interim dividend (paid)
Final dividend (proposed)
x
x
x
x
5 COMPONENTS OF CASH AND CASH EQUIVALENTS
5.1 Reconciliation
Disclose components of cash and cash equivalents and present a
reconciliation of amounts in the cash flow statement with equivalent items
reported in the balance sheet.
6 PROFORMA
6.1 Direct method
Cash flows from operating activities
Cash receipts from customers
Cash paid to suppliers and employees
Cash generatedfrom operations(see over for alternative)
Interest paid
Income taxes paid
Net cash from operating activities
Cash flows from investing activities
Purchase ofproperty, plant and equipment
Proceeds from sale of equipment
Interest received
Dividends received
Net cash used in investing activities
Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Dividends paid
Net cash used infinancing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period (Note)
Cash and cash equivalents at end of period (Note)
Could be shown as an operating cash flow.
$
x
(x)
x
(x)
(x)
(x)
x
x
x
x
x
(x)
$
x
x
x
x
x
x
6.2 Indirect method
$ $
Cash flows from operating activities
Adjustments for
Depreciation
Investment income
Interest expense
Operating profit before working capital changes
Increase in trade and other receivables
Decrease in inventories
Decrease in trade payables
Cash generated from operations
... remainder as for the direct method
6.3 Notes to the cash flow statement
x
x
(x)
x
x
(x)
x
(x)
x
Cash and cash equivalents
Cash and cash equivalents consist of cash on hand and balances with banks, and investments in money
market instruments. Cash and cash equivalents included in the cash flow statements comprise the
following balance sheet amounts.
2004 2003
$ $
Cash on hand and balances with banks
Short-term investments
x
x
x
x
x
x
7 GROUP CASH FLOW STATEMENTS
7.1 Introduction
The group cash flow statement is prepared from the consolidated financial statements and
therefore reflects the cash flows of the group (ie the parent and its subsidiaries).
The method of preparation is the same as for the individual company cash flow statement but
additional cash flows may arise as follows.
o Dividends paid to the minority interest.
o Dividends received from associates (and other equity accounted entities)
o Cash consequences of acquisition or disposal of subsidiaries
7.2 Minority interests
Use a T account to calculate dividends paid to minorities.
Minority interests
% of foreign exchange losses
Dividends paid to MI (B)
$ $
Bid -Per CBS MI X
X - Proposed dividend to MI X
X % of PAT X
% of revaluation surplus X
Cld - Per CBS MI X
- Proposed dividend to MI X
X X
lAS 7 CASH FLOW STATEMENTS
7.3 Associated undertakings
Use a T account to calculate dividend from associate.
Bid-FA inv-CBS
- Dividend debtor from A
% of PAT
Cost of new shares
$
X
X
X
X Dividends received from A (B)
$
X
C/d-FAInv-CBS X
- Dividend debtor from A X
X X
Example 1
Extracts from group accounts
Balance sheet
2004 2003
$000 $000
Investments
Interests in associated undertakings 280 271
(share of net assets only)
Current liabilities
Proposed dividend to members of parent 66 68
Proposed dividend to minority interests 5 7
Minority interests 55 35
Income statement
2004
$000
Income from interests in associate 29
Minority interests
Ordinary dividends
Required:
(43)
(98)
Show how the above would be reflected in the cash flow statement of the company.
Solution
7.4 Acquisition and disposal of subsidiaries
Show separately the cash flow arising on the acquisition or disposal as an investing activity
Disclose
o A summary of the effect of the acquisition or disposal, indicating how much of the
consideration comprised cash
Example 2
Marr Inc acquired Corben Inc for $22,224,000 during 2004. The consideration comprised
3,173,000 25c shares with a market value of $3 each with the balance in cash.
The net assets of Corben Inc on acquisition were as follows.
Tangible non current assets
Inventories
Receivables
Cash at bank and in hand
Payables
Bank overdrafts
Minority shareholders' interests
Required:
$000
12,194
9,385
15,165
1,439
(25,697)
(6,955)
(9)
5,522
Show how the acquisition will be reflected in the group cash flow statement and notes.
Solution
Each of the individual net assets of a subsidiary acquired/disposed of during the period must
be excluded when comparing group balance sheets for cash flow calculations. Their net cash
effect is already dealt with (as purchase of subsidiary and net cash/overdraft acquired) in the
statement.
Subsidiary acquired in the subtract inventory, receivables, payables

period etc at date of acquisition from movement on
these items when calculating the operating
cashflow
Subsidiary sold in the period add inventory, receivables, payables etc at

date of acquisition from movement on these
items when calculating the operating
cashflow
Example 3
Continuing from the above example, Marr Inc, the following additional information is supplied.
The profit before tax of the Marr Inc group for the year (including the post acquisition profit of
Corben Inc) was $20,199,000. Depreciation for the year was $3,158,000, and plant and machinery
with a net book value of $1,002,000 was disposed offor $1,052,000.
Extracts from consolidated balance sheet
Tangible non current assets
Inventory
Receivables
Trade payables
Required:
2004 2003
$000 $000
160,064 148,518
99,481 77,834
42,874 25,264
80,326 48,939
Show how the above information would impact the cash flow statement of the company.
Example 4
Gita Inc had held a 75% investment in Meena Inc for many years. On 31 August 2004 it disposed
of the investment in full for $1,000,000 cash.
Meena Inc's balance sheet at 31 August 2004 included
Inventory
Receivables
Cash
$000
473
520
100
Gita Inc's year end is 31 December and the consolidated balance sheet included
Inventory
Receivables
Cash
Required:
2004
$000
1,668
4,041
392
2003
$000
2,082
4,876
183
Indicate how the disposal will impact on the consolidated cash flow statement of Gita Inc for the
year ended 31 December 2004.
8 ADDITIONAL DISCLOSURES
There are a number of extra disclosures which should be made in most cases to support the
main cash flow statement.
These are:
o Analysis of cash and cash equivalents
o Major non cash transactions
o Cash and cash equivalents held by the group
o Reporting futures, options and swaps
o Voluntary disclosures
Each of these is considered briefly below.
8.1 Analysis of cash and cash equivalents
A note should be presented that reconciles amounts held as cash and cash equivalents at the
start and end of the period.
Cash and cash equivalents
Illustration
2004 2003 Change
$ $ $
Cash on hand 1,300 (1,300)
Bank overdraft (11,000) (11,000)
(11,000) 0,300) (12,300)
8.2 Major non cash transactions
Non cash transactions should be excluded from the main cash flow statement. However some
of these do have a major impact on investing and fmancing activities and should be disclosed
in a note.
Examples of such transactions could include:
o the issue of shares in order to acquire assets
o the conversion of debt to equity
o the inception of significant lease arrangements
In each case a brief description of the nature and purpose of the transaction should be given.
8.3 Cash and cash equivalents not held by the group
Where significant cash and cash equivalent balances are not available for use by the group,
this fact along with the amounts involved, should be disclosed. The situation may arise
where, for example, exchange controls or legal restrictions operate in a subsidiary's country of
operation.
8.4 Reporting futures, options and swaps
Cash payments for and receipts from such contracts should normally be classified as investing
activities. There are two exceptions to this:
o The instrument is held for trading purposes and thus is part of operating activities.
o The cash flows are considered to be fmancing in nature and should be reported as
such.
8.5 Voluntary disclosures
The standard encourages the disclosure of other information which may be relevant to users
seeking to assess the fmancial health of a business. These are:
o the amount ofundrawn borrowings that are available and any restrictions on their
future use.
o the amount of cash flows that represent increases in capacity rather than
maintenance of existing capacity.
o the amount of cash flows from each major activity related to interests in joint
ventures which have been accounted for using proportional consolidation.
o a segmental analysis, by industry and region, of cash flows arising from each major
activity. This information should be presented by way of a note and could appear as
follows:
Cash flows Segment 1 Segment 2 Total
Operating activities x x X
Investing activities x x X
Financing activities
x x X
X !
X
9 FURTHER CONSIDERATIONS-
INTERPRETATION OF CASH FLOW STATEMENTS
9.1 Introduction
Cash flow statements are a vital source of information about an entity's financial health.
The statement should be read in conjunction with the other primary statements. None of these
statements in isolation is sufficient.
The cash flow statement can be used to obtain information about an entity's:
o Liquidity (ability to service short term obligations)
o Solvency (ability to continue in business over the longer term)
o Financial adaptability (ability to meet cash demands and take advantage of new
future opportunities)
The user of cash flow information should be able to break the statement down and consider
the impact of the following:
o Unusual or discretionary cash flows
o Non cash changes
9.2 Illustration
Cash flows from operating activities $
Net profit before taxation 14,400
Adjustments for:
Depreciation 4,000
Profit on sale of equipment ( 100)
Interest expense 1,000
Operatingprofit before working capital charges 19,300
Increase in trade and other receivables ( 7,250)
Increase in inventories ( 5,000)
Decrease in trade payables ( 3,000)
Cash generated from operations 4,050
Interest paid ( 500)
Income taxes paid ( 1,200)
Net cash from operating activities 2,350
Cash flows from investing activities
Purchase ofproperty, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities
Cash flows from financing activities
Repayment of long term borrowings
Net cash used infinancing activities
Net decrease in cash and cash equivalents
Cash and cash equivalents at beginning ofperiod
Cash and cash equivalents at end ofperiod
(11,000)
350
( 4,000)
(10,650)
( 4,000)
(12,300)
1,300
(11,000)
9.3 Comments
Overall decrease in cash and cash equivalents of ($12,300) looks poor, but this figure needs
further analysis using the rest ofthe statement as follows:
Cash from operations $4,050 is reasonably strong however this is only 28% ofprofit before
taxation ($14,400)
Low "quality" ofprofits can be ascribed to significant increases in working capital (eg
inventories and receivables). The reasons for this need investigating.
Unusual or one off cash flows include $11,000 to purchase new property and plant. This
could represent the replacement of old assets or the acquisition of new ones as part of an
expansion. A similar large cash outflow may not be anticipated next year.
The repayment oflong term borrowings ($4,000) has improved the solvency of the business
and will reduce interest payments in future years.
In conclusion, with tight working capital management and fewer one off outflows next year,
the cash flow position should improve. However the large cash outflow this year presents
management with an immediate liquidity problem (overdraft $11,000) which will need to be
monitored carefully.
FOCUS
discuss the usefulness of cash flow information;
prepare a group cash flow statement classifying cash flows by standard headings and including the
acquisition or disposal of subsidiaries;
deal with associates, joint ventures and foreign currencies.
EXAMPLE SOLUTIONS
Solution 1 Group cash flow statement (extracts)
Dividend from associate
Dividends paid to minority shareholders in subsidiary undertaking (W2)
Equity dividends paid (W3)
WORKINGS
$000
20
(25)
(100)
Bid
Share ofprofit
$000
271
29
300
Dividends received from A ~
C/d
$000
20
280
300
(2)
Dividends paid to MI (B)
C/d-
(3)
Dividends paid to group ~
C/d
Minority interests
$000
25 B/d-
5
55 IS
85
Dividends
$000
100 Bid
66 IS
$000
7
35
43
85
$000
68
98
166 166
Solution 2
Group cash flow statement (extracts)
$000
Acquisitions and disposals
Purchase of subsidiary
Net overdrafts acquired with subsidiary (6,955 - 1,439)
Notes to the group cash flow statement (extracts)
(1) Purchase of subsidiary undertakings
Net assets acquired
Tangible fixed assets
Inventories
Receivables
Cash at bank: and in hand
Creditors
Bank:overdrafts
Goodwill ~
Satisfied by
Shares allotted (3,173 x 3)
Cash ~
(12,705)
(5,516)
$000
12,194
9,385
15,165
1,439
(25,697)
(6,955)
(9)
5,522
16,702
22,224
9,519
12,705
22,224
The subsidiary acquired during the year contributed $X to the group's net operating cash
flows, paid $X in respect of net returns on investments and servicing of finance, paid $X in
respect of taxation and utilised $X for capital expenditure.
Solution 3
Profit before tax
Gain or loss on disposal
Depreciation charges
Increase in inventories (99,481 -77,834 - 9,385)
Increase in receivables (42,874 - 25,264 - 15,165)
Increase in payables (80,326 - 48,939 - 25,697)
Net cash inflow from operating activities
Capital expenditure
Purchase oftangible fixed assets
Sale ofplant and machinery
Purchase of subsidiary undertaking
Net overdrafts acquired with subsidiary
WORKING
Non current assets
$000 $000
20,199
(50,000)
3,158
(12,262)
(2,445)
5,690
35,660
(3,512)
1,052
2,460
(12,705)
(5,516)
(18,221)
Bid
Subsidiary acquired
Additions (B)
$000
148,518
12,194
3,512
Depn
Disposals
Cld
$000
3,158
1,002
160,064
164,224 164,224
Solution 4
$000
Profit before tax
Increase in inventories (1,668 + 473 - 2,082)
Decrease in receivables (4,041 + 520 - 4,876)
Net cash inflow from operating activities
Disposal of subsidiary undertaking
Net cash disposed of with subsidiary
Notes to the group cash flow statement (extracts)
(6) Disposal of subsidiary undertaking
Net assets disposed of
Inventories
Receivables
Cash
Profit/(loss) on disposal
Satisfied by
X
(59)
315
x
1,000
(100)
$000
473
520
100
(X)
x
X/(X)
1,000
Cash 1,000
THE EFFECTS OF CHANGING PRICES
OVERVIEW
Objective
ounting
Limitation ofhistorical cost ace

INTRODUCTION
Holding gains
Conclusions
Effects oflower inflation

DESIGN OF SYSTEMS OF ACCOUNTS
Purpose
Definition
3 decisions
Combinations
Double entries
CURRENT CURRENT COST
PURCHASING ACCOUNTING
POWER
ACCOUNTING
Background
Background
Specific adjustments
Specific adjustments
lAS 29

The problem
Solution
Historical Cost Financial Statements -
balance sheets
Historical Cost Financial Statements -
Income Statement
Gain or Loss on Net Monetary Position
Current Cost Financial Statements
Taxes
Cash Flow Statement
Corresponding Figures
Consolidated Financial Statements
Economies Ceasing to be
Hyperinflationary
Disclosures
1 INTRODUCTION
1.1 Limitation of historical cost accounting
Historical cost accounting matches current revenues with out-of-date costs in respect of:
o Cost of goods sold,
o Measure of fixed assets consumed (ie depreciation).
Historical cost balance sheet does not measure resources employed by reference to up-to-date
costs in respect of
o Inventory,
o Tangible assets.
Return on capital employed is distorted as the net assets are distorted.
Historical cost accounting does not measure holding gainsllosses separately from operating
results.
Historical cost accounting does not measure any gain/loss on monetary items due to inflation.
Historical cost accounting gives a misleading trend of results.
1.2 Holding gains
Holding gains are changes in the value of asset due to inflation during the period of
ownership.
There are 2 types of holding gain:
o Unrealised
the asset is still owned at the balance sheet date and
revaluation surpluses
o Realised
asset has been sold (inventory) or charged to the income statement
(depreciation) during the period
o NB: Realised holding gains are actually included in the historic cost profit but not
separately disclosed! highlighted as such.
This can lead to poor quality decisions being made.
Illustration
Mr. Geller starts a business with a single item of inventory which had a cost of $200.
During the period the inventory is sold for $250 and inflation was 5%.
Income statement
$ $
Historic Cost Current Cost
Revenue 250 250
Cost of sales (200) (200
x
1.05) (210)
Profit 50 40
Year end balance sheet
$ $
Net Assets 250 250
Share Capital 200 200
Reserve 10
Retained earnings 50 40
250 250
Based on historical costs $50 might be distributed as a dividend. This would
this would erode the capital base ofbusiness.
1.3 Conclusions
Historical cost accounts are adequate for stewardship purposes but unsatisfactory for decision
making both internal and external.
1.4 Effects of lower inflation
Distortions will still exist because:
o some effects are cumulative
o inflation may have been higher in earlier years
o the company may be subject to specific price changes in excess ofthe rate of
general inflation.
2 DESIGN OF SYSTEMS OF ACCOUNTS
2.1 Purpose
Systems of accounts exist to measure profit
2.2 Definition
Profit = Net assets at end of period - Net assets at start
or I = Capital at end of period - Capital at start
2.3 3 decisions
Decisions are needed in 3 key areas when designing a system of accounts.
Basis of asset valuation
o Possibilities
historical cost
historical cost adjusted
current cost
Unit of measurement
o Possibilities
Nominal $
Unit of constant purchasing power
Capital maintenance concept
o Possibilities
Financial capital
Money
Real
Operating capital
Example 1 - Capital maintenance
Financial capital
Money Real
Operating
capital
Net Assets at end 250
Net Assets at start (200)
50
Revenue
Cost of sales
250
(200)
50
l
I
50
50
200
Balance sheet net assets
Inflation adjustment
Shareholders funds:
Brought forward
Inflation reserve
Retained earnings
l
I
I I
I I
_.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._.._ Tr .
250 I I
I I
I I
I I
J J
250
o Start period with 1 item of inventory with a cost $200 and sold it for $250
General inflation 5%
Specific inflation 10%
Analysis
Capital maintenance concept and holding gains are concepts that are intimately linked.
If a company fails to consider inflation it may make decisions which will harm it.
o This company could payout $50 as a dividend. This would erode its capital base in
real terms.
If a company does include the effects of general inflation
In this case by tucking away 5% x 200 = $10 as a "non distributable" reserve.
And suffers specific inflation in excess of general inflation it will erode its capacity to operate.
2.4 Combinations
Basis of asset Unit of Capital maintenance
valuation + measurement + concept = SYSTEM
HC + Nominal $ + FCM-Money =HCA
HC adjusted + UCpp +FCM* -Real =CPP
CC + Nominal $ + OCM =CCA
CC + Nominal $ +FCM* -Real =CCA
(Real terms version)
* both preserve financial capital but in a different way
HC Historic cost
CC Current cost
UCPP Unit of current purchasing power
HCA Historical cost accounting
Cpp
Current purchasing power
CCA Current cost accounting
OCM Operating capital maintenance
FCM Financial capital maintenance
2.5 Double entries
The double entries needed to change RCA to the other systems are relatively straightforward:
CPP Real Terms CCA OCMCCA
Asset valuation Dr Assets Dr Assets Dr Assets
CrReserve CrIS CrReserve
Use general inflation Use specific inflation Use specific inflation
Unit of measurement All items (except
those already there) are
NO ADWSTMENT NO ADWSTMENT
uplifted to year end
value
The other side of the
entry is to reserves
Capital maintenance Dr IS Dr IS Dr IS
CrReserve CrReserve CrReserve
Change in RPI Change in RPI COSA
over period of x opening CC ADA
holding of shareholders MWCA
monetary items funds GA
3 CURRENTPURCHASINGPOWER
3.1 Background
Current purchasing power (CPP) measures profits as the increase in the current purchasing
power of equity, based on the change in the general level of inflation (represented by the RPI).
Profits are therefore stated after allowing for the declining purchasing power of money due to
general price inflation.
The technique involves stating all items in the accounts in stable monetary units - the year
and value. (Note: this covers the first two decisions)
and
A profit adjustment to protect the purchasing power of capital.
Balance sheet
o Monetary items: no adjustment necessary as they are already stated in the year end
values.
o Non Monetary items are generally stated at historic cost and therefore must be
restated to the year end value.
Income statement
o All items that are not already stated in year end values must be restated. Unless told
otherwise, we assume that sales and purchases etc accrue evenly throughout the
period.
o A holding gain/loss is calculated to maintain the purchasing power of monetary
items.
4 CURRENT COST ACCOUNTS - OCM VERSION
4.1 Background
Current cost accounting (CCA) measures profits as the increase in capacity to operate. Profits
are stated after allowing for amounts that need to be set aside to maintain the capacity to
operate, ie taking account of the inflation rates specific to the assets ofthe company.
All items are restated to current cost.
Note: Monetary items are already stated at current cost - only non monetary items require
restatement.
What is current cost?
o deprival value
Lower of

Replacement cost Higher of
NRV Economic value
Note: in practice it was almost always replacement cost
it should be the depreciated replacement cost (ie the net
replacement cost)
Income statement adjustments are made to maintain the operating capability of the company.
This is achieved by simple double entries.
(But the calculation of the figures to be double entered can be quite tricky).
Aim of the operating adjustments
(1) Is to restate the cost of sales onto the same price terms as the revenue ie to match like
with like.
This is essentially an averaging exercise.
Revenue
cos
x -
Arise evenly
through year
ie at a mid
year price
opening inventory X
purchases X
X
closing inventory (X) (X)
X
--- Already at mid year price
Depreciation (X)
X
.. opening inventory must be inflated to a mid year price
closing inventory must be deflated to a mid year price
(2) To account for gain/loss on holding monetary items.
6 lAS 29 - FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES
6.1 The problem
In a hyperinflationary economy, reporting of operating results and financial position in the
local currency without restatement is not useful. Money loses purchasing power at such a rate
that comparison of amounts from transactions and other events that have occurred at different
times, even within the same accounting period, is misleading.
Hyperinflation is indicated by characteristics ofthe economic environment ofa country which
include, but are not limited to, the following:
o The general population prefers to keep its wealth in non-monetary assets or in a
relatively stable foreign currency. Amounts oflocal currency held are immediately
invested to maintain purchasing power;
o The general population regards monetary amounts not in terms of the local currency
but in terms of a relatively stable foreign currency. Prices may be quoted in that
currency;
o Sales and purchases on credit take place at prices that compensate for the expected
loss ofpurchasing power during the credit period, even ifthe period is short;
o Interest rates, wages and prices are linked to a price index; and
o The cumulative inflation rate over three years is approaching, or exceeds, 100%.
6.2 Solution
The financial statements of an entity that reports in the currency of a hyperinflationary
economy, whether they are based on a historical cost approach or a current cost approach,
should be stated in terms of the measuring unit current at the balance sheet date. The
corresponding figures for the previous period, and any information in respect of earlier
periods should also be stated in terms of the measuring unit current at the balance sheet date.
The gain or loss on the net monetary position should be included in net income and separately
disclosed.
6.3 Historical Cost Financial Statements - balance sheets
Balance sheet amounts not already expressed in terms of the measuring unit current at the
balance sheet date are restated by applying a general price index.
o Monetary items are not restated
o Assets and liabilities linked by agreement to changes in prices, such as index linked
bonds and loans, are adjusted in accordance with the agreement in order to ascertain
the amount outstanding at the balance sheet date. These items are carried at this
adjusted amount in the restated balance sheet.
o All other assets and liabilities are non-monetary. Some non-monetary items are
carried at amounts current at the balance sheet date, such as net realisable value and
market value, so they are not restated. All other non-monetary assets and liabilities
are restated.
o Some non-monetary items are carried at amounts current at dates other than that of
acquisition or that of the balance sheet, for example property, plant and equipment
that has been revalued at some earlier date. In these cases, the carrying amounts are
restated from the date of the revaluation.
o The restated amount of a non-monetary item is reduced, in accordance with
appropriate International Accounting Standards, when it exceeds the amount
recoverable from the item's future use (including sale or other disposal) ..
An investee that is accounted for under the equity method may report in the currency of a
hyperinflationary economy. The balance sheet and income statement of such an investee are
restated in order to calculate the investor's share of its net assets and results of operations.
Where the restated financial statements ofthe investee are expressed in a foreign currency
they are translated at closing rates.
At the beginning of the first period of application of this Standard, the components of owners'
equity, except retained earnings and any revaluation surplus, are restated by applying a
general price index from the dates the components were contributed or otherwise arose. Any
revaluation surplus that arose in previous periods is eliminated. Restated retained earnings are
derived from all the other amounts in the restated balance sheet.
At the end of the first period and in subsequent periods, all components of owners' equity are
restated by applying a general price index from the beginning ofthe period or the date of
contribution, if later.
6.4 Historical Cost Financial Statements - Income Statement
All items in the income statement are expressed in terms of the measuring unit current at the
balance sheet date. Therefore all amounts need to be restated by applying the change in the
general price index from the dates when the items of income and expenses were initially
recorded in the fmancial statements.
6.5 Gain or Loss on Net Monetary Position
In a period of inflation, an entity holding an excess of monetary assets over monetary
liabilities loses purchasing power and an entity with an excess of monetary liabilities over
monetary assets gains purchasing power to the extent the assets and liabilities are not linked to
a price level.
The gain or loss on the net monetary position is included in net income.
6.6 Current Cost Financial Statements
Balance Sheet - Items stated at current cost are not restated because they are already
expressed in terms of the measuring unit current at the balance sheet date. Other items in the
balance sheet are restated.
Income Statement - The current cost income statement, before restatement, generally reports
costs current at the time at which the underlying transactions or events occurred. Cost of sales
and depreciation are recorded at current costs at the time of consumption; sales and other
expenses are recorded at their money amounts when they occurred. Therefore all amounts
need to be restated into the measuring unit current at the balance sheet date by applying a
general price index.
Gain or Loss on Net Monetary Position -. The gain or loss on the net monetary position is
accounted for as explained above for HC financial statements
6.7 Taxes
The restatement of financial statements in accordance with this Standard may give rise to
differences between taxable income and accounting income. These differences are accounted
for in accordance with IAS 12, Income Taxes.
6.8 Cash Flow Statement
This Standard requires that all items in the cash flow statement are expressed in terms of the
measuring unit current at the balance sheet date.
6.9 Corresponding Figures
Corresponding figures for the previous reporting period, whether they were based on a
historical cost approach or a current cost approach, are restated by applying a general price
index so that the comparative fmancial statements are presented in terms ofthe measuring unit
current at the end of the reporting period.
Information that is disclosed in respect of earlier periods is also expressed in terms of the
measuring unit current at the end of the reporting period.
6.10 Consolidated Financial Statements
A parent that reports in the currency of a hyperinflationary economy may have subsidiaries
that also report in the currencies of hyperinflationary economies.
o The fmancial statements of any such subsidiary need to be restated by applying a
general price index of the country in whose currency it reports before they are
included in the consolidated financial statements issued by its parent.
o Where such a subsidiary is a foreign subsidiary, its restated financial statements are
translated at closing rates.
6.11 Economies Ceasing to be Hyperinflationary
When an economy ceases to be hyperinflationary and an entity discontinues the preparation
and presentation of fmancial statements prepared in accordance with the provisions of IAS 29
it should treat the amounts expressed in the measuring unit current at the end of the previous
reporting period as the basis for the carrying amounts in its subsequent financial statements.
6.12 Disclosures
The fact that the fmancial statements and the corresponding figures for previous periods have
been restated for the changes in the general purchasing power of the reporting currency and,
as a result, are stated in terms of the measuring unit current at the balance sheet date;
Whether the financial statements are based on a historical cost approach or a current cost
approach; and
The identity and level of the price index at the balance sheet date and the movement in the
index during the current and the previous reporting period.
FOCUS
discuss the impact of price level changes on business performance;
EXAMPLE SOLUTION
Solution 1
Capital maintenance
Financial capital Operating
Money Real capital
NA at end 250 250 250
NA at start (200) (210) (220)
50 40 30
Revenue 250 250 250
COS (200) (200) (200)
50 50 50
Inflation adjustment (10) l (20)-
50 40 I 30 I
I I
I I
I I
Balance sheet net assets 250 250 I 250 I
I I
I I
Shareholders funds: I I
B/f 200 200 J 200 J
Inflation reserve 10 20
Retained earnings 50 40 30
250 250 250
IAS 33 EARNINGS PER SHARE
OVERVIEW
Objective
To explainthe purpose andcalculation of earnings per share.
I
INTRODUCTION
Earnings performance
Scope
Definitions
'---------r--------'
BASIC
DILUTEDEPS
Purpose
Method
Options
EARNINGS
Which earnings?
WEIGHTED
AVERAGE
NUMBER OF
SHARES
Partly paid shares
Issues for consideration
Issues ofshares where no
consideration is
received
ORDER OF
DILUTION
Background
Method
Contracts settled
in shares
MULTIPLE
CAPITAL
CHANGES
DISCLOSURE
1 INTRODUCTION
1.1 Earnings performance
Earnings per share shows the trend of earnings performance for a company over the years.
It is felt to be more useful than an absolute profit figure which will not contain information
about the increase in investment that has been made in the period.
It is not useful in comparing companies.
1.2 Scope
lAS 33 should be applied by entities whose ordinary shares or potential ordinary shares are
publicly traded and by entities that are in the process of issuing ordinary (or potential
ordinary) shares in public securities markets. If both parent and consolidated financial
statements are presented the information required under lAS 33 need be presented only on the
basis of the consolidated information.
An entity who has neither ordinary nor potential ordinary shares which are publicly traded,
but which discloses earnings per share, should calculate and present earnings per share in
accordance with lAS 33.
1.3 Definitions
An ordinary share is an equity instrument that is subordinate to all other classes of equity
instruments.
A potential ordinary share is a financial instrument or other contract that may entitle its holder
to ordinary shares.
Examples include:
o convertible instruments,
o share options and warrants,
o share purchase plans, and
o shares which will be issued subject to certain conditions being met.
Warrants or options are fmancial instruments that give the holder the right to purchase
ordinary shares.
From lAS 32: Financial instruments: Presentation and disclosure
Afinancial instrument is any contract that gives rise to both a financial asset of one entity and
a fmancialliability or equity instrument of another entity.
An equity instrument is any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
2 BASIC EARNINGS PER SHARE (EPS)
Basic EPS should be calculated by dividing the profit or loss for the period attributable to
ordinary shareholders by the weighted average number of ordinary shares outstanding during
the period.
3 BASIC EARNINGS
3.1 Which earnings?
Basic EPS should be based on the consolidated profit or loss for the period attributable to
ordinary shareholders. It will be the consolidated profit after tax after allowing for any
minority interest.
The aim is to use that part of the total profit that is left for the equity shareholders after all
other calls on the figure.
4 BASIC WEIGHTED AVERAGE NUMBER OF ORDINARY SHARES
The number of ordinary shares should be the weighted average number of ordinary shares
outstanding during the period.
4.1 Partly paid shares
The number of ordinary shares should be calculated based on the number ofpaid shares.
Therefore if there are any shares which are not paid up we need to calculate the equivalent
number ofpaid shares for the purposes ofEPS calculations.
Illustration 1
No of shares
Dustin has the following capital structure
$1 Ordinary shares issued at I January 2004
- paid up
- paid up to 75c
On 31 March 2004 the remaining 25c were received
There were no other issues of shares during the year to 31 December 2004
Required
Calculate the number of ordinary shares to be used in the EPS calculation
Solution 1
I January to 31 December - paid up
1,000,000
600,000
400,000
600,000
I January to 31 March - paid up to 75c
I April to 31 December - fully paid up
= 400,000*75c*3/12
= 400,000*$1 *9/12
75,000
300,000
Weighted average number of ordinary shares for EPS calculation
975,000
4.2 Issues Cor consideration
The number in existence at the beginning of the period should be adjusted for shares that have
been issued for consideration during the period. You may see these issues described as issues
at full market price.
Consideration may be received in a number of ways.
o issue for cash
o issue to acquire a controlling interest in another entity
o redemption of debt
In each case the earnings will be boosted from the date of issue. In order to ensure consistency
between the top and bottom of the basic EPS calculation the shares are also included from the
date of issue.
., Weight the number of shares
Proforma
If there was a new issue of shares 3 months into an accounting
period
Number
Number of shares in issue before new issue x = X
12
Number of shares in issue after new issue x = X
12
x
4.3 Issues of shares where no consideration is received
The weighted average number of ordinary shares outstanding during the period and for all
periods presented should be adjusted for events, that have changed the number of ordinary
shares outstanding, without a corresponding change in resources. eg
o bonus issues
o bonus elements in another issue ( eg a rights issue )
o share splits
o reverse share splits
Bonus issues
o Treat as if the new shares have been in issue for the whole of the period
o Multiply the number of shares in issue by the bonus fraction
Illustration 2
Bonus issue of 1 for 10
Bonus fraction:
10+1 11
----
10 10
o The EPS will fall (all other things being equal) because the earnings are being
spread over a larger number of shares. This would mislead users when they compare
this years figure to those from previous periods.
o The comparative figure and any other figures from earlier periods which are being
used in an analysis must be adjusted. This is done by multiplying the comparative
by the inverse of the bonus fraction
Illustration 3
Last year's EPS x 10
11
Rights issues
o A rights issue has features in common with a bonus issue and with an issue at full
market price. A rights issue gives a shareholder the right to buy shares from the
company at a price set below the market value.
thus the company will receive a consideration which is available to boost
earnings - like an issue at full price, and
the shareholder receives part of the share for no consideration - like a
bonus issue.
o The method of calculating the number of shares in periods when there has been a
rights issue reflects the above.
o A bonus fraction is applied to the number of shares in issue before the date of the
rights issue and the new shares issued are pro-rated as for issues for consideration.
Proforma
Number of shares in issue before the rights issue x x Rights issue bonus fraction
12
Number of shares in issue after the rights issue x
12
Rights issue bonus fraction:
Cum rights price
Theoretical ex rights price
and can be calculated as follows
Number
x
x
x
Cum
(before the
rights issue)
Rights
(With the
issue)
Ex
(After the
rights issue)
Number
of shares
Value per
share
Total value
of shares
TERP = Value per share after the rights issue (obtained by dividing the total value by the number of
shares after the rights issue
Fraction Value per share before the rights issue
Value per share after the rights issue
According to the above table

Example 1
BInc 1 January 2004
31 March 2004
50c Shares in issue 1,000,000
Rights issue 1 for 5 at 90c
Market Value of shares $1
Number
1.1.2004 - 31.3.2004
1.4.2004- 31.12.2004
Rights issue bonus fraction
Shares
Cum
Rights
Ex
TERP
Fraction
CRP
TERP
@$ $
o For presentational purposes, in order to ensure consistency, the comparative figure
for EPS must be restated to account for the bonus element of the issue. This is
achieved by multiplying last years EPS by the inverse of the rights issue bonus
fraction
5 MULTIPLE CAPITAL CHANGES
Method
o Write down the number of shares at start of year
o Look forward through year and write down the total number of shares in issue after
each capital change
o Multiply each number by the fraction of the year that it was in existence
o Ifthe capital change has a bonus element multiply all preceding slices by the bonus
fraction
o (Remember to multiply the previous year's EPS by the inverse of all bonus
fractions)
Example 2
Multiple capital change for Dilbert who has an accounting year ending 31
December.
1.1.2004
28.2.2004
31.3.2004
31.7.2004
30.9.2004
Required:
1,000,000 in issue
Full market price 400,000
Bonus issue 1 for 2
Full market price 900,000
Rights issue 1 for 3 [Bonus fraction
Calculate the number of shares which would be used in the basic EPS
calculation
Solution
1.1.2004- 28.2.2004
1.3.2004 - 31.3.2004
1.4.2004 - 31.7.2004
1.8.2004 - 30.9.2004
1.10.2004 - 31.12.2004
Number
6 DILUTED EPS
6.1 Purpose
Diluted EPS is calculated as a warning to existing shareholders that the EPS in the future may
fall.
Potential ordinary shares may currently exist whose owners may become shareholders in the
future i.e. holders of share options.
If these parties become equity shareholders the earnings will be spread over a larger number
of shares ie they will become diluted.
Potential ordinary shares should be treated as dilutive only if their conversion to ordinary
shares would decrease profit per share from continuing ordinary operations.
6.2 Method
The profit attributable to ordinary shareholders and the weighted average number of shares
outstanding should be adjusted for the affects of all dilutive potential ordinary shares. ie
o A new EPS is calculated using:
a new number of shares
a new earnings figure
The new number of ordinary shares
o This should be the weighted average number of ordinary shares used in the basic
EPS calculation plus the weighted average number of ordinary shares which would
be issued on the conversion of all the dilutive potential ordinary shares into ordinary
shares.
o Dilutive potential ordinary shares should be deemed to have been converted into
ordinary shares at the beginning ofthe period or, iflater, the date of the issue of the
potential ordinary shares, i.e. we should treat the potential ordinary shares as if they
were ordinary shares from the date the potential ordinary share was issued.
o New number of shares
Basic number
No of shares which could
rank in the future:
from the later of
- 1st day of accounting period
- date of issue
x
x
x
The new earnings figure
o The amount of profit or loss for the period attributable to ordinary shareholder, used
in the basic EPS calculation, should be adjusted by the after-tax effect of the
potential ordinary shares becoming ordinary shares. ie add back
Any dividends on dilutive potential ordinary shares which have been
deducted in arriving at the profit or loss for the period attributed to
ordinary shareholders.
Interest recognised in the period for the dilutive potential ordinary shares
Any other changes in income or expense that would result from the
conversion of the dilutive potential ordinary shares.
Example 3
Diluted EPS
Convertible debentures
1.1.2004 Shares in issue
Profit for the year ended 31.12.2004
31.3.2004 Company issues $200,000 6% convertible debt
Terms of conversion
100 shares/$100 ifby 30.6.2006
110 shares/$100 ifby 30.6.2009
Tax rate 33%
BasicEPS
200,000
---'----- = 20c
1,000,000
Required:
Calculate diluted EPS
Solution
Diluted eps:
1,000,000
$200,000
Basic
New shares
Post tax interest saved
Diluted
Number of
shares
1,000,000
Profit
$
200,000
When there has been an actual conversion of the dilutive potential ordinary shares into
ordinary shares in the period, a further adjustment has to be made.
The new shares will have been included in the basic eps from the date of conversion. These
shares must then be included in the diluted eps calculation up to the date of conversion.
Illustration
Diluted EPS - Actual conversion during the year
5% Convertible debentures
(terms of conversion 120 ords for $100)
1,000,000
$100,000
$200,000
31.3.2004 Holders of $25,000 debentures converted to ordinary shares.
Tax rate 30%
Number of Profit
shares $
Basic 1,000,000 200,000
New shares on conversion
9/12 x $25,000
x 120
100
22,500
1,022,500 200,000
basi . $200,000 19 6
:. asic eps IS = . c
1,022,500
Dilution adjustments
Unconverledshares:
$75,000 x 120
100
90,000
Interest: $75,000 x 5% x 0.7 2,625
Converted shares pre conversion adjustment
3/12 x $25,000 x 120
100
7,500
Interest
3/12 x $25,000 x 5% x 0.7 219
1,120,000 202,844
D'1 d . $202,844 181
1 ute eps IS = . c
1,120,000
6.3 Options
An entity should assume the exercise of di1utive options and other di1utive potential ordinary
shares of the entity.
o The assumed proceeds from these issues should be considered to be received from
the issue of shares at fair value
o The difference between the number of shares issued and the number of shares that
would have been issued at fair value should be treated as an issue of ordinary shares
for no consideration.
Options will be dilutive only when they result in the entity issuing shares at below fair value.
Each issue of shares under an option is deemed to consist of two elements
o A contract to issue a number of shares at a fair value (this is taken to be the average
fair value during the period).
These are non-dilutive
o A contract to issue the remaining ordinary shares granted under the option for no
consideration.(a bonus issue)
These are dilutive
Example 4
Options
Average fair value
The company has in issue options to purchase
Exercise price
Required
Calculate the diluted EPS for the period.
Solution
Diluted eps:
1,000,000
$100,000
$8
200,000 ords
$6
Basic
Shares issued for
no consideration
Diluted
Number of
shares
1,000,000
Profit
$
100,000
EPS
7 ORDER OF DILUTION
7.1 Background
Potential ordinary shares should be treated as dilutive only if their conversion to ordinary
shares would decrease profit per share from continuing ordinary operations.
In other words, if a company has potential ordinary shares in issue they are not automatically
included in the diluted EPS calculation. There is a test to apply in respect of each category of
potential ordinary share to see if it is in fact dilutive.
Note that the test is made with reference to the profit per share from continuing ordinary
operations (this is described as the control number in the standard) and not the profit figure
used in the basic EPS calculation. If there were gains or losses from discontinued operations
in the profit for the year, those gains or losses would be eliminated for purposes of the order
of dilution.
Potential ordinary shares are dilutive when their conversion to ordinary shares decreases the
EPS from continuing operations.
Potential ordinary shares are anti-dilutive when their conversion to ordinary shares increases
the EPS from continuing operations.
Only dilutive shares are included in the diluted EPS calculation.
7.2 Method
In deciding whether potential ordinary shares are dilutive or not each category is considered
separately in sequence from the most dilutive to the least dilutive
o Step 1 Calculate the incremental EPS of each potential ordinary share separately.
This will then enable ranking of the potential ordinary shares.
This is calculated, for example, by taking the interest saved on convertible items and
dividing by the new number of ordinary shares on conversion (prorated in the year
of issue of convertible item).
o Step 2 Adjust the basic EPS by each potential issue in order of dilution.
This is done by calculating the EPS after each of the potential issues.
o Step 3 Select the lowest figure as the diluted EPS.
o This may not be the last EPS that you calculate in this process.
The method ensures that the figure for the diluted EPS is based on the maximum potential
dilution
ExampleS
Earnings
Ordinary shares in issue
Potential ordinary shares
Convertible preference shares
10% convertible debenture
Required:
Calculate the diluted EPS for the year.
Solution S
$10,000,000
2,000,000
Number of shares
Dividend per share
Conversion terms
Nominal value
Conversion terms
Taxation rate
100,000
$4.9
1 forI
$500,000
500 shares for each
$1000 debt.
40%
7.3 Contracts that may be settled in sharesChyba! Zalozka neni definovana,
If the entity has issued a contract whereby it has the option to settle that contract in either its
own equity shares or cash, the entity will presume that the contract will be settled in equity
shares for the purposes of calculating the diluted EPS.
If the contract is to be settled in equity shares or cash and the holder ofthe contract has the
option, then for diluted EPS purposes the most dilutive of the two options will be used for the
calculation ofthe diluted EPS.
8 DISCLOSURE
An entity should present basic and diluted earnings per share (or loss per share if negative) on
the face of the income statement for each class of ordinary shares that has a different right to
share in the profit for the period.
An entity should present basic and diluted earnings per share with equal prominence for all
periods presented.
An entity should disclose the following:
o The amounts used as the numerators in calculating basic and diluted earnings per
share, and a reconciliation of those amounts to the net profit or loss for the period
o The weighted average number of ordinary shares used as the denominator in
calculating basic and diluted earnings per share, and a reconciliation ofthese
denominators to each other.
If an entity discloses, an additional EPS figure using a reported component of profit other than
profit or loss for the period attributable to ordinary shareholders, such amounts should be
calculated using the weighted average number of ordinary shares determined in accordance
with lAS 33 ie
o An entity may use a non standard profit figure to calculate an EPS in addition to that
required by lAS 33 but it must use the standard number of shares in this calculation
o If a profit figure is used which is not a reported as a line item in the income
statement, a reconciliation should be provided between the figure and a line item
which is reported in the income statement.
If an EPS figure includes the effects of
o a capitalisation or bonus issue
o or share split
o or decreases as a result of a reverse share split,
The calculation of basic and diluted earnings per share for all periods presented should be
adjusted retrospectively.
If these changes occur after the balance sheet date but before issue of the financial statements,
the per share calculations for those and any prior period financial statements presented should
be based on the new number of shares. When per share calculations reflect such changes in
the number of shares, that fact should be disclosed.
Basic and diluted EPS of all periods presented should be adjusted for the effects of errors, and
adjustments resulting from changes in accounting policies.
FOCUS
calculate diluted EPS by reference to dilutive potential ordinary shares, loss per share and
particular types of dilutive instruments including partly paid shares, employee incentive
schemes and contingently issued shares.
EXAMPLE SOLUTIONS
Solution 1 Rights issues
B Inc 1.1.2004
31.3.2004
Shares in issue 1,000,000
Rights issue 1 for 5 at 90c
MV of shares $1
Number
1.1.2004 - 31.3.2004
3 1
1,000,000 x - x --
12 .9833
1.4.2004- 31.12.2004
9
1,200,000 x -
12
Rights issue bonus fraction
254,237
900,000
1,154,237
Cum
Rights
Ex
TERP
Fraction
Shares
5
1
6
5.9
6
@$
1
.9
$
5.0
.9
5.9
.9833
1
.9833

Solution 2 Multiple capital change
1.1.2004 - 28.2.2004
1,000,000
2 3 22
261,905
x x x
12 2 21
1.3.2004 - 30.3.2004
1,400,000
3 22
183,333
x x x
12 2 21
1.4.2004 - 31.7.2004
2,100,000
4 22
733,333
x x
12 21
1.8.2004 - 30.9.2004
3,000,000
2 22
523,810
x x
12 21
1.10.2004 - 31.12.2004
4,000,000
3
=1,000,000
x x
12
2,702,381
Solution 3 Diluted eps
Basic
Dilution
Shares: $200,000 x 110 x
100 12
Interest
9
$200,000 x 6% x - x 0.67
12
Number of
shares Profit
$
1,000,000 200,000
165,000
6,030
1,165,000 206,030

EPS 17.68c
Solution 4
Diluted eps:
Basic
Dilution W
Number of
shares
1,000,000
50,000
Profit
$
100,000
EPS
10c
1,050,000 100,000
WORKING
Proceeds of issue 200,000 x $6
9.5c
$1,200,000
Number of shares
Number that would have been issued at FV $1,200,000+ $8 = 150,000
Number actually issued 200,000
Number for "free" 50,000
Solution 5
Diluted eps:
Step 1 Rank:the potential issues
Prefs
Debentures
INumberof
shares
100,000
250,000
IProfit
$
490,000
30,000
EPS
$4.9
$0.12
The debentures are the most dilutive
Step 2 Diluted eps:
Number of
shares Profit EPS
$
Basic 2,000,000 10,000,000 $5
Debentures 250,000 30,000
2,250,000 10,030,000 $4.46
Prefs 100,000 490,000
2,350,000 10,520,000 $4.48
Diluted EPS is $4.46
IAS 14 SEGMENT REPORTlNG
OVERVIEW
Objective
To provide users of financial statements with information on the relative size, profit
contribution, and growth trend of the different industries and geographical areas in which a
diversified entity operates.
Purpose
INTRODUCTION
Scope
Definitions
I
SEGMENTS
I
Primary versus secondary

REPORTING
Business segments
Geographical segments
Usual basis
Reportable segments
Disclosures
Analysis ofrevenue
Analysis ofassets
Sundry disclosures
1 INTRODUCTION
1.1 Purpose
The objective of segmental information is to assist users to:
o understand the past performance of the entity,
o assess the risks and returns of the entity,
o make informed judgements about the entity as a whole.
Rates ofprofitability, opportunities for growth, future prospects, and risks to investments may
vary greatly among industry and geographical segments. Thus, users need segment
information to assess the prospects and risks of a diversified entity which may not be
determinable from aggregated data.
1.2 Scope
lAS 14 should be applied in complete sets of financial statements that comply with lASs.
Complete sets of financial statements include a balance sheet, an income statement, a cash
flow statement, a statement of changes in equity and notes.
lAS 14 should be applied by entities whose equity or debt securities are publicly traded and
by entities that are in the process of issuing equity or debt securities in public securities
markets.
Entities whose equity or debt securities are not publicly traded that choose to disclose segment
information should also comply fully with the requirements of lAS 14.
If a set of financial statements contains both the parent's fmancial statements and consolidated
financial statements, segment information need only be presented for the consolidated
financial statements.
1.3 Definitions
A business segment is a distinguishable component of an entity engaged in providing an
individual product or service or a group of related products or services and that is subject to
different risks and returns from those of other business segments. Factors that should be
considered in determining whether products and services are related include:
o The nature of the products or services,
o The nature of the production processes,
o The type or class of customer for the products or services,
o The methods used to distribute the products or provide the services, and
o If applicable, the nature of the regulatory environment, for example, banking,
insurance, or public utilities.
A geographical segment is a distinguishable component or an entity that is engaged in
providing products or services within a particular economic environment and that is subject to
risks and returns that are different from those of components in other economic environments.
Factors that should be considered in identifying geographical segments include:
o similarity of economic and political conditions,
o relationships between operations in different geographical areas,
o proximity of operations,
o special risks associated with operations in a particular area,
o exchange control regulations, and
o the underlying currency risks.
A reportable segment is a business segment or a geographical segment identified based on the
above definitions for which segment information is required to be disclosed by this standard.
Segment revenue is revenue reported in the entity's income statement that is directly
attributable to a segment and the relevant portion of entity revenue that can be allocated on a
reasonable basis to a segment, whether from sales to external customers or from transactions
with other segments of the same entity. Segment revenue does not include:
o interests or dividend income, including interest earned on advances or loans to other
segments, unless the segments operations are primarily of a fmancial nature,
o gains on sales of investments or gains on extinguishments of debt unless the
segment's operations are primarily of a financial nature.
Segment revenue includes an entity's share of profits or losses of associates, joint ventures, or
other investments, accounted for under the equity method only if those items are included in
consolidated or total entity revenue.
Segment revenue includes a joint venturer's share of the revenue of a jointly controlled entity
that is accounted for by proportionate consolidation in accordance with IAS 31 Interests in
Joint Ventures.
Segment expense is expense resulting from the operation activities of a segment that is directly
attributable to the segment and the relevant portion of an expense that can be allocated on a
reasonable basis to the segment, including expenses relating to sales with external customers
and expenses relating to transactions with other segments of the same entity. Segment
expense does not include:
o interest, including interest incurred on advances or loans from other segments,
unless the segment's operations are primarily of a financial nature
o losses on sales of investments or losses on extinguishments of debt unless the
segment's operations are primarily ofa financial nature,
o an entity's share of losses of associates, joint ventures, or other investments
accounted for under the equity method,
o income tax expense,
o general administrative expenses etc that arise at the entity level and relate to the
entity as a whole.
Segment expenses include a joint venturer's share of the expenses of a jointly controlled
entity that is accounted for by proportionate consolidation.
Segment result is segment revenue less segment expense. Segment result is determined before
minority interest.
Segment assets are those operating assets that are employed by a segment in its operating
activities and that either are directly attributable to the segment or can be allocated to the
segment on a reasonable basis.
If the segments segment results includes interest or dividend income, its segment assets
include the related receivables, loans, investments or other income-producing assets.
Segment assets do not include income tax assets but do include investment accounted for
under the equity method (but only if the related profit is included in segment results) or a
share of a j oint ventures operating assets ifproportionate consolidation is used.
Segment liabilities are operating liabilities that result from the operating activities of a
segment and that either are directly attributable to the segment or can be allocated to the
segment on a reasonable basis.
If a segments segment result includes interest expense, its segment liabilities include the
related interest bearing liabilities.
Segment liabilities do not include income tax liabilities but do include a joint venturers share
of the liabilities of a jointly controlled entity that is accounted for using proportionate
consolidation.
2 REPORTING
2.1 Primary versus secondary
lAS 14 has introduced the concept ofprimary and secondary reportable segments.
An entity has to decide which of the segmentation bases (business or geographical) is more
important; this is then taken as being the primary segment.
An entity must make extensive disclosures on the primary segments supported by less
rigorous disclosures on the secondary.
The decision as to which is the primary segment is governed by the primary source and nature
of the risks and returns of an entity.
o If the entity's risks and returns are affected predominantly by the differences in its
products and services its primary format for reporting segmental information should
be the business segments.
o Ifthe entity's risks and returns are affected predominantly by the fact that it operates
in different areas then its primary format for reporting segmental information should
be the geographical segments.
o In each case the other becomes the secondary segment.
In the majority of cases the primary segment will be the business segment.
2.2 Business segments
A business segment is a distinguishable component of an entity engaged in providing:
o an individual product or service or a group ofrelated products or services, and
o that is subject to different risks and returns from those of other business segments.
2.3 Geographical segments
A geographical segment is a distinguishable component or an entity that is engaged in
providing products or services within a particular economic environment and that is subject to
risks and returns that are different from those of components in other economic environments.
There are two ways of segmenting on a geographical basis:
o by location of assets,
o by location of customers.
The view taken depends on circumstances
Primary Secondary
Business
Geographical using a mixture of

location of customers and location of
assets.
Geographical by location of
Business and some extra information

customers about location of assets (if different
from the location of customers).
Geographical by location of assets
Business and some extra information

about location of customers (if
different from the location of assets).
2.4 Usual basis
An entity's internal reporting structure will usually form the basis for identifying the
predominant risks and returns faced by an entity.
o The internal reporting structure will usually be established to provide management
with information to enable them to control each significant component of the
business, whether by product or by area.
o This information will be useful to users.
2.5 Reportable segments
A segment should be treated as reportable when:
o the majority of its sales are to external customers,
and
o it has at least 10% of
total sales including those to other segments, or
total profit of all profit making segments, or
total loss of all loss making segments, or
total assets of all segments.
A segment may be treated as reportable if it falls below these limits.
Smaller segments may be combined with others to form a reportable segment.
At least 75% of external revenue must be attributed to reportable segments (the balance is
included as an unallocated balancing figure). This may involve the combination of smaller
segments.
Once a segment has been identified based on meeting the 10% criteria an entity should
continue to disclose in respect of that segment even if it becomes smaller than the benchmark.
2.6 Disclosures
Primary Secondary
Income statement items
Revenue - external
./ ./
Revenue from other segments
./
Basis of inter segment pricing
./
Profit or loss
./
Depreciation or amortisation
./
Non cash expenses
./
Income from associates & joint ventures
./
Exceptional items Encouraged
Balance sheet items
Total operating assets
./ ./
Cost of acquisition of non current assets
./ ./
Total operating liabilities
./
Investment in associates & joint ventures
./
Cash flow items (IAS7) lAS 7 encourages cash
disclosure by segment
2.7 Analysis of revenue
If the primary analysis is by business the secondary should be by location of customers.
If the primary analysis is by location of assets the secondary should be by business with an
analysis by location of customers if different from location of assets.
2.8 Analysis of assets
If the primary analysis is by business the secondary should be by location of assets.
If the primary analysis is by location of assets the secondary should be by business with an
analysis by location of customers if different from location of assets.
2.9 Sundry disclosures
A reconciliation of segment details of revenue, expenses, assets and liabilities to the figures in
the main financial statements.
Changes in segment accounting policies.
Types of products and services in each segment.
Composition of each geographical segment.
3 ILLUSTRATION
Illustration 1
Bill Inc is a UK company which reports in dollars.
Bill Inc has a year ended 31December
Primary reporting is on a business basis
Intersegment External Total revenue Earnings before Net invested
revenue revenue interest and tax capital
2004 2003 2004 2003 2004 2003 2004 2003 2004 2003
$m $m $m $m $m $m $m $m $m $m
Plastics 400 350 1,600 1,500 2,000 1,850 500 400 1,000 900
Construction 350 300 1,200 1,000 1,550 1,850 300 250 850 700
Plant rental 100 120 1,000 800 1,100 920 250 200 780 680
Other 20 50 200 120 220 170 5 10 120 120
Segment total 870 820 4,000 3,420 4,870 4,240 1,055 860 2,750 2,400
Less internal (870) (820) (870) (820)
Group total 0 0 4,000 3,420 4,000 3,420 1,055 860 2,750 2,400
Segment % ofprofit of Balance sheet Investments in Depreciation
Liabilities equity value of equity non current on non current
accounted accounted assets assets
companies companies
2004 2004 2004 2004 2004
$m $m $m $m $m
Plastics 1,800 0 0 1,000 120
Construction 1,500 20 120 1,400 280
Plant rental 1,300 40 460 2,000 420
Other 400 0 0 800 140
Segment total 5,000 60 580 5,200 960
Less internal (500)
Group total 4,500 60 580 5,200 960
Secondary reporting is on a geographical basis
Revenue Earning before Net Investment
interest and tax capital in non
invested current
assets
2004 2003 2004 2003 2004 2004
$m $m $m $m $m $m
Europe 1,500 1,200 500 400 1000 2,500
Ofwhich UK 1,000 800 300 250 700 2,000
The Americas 1,000 900 250 200 700 1,500
Asia 800 600 150 150 400 600
Oceania 500 520 105 70 350 400
Africa 200 200 50 40 300 200
4,000 3,420 1,055 860 2,750 5,200
FOCUS
discuss the problem areas in segmental reporting including defmitions of segments, common
costs, inter segment sales etc;
discuss the different approaches used to disclose segment information;
discuss the importance of segmental information to users of financial statements.
IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS
OVERVIEW
Objective
To explain the need for IFRS 5 "Non-current Assets Held for Sale and
Discontinued Operations".
Reasonsfor issuing IFRS 5
INTRODUCTION
DEFINITIONS
Component
Disposal group
Discontinued operation
HELD FOR SALE
CLASSIFICATION
Definitions
Held for sale non-current assets
Abandoned non-current assets
Measurement
Changes to a plan ofsale
Accountancy Tuition Centre (International Holdings) Ltd 2005
PRESENTATION
AND
DISCLOSURE
Purpose
Discontinued operations
Continuing operations
Heldfor sale non-current assets
3801
1 INTRODUCTION
1.1 Reasons for issuing IFRS 5
To establish principles for the classification, measurement and presentation of
held-for-sale non-current assets.
To replace lAS 35 "Discontinuing Operations".
The information provided enhances the ability ofusers of financial statements to
make projections of an entity's cash flows, earnings-generating capacity, and
financial position by segregating information about discontinued assets and
operations from the information about continuing operations.
As part of a short-term convergence project with the Financial Accounting
Standards Board (FASB) in the United States, IFRS 5 was issued to achieve
substantial convergence with FASB Statement 144 "Accounting for the
Impairment and Disposal of Long-Lived Assets".
2 DEFINITIONS
2.1 Component of an entity
Operations and cash flows that are clearly distinguishable from the remainder
of the entity - both operationally and for financial reporting purposes.
So a component will have been a cash-generating unit (or a group ofcash-
generating units) when heldfor use.
2.1.1 "distinguishable"
A discontinued operation must be distinguishable operationally and for
reporting purposes. This will be the case if:
o its operating assets and liabilities can be directly attributed to it;
o its income (gross revenue) can be directly attributed to it; and
o at least a majority of its operating expenses can be directly
attributed to it.
Elements are directly attributable to a component ifthey would be eliminated
when the component is discontinued.
2.2 Disposal group
A group of assets to be disposed of collectively in a single transaction, and
directly associated liabilities that will be transferred in the transaction.
Disposal may be by sale or otherwise.
The assets include goodwill acquired in a business combination if the group is:
o a cash-generating unit to which goodwill has been allocated; or
o an operation within such a cash-generating unit.
2.3 Discontinued operation
A component of an entity that either:
D has been disposed of; or
D is classified as held for sale,
and:
D represents a separate major line ofbusiness or geographical area of operations;
D is part of a single co-ordinated plan to dispose of that line of
business or area of operations; or
D is a subsidiary acquired exclusively with a view to resale.
Discontinued operations may qualify as restructurings as defined by lAS 37
"Provisions, Contingent Liabilities and Contingent Assets" but not all
restructurings will be treated as discontinued operations.
2.3.1 "separate"
A discontinued operation must be a separate major line ofbusiness or
geographical area of operations.
D A reportable segment (lAS 14 Segment Reporting), would normally
satisfy this criterion.
D A part of a segment may also satisfy the criterion.
D For an entity that does not report segment information, a major
product or service line may also satisfy the criteria ofthe definition.
Business entities frequently close facilities, abandon products or even product
lines, and change the size of their work force in response to market forces.
These changes are not usually, discontinued operations but they can occur in
connection with a discontinued operation.
For example:
D gradual or evolutionary phasing out of a product line or class of
service;
D discontinuance of several products within an ongoing line of
business;
D shifting of some production or marketing activities for a particular
line ofbusiness from one location to another;
D closing of a facility to achieve productivity improvements or other
cost savings; and
D sale of a subsidiary whose activities are similar to those of the
parent or other subsidiaries or associates within a consolidated
group.
2.3.2 "a single co-ordinatedplan"
A discontinued operation may be disposed of in its entirety or piecemeal, but
always pursuant to an overall co-ordinated plan to discontinue the entire
component.
Illustration 1
Discontinuing operations
Discontinuing operations which the Company pursuant to a single
plan is disposing of, terminating or abandoning and which can be
separated from other activities, presented separately under seg-
ment information.
Annual Report 2003 GN Store Nord
This illustration uses the lAS 35 terminology "discontinuing" rather than "discontinued".
3 HELD FOR SALE CLASSIFICATION
3.1 Definitions
Current asset: An asset that satisfies any ofthe following criteria:
o expected realisation, sale or consumption:
in the normal operating cycle; or
within twelve months after the balance sheet date;
o held primarily for trading purposes;
o cash or a cash equivalent.
Non-current asset: An asset that does not meet the definition of a current asset.
A non-current asset (or disposal group) is classified as held for sale if its
carrying amount will be recovered principally through a sale transaction
rather than through continuing use.
"Non-current assets (or disposal groups) classified as heldfor sale" will be
referred to more simply as "held for sale non-current assets" in this session.
3.2.1 Recognition criteria
The asset must be available for immediate sale in its present condition.
But may be subject to terms that are usual and customary for sales ofsuch assets.
The sale must be highly probable. That is, significantly more likely than
probable.
Probable being more likely than not.
3.2.2 Highly probable
Management must be committed to a plan to sell the asset.
An active programme to locate a buyer and complete the plan must have been
initiated.
The asset must be actively marketed for sale at a price that is reasonable
relative to its current fair value.
The sale should be expected to qualify for recognition as a completed sale
within one year from the date of classification.
However, an extensionperiod does not preclude classification as heldfor
sale ifthe delay is beyond management's control and there is sufficient
evidence ofmanagement's commitment to its plan.
The actions required to complete the plan should indicate that significant
changes to the plan or withdrawal from the plan are unlikely.
3.2.3. Assets acquired exclusivelyfor disposal
Non-current assets acquired exclusively with a view to subsequent disposal
are classified as held for sale at the acquisition date if:
D the one-year criterion is met; and
D it is highly probable that any other criteria that are not met at that
date will be met within three months.
3.2.4 Events after the balance sheet date
Assets are not classified as held for sale if the recognition criteria are only
met after the balance sheet date.
However, ifthe criteria are met before the fmancial statements are authorised
for issue, the notes shall disclose the facts and circumstances.
The event is non-adjusting (see lAS 10 "Events after the Balance Sheet Date"
in the next session).
3.3 Abandoned non-current assets
An asset that is to be abandoned is not classified as held for sale.
Its carrying amount will be recovered principally through continuing use.
However, a disposal group that is to be abandoned is treated as a discontinued
operations when it ceases to be used, providing that the definition of a
"discontinued operation" is met.
Non-current assets (or disposal groups) to be abandoned include non-current
assets (or disposal groups) that are to be used to the end of their economic life
and non-current assets (or disposal groups) that are to be closed rather than
sold. An entity shall not account for a non-current asset that has been
temporarily taken out of use as if it had been abandoned.
3.4 Measurement
3.4.1 J>rinciple
Held for sale non-current assets are carried at the lower of:
o carrying amount; and
o fair value less costs to sell.
Immediately before initial classification as heldfor sale, carrying amount is
measured in accordance with applicable IFRSs.
3.4.2 Time value
If a sale is expected to occur beyond one year, costs to sell are discounted to
their present value.
Any increase in the present value ofthe costs to sell arisingfrom the passage
oftime is treated as afinancing cost.
3.4.3 Subsequent remeasurement
Assets and liabilities in a disposal group are remeasured in accordance with
applicable IFRSs before the fair value less costs to sell of the disposal group
is remeasured.
3.4.4 Impairment losses and reversals
Impairment losses for initial or subsequent write-downs to fair value less
costs to sell must be recognised.
Reversals are recognised, but not exceeding the cumulative impairment loss
that has been recognised.
3.4.5 Depreciation
Held for sale non-current assets are not depreciated (amortised).
However, interest and other expenses attributable to the liabilities ofa
disposal group will continue to be recognised.
3.5 Changes to a plan of sale
If held for sale recognition criteria are no longer met, that classification
ceases.
A non-current asset that ceases to be classified as held for sale is measured at
the lower of:
o its carrying amount before it was classified as held for sale,
adjusted for any depreciation, amortisation or revaluations that
would have been recognised had the asset not been classified as
held for sale; and
o its recoverable amount at the date of the decision not to sell.
Any adjustment to the carrying amount is included in income from
continuing operations in the period in which the held for sale criteria ceased
to be met.
4.1 Purpose
To enable users of financial statements to evaluate the financial effects of:
o discontinued operations; and
o disposals of non-current assets (or disposal groups).
4.2 Discontinued operations
4.2.1 A single amount
A single amount on the face of the income statement comprises:
o post-tax profit or loss of discontinued operations;
o post-tax gain or loss recognised on:
the measurement to fair value less costs to sell; or
the disposal of the assets (or disposal groups) constituting
the discontinued operation.
4.2.2 An analysis
An analysis of the single amount on theface of the income statement or in the
notes into:
D the revenue, expenses and pre-tax profit or loss of discontinued
operations;
D the gain or loss recognised on:
the measurement to fair value less costs to sell; or
the disposal of the assets or disposal group(s) constituting
the discontinued operation.
Each with the related income tax expense.
If presented on the face of the income statement it is identified as relating to
discontinued operations separately from continuing operations.
The analysis is not requiredfor newly acquired subsidiaries meeting the held
for sale criteria on acquisition.
4.2.3 Net cash flows
Net cash flows attributable to the operating, investing and financing activities
of discontinued operations must be presented on the face of the fmancial
statements or in the notes.
Comparative information must be re-statedfor prior periods presented.
4.3 Continuing operations
If an entity ceases to classify a component as held for sale, the results of
operations previously presented as discontinued are reclassified to continuing
operations for all periods presented.
Amountsfor prior periods then being described as having been re-presented.
Gains and losses on the remeasurement of held for sale non-current assets
that do not meet the definition of a discontinued operation are included in
profit or loss from continuing operations.
The following requirements also apply to the assets of disposal groups
classified as held for sale.
4.4.1 Separate classification
Non-current assets classified as held for sale are to be shown separately from
other assets in the balance sheet.
The liabilities of a held for sale disposal group are similarly presented
separately from other liabilities in the balance sheet.
Offsetting ofsuch assets and liabilities is strictly prohibited.
The major classes of held for sale assets and liabilities are separately
disclosed either on the face ofthe balance sheet or in the notes
This disclosure is not requiredfor newly acquired subsidiaries meeting the
heldfor sale criteria on acquisition.
Any cumulative income or expense recognised directly in equity relating to a
held for sale non-current asset must be presented separately.
Comparative information is not restated.
Classification as heldfor sale is reflected in the period when the heldfor sale
recognition criteria are met.
4.4.2 Additional disclosures
Thefollowing note disclosures are made in the period in which a non-current
asset is classified as heldfor sale or sold.
A description of the non-current asset.
A description of the facts and circumstances of the sale or expected disposal
(and the expected manner and timing of that disposal).
Fair value gains or losses.
Ifnot separately presented on theface ofthe income statement, the caption in
the income statement that includes that gain or loss.
The segment in which the non-current asset is presented in accordance with
lAS 14 "Segment Reporting" (if applicable).
If held for sale criteria are no longer met disclose:
D the decision to change the plan to sell the non-current asset;
D the facts and circumstances leading to the decision; and
D the effect of the decision on the results of operations for the period
and any prior periods presented.
Worked example 1
Entity X has three segments:
A Tobacco
B Alcohol
C Health foods
The following information relates to the year ended 31 December 2004:
A B C
$000 $000 $000
Revenue 200 180 110
Expenses 120 105 115
Taxation (30%) 24 22.5 (1.5)
Segment C is felt to be inconsistent with the long-term direction of the Company.
Management has decided, therefore, to dispose of Segment C.
On 5 November 2004 the board of directors of X voted to approve the disposition, and
a public announcement was made. On that date, the carrying amount of Segment C' s
assets was $105,000 and it had liabilities of$15,000. The estimated recoverable
amount of the assets was determined to be $85,000 and the directors ofX concluded
that a pre-tax impairment loss of $20,000 should be recognised. This was duly
processed in November and is included in the above amounts
At 31 December 2004 the carrying amount of Segment C's assets was $85,000 and it
had liabilities of$15,000. There was no further impairment between 5 November and
the year end.
X decided to adopt the provisions of IFRS 5 by making the necessary disclosures in
the notes to the accounts.
Required:
Show how the above information would be reflected in the fmancial statements of X
for the year ended 31 December 2004.
Worked solution
$000
Revenue 490
Expenses (320)
Impairment loss (20)
150
Taxation (30%) (45)
105
Note to the fmancial statements
On 5 November 2004, the board of directors publicly announced a plan to dispose of
Segment C, the health foods division. The disposal is consistent with the Company's long-
term strategy to focus its activities on the manufacture and distribution of cigarettes and
alcoholic drinks and to divest unrelated activities. The Company is actively seeking a
buyer for Segment C and hopes to complete the sale by the end of September 2005.
At 31 December 2004, the carrying amount of the assets of Segment C was $85,000 and its
liabilities were $15,000.
During 2004, Segment C earned revenues of $110,000 and incurred expenses of $ 115,000
resulting in a pre-tax operating loss of $5,000, with a related tax benefit to the entity of
$1,500.
During 2004, Segment C's cash outflow from operating activities was XX, cash outflow
from investing activities was XX, and cash inflow from fmancing activities was XX.
Example 1
Following on from Worked example 1 the following information relates to the year
ended 31 December 2005 before taking into account the sale of Segment C:
A B C
$000 $000 $000
Revenue 230 195 90
Expenses 130 115 100
Taxation (30%) 30 24 (3)
On 30 September 2005 X sold Segment C to Z Corporation for $60,000. The carrying
amount of Segment C's net assets at that date was $70,000. The loss on disposal will
attract tax relief at 30%.
The sale contract obliges X to terminate the employment of certain employees of
Segment C, incurring an expected termination cost of $30,000, to be paid by 31 March
2006. This has not been accounted for as at the year end and will attract tax relief at
30%.
X has decided to make the disclosures required in respect of the income statement
items on the face of the income statement.
Required:
Show how the above information would be reflected in the fmancial statements of X
for the year ended 31 December 2005.
Proforma solution 1
Continuing
operations
(A and B)
2004 2005
$000 $000
Revenue
Expenses
Impairment loss
Provision for
termination of
employment
Taxation (30%)
FOCUS
Discontinued
operations
(Conly)
2004 2005
$000 $000
Entity as a whole
2004 2005
$000 $000
distinguish non-current assets, current assets and held for sale non-current assets;
recognise and measure held for sale non-current assets;
define discontinued operations in accordance with IFRS 5;
discuss the importance of identifying and reporting the results of discontinued operations.
EXAMPLE SOLUTIONS
Solution 1
Continuing Discontinued Entity as a whole
operations operations
(A and B) (Conly)
2004 2005 2004 2005 2004 2005
$000 $000 $000 $000 $000 $000
Revenue 380 425 110 90 490 515
Expenses (225) (245) (95) (100) (320) (345)
Impairment loss (20) (20)
Loss on disposal (10) (10)
Provision for (30) (30)
termination of
employment
155 180 (5) (50) 150 130
Taxation (30%) (46.5) (54) 1.5 15 (45) (39)
108.5 126 (3.5) (35) 105 91
On 30 September 2005 the Company sold its health food operations to Z Corporation for
$60,000. The Company decided to dispose of Segment C because its operations are in
areas apart from the core business areas (cigarette and beverage manufacture and
distribution) that form the long-term direction of the Company. Further, Segment C's rate
of return has not been equal to that of the Company's other two segments during the
period.
The loss on disposal of Segment C (before income tax benefit of $3,000) was $10,000.
The Company recognised a provision for termination benefits of $30,000 (before income
tax benefit of $9,000) to be paid by 31 March 2006 to certain employees of Segment C
whose jobs will be terminated as a result of the sale.
IAS 10 EVENTS AFTER THE BALANCE SHEET DATE
OVERVIEW
Objective
To defme events after thebalance sheet date.
To describe thetreatment of eventsafter thebalance sheet date.
INTRODUCTION
RECOGNITION AND
MEASUREMENT
DISCLOSURE
Objective
Scope
Definitions
Adjusting events
Non adjusting events
Dividends
Going Concern
1 INTRODUCTION
1.1 Objective
The objective ofIAS 10 is to describe:
o when an entity should adjust its fmancial statements for events after the balance
sheet date, and
o the disclosures an entity should give about the date when the financial statements
were authorised for issue and about events after the balance sheet date.
1.2 Scope
lAS 10 should be applied in the accounting for, and disclosure of, events after the balance
sheet date.
1.3 Definitions
Events after the balance sheet date are those events, both favourable and unfavourable, that
occur between the balance sheet date and the date on which the fmancial statements are
authorised for issue. Two types of events can be identified:
o those that provide further evidence of conditions that existed at the balance sheet
date (adjusting events after the balance sheet date), and
o those that are indicative of conditions that arose after the balance sheet date (non-
adjusting events after the balance sheet date).
2.1 Adjusting events
An entity should adjust its fmancial statements for adjusting events after the balance sheet
date.
Examples of adjusting events after the balance sheet date are:
o the resolution after the balance sheet date of a court case which, because it confirms
that an entity already had a present obligation at the balance sheet date, requires the
entity to recognise a provision instead ofmerely disclosing a contingent liability or
adjusting the provision already recognised,
o the bankruptcy of a customer which occurs after the balance sheet date and which
confirms that a loss already existed at the balance sheet date on a trade receivable
account,
o the discovery of fraud or error that show that the financial statements were incorrect,
and
o the sale of inventories after the year end at an amount below their cost.
2.2 Non adjusting events
An entity should not adjust its fmancial statements for non-adjusting events after the balance
sheet date.
The following are examples ofnon-adjusting events that may be of such importance that non-
disclosure would affect the ability of the users of the fmancial statements to make proper
evaluations and decisions:
o a major business combination after the balance sheet date,
o the destruction of a major production plant by a fire after the balance sheet date,
o abnormally large changes after the balance sheet date in asset prices or foreign
exchange rates, and
o a decline in market value of investments between the balance sheet date and the date
on which the financial statements are authorised for issue.
The fall in market value does not normally relate to the condition ofthe investments at the
balance sheet date, but reflects circumstances, which have arisen in the following period.
Therefore, an entity does not adjust the amounts recognised in its financial statementsfor that
investment.
2.3 Dividends
If dividends are proposed or declared after the balance sheet date, an entity should not
recognise those dividends as a liability. This is a change from previous practice.
lAS 1 requires an entity to disclose the amount of dividends that were proposed or declared
after the balance sheet date but before the fmancial statements were authorised for issue.
Some entities may wish to make this disclosure on the face of the balance sheet. They are
allowed to do this but the dividends must be presented as a component of equity not as a
liability.
2.4 Going Concern
An entity should not prepare its financial statements on a going concern basis if management
determines after the balance sheet date that:
o it intends to liquidate the entity or to cease trading, or
o it has no realistic alternative but to do so.
Deterioration in operating results and fmancial position after the balance sheet date may
indicate a need to consider whether the going concern assumption is still appropriate.
If the going concern assumption is no longer appropriate the lAS requires a fundamental
change in the basis of accounting, rather than an adjustment to the amounts recognised within
the original basis of accounting.
3 DISCLOSURE
An entity should disclose the date when the fmancial statements were authorised for issue and
the name of the governing body that gives that authorisation.
If the entity's owners or others have the power to amend the financial statements after
issuance, the entity should disclose that fact.
It is importantfor users to know when the financial statements were authorisedfor issue, as
the financial statements do not reflect events after this date.
An entity should disclose the following in respect of non-adjusting events that are of such
importance that non-disclosure would affect the ability of the users ofthe fmancial statements
to make proper evaluations and decisions.
o the nature ofthe event, and
o an estimate of its fmancial effect, or a statement that such an estimate cannot be
made.
The following disclosures are required by lAS 1 if the accounts are not prepared on the basis
of the going concern assumption:
o A note saying that the financial statements are not prepared on a going concern
basis, or
o management is aware of material uncertainties related to events or conditions, which
may cast significant doubt upon the entity's ability to continue as a going concern.
FOCUS
define an event after the balance sheet date;
account for and disclose events after the balance sheet date in accordance with lAS 10;
record the entries for dividends paid and proposed in the fmancial statements;
discuss the problem of accounting for events after the balance sheet date, including
reclassification, window dressing etc.
lAS 24 RELATED PARTIES
OVERVIEW
Objective
To evaluate related party involvement and explain the disclosure of related
parties and transactions between them.
INTRODUCTION
THE RELATED
PARTY ISSUE
DISCLOSURE
Scope
Definitions
Parties deemed not to be related
Affect on reporting enterprise
Methods for pricing relatedparty transactions
Situations where relatedparty transactions
may lead to disclosures
Disclosure required
Aggregation
1 INTRODUCTION
1.1 Scope
lAS 24 should be applied in
o Identifying related party relationships and related party transactions,
o Identifying any outstanding balances between an entity and its related party,
o Determining the disclosures to be made in respect of the above.
1.2 Definitions
Relatedparty -
(a) Parties that directly or indirectly:
control;
are controlled by;
are under common control;
have significant influence over; or
have joint control over,
the entity.
(b) Associates of the entity (according to lAS 28).
(c) Joint venturers in which the entity is a venturer (according to lAS 31)
(d) Key management personnel (i.e. persons having authority and responsibility for planning,
directing and controlling activities of the reporting entity) including directors.
Non-executive directors are included within key management personnel.
(e) Close family members of (a) or (d)
(f) Entities that are controlled by, jointly controlled by, or under significant influence of, or in
which a significant voting power is held by any person described in (d) or (e).
(g) the party is a post-employment benefit plan for the benefit of the employees or related parties
of the entity.
Substance ofrelationship, not merely legalform, should be considered. One party has the
ability to control the other party or exercise significant influence over the other party in
makingfinancial and operating decisions.
Relatedparty transactions - a transfer of resources or obligations between related parties,
regardless of whether a price is charged.
Control- power to govern the fmancial and operating policies of the entity so as to gain
benefits from its activities
Significant influence - power to participate in, but not control of, the entity's financial and
operating policy decisions.
Joint control- the contractually agreed sharing of control over an economic activity.
The last three definitions are nowconsistent with thedefinitions givenin lAS 27,28 and31.
1.3 Parties deemed not to be related
The following parties are deemed not to be related:
Two companies simply because they have a director or other member ofkey management
personnel in common
unless they:
o are a member of the key management personnel, or
o can control, jointly control or exert significant influence, or
o has significant voting power
over both entities
Providers of finance, trade unions, public utilities, government departments and agencies, in
the course of their normal dealings with an entity (even though they may restrict business
activities).
A customer, supplier, franchisor, distributor, etc with whom a significant volume ofbusiness is
transacted as a result of economic dependence.
2 THE RELATED PARTY ISSUE
2.1 Affect on reporting enterprise
Related party relationships are a normal feature of commerce and business.
A related party relationship could have an effect on financial position and operating results.
o Entering into transactions which unrelated parties would not.
o Transactions not at the same amounts as for unrelated parties.
o Even ifrelated party transactions do not occur, mere existence ofthe relationship
may affect transactions with other parties.
IAS 24 RELATED PARTIES
2.2 Methods for pricing related party transactions
Comparable uncontrolled price - price of comparable goods sold in an economically
comparable market to a buyer unrelated to the seller.
Resale price reduced by a margin to arrive at a transfer price.
Cost-plus method - supplier's cost plus an appropriate mark-up
No price - eg free provision of management services and interest free credit.
3 DISCLOSURE
3.1 Situations where related party transactions may lead to disclosures
Purchases or sales of goods, property and other assets.
Rendering or receiving of services.
Agency arrangements.
Leasing arrangements.
Transfer of research and development.
Licence agreements.
Finance (including loans and equity contributions).
Guarantees and collaterals.
Management contracts.
3.2 Disclosure required
Related party relationships where control exists (irrespective of whether there have been
related party transactions).
So a reader can form a view about the effects ofrelatedparty relationships
Illustration 1
The Company's major shareholder, Kukly Inc and its subsidiaries are related parties. It is the
company's policy to conduct all transactions and settle balances with related parties at normal
trade terms.
Name of the entity's parent - or the ultimate controlling party.
So that the reader can form a view about the effects ofrelated party relationships.
Key management compensation must be disclosed in total and for each of the following
headings:
Short term employee benefits
Post employment benefits
Other long term benefits
Termination benefits and
Equity compensation benefits
This was not included in the exposure draft but the lASE decided that users thought key
management personnel are relatedparties and therefore should be included in the
disclosures.
If there have been transactions between related parties, disclose the nature of the related party
relationships as well as the types oftransactions and the "elements" of the transactions
necessary for an understanding of the financial statements. "Elements" normally include:
o an indication of the volume (amount or proportion),
o amounts or proportions of outstanding items,
o pricing policies.
These disclosures shall be made separately for each ofthe following classifications of related
parties:
o parent;
o subsidiaries;
o associates;
o joint ventures;
o key management personnel;
o parties with joint control or significant influence over the entity;
o other.
IAS 24 RELATED PARTIES
The following transactions were carried out with related parties:
2004 2003
$m $m
Sale of goods
Kukly Inc 70 50
Kuklochka Inc 40 35
MishkaInc 20 22
130 107
Sales were carried out on commercial terms and conditions and at market prices.
2004 2003
$m $m
Purchases of goods
Tass Inc 60 50
60 50
Purchases were carried out on commercial terms and conditions. Tass Inc is a fellow subsidiary of
Kukly Inc.
2004 2003
$m $m
Year end balances relating to related parties
Receivables from related parties
Kukly Inc
MishkaInc
10
5
15
2
Payables to related parties
15 17
Tass Inc
20 5
3.3 Aggregation
Items of a similar nature may be disclosed in aggregate except when separate disclosure is
necessary for an understanding of the effects of the related party transactions.
FOCUS
discuss the related party issue;
identify related parties (including deemed and presumed) and the disclosure of related party
transactions;
discuss the effectiveness of current regulations on disclosure of related party transactions.
lAS 34 INTERIM FINANCIAL REPORTING
OVERVIEW
Objective
To set out the principles that entities should follow in drafting interim
financial reports.
SCOPE
CONTENT OF AN
INTERIM FINANCIAL
REPORT
RECOGNITION AND
MEAUREMENT
Minimum Components
Condensed Balance Sheet
Condensed Income Statement
Condensed Cash Flow Statement
Changes in Equity
Selected Note Disclosures
General comment
Taxcharge
Use ofEstimates
1 SCOPE
Does not mandate which companies should be required to publish interim
financial reports, how frequently, or how soon after the end of an interim
period. However, the IASB strongly encourages governments, securities
regulators, stock exchanges international bodies. and accountancy bodies to
require companies whose debt or equity securities are publicly traded to
provide interim financial reports that conform to the recognition and
measurement criteria in the standard.
o Entities should be encouraged to provide interim financial reports at
least as of the end ofthe first half of their financial year.
o Entities should be encouraged to make their interim financial
reports available not later than 60 days after the end of the interim
period.
To prescribe the principles for preparing and reporting information about the
financial position, performance, and changes in financial position of an entity
for less than a full fmancial year or for a twelve-month period ending on a
date other than the entity's fmancial year end.
2 CONTENT OF AN INTERIM FINANCIAL REPORT
2.1 Minimum Components
Interim financial reports should include(at a minimum):
o a condensed balance sheet,
o a condensed income statement,
o a condensed cash flow statement,
o a condensed statement of changes in equity,
o selected note disclosures.
The interim statements provide an update on the latest set of annual fmancial
statements and, accordingly, focus on new activities, events, and
circumstances and should not duplicate information previously reported.
2.2 Condensed Balance Sheet
Balance sheet should include each ofthe major components of assets,
liabilities, and equity that were presented in its most recent annual balance
sheet.
2.3 Condensed Income Statement
Income statement should include revenue, each ofthe components of income
and expense that were presented in the most recent annual income statement,
and basic and diluted earnings per share.
2.4 Condensed Cash Flow Statement
Cash flow statement should include the three major subtotals of cash flows
required by lAS 7, Cash flow statements.
2.5 Changes in Equity
The statement of changes in equity should include each of the major
components of equity that were presented in the most recent annual statement
of changes in equity.
2.6 Selected Note Disclosures
The notes should include an explanation of events and changes that are
significant to an understanding of the changes in financial position and
performance of the entity since the last annual reporting date.
The following should be disclosed:
o a statement that the accounting policies and methods of
computation followed are the same as those in the most recent
annual financial statements (or a description of the nature and
effect of any changes),
o explanation of the seasonality or cyclicality of interim operations,
o the nature and amount of items affecting assets, liabilities, equity,
net income, or cash flows that are unusual because of their nature,
size, or incidence,
o dividends paid,
o revenue and segment result for segments according to the entity's
primary basis of segment reporting,
o significant events subsequent to the end ofthe interim period,
o the effect of the acquisition or disposal of subsidiaries during the
interim period,
o significant changes in a contingent liability or a contingent asset
since the last annual balance sheet date, and
o the nature and amount of any significant re-measurements of
amounts reported in prior interim periods of the current financial
year.
Entities are encouraged to provide the following:
o A discussion of significant changes in business trends, (eg in
demand, market shares, prices, and costs),
o A description of significant new commitments such as for capital
spending,
o A discussion ofprospects for the full current financial year of
which the interim period is a part.
3.1 General comment
Entities should apply the same accounting recognition and measurement
principles in interim fmancial report as are applied in the preparation of
annual financial statements which should be measured on a year to date basis.
The entity should apply the basic principles from the "Framework" in the
recognition of assets, liabilities, income, and expenses.
3.2 Tax charge
Income tax expense should be accrued using the tax rate that would be
applicable to expected total annual earnings ( the estimated average annual
effective income tax rate applied to the pre tax income of the interim period).
3.3 Use of Estimates
The measurement procedures should be designed to ensure that information is
reliable and relevant to an understanding of the financial position or
performance of an entity. Preparation of interim financial reports generally
will require a greater use of estimation methods than annual financial reports.
The "Framework" recognises the need for trade-offs. Some degree of
reliability may have to be sacrificed to enhance relevance or timeliness.
Timeliness is particularly important for interim financial information, which
often is published more promptly than annual fmancial information. To
increase timeliness or reduce cost, it may be necessary to accept a lesser
degree of reliability.
Examples:
Inventories: Full stocktaking and valuation procedures may not be required
for inventories at interim dates. Alternative methods might include:
estimates based on sales margins,
using representative samples.
Provisions: Determination of provisions (eg for environmental costs) may be
complex, costly and time consuming. At the year end an entity might engage
outside experts to assist in the calculations. Estimates at interim dates may
entail a simple updating of the prior annual provision.
Revaluations: An entity may rely on professionally qualified valuers at
annual reporting dates though not at interim reporting dates.
FOCUS
identify current problem areas in interim reporting.
CORPORATE REPORTING ISSUES
OVERVIEW
Objective
To explain the need for guidance on reporting performance.
To examine further sundry reporting topics.
OPERATING AND
FINANCIAL REVIEW
I
CORPORATE
GOVERNANCE
I
SARBANES-OXLEY
Background
OFR in the UK
Definition
Corporate governance in other countries
Cadbury Report
Hampel Report
The way ahead
Background
Main requirements
1 OPERATING AND FINANCIAL REVIEW (OFR)
1.1 Background
lAS 1 allows entities to present, outside the fmancial statements, a fmancial
review by management, which describes and explains the main features of the
entity's financial performance and fmancial position and the principal
uncertainties it faces.
Such a report may include a review of:
D the main factors and influences determining performance,
This would include changes in the environment in which the entity operates,
the entity's response to those changes and their effect, and the entity's policy
for investment to maintain and enhance performance, including its dividend
policy;
D the entity's sources of funding, the policy on gearing and its risk
management policies; and
D the strengths and resources of the entity whose value is not reflected
in the balance sheet under lASs.
lAS 1 does not require any ofthese voluntary reports to comply with the
requirements ofIFRS.
1.2 OFR in the UK
The standard setting body in the UK has issued a non-mandatory statement
recommending that listed companies and other large corporations should
provide an operating and financial review. The review has attracted
widespread interest internationally. Such a review is also specified in the
Cadbury Code (see later).
1.2.1 Essentialfeatures
D Readily understandable by general reader of annual report.
D Deals even-handedly with good and bad aspects.
D Reference to comments made in previous statements where these
have not been borne out by events.
D Contains analytical discussion rather than mere numerical analysis.
D Discusses individual aspects ofbusiness in context of a discussion
ofbusiness as a whole.
D Explains reason for, and effect of, changes in accounting policies.
D Makes clear how ratios/other numerical information given relate to
the financial statements.
D Discusses events, trends and factors which
have affected the results but which are not expected to
continue in the future
are expected to have an impact in the future.
1.2.2 Operating review
Includes review of
D operating results for the period
D investment for the future
D profit for the financial year, total recognised gains and losses and
shareholders' perspective
D profit for the financial year, dividends and EPS
D accounting policies.
1.2.3 Financial review
Includes review of
D capital structure and treasury policy
D taxation
D funds from operating activities and other sources of cash
D current liquidity
D going concern
D balance sheet value.
2 CORPORATE GOVERNANCE
2.1 Definition
Corporate governance is defined as "the system by which companies are
directed and controlled".
2.2 Corporate governance in other countries
USA SEC imposes quarterly reporting requirements
Audit committees required for all listed companies
Germany
Japan
two-tier board system- separate management and
supervisory board
banks providing credit often have long term equity
holding
traditionally companies doing business together would
hold shares in each other although this system is now
reducing.
2.3 Cadbury Report
The Cadbury Committee was set up in 1991 to review aspects of corporate
governance - specifically related to fmancial reporting and accountability.
This report was in response to widespread concerns about certain aspects of
corporate governance in the UK.
The Cadbury Report was published in 1992 and the boards of all UK listed
companies must now comply with the Code of Best Practice contained in the
report. The contents of the report have attracted a great deal of support
amongst international investors.
The main provisions of the Code are:
D
D
D
D
D
Board of
directors
Non-executive
directors
Executive
directors
Audit committee
Directors
statements
meet regularly
monitor executive management
division of responsibility at head of company
include non-executive directors
bring independent judgement to bear on
matters of strategy, performance, resources;
should sit on remuneration committee
service contracts not exceeding 3 years
pay subject to recommendations of
remuneration committee
total emoluments disclosed fully and clearly
made up of at least 3 non-executive directors
liase with external auditors
recommend appointment and fees of external
auditor
review company statement on internal
controls
must report on effectiveness of company's
system of internal control
should report that company is a going
concern.
2.4 Hampel Report
This report followed up on issues raised by the Cadbury report. The aim of
the report was to:
D Restrict the regulatory burden on companies
D Substitute principles for detail wherever possible
D Make a positive contribution to corporate governance in addition to
the measures taken by the Cadbury Report to combat abuses.
The main provisions of the report are
2.5 The way ahead
D
D
D
D
D
D
D
Board of
directors
Non-executive
directors
Executive
directors
Audit and
accounting
Shareholders and
theAGMs
Reporting
General
directors should meet regularly
directors should be properly trained
roles of chairman and chief executive should be
separate generally
the majority should be independent;
non-executive directors should comprise at least 1/3
of the board
a senior non-executive directors should be appointed
remuneration committee should be made up of
independent non executive directors
service contracts not exceeding I year
pay subject to recommendations of remuneration
committee
total emoluments disclosed fully and clearly
Audit committee made up of at least 3 non-executive
directors
liase with external auditors
Companies without an internal audit function should
reconsider the need
directors are responsible for all controls not just
fmancial
auditors should report privately to the directors on
internal controls
companies should have a business presentation at the
AGM with a question and answer session
resolutions on separate subjects should not be
packaged together.
fmancial statements should contain a statement of the
company's approach to corporate governance and
justify any departure from best practice
the report accepts that there may be occasions when
departure from the code is justified but that this
should be explained
The London Stock Exchange is currently drafting a supercode combining the
recommendations of the Cadbury Report, the Hampel Report and the
Greenbury Report (on directors' remuneration).
3 SARBANES-OXLEY
3.1 Background
Mainly as a result of the aftermath of the Enron and Worldcom financial
disasters the US government introduced the Sarbanes - Oxley act in 2002.
The act requires directors to take responsibility for their corporate actions.
The requirements will affect any company filing on a US stock market, so it
will have a wide ranging international effect.
3.2 Main requirements
The act requires any officer of an entity which signs off an annual or
quarterly report shall have carried out the following actions:
o The must have seen the report being filed.
o Ensured that the report does not contain any material false
statements or omits any material facts from the reports.
o Ensure that the fmancial statements fairly present in all material
respects the financial condition and results of the entity for the
period reported.
The signing officers:
o are also responsible for the internal controls within an entity.
o must ensure that the internal controls are capable of bringing to
light any material information that is relevant to the period being
reported upon.
o must have evaluated the internal controls within 90 days fthe
report.
o must present within the report any conclusions about the
effectiveness of the internal controls.
The signing officer must disclose to the entity's audit committee and external
auditors the following:
o any major problems with the design or operation ofthe internal
controls which could affect the reporting of transactions. This will
include any material weaknesses in the internal controls.
o any fraud which involves management or any employee who playa
significant role within the internal controls.
The signing officer must also identify, within the report, any major changes
have occurred in respect of the internal controls since the date ofthe last
evaluation. This will include any corrective action taken in regard of any
deficiencies or weaknesses previously identified.
FOCUS
discuss the role and need for the international regulation of corporate
governance;
describe the nature of reporting the corporate governance of the entity;
describe the need for corporate governance in small companies.
IFRS 1 FlRST-TIMEADOPTION
OVERVIEW
Objective
To explain how an entity's first-time IFRS financial statements should be
prepared and presented in accordance with IFRS 1 First-Time Adoption of
International Financial Reporting Standards.
INTRODUCTION 1-------1
Background
Objective
Scope
Definitions
Stages in transition to IFRSs
Transition overview
PRACTICAL
MATTERS
Overview
Making the transition
OPENING IFRS
BALANCE SHEET
Recognition and measurement principles
Exemptions from other IFRSs
Business combinations

Cumulative translation differences
Compoundfinancial instruments
Assets and liabilities ofsubsidiaries
Mandatory exceptions to retrospective application
PRESENTATION
AND DISCLOSURE
Explanation oftransition
Reconciliations
Other disclosures
1 INTRODUCTION
1.1 Background
SIC-8: First-time Application oflASs as the Primary Basis ofAccounting
required full retrospective application unless a standard required otherwise or
amounts could not be determined.
Thiswas insufficient guidance for themany entities throughout theworld
adopting IFRSandhas been withdrawn.
The European Union's requirement that all listed companies in the European
Economic Area publish their consolidated financial statements in accordance
with International Financial Reporting Standards by 2005, meant that entities
with a financial year end of 31 December must have an IFRS balance sheet as
at 1 January 2004 (for comparative purposes).
The demand for detailed implementation guidance therefore became an
immediate priorityfor theIASB. The EEAis the25 member states of the EU
plus Iceland, NorwayandLeichtenstein.
One of the main differences between SIC-8 and IFRS 1 is that the IFRS
permits certain exemptions from recognition and measurement requirements
where compliance would otherwise cause undue cost or effort in application.
However, there are NO exemptions from IFRS 1's enhanced disclosure
requirements, detailing how the change to IFRSs has affected fmancial
position, performance and cash flows.
1.2 Objective
To ensure that an entity's first IFRS contain high quality information that is:
o transparent for users;
o comparable over all period presented;
o a starting point for accounting under IFRS; and
o generated at a cost that does not exceed the benefit (to users).
A first time adopter uses the provisions ofIFRS 1 and not the transitional
provisions of other standards unless IFRS 1 specifies otherwise.
1.3 Scope
This standard applies to:
o first IFRS financial statements; and
o any interim financial statements presented under lAS 34 for any
part of the period covered by the first IFRS financial statements.
So, for example, iffirst IFRSfinancial statements are prepared to31
December 2005, interimfinancial statements for 6 months to30 June 2005
also fall within thescope of IFRS1.
1.4 Definitions
First IFRSfinancial statements - the first annual financial statements in
which IFRSs are adopted by an explicit and unreserved statement of
compliance with IFRS.
That is compliance with all IFRSs (issued by IASB) andlASs (adopted by
IASBfrompredecessor body lASe) andapplicable standing committee
interpretations (IFRICs andSICs).
First-time adopter - an entity that presents first IFRS financial statements. If
an explicit and unreserved statement of compliance has already been made an
entity is NOT a first-time adopter.
That is evenif there wasnon-compliance andtheauditor's report carried a
qualified opinion.
Opening IFRS balance sheet - an entity's balance sheet at the date of
transition to IFRSs. This may be published or unpublished.
Previous GAAP - the basis of accounting used immediately before the
adoption ofIFRS.
Reporting date - the end ofthe latest period covered by financial statements
(or by an interim financial report).
Date oftransition - the beginning ofthe earliest comparative period
presented in the financial statements.
Deemed cost - an amount used as a surrogate for cost or depreciated cost at a
given date.
Illustration 1
An entity with a 31 December year end presenting its fmancial statements for 2005 will
have a date of transition as 1 January 2004.
lAS 1 requires oneyear of comparative information. The opening IFRS
balance sheet is not required to bepresented in the2005financial statements.
This opening balance sheet will is thestartingpointfor accountingfor all
subsequent transactions underIFRSs.
If twoyears comparative information were required (e.g. underlocal
legislation) thedate of transition wouldbeayear earlier.
1.5 Stages in transitionto IFRSs
1.5.1 Accountingpolicies
Select accounting policies that will comply with IFRSs.
The same accounting policies are used for all periods presented including the
opening IFRS balance sheet.
The version of an IFRS that is extant at the reporting date (i.e. 31 December
2005 in Illustration 1) is used subject to the exemptions permitted under
IFRS 1 (see later). Different versions effective at earlier dates must not be
applied.
If a new IFRS permits early application then a first-time adopter may adopt
that standard early, but it is not required to do so.
The transitional arrangements in other IFRSs apply to entities that already use
IFRSs. They do not apply to first time adopters except in relation to the
derecognition and financial assets and financial liabilities and hedge
accounting in accordance with lAS 39.
1.5.2 OpeningIFRS balance sheet
Prepare an opening IFRS balance sheet (i.e. at the date oftransition). This is
the starting point to accounting under IFRS.
1.5.3 Estimates
Make estimates in accordance with IFRSs for the opening balance sheet and
all other periods covered by the financial statements.
These must be consistent with estimates made as at the same date under
previous GAAP, after adjustments to reflect different accounting policies,
unless there is objective evidence that those estimates were in error.
Information received after the date of transition relevant to estimates made
under previous GAAP is treated as for non-adjusting events (lAS 10).
Illustration 2
An entity's date of transition to IFRSs is 1 January 2004.
New information on 15 July 2004 requires an increase in the estimate of the allowance
for slow-moving inventory made under previous GAAP at 31 December 2003.
The entity does not reflect that new information in its opening IFRS balance sheet.
The increase in estimate will be reflected as an additional expense in the income
statement for the year ended 31 December 2004.
IFRS I FIRST-TIME ADOPTION
An entity may need to make estimates under IFRSs at the date of transition that
were not required at that date under previous GAAP (e.g. if there was no
requirement to state inventory at the lower of cost and net realisable value). Such
estimates must reflect conditions that existed at the date oftransition to IFRSs.
For example, marketprices, interest rates, foreign exchange rates, etc.
Estimates required
by previous
GAAP?
YES
Evidence of error?
NO
Calculation
consistent with
IFRSs?
These same principles apply to estimates made for any comparative period
presented in first IFRS fmancial statements.
1.5.4 Presentation and disclosure
Make presentation and disclosure requirements in accordance with IFRS 1.
IFRS 1 does not provide any exemptions from the presentation and disclosure
requirements of other accounting standards.
At least one year's comparative information must be included (lAS 1).
Historical summaries of selected data need not comply with recognition and
measurement requirements of IFRS 1. However, such summaries and comparative
information under previous GAAP must be clearly labelled as not being prepared
under IFRS and the nature of the main adjustments to comply with IFRS disclosed.
The adjustments are not required to be quantified,
1.6 Transition overview
Previous
GAAP
IFRS
1 Jan 04
BS
BS
31 Dec 04
BS
BS
31 Dec 05
BS
The financial statements to 31 December 2004 are published under previous
GAAP. The financial statements to 31 December 2005 are prepared under
IFRS with the comparatives information restated.
2 OPENING IFRS BALANCE SHEET
2.1 Recognition and measurement principles
Recognise all assets and liabilities required by IFRSs (e.g. assets held under
finance leases and lease obligations).
Do not recognise assets and liabilities that are not allowed to be recognised
under IFRSs (e.g. "provisions" which do not meet the definition of a
liability).
Reclassify items as current/non-current, liability/equity in accordance with
IFRSs as necessary (e.g. preferred shares with fixed maturity as debt rather
than equity).
Measure all recognised assets and liabilities in accordance with IFRSs (e.g. at
cost, "fair value" or a discounted amounted).
Because the adjustments that result from changes in accounting policy on
transition arise from events and transactions before the date oftransition they
are recognized directly in retained earnings (or, if appropriate, elsewhere in
equity) at the date of transition.
2.2 Exemptions from other IFRSs
IFRS 1 basically requires full retrospective application of all extant IFRSs on
first-time adoption with limited exemptions for:
o property, plant and equipment (also investment property and intangible assets);
o business combinations;
o employee benefits;
o cumulative translation differences;
o compound financial instruments;
o assets and liabilities of subsidiaries, associates and joint ventures;
o designation ofpreviously recognised fmancial instruments;
o share-based payment transactions;
o insurance contracts; and
o decommissioning liabilities included in the cost ofproperty, plant
and equipment.
o
A first-time adopter may elect to use anyone or more of the available
exemptions.
2.3 Property, plant and equipment
Cost based measurement of some items ofproperty, plant and equipment may
involve undue cost or effort, especially ifthe entity has not kept up-to-date
fixed asset registers.
Items ofproperty, plant and equipment can therefore be measured at their fair value
at the date oftransition and that value deemed to be cost (i.e. "deemed cost").
If an entity has revalued assets under its previous GAAP and the revaluation
is broadly in line with IFRSs then that revalued amount can be taken to be the
deemed cost.
These exemptions are also available for investment property accounted for
under lAS 40's cost model and intangible assets meeting lAS 38's criteria for
asset recognition and revaluation.
If an entity has carried out a fair value exercise of all (or some) of its assets and
liabilities for a particular event (e.g. an initial public offering or privatisation)
then that fair value may be as the deemed cost at the event date.
Comparing revaluation under IFRS 1 with that under lAS 16:
o for IFRS 1 it is a "one-off' exercise - under lAS 16 revaluations
must be kept up-to-date; and
o the IFRS 1 exemption can be applied to any item(s) - under lAS 16
all items in the same class must be revalued
2.4 Business combinations
2.4.1 Electing not to apply IFRS 3
A first-time adopter does not have to apply IFRS 3 Business Combinations
retrospectively to past business combinations (i.e. business combinations that
occurred before the date of transition to IFRSs).
If, however, a first-time adopter restates any business combination to comply
with IFRS 3, all later business combinations must be restated and lAS 36
(Revised) and lAS 38 (Revised) applied.
Illustration 3
A first-time adopter reporting at 31 December 2005 elects to restate a business
combination that occurred on 30 June 2002. It must restate all business combinations
that occurred between 30 June 2002 and 1 January 2004.
This exemption also applies to past acquisitions of investments in associates
and of interests in joint ventures.
2.4.2 Consequences ofnot applyingIFRS 3 retrospectively
The classification as an acquisition, reverse acquisition or a uniting of
interests as in its previous GAAP fmancial statements is not changed.
All assets and liabilities acquired or assumed are recognised at the date of
transition except:
o some financial assets and fmancialliabilities derecognised under
previous GAAP (as above); and
o assets, including goodwill, and liabilities that were not recognised
in the acquirer's consolidated balance sheet under previous GAAP
and also would not qualify for recognition under IFRSs in the
separate balance sheet of the acquiree.
Any resulting change is adjusted against retained earnings (or, if appropriate,
another category of equity), unless it results from the recognition of an
intangible asset that was previously subsumed within goodwill (see
adjustments below).
The opening IFRS balance sheet must exclude any item recognised under
previous GAAP that does not qualify for recognition as an asset or liability
under IFRSs:
o An intangible asset that does not qualify for recognition under lAS
38 is reclassified (together with any related deferred tax and
minority interests) as goodwill;
That is unlessgoodwill wasdeducted directly fromequityunderprevious
GAAP, in which case goodwill is not recognised in theopening balance sheet.
o All other resulting changes are adjusted in retained earnings.
Where IFRS requires subsequent measurement of assets and liabilities on a
basis that is not based on original cost (e.g. fair value) such assets and
liabilities must be measured on that basis in the opening IFRS balance sheet.
That is, evenif theywere acquired orassumed in a past business combination
- any resulting change in thecarrying amount is adjusted against retained
earnings (or, if appropriate, another category of equity), not goodwill.
Immediately after the business combination, the carrying amounts determined
under previous GAAP are deemed cost under IFRSs at that date. This is used
for cost-based depreciation or amortisation from the date of the business
combination.
An item not recognised under previous GAAP but recognized under IFRS
does not have a deemed cost of zero. It is measured in the consolidated
balance sheet on the basis that IFRSs would require in the separate balance
sheet of the acquiree.
Illustration 4
Finance leases acquired in a past business combination must be capitalised in the
consolidated fmancial statements as lAS 17 Leases would require in the acquiree's
separate IFRS balance sheet.
The converse also applies. An item subsumed in goodwill under previous
GAAP that would have been recognised separately under IFRS 3 remains in
goodwill unless IFRSs would require its recognition in the separate financial
statements of the acquiree.
2.4.3 Goodwill adjustments
The carrying amount of goodwill in the opening IFRS balance sheet is the
same as under previous GAAP at the date of transition after the following
three adjustments (if applicable):
o increasing the carrying amount of goodwill for an item previously
recognised as an intangible asset that does not meet IFRS criteria;
o Similarly, decreasing the carrying amount of goodwill if an
intangible asset previously subsumed in recognised goodwill meets
IFRS criteria for recognition. (If applicable, deferred tax and
minority interests will be adjusted also.).
o adjustment for the amount of a contingency affecting the purchase
consideration for a past business combination which is resolved
before the date of transition to IFRSs. A reliable estimate of the
contingent amount is needed and its payment must be probable;
o The carrying amount should similarly be adjusted if a previously
recognised contingent adjustment can no longer be measured
reliably or its payment is no longer probable.
o an impairment test at the date oftransition. Any impairment loss is
adjusted in retained earnings (or revaluation surplus ifrequired by lAS 36).
This is regardless of whether there are any indication that the goodwill may
be impaired.
No other adjustments are made to the carrying amount of goodwill at the date
oftransition.
2.4.4 Exclusionfrom consolidation
If a subsidiary was not previously consolidated, the carrying amounts of the
subsidiary's assets and liabilities are adjusted to the amounts that IFRSs
would require in the subsidiary's separate balance sheet.
The deemed cost of goodwill is the difference at the date of transition
between:
o the parent's interest in the adjusted carrying amounts; and
o the cost of its investment in the subsidiary in the parent's separate
fmancial statements.
Example 1
Suggest three reasons why a subsidiary may not have been consolidated under previous
GAAP.
Solution
2.4.5 Deferred tax and minority interests

The measurement of deferred tax and minority interests follows from the
measurement of other assets and liabilities.
All the above adjustments to recognised assets and liabilities therefore affect
minority interests and deferred tax.
2.5 Employee benefits
At the transition date the net employee benefit liability (or asset) is measured
in accordance with lAS 19 Employee Benefits.
A first-time adopter can elect to recognise all cumulative actuarial gains and
losses at the date of transition (that is, reset any "corridor" recognised under
previous GAAP to zero).
The lAS 19 corridor approach can still be applied to actuarial gains and
losses that arise after first-time adoption of IFRS.
2.6 Cumulative translation differences
All translation adjustments arising on the translation of the financial
statements of foreign entities can be recognised in accumulated profits at the
date of transition (i.e. any translation reserve included in equity under
previous GAAP is reset to zero).
The gain or loss on subsequent disposal of the foreign entity will then be
adjusted only by those accumulated translation adjustments arising after the
opening IFRS balance sheet date.
If this exemption is not used, an entity must restate the translation reserve for
all foreign entities since they were acquired or created.
2.7 Compound financial instruments
The "split-accounting" provisions ofiAS 32 need not be applied where the
liability component of a compound financial instrument is no longer
outstanding at the date of transition.
The original equity component of the compound instrument does not have to
be reclassified out of retained earnings and into other equity.
2.8 Assets and liabilities of subsidiaries
These exemptions apply also to associates and joint ventures.
A subsidiary who adopts later than its parent may measure assetslliabi1ities at
carrying amounts determined for:
o its own transition; or
o the parents consolidated financial statements at an earlier transition.
A parent who adopts later than a subsidiary must measure assets/liabilities
based on the same carrying amounts determined for that subsidiary's
transition.
2.9 Designation of previously recognised financial instruments
lAS 39 Financial Instruments: Recognition and Measurement allows that any
financial instrument be designation on initial recognition as:
o at fair value through profit or loss; or
o available for sale.
This designation is permitted at the date oftransition also.
2.10 Share-basedpayment transactions
2.10.1 Equity instruments
Application ofIFRS 2 "Share-based Payment Transactions" is encouraged
for equity instruments granted:
o on or before 7 November 2002;
o after 7 November 2002 that vested before the later of:
the date of transition; and
1 January 2005.
However, this election can only be made if the fair value determined at the
measurement date has been publicly disclosed.
Where IFRS 2 is not applied the minimum disclosure requirements that
enable users to understand the nature and extent of share-based payment
transactions that existed during the period must still be made.
2.10.2 Liabilities
Application ofIFRS 2 is encouraged for liabilities arising from share-based
payment transactions that were settled before:
o the date of transition; and
o 1 January 2005.
Restatement of comparative information is not required to the extent that it
relates to a period or date earlier than 7 November 2002.
2.11 Insurance contracts
A first-time adopter may apply the transitional provisions of IFRS 4
Insurance Contracts.
An entity shall apply the standard from 1 January 2005 but may adopt early if
it wishes. Early adoption must be disclosed.
An entity does not have to adjust comparative periods if it adopts on 1
January 2005.
If an entity changes accounting policy for insurance liabilities it may
reclassify some or all of its financial assets as fair value throughprofit and
loss.
2.12 Decommissioningliabilities
IFRIC 1 "Changes in Existing Decommissioning, Restoration and Similar
Liabilities" requires that:
o specified changes be added to or deducted from the cost of the
related asset;
o the adjusted depreciable amount be depreciated prospectively over
the assets remaining useful life.
A first-time adopter need not comply with these requirements for changes in
such liabilities that occurred before the date of transition.
Retrospective application ofIFRIC 1 at the date oftransition would require
construction ofa historical record ofadjustments that would have been made
in the past. This will not be practicable in many cases.
A first-time adopter using this exemption:
o measures the liability at the date of transition in accordance with
lAS 37;
o estimates the amount that would have been included in the cost of
the related asset when the liability first arose (by discounting the
liability to that date using its best estimate of the applicable
historical risk-adjusted discount rate); and
o calculates accumulated depreciation on that amount, as at the date
of transition, based on the current estimate of the useful life of the
asset.
Worked example 1
Omega's first IFRS fmancial statements are for the year to 31 December 2005 and
include comparative information for 2004.
Omega acquired an oil rig on 1 January 1999, with an estimated useful life of35 Years.
As 1 January 2004 (the date oftransition), Omega estimates:
Decommissioning cost in 30 years' time - $605,000
Appropriate risk-adjusted discount rate 5% (unchanged since 1 January
1999).
Required:
Summarise the amounts to be recognised in the opening IFRS balance sheet on
1 January 2004.
Worked solution 1
Decommissioning liability recognised at transition date:
Discounting 30 years at 5%:
1
$605,000 x --3-0 = $605,000 x 0.231 = $140,000
1.05
Decommissioning cost of asset (and estimated liability) at acquisition:
Discounting the liabilityfor afurtherfive years to 1 January 1999:
1
$140,000 x -- = $140,000 x 0.784 = $109,800
1.05
5
In summary
Decommissioning cost included in cost ofplant
Accumulated depreciation ($109,800 x 5/35)
Decommissioning liability
Net assets/retained earnings
$140,000
$109,800
$000
109.8
(15.7)
(140.0)
(45.9)
2.13 Mandatory exceptions to retrospective application
As well as the optional exemptions, there are four mandatory exceptions,
concerning:
o derecognition of financial assets and fmancialliabilities;
o hedge accounting;
o estimates (see earlier in this Session); and
o assets classified as held for sale and discontinued operations.
2.13.1 Derecognition offinancial assets andfinancialliabilities
A first-time adopter must apply the derecognition requirements in lAS 39
Financial Instruments: Recognition and Measurement prospectively from 1
January 2004 (the effective date ofIAS 39).
Financial assets or financial liabilities derecognised under previous GAAP in
a financial year beginning before 1 January 2004 cannot be recognised under
IFRS.
2.13.2 Hedge accounting
The hedging requirements ofIAS 39 must be applied prospectively from the date of
transition. This means that the hedge accounting practices, if any, used in periods
prior to the date of transition may not be retrospectively changed.
An entity cannot designate a transaction as a hedge if it was not designated as
such under previous GAAP and any designated hedges under previous GAAP
will be recognised and measured under lAS 39 (irrespective ofwhether there
is hedge documentation or hedge effectiveness).
2.13.3 Heldfor sale classification and discontinued operations
The classification requirements of IFRS 5 are required to be applied
prospectively from the effective date ofIFRS 5 (i.e. 1 January 2005).
Early application is permitted provided the valuations and other information
needed to apply the IFRS were obtained when the classification criteria were
originally met.
If the date of transition is before 1 January 2005 the transitional provisions of
IFRS 5 are applied.
IFRS 5 is applied retrospectively if the date of transition is on or after 1
January 2005.
3.1 Explanation of transition
An entity must explain how the transition to IFRSs has affected its reported
financial position, performance and cash flows. This is achieved through
reconciliation and disclosure and there are no exemptions to the requirements
for these.
3.2 Reconciliations
The following are required to enable users to understand the material
adjustments to the balance sheet and income statement:
o A reconciliation of equity under IFRSs and previous GAAP as at:
the transition date; and
the end of the latest period presented under previous GAAP.
That wouldbe1 January 2004and31 December 2004for the transition
overview shown at section 1.6.
o A reconciliation ofprofit or loss reported under previous GAAP to that under
IFRS for the latest period's income statement presented under previous GAAP.
That wouldbeprofit orloss for theyear to31 December 2004for the
transition overview.
These reconciliations must distinguish between changes in accounting
policies and errors. lAS 8 disclosure requirements do not apply.
Similar reconciliations are required for interim financial reports for part of
the period covered by the first IFRS fmancial statements.
If a cash flow statement was presented under previous GAAP, material
adjustments must be explained.
If an entity uses fair value as deemed cost for any items ofproperty, plant and
equipment (or investment property or intangible asset) as an alternative to
cost-based measurement, the following must be disclosed for each line item:
o the aggregate of those fair values; and
o the aggregate adjustment to carrying amounts reported under
previous GAAP.
Example 2
Balance Sheet at 1 January 2004
Previous
GAAP
m
Property, plant and equipment 8,000
Goodwill 2,000
Intangible assets 1,000
Financial assets 7,000
Total non-current assets 18,000
Trade and other receivables 3,000
Inventories 5,000
Other receivables 600
Cash and cash equivalents 700
Total current assets 9,300
Total assets 27,300
Interest-bearing loans 9,000
Trade and other payables 4,000
Restructuring provision 30
Current tax liability 40
Deferred tax liability 600
Total liabilities 13,670
Total assets less total liabilities 13,630
Issued capital 6,500
Retained earnings 7,130
Total equity 13,630
Example 2 continued
Notes
(i) Depreciation was influenced by tax requirements under previous GAAP.
IFRS reflects the useful life of the assets. The cumulative adjustment
increases the carrying amount ofproperty, plant and equipment by 200
million.
(ii) Intangible assets acquired in a business combination included 300 million
for items that do not qualify for recognition as intangible assets under IFRS.
(iii) Financial assets with a cost of 7,000 million are all classified as available-
for-sale under lAS 39. Their fair value is 7,800 million.
(iv) Inventories are valued at direct manufacturing cost under previous GAAP.
Fixed and variable production overhead of 1,000 million must be included
to comply with lAS 2.
(v) Unrealised gains of 500 million on unmatured forward foreign exchange
contracts which are not recognised under GAAP are recognised under IFRS.
(vi) A pension liability of 100 million is recognised under IFRS but was not
recognised under GAAP. Tax base ofpension liability is zero.
(vii) A restructuring provision of 30 million relating to head office activities was
recognised under previous GAAP, but does not qualify for recognition as a
liability under IFRS.
(viii) The tax rate is 30%.
Required:
Prepare a reconciliation of equity at 1 January 2004 (date of transition to IFRS).
Proforma solution
Reconciliation ofEquity at 1 January 2004
Previous Effect of
GAAP transition to
IFRS
m m
Property, plant and equipment 8,000
Goodwill 2,000
Intangible assets 1,000
Financial assets 7,000
Total non-current assets 18,000
Trade and other receivables 3,000
Inventories 5,000
Other receivables 600
Cash and cash equivalents 700
Total current assets 9,300
Total assets 27,300
Interest-bearing loans 9,000
Trade and other payables 4,000
Restructuring provision 30
Current tax liability 40
Deferred tax liability 600
Total liabilities 13,670
Total assets less total liabilities 13,630
Issued capital 6,500
Retained earnings 7,130
Total equity 13,630
IFRS
m
4 PRACTICAL MATTERS
4.1 Overview
The finance director is most likely to be responsible for the conversion
process. In large entities a steering committee may be formed to manage the
process across the business.
Key stakeholders within the entity need to be made aware how staff may be
affected - particularly in respect of training.
Matters to be considered when making a preliminary assessment ofthe
impact of conversion will include:
o the level ofreadily available IFRS competence of staff, internal
audit and non-executive directors;
o whether specialist help may be needed and, if so, who can provide it;
o identifying agreements, contracts and reports affected by the change in
the financial reporting framework;
o making an initial estimate of the financial effect of changes in key
accounting policies;
o assessing the significance of fair values (e.g. in relation to lASs 39 and 40);
o reviewing any existing weaknesses in internal financial reporting systems;
o deciding the extent to which previous year's fmancial information (prior to
the date of transition) is to be restated.
Example 3
Suggest FOUR contractual arrangements that could be affected by the change.
4.2 Makingthe transition
4.2.1 Accounting
Accounting policies should be selected after a detailed review of the choices
available (especially on transition).
Changes may need to be made to the accounting system to collect the information
necessary to meet disclosure requirements (e.g. of segment reporting).
The group accounting manual should be updated to reflect changes in
terminology as well as changes in accounting policies, measurement bases, etc.
Accounting policies used for internal reporting (e.g. in budgeting systems) may
need to be standardised or made compatible with those used for external
financial reporting.
4.2.2 Treasury
Treasury managers will need to review treasury policy and how they hedge risk.
Some entities may not be able to hedge account in accordance lAS 39 even if
they change their hedging strategy.
Loan agreements may need to renegotiated to avoid breaching covenant limits.
4.2.3 IT and systems
Accounting system changes may be required as a direct result of the change to IFRS.
Changes in IT and systems may also be required in response to the
identification ofbusiness improvement opportunities.
A test run with prior period information may beadvisable before theaudit
committee (if any) confirms management's choice of accounting policies.
4.2.4 Human resources
Resource planning should take account of:
o the impact ofthe change on long-term recruitment plans;
o how day-to-day responsibilities of seconded staff will be covered;
o temporary specialist assistance needed.
Remuneration schemes will need to be reviewed and renegotiated.
Staff will need to be trained.
4.2.5 Training
Internal experts with specialist IFRS knowledge will need to be involved in
the training of others in the organisation. This may require that they be
trained as trainers.
Subsidiary fmance managers will need a broad understanding of the impact
of IFRS on the entity and changes in policy and procedure.
General business managers will need to be made aware of the impact of IFRS
on the business, its reporting and planning processes.
4.2.6 Communication
The financial effects of the change must be communicated to shareholders,
analysts, employees, lenders, etc. This may require a public relations plan to
advertise the adoption ofIFRS.
FOCUS
apply the accounting standard on first-time adoption ofIFRSs, including;
defmitions
adjustments
exceptions
estimates
adoption dates
disclosure.
EXAMPLE SOLUTIONS
Solution 1 - Exclusion from consolidation
It was not regarded as a subsidiary under previous GAAP - the defmition of
subsidiary being based on legal ownership rather than control.
Previous GAAP permitted that certain subsidiaries be excluded from
consolidation (e.g. on the grounds that their activities are sufficiently
different from those of the rest of the group).
The parent did not prepare consolidated financial statements (e.g. in
jurisdictions where financial statements are for legal entities only).
Solution 2 - Reconciliation of equity at 1 January 2004
Previous Effect of IFRS
GAAP transition to
IFRS
m m m
Property, plant and equipment (i) 8,000 200 8,200
Goodwill (ii) 2,000 300 2,300
Intangible assets (ii) 1,000 (300) 700
Financial assets (iii) 7,000 800 7,800
Total non-current assets 18,000 1,000 19,000
Trade and other receivables 3,000 0 3,000
Inventories (iv) 5,000 1,000 6,000
Other receivables (v) 600 500 1,100
Cash and cash equivalents 700 0 700
Total current assets 9,300 1,500 10,800
Total assets 27,300 2,500 29,800
Interest-bearing loans 9,000 0 9,000
Trade and other payables 4,000 0 4,000
Employee benefits (vi) 0 100 100
Restructuring provision (vii) 30 (30) 0
Current tax liability 40 0 40
Deferred tax liability (W2) 600 729 1,329
Total liabilities 13,670 799 14,469
Total assets less total liabilities 13,630 1,701 15,331
Issued capital 6,600 0 6,500
Revaluation reserve 70% x (iii) 0 560 560
Retained earnings (WI) 7,130 1141 8,271
Total equity 13,630 1,701 15,331
WORKINGS
Depreciation
Production overhead
Foreign exchange contract
Pension liability
Restructuring provision
Tax effect of the above
(i)
(iv)
(v)
(vi)
(vii)
m
200
1,000
500
(100)
30
1,630
(489)
Total adjustment to retained earnings
(2) Deferred tax liability
1141
Revaluation reserve
Retained earnings
Increase in deferred tax liability
30% x (iii)
30% x (WI)
m
240
489
729
Because the tax base at 1 January 2004 ofthe items reclassifiedfrom
intangible asset to goodwill equals their carrying amount at that date, the
reclassification does not affect deferred tax liabilities.
Solution 3 - Arrangements affected
Bank and other loan agreements (e.g. financial ratios specified in loan
covenants may be adversely affected).
Reporting to industry regulators.
Remuneration schemes and profit-related pay. Negotiations with the tax
authorities may be necessary to maintain tax efficient schemes.
Performance related share option schemes.
INDEX
B
A
c
3506
1006
307
508
909
505
3802
903
504
4311
1911
309
2303
403
507
4102
4102
4102
2310
1708
1708,2405
1912
3808
803
1303,2203,2204,2310
1617
3322
4204
3102
4201
1403
3324
1317,1406
3508
3321
3108
4311
3804
510
3509
511
3508
1803
1803
510
3306
Combinations
Commencement of Capitalisation
Comparability
Comparative information
Compensation for impairment
Compliance with lASs
Component
Components of cost
Components of fmancial statements
Compound fmancial instruments
Compound instruments
Concepts of capital
Conceptual background
Consignment inventory
Consistency
Consolidated Balance Sheet
Consolidated Cash Flow Statement
Consolidated Income Statement
Consolidated income statements
Contingent assets
Contingent liabilities
Contingent settlement provisions
Continuing operations
Contract costs
Control
Corporate assets
Corporate failure
Corporate governance
Corporate reconstruction
Cost
Cost and price indices
Cost model
CPP specific adjustments
Creative accounting
Creditors buffer
Cumulative translation differences
Current asset
Current assets
Current cost accounts
Current liabilities
Current purchasing power CPP
Current tax assets
Current tax liabilities
Current/non-current distinction
Customers
4204
309
909
3407,3417,3418
1932
1613
2112
3509
1007
3204
3009
Accounting for leases 1202
Accounting for subsidiaries 2202
Accounting policies 2206,2813,3308,4304
Accrual basis 305,506
Acquired in-process research and development
1311
3413
1318
2016
3902
507,4007
1220
107
3322
1323,2416
3323
3411
Cadbury Report
Capital maintenance
Carrying Amount
Cash equivalents
Cash flow hedges
Cash-generating units
Cash-settled transactions
CCA specific adjustments
Cessation of Capitalisation
City code on takeovers and mergers
Closing rate method
Balance Sheet 510
Balance Sheet approach 1806
Balance Sheet presentation 513
Barriers to harmonisation 205
Basic earnings 3603
Basic earnings per share 3603
Basic weighted average number of ordinary
shares 3603
Benchmark treatment 107
BigGAAP 108
Borrowing costs allowed alternative treatment
1003
Borrowing costs arguments 1002
Borrowing costs benchmark treatment 1003
Borrowing costs eligible for capitalisation1004
Business Combinations 1822
Business reporting on the Internet 524
Business segments 3705
Acquisition and disposal of subsidiaries
Active markets
Actuarial Valuation Method
Adjusting events
Aggregation
Allocation of fmance income
Allowed alternative treatment
Altman
Amortisation
Argenti
Associated undertakings
INDEX
D
3010
904,1310
408
505
905,1927,2403
1930
1608
1404
1924
1926
3405
1322
4303
3014
3009
3009
1103
301
1712
3418
F
Exchange difference
Exchange of assets
Factoring of debts
Fair presentation
Fair value
Fair value hedges
Fair value less costs to sell
Fair value model
Financial asset
Financial liability
Financing activities
Finite useful lives
First-time adopter
Foreign associates
Foreign currency translation
Foreign entity
Forgivable loans
Framework
Future operating losses
Futures
G
G4 + 1 113
G4+1 Discussion Paper on Leases 1226
G4+1 Position Paper on reporting financial
performance 521
G4+1 Proposals 522
GAJ\P 102
Gain or Loss on Net Monetary Position 3512
Gains and losses 1505
Geographical segments 3705
Going concern 305, 506, 3903
Goodwill 2401, 2402, 3011
Goodwill adjustments 4309
Government and their agencies 3306
Government Assistance 1105
Government grant 1309
Government grants 1103, 1506
Grants related to assets 1104
Grants related to income 1105
Growth of IASs 207
v
4306
4307
3317
307
4310
2106
3304
202
3603
2804
2104,2106
2105
4304
208
3805
2413
2508
1710
1809
2612
1815
1813
1804
2006
2005
307
2618
505
908
908,3806
909
402
1924
309
1313
3609
3404,3408
520
602
508
3803
2016
3802
3014
2602
1406,2601
3110,3111
3110
1911,2815,3903
E
Efficiency
Elements of financial statements
Employee benefits
Employee's remuneration
Employees
Environmental factors
EPS
Equity accounting
Equity instrument
Equity-settled transactions
Estimates
European Union directives
Events after the balance sheet date
Excess
Excluded topics
Exemptions from IFRSs
Exemptions from other IFRSs
D shaped groups
Decommissioning liabilities
Deductible Temporary Difference
Deemed disposals
Deferred tax assets
Deferred tax liabilities
Deferred taxation
Defined benefit schemes
Defined contribution schemes
Definitions of elements
Demergers
Departure from IAS
Depreciable amount
Depreciation
Derecognition
Derecognition
Derecognition
Determination of profit
Development phase
diluted EPS
Direct method
Directly to equity
Disaggregation
Disclosure
Discontinued operation
Discount Rate
Disposal group
Disposal of foreign entity
Disposal possibilities
Disposals
Distributable profit
Distribution
Dividends
lAS 1Presentation ofFinancial Statements
501
lAS 10 Defmitions 3902
lAS 10 Events after the Balance Sheet Date
3901
lAS 10 Scope 3902
lAS 11 Rules 804
lAS 11 Scope 802
lAS 12 Income Taxes 1801
lAS 12 Scope 1802
lAS 14 Scope 3702
lAS 14 Segment Reporting 3701
lAS 16 Exclusions 902
lAS 16 Property, Plant and Equipment 901
lAS 16 Scope 902
lAS 17 Leases 1201
lAS 17 Scope 1202
lAS 18 Revenue 701
lAS 18 Scope 702
lAS 19 Employee Benefits 2001
lAS 19 Scope 2002
lAS 20 Accountingfor Government Grants &
Disclosure ofGovernment Assistance 1101
lAS 20 Scope 1102
lAS 21 The Effects ofChanges in Foreign
Exchange Rates 3001
lAS 23 Borrowing Costs 1001
H
Hampel Report
Harmonisation
Hedge accounting
Hedging instruments
Held for sale classification
Highly probable
Holding gains
Hyperinflationary
Hyperinflationary Economies
Ch
Change in tax rates
Changes in equity
Changes in provisions
I
4205
202
1929,4315
1929
3804
3805
3502
3513
3511
1819
517,4103
1709
INDEX
lAS 23 Definitions 1003
lAS 23 Scope 1002
lAS 24 Related Parties 4001
lAS 24 Scope 4002
lAS 27 "Consolidated and Separate Financial
Statements" 2201,2208
lAS 28 "Investments in Associates" 2801
lAS 31 "Interest in Joint Ventures" 2901
lAS 32 "Financial Instruments: Disclosure and
Presentation" 1901
lAS 33 Earningper Share 3601
lAS 33 Scope 3602
lAS 34 Interim Financial Reporting 4101
lAS 34 Scope 4102
lAS 36 "Impairment of Assets" 1601
lAS 37 Provisions, Contingent Liabilities and
Contingent Assets 1701
lAS 37 Scope 1702
lAS 38 "Intangible Assets" 1301
lAS 39 "Financial Instruments: Recognition
and Measurement" 1901
lAS 40 Investment Properties 1401
lAS 40 Scope 1402
lAS 41 Agriculture 1501
lAS 41 Scope 1502
lAS 7 Cash Flow Statements 3401
lAS 8 Accounting policies, changes in
accounting estimates and errors 601
lAS 8 Scope 604
IASB 104, 206
lASs 106
lASs development 106
lASs interpretation 106
lASs scope and application 107
Identifiability 1303
Identifiable assets and liabilities 2405,2406
IFAC 103
IFRIC 110
IFRIC 1 1709,4313
IFRS 1 First-time adoption ofIntemational
Financial Reporting Standards 4301
IFRS 2 "Share-based Payment" 2101
IFRS 3 "Business Combinations" 2201, 2209
IFRS 5 3801
Impairment 909, 1327,2813
Impairment losses 1603
Impairment review 2416
Income statement presentation 514
INDEX
503,504
104
3509
508
4202
1712
4304,4306
3404
4202
2111
3418,3613
3615
3101
904
2310
o
Monopolies & Mergers Commission 3204
Movement deferred tax balance 1817
N
Objectives of financial statements
Objectives ofIASB
OCMversion
Offsetting
OFR
Onerous contracts
Opening IFRS balance sheet
Operating activities
Operating and fmancial review
Option-pricing model
Options
Order of dilution
Organizational structure
Overhaul costs
Ownership
National standard setting bodies 112
Net investment in a foreign entity 3006
Nokia 1918
Non adjusting events 3903
Non cash transactions 3417
Non current asset transfers 2310
Non depreciation 913
Non-current asset 3804
Non-monetary government grants 1104
2902
2908
2909
2904
110
2206
2406
3405
3303
3319
206
1327
1205
3404,3409
3503
1403
903
1328, 1603
1826
2815
1911
706
1312
1312
106
103
Joint ventures
Jointly controlled assets
Jointly controlled entities
Jointly controlled operations
J
K
Indefmite useful lives
Indicators of finance leases
Indirect method
Inflation
Initial measurement
Initial measurement at cost
Intangible assets
Inter company transactions
Inter-company trading
Interest
Interest, royalties and dividends
Internally generated goodwill
Internally generated intangible assets
International Accounting Standards
International Federation of Accountants
International Financial Reporting
Interpretations Committee
Intra-group trading
Inventories
Investing activities
Investors
Investors' ratios
IOSCO project
Key areas syllabus v
p
L
M
904
3603
2017
602,3310
2702
906
2413
2004
524
3324
4004
3705
207
206
4307
1704,2405
3306
2403
2206,2402
3108
302
Part replacement
Partly paid shares
Past Service Cost
Performance
Piecemeal acquisitions
Plant and equipment
Positive goodwill
Post retirement benefits
Presentation of accounting policies
Price indices
Pricing related party transactions
Primary Segment
Problems with adoption ofIASs
Progress on harmonisation
Provisions
Public
Purchase consideration
Purchase method
Purchase of own shares
Purpose Framework
2406
507
1503,1708,2005,3902
309
702
2311
3410
Marketable securities
Materiality
Measurement
Measurement bases
Measurement of revenue
Mid-year acquisitions
Minority interests
Land and buildings 905
Lease classification 1205
Lenders 3305
Lessee accounting finance lease 1210
Lessee accounting operating lease 1218
Lessor accounting finance lease 1220
Lessor accounting operating lease 1221
Limitations ofratios 3306
Little GAAP 108
Long term solvency 3314
INDEX
s
Sale and leaseback 1222
Sale and leaseback finance lease 1222
Sale and leaseback operating lease 1224
Sale and repurchase agreements 405
Sale of goods 703
Scope Framework 302
Secondary Segment 3705
Segment reporting 1624
Share option 2104
Share-based payments 2102
Shares valuation 3201
Short term employee benefits 2004
Short term liquidity 3312
SIC 10 - Government assistance - No specific
relation to operating activities 1106
SIC 21 - Income Taxes - Recovery of
Revalued Non-Depreciable Assets 1820
Realised 3110
Recognition 402,1403,1503,2005,3902
Recognition assets and liabilities 402
Recognition criteria 308,903, 1312
Recoverable amount 1607
Recycling 522
Refurbishment Costs 1715, 1716
Regulatory environment 3204
Regulatory framework 2301
Related party 4003
Relevance 306
Reliability 306
Rendering of services 704
Rentals in advance 1213
Rentals in arrears 1211
Repairs and maintenance 1715
Reportable segments 3706
Research and development expenditure 1332
Research phase 1313
Residual value 1324
Restructuring 1713
Retirements and disposals 1327
Retrospective application 4315
Revaluation model 1317
Revaluations 905, 1332, 2410, 3111
Revenue recognition Key issues 802
Reversals of impairment losses 1622
Risks and rewards of ownership 1205
iii
iii
1207
2803,2804
2204
3102
104
2507
2505
904,1311
905
401
504
3305
1007
3418
1809, 1824
4104
1818
1809
1823, 1824
1406
4305
4304
1913
3324
2202
2502
305
305
2306,2310,2816
1710
4104
908,1321
3302
303
T
SIC 25 - Income Taxes - Changes in the Tax
Status of an Entity or its Shareholders 1821
SIC 7 - Introduction of the Euro 3015
SIC-12: Consolidation 2204
SIC-13: Jointly Controlled Entities 2914
SIC-15: Operating Leases 1218
SIC-27: Evaluating the Substance of
Transactions
Significant influence
Special purpose entities
Stakeholders
Structure of IASB
Sub associate
Sub subsidiary
Subsequent expenditure
Subsequent measurement
Substance over form
Supplementary statements
Suppliers and other creditors
Suspension of Capitalisation
Swaps
Syllabus aim
Syllabus objectives
u
Underlying Assumptions
Understandability
Unrealised profit
Unwinding of the discount
Use of Estimates
Useful life
Users
Users and their information needs
Tax base
Tax charge
Tax rates
Taxable Temporary Difference
Temporary differences
Transfers
Transition overview
Transition to IFRSs
Treasury shares
Trend analysis
True and fair
Types of structure
305
407
Q
R
Qualitative Characteristics
Quasi subsidiaries
INDEX
v w
Valuation technique
Valuations asset based methods
Valuations dividends based
Valuations earnings based methods
Value in use
Vesting conditions
2111
3202
3203
3203
1610
2104,2107
Withholding tax 1803

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ACCA Advanced Corporate Reporting 2005

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The classification and recording of

Objective is to express an opinion

The presentation and interpretation of

Draft statement ofprinciples

Investors and their

Risk and return of investment. Need information

Employees and their

Stability and profitability of employers.

Ability to provide remuneration, retirement benefits

Whether loans and interest will be paid when due.

Suppliers and other

Whether amounts owing will be paid when due.

Continuance - important for long-term involvement

Allocation of resources and, therefore, activities of

Information to regulate activities, determine

Contribution to local economy including number of

Trends and recent developments in prosperity and

To predict capacity to activities.

To form judgements about equivalents and needs to

Principal qualitative characteristics

The amount paid (or the fair

The amount received in

The amount that would have to

The undiscounted amount that

The amount that could currently

At settlement values (i.e. the

Present discounted value of the

Present discounted value of the

Finance cost recognised on

Finance cost recognised

Finance is offbalance sheet

Finance is on balance sheet

Present separately in financial

Aggregate with amounts of similar

Need not be presented separately.

DISCLOSE unless an lAS

INCLUDE when relevant to

Expenses are aggregated by nature eg

Simple to apply in many small entities

Provides more relevant info to users

Cost allocation can be arbitrary and

Less judgement required involves considerable judgement.

The requirements may be satisfied in a number ofways.

In many jurisdictions a columnar format is adopted with a separate column

An alternative approach would be to present a separate component of the

Interest - charges for use of

Royalties - charges for use of

For each class

Items stated at revalu

Credit directly to shareholders'

Take to income over one or

Financing device should be

Receipts from a source other

No repayment is expected :. shareholders'interests.

Government grants are rarely

As extension of fiscal policies,

Free technical or marketing advice

Government procurement policy

Existence ofbenefit might be

Terms ofthe lease

Land and buildings

Rentals in arrears for an 0

Rentals in advance lease