ACCA –

FINANCIAL REPORTING

STUDY NOTES
 TABLE OF CONTENTS
Sr. # Topic Page #
1. Conceptual and regulatory framework 1
2. IAS 1 Presentation of Financial Statements 9
3. Companies – Basic adjustments 13
4. IAS 16 Property, Plant and Equipment 17
5. IAS 38 Intangible Assets 35
6. IAS 36 Impairment of Assets 43
7. IAS 40 Investment Property 50
8. IAS 2 Inventories 55
9. IAS 41 Agriculture 58
10. IAS 8 Accounting Policies, Changes in 61
Accounting Estimates and Errors

11. IAS 23 Borrowing Costs 66

12. Financial instruments 69
13. IAS 37 Provisions, Contingent Liabilities and 87
Contingent Assets
14. IFRS 16 Leases 94
15. IFRS 13 Fair Value Measurement 103
16. IAS 20 Accounting for Government Grants and 108
Disclosure of Government Assistance

17. IAS 10 Events after the Reporting Period 112

18. IAS 12 Income Taxes 120
19. IFRS 15 Revenue from Contracts with Customers 126
 TABLE OF CONTENTS
20. IAS 7 Statement of Cash Flows 133
21. IFRS 5 Non-Current Assets Held for Sale and 143
Discontinued Operations
22. IAS 21 The Effects of Changes in Foreign 148
Exchange Rate
23. IAS 33 Earnings per Share 150
24. Consolidated Financial Statements 161
25. Consolidated statement of financial position 164
26. Consolidated statement profit or loss and other 172
comprehensive income
27. Investments in associates & disposal of 174
subsidiary
28. Disposal of investment 177
29. Interpretation of financial statements and ratio 179
analysis
30. Not for profit and public sector entities 197
Detailed syllabus
A The conceptual and regulatory framework for
financial reporting
1. The need for a conceptual framework and
the characteristics of useful information
2. Recognition and measurement 3.
Regulatory framework
4. The concepts and principles of groups and
consolidated financial statements
B Accounting for transactions in financial
statements
1. Tangible non-current assets
7. Provisions and events after the reporting
period
8. Taxation
9. Reporting financial performance
10. Revenue
11. Government grants
12. Foreign currency transactions
C Analysing and interpreting the financial
statements of single entities and groups
1. Limitations of financial statements
2. Calculation and interpretation of accounting
ratios and trends to address users’ and
stakeholders’ needs

2. Intangible assets 3. Limitations of interpretation techniques

3. Impairment of assets 4. Specialised, not-for-profit, and public sector

entities
4. Inventory and biological assets
D Preparation of financial statements
5. Financial instruments
1. Preparation of single entity financial statements
6. Leasing
2. Preparation of consolidated financial
statements including an associate
Approach to examining the syllabus

The syllabus is assessed by a three-hour examination available in both computerbased and paper-based
formats.*

*For paper-based exams there is an extra 15 minutes to reflect the manual effort required.

All questions are compulsory. The exam will contain both computational and discursive elements.

Some questions will adopt a scenario/case study approach.

Computer-based exams

*For computer-based exams an extra 20 minutes is provided to candidates to reflect the additional content as
per below. The total exam time is therefore 3 hours and 20 minutes. Prior to the start of the exam candidates
are given an extra 10 minutes to read the exam instructions.

Section A of the computer-based exam comprises 15 objective test questions of 2 marks each plus additional
content as per below.

Section B of the computer-based exam comprises three questions each containing five objective test questions
plus additional content as per below.

For the computer-based exam candidates will be delivered an extra 10 marks of objective test content (either
five single OT questions OR five OT questions based around a single scenario), for which candidates are given an
extra 20 minutes. These questions are included to ensure fairness, reliability and security of exams. These
questions do not directly contribute towards the candidate’s score. Candidates will not be able to differentiate
between the questions that contribute to the result and those that do not.

Section C of the exam comprises two 20 mark constructed response questions.

Paper-based exams

*For paper-based exams an extra 15 minutes is provided to candidates to reflect the manual effort required as
compared to the time needed for the computer-based exams. The total exam time is therefore three hours and
15 minutes. Prior to the start of the exam candidates are given an extra 10 minutes to read the exam instructions.

Section A of the paper-based exam comprises 15 multiple choice questions of 2 marks each

Section B of the paper-based exam comprises three questions containing five multiple choice questions.
Section C of the exam comprises two 20 mark questions.

The 20 mark questions will examine the interpretation and preparation of financial statements for either a single
entity or a group. The section A questions and the other questions in section B can cover any areas of the
syllabus.

An individual question may often involve elements that relate to different subject areas of the syllabus. For
example the preparation of an entity’s financial statements could include matters relating to several accounting
standards.

Questions may ask candidates to comment on the appropriateness or acceptability of management’s opinion or
chosen accounting treatment. An understanding of accounting principles and concepts and how these are
applied to practical examples will be tested.

Questions on topic areas that are also included in Paper F3 will be examined at an appropriately greater depth
in this paper.

Candidates will be expected to have an appreciation of the need for specified accounting standards and why
they have been issued. For detailed or complex standards, candidates need to be aware of their principles and
key elements.
Study Guide
A. the conceptual and regulatory
framework for financial reporting
1. The need for a conceptual framework and the
characteristics of useful information
a) Describe what is meant by a
conceptual framework for financial
reporting.[2]
b) Discuss whether a conceptual framework is
necessary and what an alternative system might
be.[2]
c) Discuss what is meant by relevance and faithful
representation and describe the qualities that
enhance these characteristics.[2]
d) Discuss whether faithful representation
constitutes more than compliance with
accounting standards.[1]
e) Discuss what is meant by
understandability and verifiability in relation to
the provision of financial information.[2]
f) Discuss the importance of comparability and
timeliness to users of financial statements.[2]
g) Discuss the principle of
comparability in accounting for changes in
accounting policies.[2]
2. Recognition and measurement
a) Define what is meant by ‘recognition’
in financial statements and discuss the
recognition criteria.[2]
b) Apply the recognition criteria to: [2]
i) assets and liabilities.
ii) income and expenses.
c) Explain and compute amounts using
[2]
the following measures : i) historical cost
ii) current cost iii) net realisable value iv)
present value of future cash
flows
v) fair value
d) Discuss the advantages and disadvantages of
historical cost accounting.
e) Discuss whether the use of current
value accounting overcomes the problems of
historical cost accounting.[2]
f) Describe the concept of financial
and physical capital maintenance
and how this affects the
determination of profits.[1]
3. Regulatory framework
a) Explain why a regulatory framework is needed
including the advantages and disadvantages of
IFRS over a national regulatory framework.[2]
b) Explain why accounting standards
on their own are not a complete regulatory
framework.[2]
c) Distinguish between a principles based and a
rules based framework
and discuss whether they can be
complementary.[1]
d) Describe the IASB’s Standard setting process
including revisions to and interpretations of
Standards.[2] e) Explain the relationship of
national standard setters to the IASB in
respect of the standard setting process.[2]
4. The concepts and principles of groups and
consolidated financial statements
a) Describe the concept of a group as a single
economic unit.[2]
b) Explain and apply the definition of a
subsidiary within relevant accounting
standards.[2]
c) Using accounting standards and other
regulation, identify and outline the
circumstances in which a group is required to
prepare consolidated financial statements. [2]
d) Describe the circumstances when a group may
claim exemption from the preparation of
consolidated financial statements.[2]
e) Explain why directors may not wish to
consolidate a subsidiary and when this is
permitted by accounting standards and other
applicable
regulation.[2]
f) Explain the need for using
 coterminous year ends and uniform accounting
polices when preparing consolidated financial
statements.[2]
g) Explain why it is necessary to
eliminate intra group transactions. [2]
h) Explain the objective of consolidated financial
statements. [2]
i) Explain why it is necessary to use fair values for
the consideration for an investment in a
subsidiary together with the fair values of a
subsidiary’s identifiable assets and liabilities
when preparing consolidated financial
statements. [2]
j) Define an associate and explain the principles
and reasoning for the use of equity accounting.
[2]
B Accounting for
transactions in financial statements
1. Tangible non-current assets
a) Define and compute the initial measurement of
a non-current asset (including borrowing costs
and an asset that has been
self-constructed).[2]
b) Identify subsequent expenditure that
may be capitalised, distinguishing between
capital and revenue
items.[2]
c) Discuss the requirements of relevant
accounting standards in relation to the
revaluation of non-current assets.[2]
d) Account for revaluation and disposal
gains and losses for non-current
assets.[2]
e) Compute depreciation based on the cost and
revaluation models and on assets that have two
or more
significant parts (complex assets).[2]
f) Discuss why the treatment of
investment properties should differ from other
properties.[2]
g) Apply the requirements of relevant
accounting standards to an investment
property.[2]
2. Intangible non-current assets
a) Discuss the nature and accounting
treatment of internally generated and
purchased intangibles.[2]
b) Distinguish between goodwill and other
intangible assets.[2]
c) Describe the criteria for the initial
recognition and measurement of intangible
assets.[2]
d) Describe the subsequent accounting
treatment, including the principle of impairment
tests in relation to
goodwill.[2]
e) Indicate why the value of purchase
consideration for an investment may be less
than the value of the acquired identifiable net
assets and how the difference should be
accounted for.[2]
f) Describe and apply the requirements
of relevant accounting standards to research
and development
expenditure.[2]
3. Impairment of assets
a) Define, calculate and account for an
impairment loss.[2]
b) account for the reversal of an
impairment loss on an individual asset
c) Identify the circumstances that may indicate
impairments to assets.[2]
d) Describe what is meant by a cash generating
unit.[2]
e) State the basis on which impairment losses
should be allocated, and allocate an impairment
loss to the assets of a cash generating unit.[2]
4. Inventory and biological assets
a) Describe and apply the principles of inventory
valuation.[2]
b) Apply the requirements of relevant
accounting standards for biological assets.[2]
5 Financial instruments
a) Explain the need for an accounting standard on
financial instruments.[1]
b) Define financial instruments in terms
of financial assets and financial
liabilities.[1]
c) Explain and account for the factoring of
receivables.
d) Indicate for the following categories of financial
instruments how they should be measured and
how any gains and losses from subsequent
measurement should be treated in the financial
statements: [1] i) amortised cost ii) fair value
through other comprehensive income ( including
where an irrevocable election has been made
for equity instruments that are not held for
trading)
iii) fair value through profit or loss [2]
e) Distinguish between debt and equity capital.[2]
f) Apply the requirements of relevant
accounting standards to the issue and finance
costs of: [2] i) equity ii) redeemable preference
shares and debt instruments with no
conversion rights (principle of amortised cost)
iii) convertible debt
6. Leasing
a) Account for right of use assets and
lease liabilities in the records of the lessee.[2]
b) Explain the exemption from the
recognition criteria for leases in the records of
the lessee.[2]
c) Account for sale and leaseback agreements.[2]
7. Provisions and events after the reporting period
a) Explain why an accounting standard
on provisions is necessary.[2]
b) Distinguish between legal and constructive
obligations.[2]
c) State when provisions may and may not be
made and demonstrate how they should be
accounted for.[2]
d) Explain how provisions should be measured.[1]
e) Define contingent assets and liabilities and
describe their
accounting treatment and required
disclosures.[2]
f) Identify and account for:[2]
i) warranties/guarantees ii) onerous contracts
iii) environmental and similar provisions
iv) provisions for future repairs or
refurbishments.
g) Events after the reporting period
i) distinguish between and account
for adjusting and non-adjusting events
after the reporting period [2]
ii) Identify items requiring separate
disclosure, including their accounting
treatment and required disclosures.[2]
8. Taxation
a) Account for current taxation in
accordance with relevant accounting
standards.[2]
b) Explain the effect of taxable
temporary differences on accounting and
taxable profits.[2]
c) Compute and record deferred tax
amounts in the financial statements.[2]
9. Reporting financial performance
a) Discuss the importance of identifying
and reporting the results of discontinued
operations.[2]
b) Define and account for non-current
assets held for sale and discontinued
operations.[2]
c) Indicate the circumstances where separate
disclosure of material items of income and
expense is required.[2]
d) Account for changes in accounting estimates,
changes in accounting policy and correction of
prior period errors
e) Earnings per share ( eps )
i) calculate the eps in accordance with
relevant accounting standards (dealing with
bonus issues, full market value issues and
rights issues) [2]
ii) explain the relevance of the diluted eps and
calculate the diluted eps involving
convertible debt and share options
(warrants) [2]
10. Revenue
a) Explain and apply the principles of recognition
of revenue:
(i) Identification of contracts
(ii) Identification of performance obligations
(iii) Determination of transaction price
(iv) Allocation of the price to performance
obligations
(v) Recognition of revenue when/as
performance obligations are satisfied.
b) Explain and apply the criteria for recognising
revenue generated from contracts where
performance obligations are satisfied over time
or at a point in time.[2]
c) Describe the acceptable methods for
measuring progress towards complete
satisfaction of a performance obligation.[2]
d) Explain and apply the criteria for the
recognition of contract costs. [2]
e) Apply the principles of recognition
of revenue, and specifically account for the
following types of transaction:[2]
(i) principal versus agent ii) repurchase
agreements iii) bill and hold arrangements
iv) consignments
f) Prepare financial statement extracts for
contracts where performance obligations are
satisfied over time.[2]
11. Government grants
a) Apply the provisions of relevant accounting
standards in relation to accounting for
government grants.[2]
12. Foreign currency transactions
a) Explain the difference between functional and
presentation currency and explain why
adjustments for foreign currency transactions
are necessary.
b) Account for the translation of foreign currency
transactions and monetary/non-monetary
foreign currency items at the reporting date.
C Analysing and interpreting the
financial statements of single
entities and groups
1. Limitations of financial statements
a) Indicate the problems of using historic
information to predict future performance and
trends.[2]
b) Discuss how financial statements may be
manipulated to produce a
desired effect (creative accounting, window
dressing).[2]
c) Explain why figures in a statement of financial
position may not be representative of average
values throughout the period for example, due
to:[2]
i) seasonal trading ii) major asset acquisitions
near the end of the accounting period.
d) Explain how the use of consolidated
financial statements might limit interpretation
techniques
2 Calculation and interpretation of accounting
ratios and trends to address users’ and
stakeholders’ needs
a) Define and compute relevant financial ratios.[2]
b) Explain what aspects of performance specific
ratios are intended to assess.[2]
c) Analyse and interpret ratios to give an
assessment of an entity’s/group’s performance
and financial position in comparison with: [2]
i) previous period’s financial statements
ii) another similar entity/group for the same
reporting period
iii) industry average ratios.
d) Interpret financial statements to give
advice from the perspectives of different
stakeholders.[2]
e) Discuss how the interpretation of current value
based financial statements would differ from
those using historical cost based accounts.[1]
3. Limitations of interpretation techniques
a) Discuss the limitations in the use of
ratio analysis for assessing corporate
performance.[2]
b) Discuss the effect that changes in accounting
policies or the use of different accounting
polices between entities can have on the ability
to interpret performance.[2]
c) Indicate other information, including non-
financial information, that may be of relevance
to the assessment of
an entity’s performance.[1]
d) Compare the usefulness of cash flow
information with that of a statement of profit or
loss or a statement of profit or loss and other
comprehensive income.[2]
e) Interpret a statement of cash flows
(together with other financial
information) to assess the
performance and financial position of an
entity.[2]
f) i) explain why the trend of eps may be a more
accurate indicator of performance than a
company’s profit trend and the importance of
eps as a stock market indicator [2]
ii) discuss the limitations of using
eps as a performance
measure.[3]
4. Specialised, not-for-profit and public sector
entities
a) Explain how the interpretation of the
financial statement of a specialised, not-for-
profit or public sector organisations might differ
from that of a profit making entity by reference
to the different aims, objectives and reporting
requirements.[1]
D Preparation of financial statements
1. Preparation of single entity financial statements
a) Prepare an entity’s statement of
financial position and statement of profit or loss
and other comprehensive income in accordance
with the structure and content prescribed within
IFRS and with accounting treatments as
identified within syllabus areas A, B and C. [2]
b) Prepare and explain the contents
and purpose of the statement of changes in
equity. [2]
c) Prepare a statement of cash flows for a single
entity (not a group) in accordance with relevant
accounting standards using the indirect method
. [2]
2. Preparation of consolidated financial statements
including an associate
a) Prepare a consolidated statement of financial
position for a simple group (parent and one
subsidiary and associate) dealing with pre and
post acquisition profits, non-controlling interests
and consolidated
goodwill.[2]
b) Prepare a consolidated statement of profit or
loss and consolidated statement of profit or loss
and other comprehensive income for a simple
group dealing with an acquisition in the period
and non-controlling
interest.[2]
c) Explain and account for other
reserves (e.g. share premium and
revaluation surplus).[1]
d) Account for the effects in the
financial statements of intra-group
trading.[2]
e) Account for the effects of fair value
adjustments (including their effect on
consolidated goodwill) to: [2] i) depreciating and
non-
depreciating non-current assets
ii) inventory iii) monetary liabilities iv) assets and
liabilities not included in the subsidiary’s own
statement of financial position, including
contingent assets and liabilities
f) Account for goodwill impairment.[2]
g) Describe and apply the required
accounting treatment of consolidated
goodwill.[2]
h) Explain and illustrate the effect of the disposal of
a parent’s investment in a subsidiary in the
parent’s individual financial statements and/or
those of the group ( restricted to disposals of the
parent’s entire investment in the subsidiary).
Summary of changes to Financial Reporting ( FR )
ACCA periodically reviews its qualification syllabuses so that they fully meet the needs of stakeholders such as
employers, students, regulatory and advisory bodies and learning providers.

Note of significant changes to study guide:

Table 1 – Deletions

Section and subject area Syllabus content

D1c) Prepare a statement of cash
flows for a single entity (not a
group) in accordance with
relevant accounting standards
using the indirect method
The direct method has been excluded
from the Financial Reporting (FR)
syllabus as it is examined in Financial
Accounting ( FA )

0
THE CONCEPTUAL AND REGULATORY FRAMEWORK FOR FINANCIAL REPORTING

CONCEPTUAL FRAMEWORK

The IFRS Framework describes the basic concepts that underlie the preparation and presentation of financial
statements for external users. A conceptual framework can be seen as a statement of generally accepted accounting
principles (GAAP) that form a frame of reference for the evaluation of existing practices and the development of
new ones.

Purpose of framework

It is true to say that the Framework:

 Seeks to ensure that accounting standards have a consistent approach to problem solving and do not
represent a series of ad hoc responses that address accounting problems on a piece meal basis
 Assists the IASB in the development of coherent and consistent accounting standards
 Is not a standard, but rather acts as a guide to the preparers of financial statements to enable them to
resolve accounting issues that are not addressed directly in a standard
 Is an incredibly important and influential document that helps users understand the purpose of, and
limitations of, financial reporting
 Used to be called the Framework for the Preparation and Presentation of Financial Statements
 Is a current issue as it is being revised as a joint project with the IASB's American counterparts the Financial
Accounting Standards Board.
Advantages of a conceptual framework

 Financial statements are more consistent with each other

 Avoids firefighting approach and a has a proactive approach in determining best policy
 Less open to criticism of political/external pressure
 Has a principles based approach
 Some standards may concentrate on effect on statement of financial position; others on statement of profit
or loss
Disadvantages of a conceptual framework

 A single conceptual framework cannot be devised which will suit all users
 Need for a variety of standards for different purposes
 Preparing and implementing standards may still be difficult with a framework
The purpose of financial reporting is to provide useful information as a basis for economic decision making.

OVERVIEW OF THE CONTENTS OF THE FRAMEWORK

The starting point of the Framework is to address the fundamental question of why financial statements are actually
prepared. The basic answer to that is they are prepared to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing
resources to the entity.

In turn this means the Framework has to consider what is meant by useful information. In essence for information
to be useful it must be considered both relevant, i.e. capable of making a difference in the decisions made by users
and be faithful in its presentation, i.e. be complete, neutral and free from error. The usefulness of information is
enhanced if it is also comparable, verifiable, timely, and understandable.

1
The Framework also considers the nature of the reporting entity and, in what reminds me of my school chemistry
lessons, the basic elements from which financial statements are constructed. The Framework identifies three
elements relating to the statement of financial position, being assets, liabilities and equity, and two relating to the
statement of profit or loss, being income and expenses. The definitions and recognition criteria of these elements
are very important and these are considered in detail below.

THE FIVE ELEMENTS

An asset is defined as a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.

Assets are presented on the statement of financial position as being noncurrent or current. They can be intangible,
that is, without physical presence – for example, goodwill. Examples of assets include property plant and equipment,
financial assets and inventory.

While most assets will be both controlled and legally owned by the entity it should be noted that legal ownership is
not a prerequisite for recognition, rather it is control that is the key issue. For example IFRS 16, Leases, with regard
to a lessee, is consistent with the Framework's definition of an asset. IFRS 16 requires that the lessee should
recognise a leased asset on the statement of financial position in respect of the benefits that it controls, even though
the asset subject to the lease is not the legally owned by the lessee. So this reflects that from lessee’s perspective
the economic reality of a lease is a loan to buy an asset, and so the accounting is a faithful presentation.

A liability is defined as 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.

Liabilities are also presented on the statement of financial position as being noncurrent or current. Examples of
liabilities include trade payables, tax creditors and loans.

It should be noted that in order to recognise a liability there does not have to be an obligation that is due on demand
but rather there has to be a present obligation. Thus for example IAS 37, Provisions, Contingent Liabilities and
Contingent Assets is consistent with the Framework's approach when considering whether there is a liability for the
future costs to decommission oil rigs. As soon as a company has erected an oil rig that it is required to dismantle at
the end of the oil rig's life, it will have a present obligation in respect of the decommissioning costs. This liability will
be recognised in full, as a non-current liability and measured at present value to reflect the time value of money.
The past event that creates the present obligation is the original erection of the oil rig as once it is erected the
company is responsible to incur the costs of decommissioning.

2
Equity is defined as the residual interest in the assets of the entity after deducting all its liabilities.

The effect of this definition is to acknowledge the supreme conceptual importance of identifying, recognising and
measuring assets and liabilities, as equity is conceptually regarded as a function of assets and liabilities, i.e. a
balancing figure.

Equity includes the original capital introduced by the owners, i.e. share capital and share premium, the accumulated
retained profits of the entity, i.e. retained earnings, unrealised asset gains in the form of revaluation reserves and,
in group accounts, the equity interest in the subsidiaries not enjoyed by the parent company, ie the non-controlling
interest (NCI). Slightly more exotically, equity can also include the equity element of convertible loan stock, equity
settled share based payments, differences arising when there are increases or decreases in the NCI, group foreign
exchange differences and contingently issuable shares. These would probably all be included in equity under the
umbrella term of Other Components of Equity.

Income is defined as the increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to
contributions from equity participants.

Most income is revenue generated from the normal activities of the business in selling goods and services, and as
such is recognised in the Income section of the statement of profit or loss and other comprehensive income, however
certain types of income are required by specific standards to be recognised directly to equity, ie reserves, for
example certain revaluation gains on assets. In these circumstances the income (gain) is then also reported in the
Other Comprehensive Income section of the statement of profit or loss and other comprehensive income.

The reference to ‘other than those relating to contributions from equity participants’ means that when the entity
issues shares to equity shareholders, while this clearly increases the asset of cash, it is a transaction with equity
participants and so does not represent income for the entity.

Again note how the definition of income is linked into assets and liabilities. This is often referred to as ‘the balance
sheet approach’ (the former name for the statement of financial position).

Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

The reference to ‘other than those relating to distributions to equity participants’ refers to the payment of dividends
to equity shareholders. Such dividends are not an expense and so are not recognised anywhere in the statement of
profit or loss and other comprehensive income. Rather they represent an appropriation of profit that is as reported
as a deduction from Retained Earnings in the Statement of Changes in Equity.

Examples of expenses include depreciation, impairment of assets and purchases. As with income most expenses are
recognised in the Statement of profit or loss section of the statement of profit or loss and other comprehensive
income, but in certain circumstances expenses (losses) are required by specific standards to be recognised directly
in equity and reported in the Other Comprehensive Income Section of the statement of profit or loss and other
comprehensive income. An example of this is an impairment loss, on a previously revalued asset, that does not
exceed the balance of its Revaluation Reserve.

3
The recognition criteria for elements

The Framework also lays out the formal recognition criteria that have to be met to enable elements to be recognised
in the financial statements. The recognition criteria that have to be met are that

 That an item that meets the definition of an element and

 It is probable that any future economic benefit associated with the item will flow to or from the entity and
 The item’s cost or value can be measured with reliability.
Measurement issues for elements

Finally the issue of whether assets and liabilities should be measured at cost or value is considered by the
Framework. To use cost, it should be reliable as the cost is generally known, though cost is not necessarily very
relevant for the users as it is past orientated. To use a valuation method is generally regarded as relevant to the
users as it is up to date, but value does have the drawback of not always being reliable. This conflict creates a
dilemma that is not satisfactorily resolved as the Framework is indecisive and acknowledges that there are various
measurement methods that can be used. The failure to be prescriptive at this basic level results in many accounting
standards doubtful how they wish to measure assets. For example, IAS 40, Investment Properties and IAS 16,
Property, Plant and Equipment both allow the preparer the choice to formulate their own accounting policy on
measurement.

Recognition of the elements of financial statements

Recognition is the process of incorporating in the statement of financial position or statement of profit or loss an
item that satisfies the following criteria for recognition:

 The item that meets the definition of an element

 It is probable that any future economic benefit associated with the item will flow to or from the entity and
 The item’s cost or value can be measured with reliability.

Recap: Application of recognition criteria

 An asset is recognised in the statement of financial position when it is probable that the future economic
benefits will flow to the entity and the asset has a cost or value that can be measured reliably.
 A liability is recognised in the statement of financial position when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present obligation and the
amount at which the settlement will take place can be measured reliably.
 Income is recognised in the statement of profit or loss when an increase in future economic benefits related
to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.
 Expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or
an increase of a liability has arisen that can be measured reliably.

Measurements of elements in financial statements

The IFRS Framework acknowledges that a variety of measurement bases:

 Historical cost
 Current cost (Assets are carried at the amount of cash or cash equivalents that would have to be paid if the
same or an equivalent asset was acquired currently)

4
  Net realisable value (The amount of cash or cash equivalents that could currently be obtained by selling an
asset in an orderly disposal)
 Present value (A current estimate of the present discounted value of the future net cash flows in the normal
course of business)
 Fair value (As per IFRS 13)

HISTORICAL COST ACCOUNTING

The application of historical cost accounting means that assets are recorded at the amount they originally cost, and
liabilities are recorded at the proceeds received in exchange for the obligation.

Advantages

 Simple to understand
 Figures are objective, reliable and verifiable
 Results in comparable financial statements
 There is less possibility for manipulation by using 'creative accounting' in asset valuation.

Disadvantages

 The carrying value of assets is often substantially different to market value

 No account is taken of inflation meaning that profits are overstated and assets understated
 Financial capital is maintained but not physical capital
 Ratios like Return on capital employed are distorted
 It does not measure any gain/loss of inflation on monetary items arising from the impact
 Comparability of figures is not accurate as past figures are not restated for the effects of inflation

FINACIAL AND PHYSICAL CAPITAL MAINTENANCE

The IASB Conceptual Framework identifies two concepts of capital:

1. A financial concept of capital

2. A physical concept of capital

Financial capital maintenance

A financial concept of capital is whereby the capital of the entity is linked to the net assets, which is the equity of
the entity.

When a financial concept of capital is used, a profit is earned only if the financial amount of the net assets at the end
of the period is greater than the net assets at the beginning of the period, adjusted for any distributions paid to the
owners during the period, or any equity capital raised.

The main concern of the users of the financial statements is with the maintenance of the financial capital of the
entity.

Assets – Liabilities = Equity

Opening equity (net assets) + Profit – Distributions = Closing equity (net assets)

5
Physical capital maintenance

A physical concept of capital is one where the capital of an entity is regarded as its production capacity, which could
be based on its units of output.

When a physical concept of capital is used, a profit is earned only if the physical production capacity (or operating
capability) of the entity at the end of the period is greater than the production capacity at the beginning of the
period, adjusted for any distributions paid to the owners during the period, or any equity capital raised.

QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION

 They identify the types of information likely to be most useful to users in making decisions about the
reporting entity on the basis of information in its financial report.

Fundamental qualitative characteristics

 Relevance
Relevant financial information is capable of making a difference in the decisions made by users if it has
predictive value, confirmatory value, or both.

Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items
to which the information relates in the context of an individual entity's financial report

 Faithful representation
Information must be complete, neutral and free from material error

Enhancing qualitative characteristics

 Comparability
Comparison with similar information about other entities and with similar information about the same
entity for another period or another date:
 Verifiability
It helps to assure users that information represents faithfully the economic phenomena it purports to
represent. Verifiability means that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement
 Timeliness
It means that information is available to decision-makers in time to be capable of influencing their decisions.
 Understandability
Classifying, characterising and presenting information clearly and concisely. Information should not be
excluded on the grounds that it may be too complex/difficult for some users to understand
The IFRS framework states that going concern assumption is the basic underlying assumption

STANDARD SETTING PROCESS

The due process for developing an IFRS comprises of six stages:

1. Setting the agenda

2. Planning the project
3. Development and publication of Discussion Paper
4. Development and publication of Exposure Draft
5. Development and publication of an IFRS Standard

6
 6. Procedures after a Standard is issued
REGULATORY FRAMEWORK

International Financial Reporting Standards Foundation (IFRS Foundation)

Responsible for governance of standard setting process. It oversees, funds, appoints and monitors the operational
effectiveness of:

IFRS Advisory Council (IFRS International Accounting International Financial Reporting

AC)
Provide advice to IASB on:
 their agenda and work
prioritization
 the impact of proposed
standards
 Provides strategic advice
Standards Board (IASB)
 Develop new accounting
standards
 Liaise with national
standard-setting bodies to
promote convergence of
international and national
accounting standards
Standards Interpretations Committee
(IFRS IC)
 Assist the IASB to establish and
improve
standards
 Issues Interpretations
(known as IFRICs) which provide
timely guidance on emerging
accounting issues not addressed
in full standards

 Assist in the international/national

convergence process

PRINCIPLES VS RULES-BASED APPROACH

Rules-based accounting system

 Likely to be very descriptive

 Relies on a series of detailed rules or accounting requirements that prescribe how financial statements
should be prepared
 Considered less flexible, but often more comparable and consistent, than a principles-based system
 Can lead to looking for ‘loopholes’

Principles-based accounting system

 It relies on generally accepted accounting principles that are conceptually based and are normally
underpinned by a set of key objectives
 More flexible than a rules-based system
 Require judgment and interpretation which could lead to inconsistencies between reporting entities and
can sometimes lead to the manipulation of financial statements
Because IFRSs are based on The Conceptual Framework for Financial Reporting, they are often regarded as being a
principles-based system.

PAST EXAMS ANALYSIS

7
 Topic Exam Attempt Question
Sept. 16 MCQ. 1,9
Spec. exam Sept. 16 MCQ.4, 13
June 15 MCQ.1,6
Dec. 14 MCQ.3,5,7,20
Framework
Dec. 13 Q.4 (a)
Dec. 12 Q.4(a)
June 12 Q.5
June 11 Q.4 (a)

8
 PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES

IAS 1 Presentation of financial statements

A complete set of financial statements comprises:

 A statement of financial position

 Either
– A statement of comprehensive income, or
– A statement of profit or loss and other comprehensive income
 A statement of changes in equity
 A statement of cash flows
 Accounting policies and explanatory notes

9
 STATEMENT OF FINANCIAL POSITION

A recommended format is as follows:

XYZ Co. Statement of Financial Position as at 31 December 20X8

Assets $ $
Non-current assets:
Property, plant and equipment X
Intangible assets X

X
Current assets:
Inventories X
Trade receivables X
Cash and cash equivalents X
X
Total assets X

Equity and liabilities

Capital and reserves:
Share capital X
Retained earnings X
Other components of equity X
X
Total equity X
Non-current liabilities:
Long-term borrowings X
Deferred tax X
X
Current liabilities:
Trade and other payables X
Short-term borrowings X
Current tax payable X
Short-term provisions X
X
Total equity and liabilities X

Current assets include all items which:

 Will be settled within 12 months of the reporting date, or

 Are part of the entity's normal operating cycle.

Within the capital and reserves section of the statement of financial position, other components of equity include:

 Revaluation reserve
 General reserve

10
Statement of changes in equity

The statement of changes in equity provides a summary of all changes in equity arising from transactions with
owners in their capacity as owners.

This includes the effect of share issues and dividends.

XYZ Group

Statement of changes in equity for the year ended 31 December 20X8

Share Share Revaluation Retained Total

capital premium surplus earnings equity
$ $ $ $ $
Balance at 31 X X X X X
December 20X6
Change in (X) (X)
accounting policy __ __ __ __
Restated balance X X X X X
Dividends (X) (X)
Issue of share X X X
Capital
Total X X X
Comprehensive
income for the year
Transfer to (X) X -
retained earnings __ __ __ __
Balance at 31 X X X X X
December 20X7

11
 Statement of Profit or Loss and Other Comprehensive Income

A recommended format for the statement of profit or loss and other comprehensive income is as follows:

XYZ Co.

Statement of profit or loss and other comprehensive income

For the year ended 31 December 20X8

$
Revenue X
Cost of sales (X)
Gross profit X
Distribution costs (X)
Administrative expenses (X)
Profit from operations X
Finance costs (X)
Profit before tax X
Income tax expense (X)
Net Profit for the period X

$
Profit for the year X
Other comprehensive income
Gain on property revaluation X
Income tax relating to components of other comprehensive income (X)

Other comprehensive income for the year, net of tax X

Total comprehensive income for the year X

12
 COMPANIES – BASIC ADJUSTMENTS

TYPES OF SHARES

There are a number of different types of shares which companies may issue.

 Ordinary shares
 Preference shares
There are two types of preference share:

 Irredeemable preference shares exist, much like ordinary shares. The amount issued in form of
Irredeemable preference shares is not payable after a fixed period.
 Redeemable preference shares are issued for a fixed term. At the end of this term, the shareholder
redeems their shares and in return is repaid the amount they initially bought the shares for (normally plus
a premium). In the meantime they receive a fixed dividend.

ACCOUNTING FOR A SHARE ISSUE

The accounting entry to record the issue of shares is:

Dr Cash Proceeds received

Cr Share capital Nominal value of shares issued

Cr Share premium Premium on issue of shares.

ACCOUNTING FOR A RIGHTS ISSUE

A rights issue is an issue of new shares to existing shareholders in proportion to their existing shareholding. The issue
price is normally less than market value to encourage shareholders to exercise their rights and buy shares.

Dr Cash Proceeds received

Cr Share capital Nominal value of shares issued

Cr Share premium Premium on issue of shares.

ACCOUNTING FOR A BONUS ISSUE

A bonus issue is an issue of new shares at no cost to existing shareholders, in proportion to their existing
shareholding. An issue of this type does not raise cash, but is funded by the existing share premium account (or
retained profits if the share premium account is insufficient), and accounted for by:

Dr Share premium/Retained profits Nominal value of shares issued

Cr Share capital Nominal value of shares issued

13
LOAN NOTES

A company can raise finance either through the issue of shares or by borrowing money.

An issue of loan notes is recorded by:

Dr Cash

Cr Loan notes (non-current liability)

Interest paid on the loan notes is recorded by:

Dr Finance cost (interest expense)

Cr Cash / accrual

 Finance cost is charged on effective rate of interest

 Cash paid is as per the nominal rate of interest
 The differential amount becomes a part of the closing liability of loan

DIVIDENDS

Ordinary dividends = No. of shares x Per share dividend

Preference dividends = Amount of preference shares x % of dividend

SUSPENSE ACCOUNTS AND ERROR CORRECTION

Suspense accounts and error correction are popular topics for examiners because they test understanding of
bookkeeping principles so well.

A suspense account is a temporary resting place for an entry that will end up somewhere else once its final
destination is determined. There are two reasons why a suspense account could be opened:

1. A bookkeeper is unsure where to post an item and enters it to a suspense account pending instructions
2. There is a difference in a trial balance and a suspense account is opened with the amount of the difference
so that the trial balance agrees (pending the discovery and correction of the errors causing the difference).
This is the only time an entry is made in the records without a corresponding entry elsewhere (apart from
the correction of a trial balance error – see error type 8 in Table 1).

14
Types of error

Before we look at the operation of suspense accounts in error correction, we need to think about types of error –
not all types affect the balancing of the records and hence the suspense account. Refer to Table 1.

Table 1: Types of error

Suspense account
Error type
involved?

1 Omission – a transaction is not recorded at all No

2 Error of commission – an item is entered to the correct side of the wrong account (there is a
No
debit and a credit here, so the records balance)
3 Error of principle – an item is posted to the correct side of the wrong type of account, as when
cash paid for plant repairs (expense) is debited to plant account (asset)
No
(errors of principle are really a special case of errors of commission, and once again there is a debit
and a credit)
4 Error of original entry – an incorrect figure is entered in the records and then posted to the
correct account
No
Example: Cash $1,000 for plant repairs is entered as $100; plant repairs account is debited with
$100
5 Reversal of entries – the amount is correct, the accounts used are correct, but the account that
should have been debited is credited and vice versa
Example: Factory employees are used for plant maintenance:
Correct entry: No
Debit: Plant maintenance
Credit: Factory wages
Easily done the wrong way round
6 Addition errors – figures are incorrectly added in a ledger account Yes
7 Posting error
a. an entry made in one record is not posted at all
b. an entry in one record is incorrectly posted to another
Yes
Examples: cash $10,000 entered in the cash book for the purchase of a car is:
a. not posted at all
b. posted to Motor cars account as $1,000
8 Trial balance errors – a balance is omitted, or incorrectly extracted, in preparing the trial balance Yes
9 Compensating errors – two equal and opposite errors leave the trial balance balancing (this type
Yes, to correct each of
of error is rare, and can be because a deliberate second error has been made to force the
the errors as discovered
balancing of the records or to conceal a fraud). Yes, to correct each of the errors as discovered

Correcting errors

Errors 1 to 5, when discovered, will be corrected by means of a journal entry between the accounts affected. Errors
6 to 9 also require journal entries to correct them, but one side of the journal entry will be to the suspense account
opened for the difference in the records. Type 8, trial balance errors, are different. As the suspense account records
the difference, an entry to it is needed, because the error affects the difference. However, there is no ledger entry
for the other side of the correction – the trial balance is simply amended.

15
 PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Dec. 15 Q.1 (iv), (vii)
June 15 MCQ.19 Q.3(i),(ii)
Dec. 14 Q.2(i)
June 14 Q.2 (iii),(v)
Basic adjustments – Companies Dec. 13 Q.2 (v)
June 13 Q.2(v)
Dec. 12 Q.2(ii),(iii)
June 12 Q.2 (i)
June 11 Q.2 (i)

16
 IAS 16 – PROPERTY, PLANT AND EQUIPMENT

The accounting for IAS 16, Property, Plant and Equipment is a particularly important area of the Paper FR syllabus.
You can almost guarantee that in every exam you will be required to account for property, plant and equipment at
least once.

Objective:

The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and equipment.

Definitions:

Property plant and equipment are intangible assets that:

 Are held for use in the production or supply of goods or services ,for rental to others, or for administrative
purposes; and
 Are expected to be used during more than one year.
Carrying amount is the amount at which an asset is recognized after deducting any accumulated depreciation and
accumulated impairment losses

Depreciation is systematic allocation of the depreciable amount of assets over its useful life.

Depreciable amount is the cost of an asset less its residual value.

Residual Value is the estimated amount that an entity can obtain when disposing of an asset after its useful life
has ended. When doing this the estimated costs of disposing of the asset should be deducted.

There are essentially four key areas when accounting for property, plant and equipment:

 Initial recognition and measurement

 Depreciation
 Revaluation
 Derecognition (disposals).
Initial recognition:

PPE are recognized if

 It is probable that future economic benefits associated with the item will flow to the entity; and
 The cost of the item can be measured reliably.
Note: This criteria is applicable for both initial and subsequent recognition.

Aggregation and segmenting This IAS does not provide what constitute an item of property, plant and equipment
and judgment is required in applying the recognition criteria to specific circumstances or types of enterprise. That
is: -

i. It may be appropriate to aggregate individually insignificant items, such as moulds, tools dies, etc.
ii. It may be appropriate to allocate total expenditure on an asset to its component parts and account for each
component separately e.g. an aircraft and its engines, parts of a furnace.

17
Initial measurement:

PPE are initially recognized at the cost.

Elements of costs comprise:

 Its purchase price

 Any costs directly attributable to bringing the asset to the location and condition necessary for it to be
capable of operating,
 The initial estimate of the costs of dismantling and removing the item and restoring the site on which it is
located. The present value of dismantling cost will be added to the cost of asset and provision will be created
and the company will have to unwind this provision at every year end. The amount will be recognized in
statement of profit or loss as finance cost and provision will be increased in statement of financial position.
This treatment is as the accounting for provision as per IAS 37, Provisions, Contingent Assets and Liabilities
 Directly attributable cost of bringing the assets to the location and condition necessary for the intended
performance, e.g.
o Costs of employees benefits arising directly from the construction or acquisition of property, plant
and equipment
o The cost of site preparation
o Initial delivery and handling costs
o Installation costs
o Cost of testing whether the asset is functioning properly after the net proceeds from the sale of any
trial production (samples produced while testing equipment)
o Professional fees (architects, engineers)
o Borrowing costs in accordance with IAS 23, Borrowing Costs.
Where these costs are incurred over a period of time (such as employee benefits), the period for which the costs
can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until
a later date. As soon as an asset is capable of operating it is ready for use. The fact that it may not operate at normal
levels immediately, because demand has not yet built up, does not justify further capitalisation of costs in this period.
Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE.

IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a
constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23,
Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. In
order to be consistent with the treatment of ‘other costs’, only those finance costs that would have been avoided if
the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance
the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the
borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted
average borrowing rate of the entity should be used. (IAS 23 discussed in detail later)

The cost of the asset will include the best available estimate of the costs of dismantling and removing the item and
restoring the site on which it is located, where the entity has incurred an obligation to incur such costs by the date
on which the cost is initially established. This is a component of cost to the extent that it is recognised as a provision
under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37,
the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately
discounted where the effect is material.

18
Measurement of self-constructed and exchanged assets

 Cost of self-constructed assets will be the cost of its production

 If an asset is exchanged, the cost will be measured at the fair value unless

(a) The exchange transaction lacks commercial substance or

(b) The fair value of neither the asset received nor the asset given up is reliably measurable. If the acquired
item is not measured at fair value, its cost is measured at the carrying amount of the asset given up.

Note: Attempt Question 1 from Concept test questions at the end of this chapter.

Subsequent costs (Subsequent recognition)

Once an item of PPE has been recognised and capitalised in the financial statements, a company may incur further
costs on that asset in the future. IAS 16 requires that subsequent costs should be capitalised if:

 it is probable that future economic benefits associated with the extra costs will flow to the entity
 The cost of the item can be reliably measured.
All other subsequent costs should be recognised as an expense in the statement of profit or loss in the period that
they are incurred.

Note: Attempt Question 2 from Concept test questions at the end of this chapter.

Measurement Subsequent to Initial Recognition:

IAS 16 permits two accounting models:

 Cost Model
 Revaluation Model

Under both models, the assets are reflected in statement of financial position at carrying value
Carrying value:
Amount at which the asset is recognised after deducting any accumulated depreciation and accumulated
impairment losses.

DEPRECIATION OF PPE

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’.
‘Depreciable amount’ is the cost of an asset, cost less residual value, or other amount. Depreciation is not providing
for loss of value of an asset, but is an accrual technique that allocates the depreciable amount to the periods
expected to benefit from the asset. Therefore assets that are increasing in value still need to be depreciated.

The depreciation method used should reflect the pattern in which the asset's economic benefits are consumed by
the entity; a depreciation method that is based on revenue that is generated by an activity that includes the use of
an asset is not appropriate.

19
IAS 16 requires that depreciation should be recognised as an expense in the statement of profit or loss, unless it is
permitted to be included in the carrying amount of another asset.

Depreciation begins when the asset is available for use and continues until the asset is derecognised, even if it is
idle.

Depreciation methods

A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common
methods, specifically mentioned in IAS 16, are the straight line method, and the reducing (or diminishing) balance
method.

 Straight line
• % on cost, or
• Cost – residual value
Useful economic life

 Reducing balance
• % on carrying value

Useful economic lives and residual value

The assessments of the useful life (UL) and residual value (RV) of an asset are extremely subjective. They will only be
known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual
depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period.
If either changes significantly, then that change should be accounted for over the remaining estimated useful
economic life.

Component depreciation

If an asset comprises two or more major components with different economic lives, then each component should
be accounted for separately for depreciation purposes and depreciated over its own useful economic life.

Note: Attempt Question 3 & 4 from Concept test questions at the end of this chapter.

MODELS FOR SUBSEQUENT MEASUREMENT

Cost Model
The asset is carried at cost less accumulated depreciation and impairment.

Revaluation Model. The asset is carried at a revalued amount, being its fair value at the date of revaluation less
subsequent depreciation and impairment, provided that fair value can be measured reliably.

The change from cost model to revaluation model is a change in accounting policy but is dealt with prospectively.

20
Revaluation model:

If the revaluation policy is adopted this should be applied to all assets in the entire category, ie if you revalue a
building, you must revalue all land and buildings in that class of asset. Revaluations must also be carried out with
sufficient regularity so that the carrying amount does not differ materially from that which would be determined
using fair value.

 Revalued assets are depreciated in the same way as under the cost model.
Accounting for a revaluation

There are a series of accounting adjustments that must be undertaken when revaluing a non-current asset. These
adjustments are indicated below.

The initial revaluation

You may find it useful in the exam to first determine if there is a gain or loss on the revaluation with a simple
calculation to compare:

Carrying value of non-current asset at revaluation date X

Valuation of non-current asset X

Difference = gain or loss revaluation X

Gain on revaluation should be credited to other comprehensive income and accumulated in equity under the
heading "revaluation surplus" unless it represents the reversal of a revaluation decrease of the same asset previously
recognized as an expense, in which case it should be recognized as income.

Double entry:

 Dr Non-current asset cost (difference between valuation and original cost/valuation)

 Dr Accumulated depreciation (with any historical cost accumulated depreciation)
 Cr Revaluation reserve (gain on revaluation)
Note: Attempt Question 5 & 6 from Concept test questions at the end of this chapter.

A loss on revaluation should be recognized as an expense to the extent that it exceeds any amount previously
credited to the revaluation surplus relating to the same asset.

A revaluation loss should be charged against any related revaluation surplus to the extent that the decrease does
not exceed the amount held in the revaluation reserve in respect of the same asset. Any additional loss must be
charged as an expense in the statement of profit or loss.

21
Double entry:

 Dr Revaluation reserve (to maximum of original gain)

 Dr Statement of profit or loss (any residual loss)
 Cr Non-current asset (loss on revaluation)
Note: Attempt Question 7 from Concept test questions at the end of this chapter.

Depreciation

The asset must continue to be depreciated following the revaluation. However, now that the asset has been revalued
the depreciable amount has changed. In simple terms the revalued amount should be depreciated over the assets
remaining useful economic life.

Reserves transfer

The depreciation charge on the revalued asset will be different to the depreciation that would have been charged
based on the historical cost of the asset. As a result of this, IAS 16 permits a transfer to be made of an amount equal
to the excess depreciation from the revaluation reserve to retained earnings.

Double entry:

 Dr Revaluation reserve
 Cr Retained earnings
Be careful, in the exam a reserves transfer is only required if the examiner indicates that it is company policy to make
a transfer to realised profits in respect of excess depreciation on revalued assets. If this is not the case then a reserves
transfer is not necessary.

This movement in reserves should also be disclosed in the statement of changes in equity.

Note: Attempt Question 8 from Concept test questions at the end of this chapter.

Exam focus

In the exam make sure you pay attention to the date that the revaluation takes place. If the revaluation takes place
at the start of the year then the revaluation should be accounted for immediately and depreciation should be
charged in accordance with the rule above.

If however the revaluation takes place at the year-end then the asset would be depreciated for a full 12 months first
based on the original depreciation of that asset. This will enable the carrying amount of the asset to be known at the
revaluation date, at which point the revaluation can be accounted for.

A further situation may arise if the examiner states that the revaluation takes place mid-way through the year. If this
were to happen the carrying amount would need to be found at the date of revaluation, and therefore the asset
would be depreciated based on the original depreciation for the period up until revaluation, then the revaluation
will take place and be accounted for. Once the asset has been revalued you will need to consider the last period of
depreciation. This will be found based upon the revaluation rules (depreciate the revalued amount over remaining
useful economic life). This will be the most complicated situation and you must ensure that your working is clearly

22
structured for this; i.e. depreciate for first period based on old depreciation, revalue, then depreciate last period
based on new depreciation rule for revalued assets.

How will the office block be accounted for in the year ended 31 March 2010?

Derecognition

Property, plant and equipment should be derecognised when it is no longer expected to generate future economic
benefit or when it is disposed of.

When property, plant and equipment is to be derecognised, a gain or loss on disposal is to be calculated. This can
be found by comparing the difference between:

Carrying value X

Disposal proceeds X

Profit or loss on disposal X

Tip: When the disposal proceeds are greater than the carrying value there is a profit on disposal and when the
disposal proceeds are less than the carrying value there is a loss on disposal.

Note: Attempt Questions 9, 10 & 11 from Concept test questions at the end of this chapter.

Disposal of previously revalued assets

When an asset is disposed of that has previously been revalued, a profit or loss on disposal is to be calculated (as
above). Any remaining surplus on the revaluation reserve is now considered to be a ‘realised’ gain and therefore
should be transferred to retained earnings as:

 Dr Revaluation reserve
 Cr Retained earnings

In summary, it can be seen that accounting for property, plant and equipment is an important topic that features
regularly in the Paper FR exam. With most of what is examinable feeding though from Paper F3 this should be a
comfortable topic that you can tackle well in the exam.

NOTES

 Each year, the amount by which the new depreciation exceeds the old depreciation should be transferred
from the revaluation reserve in the capital section of the statement of financial position to the retained
earnings.
 When a revalued asset is disposed of, any revaluation surplus may be transferred directly to retained
earnings, or it may be left in equity under the heading revaluation surplus.

23
Impairment:

An item of PPE shall not be carried at more than recoverable amount. Recoverable amount is the higher of an asset's
fair value less costs to sell and its value in use.

De-recognition:

 Remove from statement of financial position when disposed of or abandoned

Recognize any gain or loss in the statement of profit or loss.

24
 CONCEPT CHECK QUESTIONS

QUESTION 1

Construction of Deb and Ham’s new store began on 1 April 2009.

The following costs were incurred on the construction:

$000
Freehold land 4,500
Architect fees 620
Site preparation 1,650
Materials 7,800
Direct labour cost 11,200
Legal fees 2,400
General overhead 940

The store was completed on 1 January 2010 and brought into use following its grand opening on the 1 April 2010.
Deb and Ham issued a $25m unsecured loan on 1 April 2009 to aid construction of the new store (which meets the
definition of a qualifying asset per IAS 23). The loan carried an interest rate of 8% per annum and is repayable on 1
April 2012.

Required

Calculate the amount to be included as property, plant and equipment in respect of the new store and state what
impact the above information would have on the statement of profit or loss (if any) for the year ended 31 March
2010.

Solution

This is an example of a self-constructed asset. All costs to get the store to its present location and condition for its
intended use should be capitalised. All of the expenditure listed in the question, with the exception of general
overheads would qualify for capitalisation. The interest on the loan should also be capitalised from 1 April 2009 as
in accordance with IAS 23 (Discussed in detail in a later chapter) it meets the definition of a qualifying asset. The
recognition criteria for capitalization appears to be met ie activities to prepare the asset for its intended use are in
progress, expenditure for the asset is being incurred and borrowing costs are being incurred. Capitalisation of the
interest on the loan must cease when the asset is ready for use, ie 1 January 2010. At this point any remaining
interest for the period should be charged as a finance cost in the statement of profit or loss.

25
Property, plant and equipment

Store:

$000
Freehold land 4,500
Architect fees 620
Site preparation 1,650
Materials 7,800
Direct labour cost 11,200
Legal fees 2,400
Borrowing costs 940
(25,000 x 8% 9/12) 1,500
Total to be capitalized 29,670

Statement of profit or loss impact

With regards to the statement of profit or loss this should be charged with:

¤ General overheads of $940,000

¤ Remaining interest for Jan–Mar which is now an expense $500,000 (25,000 x 8% x 3/12) and;

¤ Depreciation of the store. Even though the asset has not yet been brought into use, IAS 16 states depreciation of
an asset begins when it is available for use, ie when it is in the location and condition necessary for it to be capable
of operating in the manner intended by management.

QUESTION 2

On 1 March 2010 Yucca purchased an upgrade package from Plant at a cost of $18,000 for the machine it originally
purchased in 2008 (Example 1). The upgrade took a total of two days where new components were added to the
machine. Yucca agreed to purchase the package as the new components would lead to a reduction in production
time per unit of 15%. This will enable Yucca to increase production without the need to purchase a new machine.

Should the additional expenditure be capitalised or expensed?

Solution

The $18,000 should be capitalised as part of the cost of the asset as the revenue earning capacity of the machine
has significantly increased, which could in turn lead to the inflow of additional economic benefit and the cost of the
upgrade can be reliably measured.

QUESTION 3

An item of plant was acquired for $220,000 on 1 January 20X6. The estimated UL of the plant was five years and the
estimated RV was $20,000. The asset is depreciated on a straight line basis. On 31 December 20X6 the future
estimate of the UL of the plant was changed to three years, with an estimated RV of $12,000.

26
Solution

At the date of purchase, the plant’s depreciable amount would have been $200,000 ($220,000 – $20,000). Therefore,
depreciation of $40,000 would have been charged in 20X6, and the carrying value would have been $180,000 at the
end of 20X6. Given the reassessment of the UL and RV, the depreciable amount at the end of 20X6 is $168,000
($180,000 – $12,000) over three years. Therefore, the depreciation charges in 20X7, 20X8 and 20X9 will be $56,000
($168,000/3) unless there are future changes in estimates. Where an asset comprises two or more major
components with substantially different economic lives, each component should be accounted for separately for
depreciation purposes, and each depreciated over its UL.

Statement of profit or loss extract

Depreciation expense $37,500

Statement of financial position extract

Plant

(200,000 – 50,000 – 37,500) $112,500

Working for depreciation:

31/03/09 Cost 200,000

Depreciation – 25% (50,000)

Carrying value 150,000

31/03/10 Carrying value 150,000

Depreciation – 25% (37,500)

Carrying value 112,500

QUESTION 4

On 1 January 20X2, an entity purchased a furnace for $200,000. The estimated UL of the furnace was 10 years, but
its lining needed replacing after five years. On 1 January 20X2 the entity estimated that the cost of relining the
furnace (at 1 January 20X2 prices) was $50,000. The lining was replaced on 1 January 20X7 at a cost of $70,000.

Requirement

Compute the annual depreciation charges on the furnace for each year of its life.

Solution

27
20X2–20X6 inclusive

The asset has two depreciable components: the lining element (allocated cost $50,000 – UL five years); and the
balance of the cost (allocated cost $150,000 – UL 10 years). Therefore, the annual depreciation is $25,000 ($50,000
x 1/5 + $150,000 x 1/10). At 31 December 20X6, the ‘lining component’ has a written down value of zero.

20X7–20Y1 inclusive

The $70,000 spent on the new lining is treated as the replacement of a separate component of an asset and added
to PPE. The annual depreciation is now $29,000 ($70,000 x 1/5 + $150,000 x 1/10).

QUESTION 5

A property was purchased on 1 January 20X0 for $2m (estimated depreciable amount $1m – useful economic life 50
years). Annual depreciation of $20,000 was charged from 20X0 to 20X4 inclusive and on 1 January 20X5 the carrying
value of the property was $1.9m. The property was revalued to $2.8m on 1 January 20X5 (estimated depreciable
amount $1.35m – the estimated useful economic life was unchanged). Show the treatment of the revaluation surplus
and compute the revised annual depreciation charge.

Solution

The revaluation surplus of $900,000 ($2.8m – $1.9m) is recognised in the statement of changes in equity by crediting
a revaluation reserve. The depreciable amount of the property is now $1.35m and the remaining estimated useful
economic life 45 years (50 years from 1 January 20X0). Therefore, the depreciation charge from 20X5 onwards would
be $30,000 ($1.35m x 1/45).

A revaluation usually increases the annual depreciation charge in the statement of profit or loss. In the above
example, the annual increase is $10,000 ($30,000 – $20,000). IAS 16 allows (but does not require) entities to make
a transfer of this ‘excess depreciation’ from the revaluation reserve directly to retained earnings.

QUESTION 6

A company purchased a building on 1 April 2007 for $100,000. The asset had a useful economic life at that date of
40 years. On 1 April 2009 the company revalued the building to its current fair value of $120,000.

What is the double entry to record the revaluation?

Gain on revaluation:

Carrying value of non-current asset at revaluation date

(100,000 – (100,000/40 years x 2 years)) 95,000

Valuation 120,000
Gain on revaluation 25,000

28
Double entry:

Dr Building cost (120,000 – 100,000) 20,000

Dr Accumulated depreciation (100,000/40 years x 2 years) 5,000

Cr Revaluation reserve 25,000

QUESTION 7

The property referred to in Example 1 was revalued on 31 December 20X6. Its fair value had fallen to $1.5m.
Compute the revaluation loss and state how it should be treated in the financial statements.

Solution

The carrying value of the property at 31 December 20X6 would have been $2.74m ($2.8m – 2 x $30,000). This means
that the revaluation deficit is $1.24m ($2.74m – $1.5m).

If the transfer of excess depreciation (see above) is not made, then the balance in the revaluation reserve relating
to this asset is $900,000 (see Example 1). Therefore $900,000 is deducted from equity and $340,000 ($1.24m –
$900,000) is charged to the statement of profit or loss.

If the transfer of excess depreciation is made, then the balance on the revaluation reserve at 31 December 20X6 is
$880,000 ($900,000 – 2 x $10,000). Therefore $880,000 is deducted from equity and $360,000 ($1.24m – $880,000)
charged to the statement of profit or loss.

QUESTION 8

A company revalued its property on 1 April 2009 to $20m ($8m for the land). The property originally cost $10m ($2m
for the land) 10 years ago. The original useful economic life of 40 years is unchanged. The company’s policy is to
make a transfer to realised profits in respect of excess depreciation.

How will the property be accounted for in the year ended 31 March 2010?

29
SOLUTION

Statement of comprehensive income extract for the year ended

31 March 2010
$000
Depreciation expense 400
Other comprehensive income:
Revaluation gain 12,000

Statement of financial position extract as at 31 March 2010

$000
Non-current assets
Property
(20,000-400) 19,600

Equity
Revaluation reserve
(12,000-200) 11,800

Revaluation reserve Retained earnings

$000 $000
Revaluation gain 12,000
Reserves transfer (200) 200

Workings:
Gain on revaluation:
$000
Carrying value of non-current asset at revaluation date
(10,000 – ((10,000 – 2,000)/40 years x 10 years)) 8,000
Valuation 20,000
Gain on revaluation 12,000

Double entry:
Dr Property
(20,000 – 10,000) 10,000
Dr accumulated deprecation
((10,000 – 2,000)/40 years x 10 years) 2,000
Cr Revaluation reserve 12,000

Deprecation charge for year to 31 March 2010:

Dr depreciation expense 400
((20,00-8,000)/30 years) 400

Reserves transfer:
Historical cost depreciation charge
((10,000-2,000)/40 years) 200
Revaluation depreciation charge 400
Excess depreciation to be transferred 200

Dr Revaluation reserve 200

Cr Retained earnings 200

30
QUESTION 9

A company purchased a building on 1 April 2005 for $100,000 at which point it was considered to have a useful
economic life of 40 years. At the year end 31 March 2010 the company decided to revalue the building to its current
value of $98,000.

How will the building be accounted for in the year ended 31 March 2010?

Solution

Statement of profit or loss

Depreciation charge 2,500

Other comprehensive income:

Revaluation gain 10,500

Statement of financial position extract 31 March 2010

Building at valuation 98,000

Statement of changes in equity extract Revaluation

reserve
Revaluation gain 10,500

Working paper:

Note: revaluation takes place at year end, therefore a full year on depreciation must be charged.

(W1) Depreciation year ended 31 Mach 2010

100,00000
= $2,500
40 𝑦𝑒𝑎𝑟𝑠

(W2) Revaluation

The carrying value of the asset at 31 March 2010 can now be found and revalued.

Carrying value of non-current assets at revaluation date

(100,000 – (100,000/40 years x 5 years))) 87
Valuation of non-current asset 98
Gain or loss on revaluation 10

Double entry:

Dr Accumulated depreciation 12,500

Cr NCA cost 2,500
Cr Revaluation reserve 10,500

31
QUESTION 10

At 1 April 2009 HD Ltd carried its office block in its financial statements at its original cost of $2 million less
depreciation of $400,000 (based on its original life of 50 years). HD Ltd decided to revalue the office block on 1
October 2009 to its current value of $2.2m. The useful economic life remaining was reassessed at the time of
valuation and is considered to be 40 years at this date. It is the company’s policy to charge depreciation
proportionally.

Solution

The extract of statement of profit or loss and other comprehensive income is as follows:

Depreciation charge
(20,000 (W1) + 27,500 (W2) 47,500

Other comprehensive income:

Revaluation gain 620,000

Statement of financial position extract 31 March 2010

Office block (carrying value at 31 March):
Valuation 2,200,000
Deprecation (27,500)
Carrying value 2,172,500

Statement of changes in equity extract Revaluation

reserve
Revaluation gain 620,000

Working paper:

Note: revaluation takes place part way through the year and therefore depreciation must first be charge for the
period 1 April 09 – 30 September 09, then the revaluation can be recorded and then depreciation needs to be
charged for the period 1 October 2009 – 31 March 2010.

(W1) Depreciation 1 April – 30 September 2009

2,000,00000 6
𝑥 = $20,000
50 𝑦𝑒𝑎𝑟𝑠 12

(W2) Revaluation

32
The carrying value of the asset at 1 October 2009 can now be found and revalued.

Carrying value of non-current assets at revaluation date

(2,000,000 – (400,000 – 20,000))) 1,580,000
Valuation of non-current asset 2,200,000
Gain on revaluation 620,000

Double entry:

Dr NCA cost (2,200,000 – 2,000,000 200,000

Cr Accumulated depreciation 420,000
Cr Revaluation reserve 620,000

(W3) Depreciation 1 October – 31 March 2010

2,200,00000 6
𝑥 = $27,500
40 𝑦𝑒𝑎𝑟𝑠 12

QUESTION 11

An asset that originally cost $16,000 and had accumulated depreciation on it of $8,000 was disposed of during the
year for $5,000 cash.

How should the disposal be accounted for in the financial statements?

Solution

The asset and its associated depreciation should be removed from the statement of financial position and a profit
or loss on disposal should be recorded in the statement of profit or loss.

The loss on disposal is:

Carrying value at disposal date (16,000 – 8,000) 8,000

Disposal proceeds (5,000)
Loss on disposal 3,000

33
 PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 6,16 Q.31(ii)
March/June 16 Q.3 (iv)
Spec. exam Sept. 16 MCQ.1
Dec. 15 Q.1 (iii)
June 15 MCQ.9,13 Q.3(iii)
Dec. 14 Q.2(ii)
IAS 16
June 14 Q.2(ii), Q.4
Dec. 13 Q.2(ii)
June 13 Q.2(ii)
June 12 Q.2 (ii)
Dec. 11 Q.2 (ii)
June 11 Q.2 (ii)

34
 IAS 38 - INTANGIBLE ASSETS
OBJECTIVE

The objective of this IAS is to prescribe accounting treatment for intangible assets.

INTANGIBLE ASSET

An intangible asset is an identifiable non-monetary asset without physical substance held for use in the production
or supply of goods or services, for rental to others, or for administrative purposes.

Thus, the three critical attributes of an intangible asset are:

 Identifiability
 Control (power to obtain benefits from the asset)
 Future economic benefits (such as revenues or reduced future costs)
Intangible assets are business assets that have no physical form. Unlike a tangible asset, such as a computer, you
can’t see or touch an intangible asset.

There are two types of intangible assets: those that are purchased and those that are internally generated. The
accounting treatment of purchased intangibles is relatively straightforward in that the purchase price is capitalised
in the same way as for a tangible asset. Accounting for internally-generated assets, however, requires more thought.

R&D costs fall into the category of internally-generated intangible assets, and are therefore subject to
specific recognition (Discussed later).

Identifiability:

An intangible asset can be termed identifiable if it:

 Is separable or
 Arises from contractual or other legal rights
An intangible asset needs to be identifiable to be recorded in financial statements. To be separable, the asset should
be capable of being disposed of on its own, with the remainder of the business being retained.

Goodwill can only be disposed of as part of the sale of a business, so is not separable. The lack of identifiability
prevents internally generated goodwill from being recognized.

Examples of intangible assets include:

o Computer software
o Patents
o Copyrights
o Motion picture films
o Mortgage servicing rights
o Licenses
o Import quotas
o Franchises
o Marketing rights

35
Level of control

Another aspect of the definition of an intangible asset is that it must be under the control of the entity as a
consequence of a past event. The entity must be able to enjoy the future benefits from the asset and deter external
parties from access to those benefits. A legally enforceable right is an example of such control but isn’t a necessary
prerequisite for determining control.

Some notable points to consider are:

a) Control over technical knowledge only exists if it is protected by a legal right

b) The skill of employees, arising out of the benefits of training costs, are unlikely to be considered as intangible
assets because of the relative uncertainty over the future actions of staff. The problem from a control point of
view is that the staff can leave at any point in time, taking their new skills with them.
c) Market share and customer loyalty are also fickle by nature and cannot be considered as intangible assets.
RECOGNITION AND MEASUREMENT

The recognition of an intangible asset requires an entity to demonstrate that the item meets:-

a) The definition of an intangible asset

b) The recognition criterion that:-

 It is probable that the expected economic benefits that are attributable to the asset will flow to the
entity; and
 The cost of the asset can be measured reliably
An intangible asset shall be measured initially at cost.

Separate rules for recognition and initial measurement exist for intangible assets depending on whether they were:

 Acquired separately: At cost

 Acquired as part of a business combination: At fair value
 Acquired by way of a government grant: As per IAS 20
 Obtained in an exchange of assets: At fair value
 Generated internally
Separate acquisition

The cost of a separately acquired intangible asset can be measured reliably when purchase consideration is in the
form of cash or other monetary assets. The cost comprises:-

a) Its purchase price, including import duties and non-refundable purchase taxes after deducting trade discounts
and rebates; and
b) Professional fees arising directly from bringing the asset to its working condition; and
c) Costs of testing whether the asset is functioning properly
Examples of expenditures that are not part of cost of an intangible asset are:-

a) Costs of introducing a new product or service (advertising cost)

b) Costs of conducting business in a new location or with a new class of customers (training cost of staff)
c) Pre-operating losses, Administration and other general overheads
The capitalization of expenses ceases when the asset is ready for its intended use therefore; the expenditures
incurred afterwards are not capitalized.

36
Deferred payments

If the payment for an intangible asset is deferred beyond normal credit terms, its cost will be the cash price
equivalent. The difference between this amount and the total payments will be recognized as interest expense or
will be capitalized if meets the requirements of IAS-23.

Acquisition as part of business combination

An acquirer recognizes an intangible asset, distinct from goodwill, on the acquisition date if the asset’s fair value can
be measured reliably, irrespective of whether the asset had been recognized by the acquiree before the business
combination (Research and development).

The circumstances when an entity cannot measure the fair value are when the intangible asset arises from legal or
other contractual rights and either:-

a) Is not separable; or
b) Is separable, but there is no history or evidence of exchange transactions for the same or similar
assets, and otherwise estimating fair value would be depended on immeasurable variables.
Acquisition by way of Government Grant

If an intangible asset is acquired through a government grant then the related asset and government grant will be
recognized as per the requirements of IAS-20.

Exchanges of asset

An asset may be acquired in exchange or part exchange for a non-monetary asset or assets, or a combination of
monetary and non-monetary assets.

The cost of such an item is the fair value unless the exchange transaction lacks commercial substance or the fair
value of the asset given up/ acquired is not reliably measureable, in which case the cost of the asset acquired will be
the carrying value of the asset given up.

The entity determines whether the exchange transaction has the commercial substance by considering the extent
to which its cash flows differ as a result of the transaction.

A transaction has commercial substance if:-

 The risk, timing and amount of cash flows of the asset acquired differ from the asset transferred.
 The entity specific value of the portion of the entity‘s operations affected by the transaction changes as a
result of the exchange (post tax cash flows).
 The difference in above two is significant relative to the fair value of the assets exchanged.
If the entity is able to measure the fair value of any of the asset given up/acquired then the cost of the new asset is
the fair value of the asset given up unless the fair value of the asset acquired is more reliable.

37
Fair value

The quoted market price in an active market provides the most reliable estimate of the fair value of an intangible
asset.

INTERNALLY GENERATED INTANGIBLE ASSETS

To assess whether an internally generated intangible assets meets the criteria for recognition, an enterprise classifies
the generation of the asset into RESEARCH and DEVELOPMENT.

REASON FOR SPENDING MONEY ON RESEARCH & DEVELOPMENT

Many businesses in the commercial world spend vast amounts of money, on an annual basis, on the research and
development of products and services. These entities do this with the intention of developing a product or service
that will, in future periods, provide significant amounts of income for years to come.

DEFINITIONS

Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical
knowledge and understanding.

An example of research could be a company in the pharmaceuticals industry undertaking activities or tests aimed at
obtaining new knowledge to develop a new vaccine. The company is researching the unknown, and therefore, at
this early stage, no future economic benefit can be expected to flow to the entity.

Development is the application of research findings or other knowledge to a plan or design for the production of
new or substantially improved materials, devices, products, processes, systems or services before the start of
commercial production or use.

An example of development is a car manufacturer undertaking the design, construction, and testing of a pre-
production model.

ACCOUNTING TREATMENT

Research phase

It is impossible to demonstrate whether or not a product or service at the research stage will generate any probable
future economic benefit. As a result, IAS 38 states that all expenditure incurred at the research stage should be
written off to the statement of profit or loss as an expense when incurred, and will never be capitalised as an
intangible asset.

DEVELOPMENT PHASE

An intangible asset arising from development (or from the development phase of an internal project) should be
recognized as asset (capitalized) if, and only if, an enterprise can demonstrate all of the following:

(a) The technical feasibility of completing the intangible asset so that it will be available for use or sale;
(b) Its intention to complete the intangible asset and use or sell it;
(c) Its ability to use or sell the intangible asset;
(d) How the intangible asset will generate probable future economic benefits. Among other things, the enterprise
should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself
or, if it is to be used internally, the usefulness of the intangible asset;

38
(e) The availability of adequate technical, financial and other resources to complete the development and to use
or sell the intangible asset; and
(f) Its ability to measure the expenditure attributable to the intangible asset during its development reliably.
If any of the recognition criteria are not met then the expenditure must be charged to the statement of profit or loss
as incurred. Note that if the recognition criteria have been met, capitalisation must take place.

Internally generated brands, mastheads, publishing titles, customer lists and similar items should not be recognised
as intangible assets.

Treatment of capitalised development costs

Once development costs have been capitalised, the asset should be amortised in accordance with the accruals
concept over its finite life. Amortisation must only begin when commercial production has commenced (hence
matching the income and expenditure to the period in which it relates).

Each development project must be reviewed at the end of each accounting period to ensure that the recognition
criteria are still met. If the criteria are no longer met, then the previously capitalised costs must be written off to the
statement of profit or loss immediately.

EXAMPLE

A company incurs research costs, during one year, amounting to $125,000, and development costs of $490,000.
The accountant informs you that the recognition criteria as prescribed by IAS 38 has been met. What effect will the
above transactions have on the financial statements when following the International Accounting Standards?

Solution

$125,000 will be charged as expense in statement of profit or loss. $490,000 will be capitalized in statement of
financial position.

Past expense not recognized as an asset

Expenditure on an intangible asset that was initially recognized as an expense shall not be recognized as part of the
cost of an intangible asset.

Cost of an internally generated intangible asset

The cost comprises all directly attributable costs necessary to create, produce and prepare the asset to be capable
of operating in the manner intended by the management.

a) Costs, of materials and services used or consumed in generating the intangible asset;
b) Costs of employee benefits arising from the generation of intangible assets
c) Fees to register a legal right; and
d) Amortization of patents and licenses that are used to generate the intangible asset
The following are not components of the cost of an internally generated intangible asset:

(a) Selling, administrative and other general overhead expenditure unless this expenditure can be directly
attributed to preparing the asset for use;
(b) Clearly identified inefficiencies and initial operating losses incurred before an asset achieves planned
performance; an d

39
Expenditure on training staff to operate the asset.

SUBSEQUENT MEASUREMENT OF INTANGIBLE ASSETS

COST MODEL

After initial recognition, an intangible asset shall be carried at its cost less any accumulated amortization and any
accumulated impairment loss.

REVALUATION MODEL

After initial recognition an intangible asset whose fair value can be determined with reference to the active market
shall be carried at revalued amount, less subsequent accumulated amortization and subsequent accumulated
impairment losses.

ACCOUNTING TREATMENT

Classification of intangible assets based on useful life

Intangible assets are classified as having:

 Indefinite life: no foreseeable limit to the period over which the asset is expected to generate net cash
inflows for the entity.
 Finite life: a limited period of benefit to the entity.

An entity shall assess whether the useful life of an intangible asset is finite or indefinite and if finite, the length of,
or number of production or similar units constituting, that useful life.
An intangible asset shall be regarded by the entity as having an indefinite useful life when, based on an analysis of
all of the relevant factors, there is no foreseeable limit to the period over which the asset is expected to generate
net cash inflows for the entity

The useful life of an intangible asset that is not being amortized shall be reviewed in each period to determine
whether events and circumstances continue to support an indefinite useful life assessment for that asset. If they do
not, the change in the useful life assessment from indefinite to finite shall be accounted for as change in an
accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

Amortisation and Impairment

 The depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic
basis over its useful life.
 The amortization method should reflect the pattern of benefits
 Amortise when commercial production begins
 The amortization period and the amortization method for an intangible asset with a finite useful life shall
be reviewed at least at each financial year end.
 An intangible asset with an indefinite useful life shall not be amortized but will be tested for impairment at
every reporting date.
 The recoverable amount of the asset should be determined at least at each financial year end and any
impairment loss should be accounted for in accordance with IAS 36.

40
QUESTION

Dimitri Co. is engaged in a number of research and development projects:

A project to develop a new process which will save time in the production of widgets.
Project Alpha: This project was started on 1 January 20X8 and met the capitalization criteria on 31
August 20X8

Project Beta: A project to investigate the properties of a chemical compound

A development project which was completed on 30 June 20X8. Related costs in the
statement of financial position at the start of the year were $290,000. Production and
Project Charlie:
sales of the new product commenced on 1 September and are expected to last 36
months

Costs for the year ended 31 December 20X8 are as follows:

$
Project A 34,000
Project B costs to 31 August 78,870
Project B costs from 31 August 27,800
Project C costs to 30 June 19,800

What amount is expensed to the statement of profit or loss in respect of these projects in the year ended 31
December 20X8?

Solution:
$147,292

DISPOSAL
Remove from statement of financial position when disposed of or abandoned. Recognize any gain or loss in the
statement of profit or loss.

GOODWILL

Goodwill is not normally recognised in the accounts of a business at all. The reason for this is that goodwill is
considered inherent in a business and it does not have any objective value.

Purchased goodwill

There is one exception to the principle that goodwill has no objective value, this is when a business is sold.

Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible
substance, and so it is an intangible non-current asset. It is dealt with under IFRS 3 Business Combinations

41
SUBSEQUENT EXPENDITURE

Due to the nature of intangible assets, subsequent expenditure will only rarely meet the criteria for being recognised
in the carrying amount of an asset. Subsequent expenditure on brands, mastheads, publishing titles, customer lists
and similar items must always be recognised in profit or loss as incurred.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Dec. 15 Q.1 (ii)
IAS 38 June 15 MCQ.2
June 14 Q.5(i)

42
 IAS 36 – IMPAIRMENT OF ASSETS

OBJECTIVE

The objective of this IAS is to set rules to ensure that the assets of an enterprise are carried at no more than their
recoverable amount.

DEFINITIONS

 Recoverable amount is the higher of an asset’s net selling price and its value in use.
 Value in use is the present value of estimated future cash flows expected to arise from the continuing use
of an asset and from its disposal at the end of its useful life.
 Net selling price the amount obtainable from the sale of an asset in an arm’s length transaction between
knowledgeable, willing parties, less the costs of disposal.
 An impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable
amount.
 A cash-generating unit is the smallest identifiable group of assets that generates cash inflows from
continuing use that are largely independent of the cash inflows from other assets or groups of assets.
 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.
IMPAIRMENT ASSESSMENT

An enterprise should assess at each reporting date: -

a) Whether there is any indication that an asset may be impaired;

b) Irrespective of any indication of impairment, an entity shall also: -
 Test in case of intangible assets having indefinite life or under development; and
 Test goodwill acquired in business combination for impairment annually
External sources of information include:
 Decline in asset’s market value significantly more than expected
 Significant changes with an adverse effect in the technological, market, economic or legal environment in
which the enterprise operates;
 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
Internal sources of information include:
 Obsolescence or physical damage
 Significant changes with an adverse effect in the extent to which, or manner in which, an asset is used or is
expected to be used. These changes include plans to discontinue or restructure the operation to which an
asset belongs.
 Economic performance of an asset is worse than expected.
 Other evidence from internal reporting may be: -
 Cash flows for acquiring and maintaining the asset are significantly higher than the originally budgeted;
 Actual cash flows are worst that the budgeted; and
 Operating losses or net cash outflows when current period amounts are aggregated with the budgeted
amounts for the future

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MEASURING RECOVERABLE AMOUNT

Recoverable
Amount

Higher of

Value in Use Value in Sale

Entities have to bear in mind the following steps and considerations when evaluating an asset’s recoverable amount:

 Recoverable amount is the higher of an asset’s net selling price and its value in use
 It is not always necessary to determine both an asset’s net selling price and its value in use. For example, if
either of these amounts exceeds the asset’s carrying amount, the asset is not impaired and it is not
necessary to estimate the other amount.
 If asset is held for disposal then present value of cash flow from the use of asset until its disposal are likely
to be negligible, in this case recoverable amount shall be equal to the selling price.
 If it is not possible to determine the fair value less costs to sell because there is no active market for the
asset, the company can use the asset's value in use as its recoverable amount. Similarly, if there is no reason
for the asset's value in use to exceed its fair value less costs to sell, then the latter amount may be used as
its recoverable amount.
For example, where an asset is being held for disposal, the value of this asset is likely to be the net disposal proceeds.
The future cashflows from this asset from its continuing use are likely to be negligible

 Recoverable amount is determined for an individual asset. If the asset does not generate cash flows
independent from other assets. This asset is clubbed to cash generating unit and impairment loss is
calculated of this cash-generating unit.
Measurement of net selling price (Value in sale)

 Price in Binding Sale Agreement less Disposal Cost.

 Cost of disposal includes legal costs, stamp duty and similar transaction taxes, costs of removing the asset,
and direct incremental costs to bring an asset into condition for its sale.
Measurement of Value in Use

Estimating the value in use of an asset involves the following steps:

 Estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its
ultimate disposal; and
 Applying the appropriate discount rate to these future cash flows.
It is important that any cashflows projections are based upon reasonable and supportable assumptions over a
maximum period of five years unless it can be proven that longer estimates are reliable. They should be based upon
most recent financial budgets and forecasts.

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Discount Rate

 The discount rate should be a pre-tax rate.

 It should reflect the current market assessments of the time value of money and the risks that relate to the
asset for which the future cashflows have not yet been adjusted.
RECOGNITION AND MEASUREMENT OF IMPAIRMENT LOSS

If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset
should be reduced to its recoverable amount. That reduction is an impairment loss.

Recoverable Carrying Impairment

value value expense

An impairment loss should be recognized as an expense in the statement of profit or loss immediately, unless the
asset is carried at revalued amount. An impairment loss on a revalued asset is recognized directly against any
revaluation surplus for the asset to the extent that the impairment loss does not exceed the amount held in the
revaluation surplus for that same asset.

After the recognition of an impairment loss, the depreciation (amortization) charge for the asset should be adjusted
in future periods to allocate the asset’s revised carrying amount, less its residual value (if any), on a systematic basis
over its remaining useful life.

Question 1
Metric owns an item of plant which has a carrying amount of $248,000 as at 1 April 2014. It is being depreciated at
12½% per annum on a reducing balance basis.

The plant is used to manufacture a specific product which has been suffering a slow decline in sales. Metric has
estimated that the plant will be retired from use on 31 March 2017. The estimated net cash flows from the use of
the plant and their present values are:

Net cash flows Present values

$ $
Year to 31 March 2015 120,000 109,200
Year to 31 March 2016 80,000 66,400
Year to 31 March 2017 52,000 39,000
–––––––– ––––––––
252,000 214,600
–––––––– ––––––––
On 1 April 2015, Metric had an alternative offer from a rival to purchase the plant for $200,000.

45
At what value should the plant appear in Metric’s statement of financial position as at 31 March 2015?

A. $248,000
B. $217,000
C. $214,600
D. $200,000

Answer: C

Is the lower of its carrying amount ($217,000) and recoverable amount ($214,600) at 31 March 2015.

Recoverable amount is the higher of value in use ($214,600) and fair value less (any) costs of disposal ($200,000)).

Carrying amount = $217,000 (248,000 – (248,000 x 12·5%))

Value in use is based on present values = $214,600

CASH GENERATING UNIT

A cash generating unit (CGU) is the smallest identifiable group of assets for which independent cash flows can be
identified and measured. For example, for a restaurant chain a CGU might be each individual restaurant.

Identification of Cash-Generating Unit to which an asset belongs

 If there is any indication that an asset may be impaired, recoverable amount should be estimated for the
individual asset. If it is not possible to estimate the recoverable amount of the individual asset, an enterprise
should determine the recoverable amount of the cash-generating unit to which the asset belongs (the
asset’s cash-generating unit).
 The recoverable amount of an individual asset cannot be determined if:

o The asset’s value in use cannot be estimated to be close to its net selling price (for example, when
the future cash flows from continuing use of the assets cannot be estimated to be negligible); and
o The asset does not generate cash inflows from use that are independent of those from other asset.
In such cases, value in use and, therefore recoverable amount, can be determined only for the
asset’s cash-generating unit.
o An asset’s cash generating unit is the smallest group of assets that includes the asset and that
generates cash inflows from continuing use that are largely independent of the cash inflows from
other assets or groups of assets.
Recoverable amount and carrying amount of cash generating unit

The recoverable amount of a cash-generating unit is the higher of the cash-generating unit’s net selling price and
value in use.

The carrying amount of a cash-generating unit includes the carrying amount of only those assets that can be
attributed directly, or allocated on a reasonable and consistent basis, to the cash-generating unit and that will
generate the future cash inflows estimated in determining the cash-generating unit’s value in use.

46
Goodwill

 As goodwill acquired in a business combination does not generate cash flows independently of other assets,
it must be allocated to each of the acquirer’s cash generating units
 A CGU to which goodwill has been allocated is tested for impairment annually. The carrying amount of the
CGU including the goodwill is compared with its recoverable amount.
RECOGNITION OF IMPAIRMENT LOSS OF CASH-GENERATING UNIT

An impairment loss should be recognized for a cash-generating unit if, and only if, its recoverable amount is less than
its carrying amount. The impairment loss should be allocated to reduce the carrying amount of the assets of the unit
in the following order:

 First to any asset that is impaired (e.g. if an asset was specifically damaged)
 Second, to goodwill in the cash generating unit
 Third, to all other assets in the CGU on a pro rata basis based on carrying value

These reductions in carrying amounts should be treated as impairment losses on individual assets.

In allocating in impairment loss, the carrying amount of an asset should not be reduced below the highest of:

Its net selling price (if determinable);

Its value in use (if determinable);

Zero

If this rule is applied then the impairment loss not allocated to the individual asset will be allocated on a pro-rata
basis to the other assets of the group.

Question 2
The net assets of Fyngle, a cash generating unit (CGU), are:

$
Property, plant and equipment 200,000
Allocated goodwill 50,000
Product patent 20,000
Net current assets (at net realisable value) 30,000
––––––––
300,000
––––––––

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As a result of adverse publicity, Fyngle has a recoverable amount of only $200,000.

What would be the value of Fyngle’s property, plant and equipment after the allocation of the impairment loss?

A $154,545
B $170,000
C $160,000
D $133,333

Solution:

Option A

Goodwill should be written off in full and the remaining loss is allocated pro rata to property plant and equipment
and the product patent.

B/f Loss Post loss

$ $ $
Property, plant and equipment 200,000 (45,455) 154,545
Goodwill 50,000 (50,000) nil
Product patent 20,000 (4,545) 15,455
Net current assets (at NRV) 30,000 nil 30,000
300,000 (100,000) 200,000
REVERSAL OF IMPAIRMENT LOSS

An enterprise should assess at each reporting date whether there is any indication that an impairment loss
recognized for an asset in prior years may no longer exist or may have decreased. If any such indication exists, the
enterprise should estimate the recoverable amount of that asset.

Considerations on reversal of an impairment loss for an individual asset:

 The increase in carrying value of the asset due to a reversal on impairment loss can only be up to should
not exceed the carrying amount that would have been determined (net of amortization or depreciation)
had no impairment loss been recognized for the asset in prior years.
 A reversal of an impairment loss been recognized as income immediately in the statement of profit or loss,
unless the asset is carried at revalued amount (for example, under the allowed alternative treatment in IAS
16, Property, Plant and Equipment). Any reversal of an impairment loss on a revalued asset should be
treated as a revaluation increase as per the respective standard.
 A reversal of an impairment loss on a revalued asset is credited directly to equity under the heading
revaluation surplus. However, to the extent that an impairment loss on the same revalued asset was
previously recognized as an expense in the statement of profit or loss, a reversal of that impairment loss is
recognized, as income in the statement of profit or loss.
After a reversal of an impairment loss is recognized, the depreciation (amortization) charge for the asset should be
adjusted in future periods to allocate the asset’s revised carrying amount, less its residual value (if any), on a
systematic basis over its remaining useful life.

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Considerations on reversal of an impairment loss for 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 asset of the unit in the following order:

 First, reverse on assets other than goodwill on a pro-rata basis based on the carrying amount of each asset
in the unit; and
 An impairment loss recognized for goodwill shall not be reversed in a subsequent period.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 17,18,19,20
June 15 MCQ.4
IAS 36
Dec. 14 MCQ.12,18
June 12 Q.4

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 IAS 40-INVESTMENT PROPERTY

OBJECTIVE

The objective of this Standard is to prescribe the accounting treatment for investment property and related
disclosure requirements.

DEFINITIONS:

Investment property is property held to earn rentals or for capital appreciation or both, rather than for:

a) Use in the production or supply of goods or services or for administrative purposes; or

b) Sale in the ordinary course of business.
Owner-occupied property 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.

CLASSIFICATION

The following are examples of investment property:

a) Land held for long-term capital appreciation

b) Land held for a currently undetermined future use
c) Building leased out under operating lease
d) A building that is vacant but is held to be leased out under one or more operating leases.
e) Property that is being constructed or developed for future use as investment property
The following are examples of items that are not investment property:
a) Property held for use in the production or supply of goods or services or for administrative purposes
b) Property held for sale in the ordinary course of business or in the process of construction of development
for such sale (IAS 2 Inventories)
c) Property being constructed or developed on behalf of third parties
d) Owner-occupied property (IAS 16 Property, Plant and Equipment), including property held for future use as
owner-occupied property, property held for future development and subsequent use as owner-occupied
property, property occupied by employees and owner-occupied property awaiting disposal
e) Property leased to another entity under a finance lease

Property held under an operating lease.

A property interest that is held by a lessee under an operating lease may be classified and accounted for as
investment property provided that:

 The rest of the definition of investment property is met

 The operating lease is accounted for as if it were a finance lease in accordance with IFRS 16 Leases
 The lessee uses the fair value model set out in this Standard for the asset recognised
An entity may make the foregoing classification on a property-by-property basis.

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Partial own use

If the owner uses part of the property for its own use, and part to earn rentals or for capital appreciation, and the
portions can be sold or leased out separately, they are accounted for separately. Therefore the part that is rented
out is investment property. If the portions cannot be sold or leased out separately, the property is investment
property only if the owner-occupied portion is insignificant.

Ancillary services

If the entity provides ancillary services to the occupants of a property held by the entity, the appropriateness of
classification as investment property is determined by the significance of the services provided. If those services are
a relatively insignificant component of the arrangement as a whole (for instance, the building owner supplies security
and maintenance services to the lessees), then the entity may treat the property as investment property. Where the
services provided are more significant (such as in the case of an owner-managed hotel), the property should be
classified as owner-occupied.

Intra-company rentals

Property rented to a parent, subsidiary, or fellow subsidiary is not investment property in consolidated financial
statements that include both the lessor and the lessee, because the property is owner-occupied from the perspective
of the group. However, such property could qualify as investment property in the separate financial statements of
the lessor, if the definition of investment property is otherwise met.

RECOGNITION:

Investment property shall be recognized as an asset when

(a) It is probable that the future economic benefits that are associated with the investment property will flow to
the entity; and
(b) The cost of the investment property can be measured reliably.
MEASUREMENT

Initial measurement

 An investment property shall be measured initially at its Cost + Transaction costs.

 The cost of a purchased investment property = Purchase price + any directly attributable expenditure.

The cost should not include start-up costs, abnormal waste, or initial operating losses incurred before the investment
property achieves the planned level of occupancy.

Subsequent expenditure

This should be added to the carrying amount of the investment property when it is probable that future economic
benefits in excess of the originally assessed standard of performance of the existing investment property will flow
to the enterprise. All other subsequent expenditure should be recognized as an expense in the period in which it is
incurred.

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Exchanges of assets

An investment property may be acquired in exchange or part exchange for a non-monetary asset or assets or a
combination of monetary and non-monetary assets.

The cost of such an item is the fair value unless the exchange transaction lacks commercial substance or the fair
value of the asset given up / acquired is not reliably measurable. Then the cost of the asset acquired will be the
carrying value of the asset given up

SUBSEQUENT MEASUREMENT

IAS 40 permits entities to choose between

 A fair value model, and

 A cost model.

COST MODEL:

Under cost model, investment property should be measured at depreciated cost, less any accumulated impairment
losses.

FAIR VALUE MODEL

Under the fair value model the entity should:

 Revalue all its investment property to 'fair value' (open market value) at the end of each financial year, and
 Take the resulting gain or loss to profit or loss for the period in which it arises.
Fair value is the price that would be received to sell an asset or paid to transfer a liability, in an orderly
transaction between market participants at the measurement date.

Investment property is remeasured at fair value, which is the amount for which the property could be exchanged
between knowledgeable, willing parties in an arm's length transaction.

Fair value should reflect the actual market state and circumstances as of the reporting date. The best evidence of
fair value is normally given by current prices on an active market for similar property in the same location and
condition and subject to similar lease and other contracts. In the absence of such information, the entity may
consider current prices for properties of a different nature or subject to different conditions, recent prices on less
active markets with adjustments to reflect changes in economic conditions, and discounted cash flow projections
based on reliable estimates of future cash flows.

There is a rebuttable presumption that the entity will be able to determine the fair value of an investment property
reliably on a continuing basis. However:

 If an entity determines that the fair value of an investment property under construction is not reliably
determinable but expects the fair value of the property to be reliably determinable when construction is
complete, it measures that investment property under construction at cost until either its fair value
becomes reliably determinable or construction is completed.
 If an entity determines that the fair value of an investment property (other than an investment property
under construction) is not reliably determinable on a continuing basis, the entity shall measure that

52
 investment property using the cost model in IAS 16. The residual value of the investment property shall be
assumed to be zero. The entity shall apply IAS 16 until disposal of the investment property.
Where a property has previously been measured at fair value, it should continue to be measured at fair value until
disposal, even if comparable market transactions become less frequent or market prices become less readily
available.

COST MODEL

The cost model is the same treatment in IAS 16. Investment property should be measured at cost less accumulated
depreciation less any accumulated impairment losses. An enterprise that chooses the cost model should disclose
the fair value of its investment property.

Adoption and change of models

One method must be adopted for all of an entity's investment property. Change is permitted only if this results in a
more appropriate presentation. IAS 40 notes that this is highly unlikely for a change from a fair value model to a cost
model.

TRANSFERS:

Transfers to, or from, investment property should only be made when there is a change in use, evidenced by one or
more of the following:

 Commencement of owner-occupation (transfer from investment property to owner-occupied property)

 Commencement of development with a view to sale (transfer from investment property to inventories)
 End of owner-occupation (transfer from owner-occupied property to investment property)
 Commencement of an operating lease to another party (transfer from inventories to investment property)
 End of construction or development (transfer from property in the course of construction/development to
investment property

When an entity decides to sell an investment property without development, the property is not reclassified as
inventory but is dealt with as investment property until it is derecognised.

RULES FOR TRANSFER:

 For a transfer from investment property carried at fair value to owner-occupied property or inventories,
the fair value at the change of use is the 'cost' of the property under its new classification
 For a transfer from owner-occupied property to investment property carried at fair value, IAS 16 should be
applied up to the date of reclassification. Any difference arising between the carrying amount under IAS 16
at that date and the fair value is dealt with as a revaluation under IAS 16
 For a transfer from inventories to investment property at fair value, any difference between the fair value
at the date of transfer and it previous carrying amount should be recognized in profit or loss
 When an entity completes construction/development of an investment property that will be carried at fair
value, any difference between the fair value at the date of transfer and the previous carrying amount should
be recognized in profit or loss.

When an entity uses the cost model for investment property, transfers between categories do not change the
carrying amount of the property transferred, and they do not change the cost of the property for measurement or
disclosure purposes.

53
DISPOSAL

An investment property should be derecognized on disposal or when the investment property is permanently
withdrawn from use and no future economic benefits are expected from its disposal.

 The gain or loss on disposal should be calculated as the difference between the net disposal proceeds and the
carrying amount of the asset and should be recognized as income or expense
 Compensation from third parties is recognized when it becomes receivable.

ACCOUNTING TREATMENT DIFFERENCE – Fair value model & Revaluation model

Superficially, the revaluation model and fair value sound very similar; both require properties to be valued at their
fair value which is usually a market-based assessment (often by an independent value).

However, any gain (or loss) over a previous valuation is taken to profit or loss if it relates to an investment property,
whereas for an owner-occupied property, any gain is taken to a revaluation reserve (via other comprehensive income
and the statement of changes in equity).

A loss on the revaluation of an owner-occupied property is charged to profit or loss unless it has a previous surplus
in the revaluation reserve which can be used to offset the loss until it is exhausted. A further difference is that owner-
occupied property continues to be depreciated after revaluation, whereas investment properties are not
depreciated.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

IAS 40 June 13 Q.5

54
 IAS 2 – INVENTORIES

Objective

The objective of this IAS is to prescribe the accounting treatment of inventories.

DEFINITIONS

Inventories are assets; -

a) Held for sale in the ordinary course of business

b) In the process of production for such sale; or (work in progress, finished goods awaiting to be sold)
c) In the form of materials or supplies to be consumed in the production process or in the rendering
of services
Net Realizable Value is the estimated selling price in the ordinary course of business less the estimated costs of
completion and the estimated cost necessary to make a sale.
MEASUREMENT OF INVENTORIES

Inventory shall be measured at the lower of cost and net realizable value.

COST OF INVENTORIES

The cost of inventories will comprise all costs of purchase, costs of conversion and other costs incurred in bringing
the inventories to their present location and condition.

(a) Purchase cost comprise the;

i) Purchase price plus;
ii) Import duties and other non –refundable taxes;
iii) Transport, handling and any other cost directly attributable to the acquisition of finished goods,
services and materials; less
iv) Trade discounts, rebates and other similar amounts

(b) Cost of conversion

i) Costs directly related to the units of production (direct labor); and
ii) Systematic allocation of fixed and variable production overheads that are incurred in converting
materials into finished goods. (Factory rent, depreciation of machinery, supervisor salary, power
consumption)
The allocation of fixed overheads to the costs of conversion is based on the normal capacity of the production
facilities.

(c) Other cost incurred in bringing the inventories to their present location and condition (i.e. non production
overheads or costs of designing products for specific customers).
The Standard excludes the following from the cost of inventories

a) The abnormal amount of wasted material, labor or other production cost;

b) Storage costs unless necessary for production before the further production process/stage;
c) Administrative overheads that do not contribute to bringing inventories to their present location and condition;
and
(d) Selling cost

55
 (e) Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a
foreign currency
(f) Interest cost when inventories are purchased with deferred settlement terms
Costs of Inventories of a service provider

The cost of inventories of service providers includes primarily the labour and other cost of the personnel directly
engaged in providing the service including supervisory personnel and directly attributable overheads.

COST FORMULAS

For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost formulas.

The LIFO formula, which had been allowed prior to the 2003 revision of IAS 2, is no longer allowed.

NET REALIZABLE VALUE

As a general rule assets should not be carried at amounts greater than those expected to be realized from their sale
or use. In case of inventories this amount could fall below cost when items are damaged or become wholly or
partially obsolete, or where the costs to completion have increased in order to make the sale or the prices have
declined. (Prudence Concept).

The principal situations in which NRV is likely to be less than cost, i.e. where there has been:

 An increase in costs or a fall in selling price

 A physical deterioration in conditions of inventory
 Obsolescence of products
 A decision as part of the company’s marketing strategy to manufacture and sell products at a loss
 Errors in production or purchasing
RULES:

 The write down of inventories would normally take place on an item-by-item basis but similar or related
items may be grouped together (in case of service provider each service will be treated as item).
 The NRV should be based on the most reliable evidence available at the time of estimates are made.
 Fluctuations after reporting date should also be taken into account to the extent they confirm the
conditions existing at the reporting date.
 The estimate of NRV should also take into account the purpose for which the inventory is held (firm sale /
purchase contracts).
 Materials or supplies held for use in the production process should not be written down below cost if the
finished products in which they will be incorporated are expected to be sold at or above cost. Otherwise,
when the decline in the value of materials indicates that the cost of finished goods exceeds NRV, the
materials should be written down to NRV.
 NRV should be reassessed at each reporting date and necessary adjustments such as further reduction or
increase in NRV should be made however, reversal of write down is limited to the original write down of
inventories.
 Material reductions should be disclosed separately

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RECOGNITION AS EXPENSE

The following treatment is required, when inventories are sold.

a) The carrying amount is recognized as an expense in the period in which the related revenue is recognized
(matching concept)
b) The amount of any write down of inventories to NRV and all losses of inventories are recognized as an
expense in the period in which the related write down or loss occurred
c) The amount of any reversal of any write down of inventories, arising from the increase in NRV is recognized
as a reduction in the amount of inventories recognized as an expense in the period in which the reversal
occurs.
Question

On 30 September 2014, Razor’s closing inventory was counted and valued at its cost of $1 million. Some items of
inventory which had cost $210,000 had been damaged in a flood (on 15 September 2014) and are not expected to
achieve their normal selling price which is calculated to achieve a gross profit margin of 30%. The sale of these goods
will be handled by an agent who sells them at 80% of the normal selling price and charges Razor a commission of
25%.

At what value will the closing inventory of Razor be reported in its statement of financial position as at 30
September 2014?

A $1 million
B $790,000
C $180,000
D $970,000

Answer

Option D

The normal selling price of damaged inventory is $300,000 (210/70%).

This will now sell for $240,000 (300,000 x 80%), and have a NRV of $180,000 (240 – (240 x 25%)). The expected loss on the
inventory is $30,000 (210 cost – 180 NRV) and therefore the inventory should be valued at $970,000 (1,000 – 30).

The inventories allocated to other assets i.e. when the inventory becomes the part of cost of self-constructed assets,
the inventories are recognized as an expense over the useful life of those assets.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Dec.14 MCQ.8
IAS 2 Dec. 11 Q.2 (iv)
June 11 Q.2 (v)

57
 IAS 41 – AGRICULTURE

OBJECTIVE

The objective of IAS 41 is to establish standards of accounting for agricultural activity

SCOPE

Within scope are Biological assets, Agricultural produce at the point of harvest and Government grants related to
biological assets.

Excluded from scope are Land and Intangible assets related to agricultural activity

DEFINITIONS

ACTIVE MARKET:

Exists when; the items traded are homogenous, willing buyers and sellers can normally be found at any time and
prices are available to the public.

AGRICULTURAL ACTIVITY:

The management of the transformation of a biological asset for sale into agricultural produce or another biological
asset.

Biological asset: A living animal or plant.

Agricultural produce: The harvested produce of the entity’s biological assets.

Biological transformation: The process of growth, degeneration, production, and procreation that cause an increase
in the value or quantity of the biological asset.

Harvest: The process of detaching produce from a biological asset or cessation of its life.

Bearer plant: A living plant that:

a. Is used in the production or supply of agricultural produce

b. Is expected to bear produce for more than one period, and
c. Has a remote likelihood of being sold as agricultural produce, except for incidental scrap sales.

Costs to sell: The incremental costs directly attributable to the disposal of an asset, excluding finance costs and
income taxes

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RECOGNITION

Biological assets or agricultural produce are recognised when:

 Entity controls the asset as a result of a past event

 Probable that future economic benefit will flow to the entity; and
 Fair value or cost of the asset can be measurement reliably.
MEASUREMENT

Biological assets

Biological assets within the scope of IAS 41 are measured on initial recognition and at subsequent reporting dates at
fair value less estimated costs to sell, unless fair value cannot be reliably measured.

If no reliable measurement of fair value (no quoted market price in an active market and alternative fair value
measurements unreliable), biological assets are stated at cost less accumulated depreciation and accumulated
impairment losses.

If circumstances change and fair value becomes reliably measurable, a switch to fair value less costs is required.

Agricultural produce

Agricultural produce is measured at fair value less estimated costs to sell at the point of harvest.

Unlike a biological asset, there is no exception in cases in which fair value cannot be measured reliably. According to
IAS 41, agricultural produce can always be measured reliably because harvested produce is a marketable commodity.

Point of-sale costs include brokers’ and dealers’ commissions, any levies by regulatory authorities and commodity
exchanges, and any transfer taxes and duties. They exclude transport and other costs necessary to get the assets to
a market.

Treatment of gain/loss

 The gain on initial recognition of biological assets at fair value less costs to sell, and changes in fair value
less costs to sell of biological assets during a period, are included in profit or loss.
 A gain on initial recognition (e.g. as a result of harvesting) of agricultural produce at fair value less costs to
sell are included in profit or loss for the period in which it arises.
 All costs related to biological assets that are measured at fair value are recognised as expenses when
incurred, other than costs to purchase biological assets.

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Government grants

An unconditional government grant related to a biological asset measured at fair value less estimated point-of-sale
costs is recognised as income when, and only when, the government grant becomes available

A conditional government grant, including where a government grant requires an entity not to engage in specified
agricultural activity, is recognised as income in profit or loss when and only when, the conditions of the grant are
met.

OTHER ISSUES

 The change in fair value of biological assets is part physical change (growth, etc) and part unit price change.
Separate disclosure of the two components is encouraged, not required.
 Agricultural produce is measured at fair value less costs to sell at harvest, and this measurement is
considered the cost of the produce at that time (for the purposes of IAS 2 Inventories or any other
applicable standard).
 Agricultural land is accounted for under IAS 16 Property, Plant and Equipment. However, biological assets
(other than bearer plants) that are physically attached to land are measured as biological assets separate
from the land. In some cases, the determination of the fair value less costs to sell of the biological asset
can be based on the fair value of the combined asset (land, improvements and biological assets).
 Intangible assets relating to agricultural activity (for example, milk quotas) are accounted for under IAS 38
Intangible Assets.
Question

To which of the following items does IAS 41 Agriculture apply?

(i) A change in the fair value of a herd of farm animals relating to the unit price of the animals

(ii) Logs held in a wood yard

(iii) Farm land which is used for growing vegetables

(iv) The cost of developing a new type of crop seed which is resistant to tropical diseases

A All four
B (i) only
C (i) and (ii) only
D (ii) and (iii) only

Solution
Option B

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

IAS 41 June 15 MCQ.10

60
 IAS-8
ACCOUNTING POLICIES, CHANGE IN ACCOUNTING ESTIMATES AND ERRORS

Objective:

The objective of this Standard is to prescribe the criteria for selecting and changing accounting policies, the
accounting treatment and disclosure of changes in accounting policies, accounting estimates and corrections of
errors.

ACCOUNTING POLICIES

Definitions:

Accounting Policies are the specific principles, bases, conventions, rules and practices applied by an entity in
preparing and presenting financial statements.

Material Omissions or misstatements of items are material if they could, influence the economic decisions that users
make on the basis of the financial statements.

SELECTION OF ACCOUNTING POLICIES

Management selects accounting policies by applying accounting standards or using judgment:

Compulsory - Where a specific standard relates to a transaction or event, the accounting policy applied to that item
shall be determined by applying that standard.

Voluntary - Where there is no specific standard to deal with a particular transaction, event or condition,
management shall develop and apply accounting policies resulting in reliable .and more relevant information.

In developing accounting policy management should consider:

a) The requirements and guidance of accounting standards dealing with similar and related issues; and

b) The contents of the Accounting Framework for the Preparation and Presentation of Financial statements
(The Framework).

CHANGE IN ACCOUNTING POLICIES

The management can change accounting policy under the following circumstances:

Compulsory - Where a change is required by a specific standard or interpretation (external).

Voluntary - Management determines that a change in policy will result in the financial statements providing reliable
and more relevant information (internal).

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Consistency in accounting policies

Although accounting policies can and sometimes must be changed in order to achieve comparability there is an
underlying requirement to be consistent in the selection and application of accounting policies.

To improve comparability, consistency requires that the same accounting policies should be applied to similar items
within each period, and from one period to the next.

Meaning of Relevant and Reliable

Relevant information helps the user to make economic decisions.

Reliable financial statements:

- Present faithfully the effects of transaction on financial position, financial performance and cash flows;

- Reflect the economic substance or transactions, other events and conditions

- Be neutral (no bias or error) Be prudent

- Be complete in all material respects.

Application of Changes in Accounting Policy

The change in accounting policy is applied retrospectively

Compulsory/Specific - Where a new standard/Interpretation forces a change in accounting policy and that standard
has specific transitional provisions then the entity must apply those provisions in accounting for the change.

Compulsory/Non-Specific - Where the change in accounting policy is compulsory but with no specific transitional
provisions, the change shall be applied retrospectively.

Voluntary - Where the change is voluntary, the change shall be applied retrospectively.

Retrospective application

It is applying a new accounting policy to transactions and other events as if that policy had always been applied, i.e.
make prior period adjustments.

This means restating the opening balance of equity for the earliest prior period presented and the other comparative
amounts disclosed for each prior period presented as if the new accounting policy had always been applied.

Items NOT changes in accounting policy

IAS 8 states that the introduction of an accounting policy to account for transactions where circumstances have
changed is not a change in accounting policy.

Similarly, a policy for transactions that did not occur previously or that were immaterial is not a change in policy and
therefore would be applied prospectively.

Question

62
Which of the following is a change of accounting policy under IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors?

A Classifying commission earned as revenue in the statement of profit or loss, having previously classified it as other
operating income

B Switching to purchasing plant using finance leases from a previous policy of purchasing plant for cash

C Changing the value of a subsidiary’s inventory in line with the group policy for inventory valuation when preparing
the consolidated financial statements

D Revising the remaining useful life of a depreciable asset

Solution

Option A

A change of classification in presentation in financial statements is a change of accounting policy (CAP) under IAS 8.

Limitations of Retrospective Application

IAS 8 does not permit the use of hindsight when applying a new accounting policy, either in making assumptions
about what management's intentions would have been in a prior period or in estimating amounts to be recognised,
measured or disclosed in a prior period.

When it is impracticable to determine the effect of a change in accounting policy on comparative information, the
entity is required to apply the new policy to the carrying amounts of the assets and liabilities as at the beginning of
the earliest period for which retrospective application is practicable. This could actually be the current period but
the entity should attempt to apply the policy from the earliest date possible.

The application of the requirement of a standard or interpretation is "impracticable" if the entity cannot apply it
after making every effort to do so.

Disclosures for Changes in Accounting Policies

When initial application of the standard or interpretation has an effect on current or prior periods, would have an
effect but it is impracticable to determine, or might have an effect, then entities shall disclose:

 The title of the Standard or Interpretation;

 If applicable, that the changes were made in accordance with the transitional provisions;
 The nature of the change;
In addition, for voluntary changes in accounting policies, a description must be provided of the reason for the new
policy providing reliable and more relevant information.

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CHANGES IN ACCOUNTING ESTIMATES

Definition

A change in accounting estimate is an adjustment of the carrying amount of an asset or liability, or related expense,
resulting from reassessing the expected future benefits and obligations associated with that asset or liability.

Where the basis of measurement for the amount to be recognised is uncertain, an entity will use an estimation
technique, which is a normal part of the preparation of the financial statements without undermining their reliability.

Estimates involve judgments based on the latest available, reliable information and are applied in determining the
useful lives of property, plant and equipment, provisions, fair values of financial assets and liabilities and actuarial
assumptions relating to defined benefit pension schemes.

Many items in financial statements cannot be measured with precision but will be estimated. Estimation involves
judgment based on the latest available reliable information. Examples include:

 Estimating the recoverability of receivables at the year end, i.e. bad debts
 Inventory obsolescence
 Fair values of assets/liabilities
 Determining the remaining useful lives of; or the expected patterns of consumption of depreciable assets
 Estimating Income tax expenses
Comparison between change in accounting policy and estimate

Accounting estimates need to be distinguished from accounting policies as the effect of a change in an estimate is
reflected in the Statement of profit or loss and other comprehensive income, whereas a change in accounting policy
will generally require a prior period adjustment. If there is a change in the circumstances on which the estimate was
based or new information has arisen or more experience relating to the estimation process has occurred, then the
estimate may need to be changed. A change in the measurement basis is not a change in an accounting estimate,
but is a change in accounting policy. For example, if there is a move from historical cost to fair value, this is a change
in accounting policy but a change in the method of depreciation is a change in accounting estimate.

Accounting for changes in estimates

The effect of a change in an accounting estimate shall be recognized prospectively by including it in profit or loss in:

 The period of the change, if the change affects that period only e.g. change is estimated irrecoverable and
doubtful debts; or
 The period of the change and future periods, if the change affects both e.g. change in useful life of a
depreciable asset.
To the extent that a change in an accounting estimate gives rise to changes in assets and liabilities, or relates to an
item of equity, it shall be recognized by adjusting the carrying amount of the related asset, liability or equity item in
the period of the change.

ERRORS

Prior period errors are omissions from, and misstatements in, the entity’s financial statements for one or more prior
periods arising from a failure to use, or misuse of, reliable information that:

64
  Was available when financial statements for those periods were authorized for issue; and
 Could reasonably be expected to have been obtained and taken into account in the preparation and
presentation of those financial statements.
Accounting for errors

An entity shall correct material prior period errors retrospectively in the first set of financial statements authorized
for issue after their discovery by:

 Restating the comparative amounts for the prior period(s) presented in which the error occurred; or
 If the error occurred before the earliest prior period presented, restating the opening balances of assets,
liabilities and equity for the earliest prior period presented
PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 17 Q.1 (iii)
Dec. 14 MCQ.1
IAS 8
June 14 Q.5(i)
June 12 Q.2 (iii)

65
 IAS 23-BORROWING COST

OBJECTIVE:

To prescribe the accounting treatment for borrowing cost.

DEFINITIONS:

Borrowing costs are interest and other costs, incurred by an entity in connection with the borrowing of funds in
order to construct an asset.

Borrowing cost includes

 Interest on bank overdraft and short term borrowing;

 Finance lease charges in respect of finance lease; and
 Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an
adjustment of interest cost
 Issuance costs
 Discount on issuance and premium on redemption

Qualifying asset: A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its
intended use or sale (e.g. inventories, manufacturing plants, power generation facilities, intangible assets,
investment properties etc.). However, financial assets, inventories produced over short period of time and assets
ready for intended sale are not qualifying assets.

ACCOUNTING TREATMENT:

Recognition

An entity should capitalize the borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset as part of the cost of that asset and, therefore, should be capitalized.

Other borrowing costs are expensed in statement of profit or loss when occurred.

Return on any surplus funds invested is first deducted from the amount of interest and then the remaining amount
is capitalized.

Specific Funds

The borrowing cost of funds, borrowed specifically for the qualifying asset, is the actual cost incurred on the funds
during the period less any investment income on the temporary investment of funds.

66
General funds

The borrowing cost of funds, borrowed generally, will be determined by applying a capitalization rate to the
expenditures incurred on those assets. The capitalization rate is the weighted average rate of the borrowings cost
applicable to the borrowings of the entity outstanding during that period other than specific borrowings. The amount
of borrowing cost capitalized during a period should not exceed the borrowing costs incurred during the period.
(Group borrowings)

Excess of carrying amount of the qualifying asset over recoverable amount

When the carrying amount exceeds the recoverable amount of that asset, the asset should be written down to its
recoverable value. (IAS 36)

PERIOD OF CAPITALIZATION

Commencement of capitalization

The capitalization commences: -

 Expenditures for the assets are being incurred;

 Borrowing costs are being incurred; and
 Activities necessary to prepare the asset for its intended use/sale are in progress
Expenditures on a qualifying asset include only those expenditures, which have resulted in transfer of cash/other
asset or assumption of interest bearing liabilities and will be reduced by any Government Grant (IAS –20).

The activities necessary to complete the qualifying asset include beside physical construction the
technical/administrative work such as obtaining permits prior to physical construction. However, such activities
exclude the holding of an asset when no production or development that changes the asset’s condition is taking
place (e.g. borrowing cost incurred while land is under development are capitalized during the period when activities
related to the development are in progress).

Suspension of capitalization

Capitalization should cease when during the extended period the active development is interrupted. Examples are:-

 Borrowing costs incurred during extended periods when activities to prepare an asset for its intended
use/sale are interrupted (costs of holding partially completed assets)
 On temporary delays the capitalization is not suspended (Geographical region involved - delays due to high
water levels, inventories to mature for sale, due to bad weather, strikes etc)
Cessation of capitalization

The capitalization should cease, when substantially all the activities necessary to complete the qualifying asset for
its intended use/sale are complete (physical construction is complete, administrative or decorative work may
continue).

When the construction of a qualifying asset is in parts the capitalization of borrowing cost should cease, when the
relevant part is complete for its intended use/sale (building park).

Question

67
On 1 October 20X1, Bash Co borrowed $6m for a term of one year, exclusively to finance the construction of a new
piece of production equipment. The interest rate on the loan is 6% and is payable on maturity of the loan. The
construction commenced on 1 November 20X1 but no construction took place between 1 December 20X1 to 31
January 20X2 due to employees taking industrial action. The asset was available for use on 30 September 20X2 having
a construction cost of $6m.

What is the carrying amount of the production equipment in Bash Co’s statement of financial position as at 30
September 20X2?

Solution: $6,270,000

DISCLOSURE

 The accounting policy adopted.

 Amount of borrowing cost capitalized during the period.
 Capitalization rate used.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

IAS 23 Sept. 16 MCQ.15

68
 FINANCIAL INSTRUMENTS

FINANCIAL INSTRUMENTS: INTRODUCTION

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or
equity instrument of another entity.

With references to assets, liabilities and equity instruments, the statement of financial position immediately comes
to mind. Further, the definition describes financial instruments as contracts, and therefore in essence financial
assets, financial liabilities and equity instruments are going to be pieces of paper.

Examples

i) When an invoice is issued on the sale of goods on credit, the entity that has sold the goods has a
financial asset – the receivable – while the buyer has to account for a financial liability – the payable.
ii) When an entity raises finance by issuing equity shares. The entity that subscribes to the shares has a
financial asset – an investment – while the issuer of the shares who raised finance has to account for
an equity instrument – equity share capital.
iii) When an entity raises finance by issuing bonds (debentures). The entity that subscribes to the bonds –
i.e. lends the money – has a financial asset – an investment – while the issuer of the bonds – i.e. the
borrower who has raised the finance – has to account for the bonds as a financial liability.
iv) So, accounting for financial instruments in simple terms is how to account for investments in shares,
investments in bonds and receivables (financial assets), how to account for trade payables and long-
term loans (financial liabilities) and how to account for equity share capital (equity instruments).
In considering the rules as to how to account for financial instruments there are various issues around
classification, initial measurement and subsequent measurement.

FINANCIAL ASSETS

Definition

A financial asset is any asset that is:

 Cash
 A contractual right to receive cash or another financial asset from another entity
 A contractual right to exchange financial assets/liabilities with another entity under conditions that are
potentially favorable
 An equity instrument of another entity.
Examples of financial assets include:

 Trade receivables
 Investment in equity shares.

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Classification and accounting treatment

IFRS 9, Financial Instruments has simplified the way that financial assets are accounted.

When an entity acquires a financial asset it will be acquiring a debt asset (e.g. an investment in bonds, trade
receivables) or an equity asset (e.g. an investment in ordinary shares).

Financial assets have to be classified and accounted for in one of three categories: amortised cost, Fair Value Through
Profit or Loss or Fair Value Through Other Comprehensive Income (FVTOCI).

They are initially measured at fair value plus, in the case of a financial asset not at FVTPL, transaction costs.

Accounting for financial assets that are debt instruments

A financial asset that is a debt instrument will be subsequently accounted for using amortised cost if it meets two
simple tests. These two tests are the business model test and the cash flow test.

The business model test is met where the purpose is to hold the asset to collect the contractual cash flows (rather
than to sell it prior to maturity to realise its fair value changes). The cash flow test will be met when the contractual
terms of the asset give rise on specified dates to cash flows that are solely receipts of either the principal or interest.
Interest is compensation for time value of money and credit risk.

Important points

 Assessment of business management model is on portfolio level not on individual investment

 Irregular sales of investments do not impact business management model
 Businesses may have different business management models for different investments
These tests are designed to ensure that the fair value of the asset is irrelevant, as even if interest rates fall – causing
the fair value to raise – then the asset will still be passively held to receive interest and capital and not be sold on.

All other financial assets that are debt instruments must be measured at FVTPL.

Accounting for financial assets that are equity instruments (for example, investments in equity shares)

Equity investments have to be measured at fair value in the statement of financial position. As with financial assets
that are debt instruments, the default position for equity investments is that the gains and losses arising are
recognised in income (FVTPL).

However, there is an election that equity investments can at inception be irrevocably classified and accounted as
FVTOCI, so that gains and losses arising are recognised in other comprehensive income, thus creating an equity
reserve, while dividend income is still recognised in income. Such an election cannot be made if the equity
investment is acquired for trading. On disposal of an equity investment accounted for as FVTOCI, the gain or loss to
be recognised in income is the difference between the sale proceeds and the carrying value. Gains or losses
previously recognised in other comprehensive income cannot be recycled to income as part of the gain on disposal.

For example, let us consider the case of an equity investment accounted for at FVTOCI that was acquired several
years ago for $10,000 and by the last reporting date has been revalued to $30,000. If the asset is then sold for
$31,000, the gain on disposal to be recognised in the statement of profit or loss is only $1,000 as the previous gain

70
of $20,000 has already been recognised and reported in the other comprehensive statement of profit or loss. IFRS 9
requires that gains can only be recognised once. The balance of $20,000 in the equity reserves that relates to the
equity investment can be transferred into retained earnings as a movement within reserves.

The accounting for financial assets can be summarised in the diagram below.

Reclassification of financial assets

As we have seen once an equity investment has been classified as FVTOCI this is irrevocable so it cannot then be
reclassified. Nor can a financial asset be reclassified where the fair value option has been exercised. However if, and
only if the entity's business model objective for its financial assets changes so its previous model assessment would
no longer apply then other financial assets can be reclassified between FVTPL and amortised cost, or vice versa. Any
reclassification is done prospectively from the reclassification date without restating any previously recognised
gains, losses, or interest.

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Examples
Investment in perpetuity bond At FVTPL
Investment in convertible bond At FVTPL
Investment in fixed rate bond Could be at amortised cost
Investment in variable interest rate bond Could be at amortised cost, market interest rates are reset
periodically therefore it accounts for time value of money
and credit risk of the company
Investment in bond of $10,000 at 6%
variable with:
Gold price At FVTPL
Stock market At FVTPL
Measurement of Financial Assets

1) At Amortised cost:
Initial measurement: Fair value (Cash paid) + Transaction cost
Subsequent measurement: At amortised cost using effective interest rate method

2) At FVTOCI:
Initial measurement: Fair value (Cash paid) + Transaction cost
Subsequent measurement: At fair value and gain/loss will be charged to OCI

3) At FVTPL:
Initial measurement: Fair value (Cash paid)
Transaction cost is charged to P&L
Subsequent measurement: At fair value and gain/loss will be charged to P&L

Note: Attempt Question 1 from Concept test questions at the end of this chapter.

FINANCIAL LIABILITIES AND EQUITY INSTRUMENTS

Financial liabilities

A financial liability is any liability that is a contractual obligation:

 To deliver cash or another financial asset to another entity

Examples of financial liabilities include:

 Trade payables
 Debenture loans
 Redeemable preference shares
Equity instruments

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all
of its liabilities.

Initial recognition of financial instruments

An entity should recognise a financial asset or a financial liability in its statement of financial position:

 When, and only when, it becomes a party to the contractual provisions of the instrument, even at nil cost
 At fair value of consideration given/received i.e. this is normally cost

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Classification and accounting treatment

The equity instruments and financial liabilities arise when the entity raises finance – ie receives cash in return for
issuing a financial instrument.

Distinguishing between debt and equity

For an entity that is raising finance it is important that the instrument is correctly classified as either a financial
liability (debt) or an equity instrument (shares). This distinction is so important as it will directly affect the calculation
of the gearing ratio, a key measure that the users of the financial statements use to assess the financial risk of the
entity. The distinction will also impact on the measurement of profit as the finance costs associated with financial
liabilities will be charged to the statement of profit or loss, thus reducing the reported profit of the entity, while the
dividends paid on equity shares are an appropriation of profit rather than an expense.

When raising finance the instrument issued will be a financial liability, as opposed to being an equity instrument,
where it contains an obligation to repay. Thus, the issue of a bond (debenture) creates a financial liability as the
monies received will have to be repaid, while the issue of ordinary shares will create an equity instrument. In a
formal sense an equity instrument is any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.

It is possible that a single instrument is issued that contains both debt and equity elements. An example of this is a
convertible bond – ie where the bond contains an embedded derivative in the form of an option to convert to shares
rather than be repaid in cash. The accounting for this compound financial instrument will be discussed later.

EQUITY INSTRUMENT

Equity instruments are initially measured at fair value less any issue costs. In many legal jurisdictions when equity
shares are issued they are recorded at a nominal value, with the excess consideration received recorded in a share
premium account and the issue costs being written off against the share premium.

Note: Attempt Question 2 from Concept test questions at the end of this chapter.

Equity instruments are not remeasured. Any change in the fair value of the shares is not recognised by the entity, as
the gain or loss is experienced by the investor, the owner of the shares. Equity dividends are paid at the discretion
of the entity and are accounted for as reduction in the retained earnings, so have no effect on the carrying value of
the equity instruments.

As an aside, if the shares being issued were redeemable, then the shares would be classified as financial liabilities
(debt) as the issuer would be obliged to repay back the monies at some stage in the future.

FINANCIAL LIABILITIES

A financial instrument will be a financial liability, as opposed to being an equity instrument, where it contains an
obligation to repay. Financial liabilities are then classified and accounted for as either fair value through profit or
loss (FVTPL) or at amortised cost.

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Financial liabilities at amortised cost

The default position is, and the majority of financial liabilities are, classified and accounted for at amortised cost.

Financial liabilities that are classified as amortised cost are initially measured at fair value minus any transaction
costs.

Accounting for a financial liability at amortised cost means that the liability's effective rate of interest is charged as
a finance cost to the statement of profit or loss (not the interest paid in cash) and changes in market rates of interest
are ignored – ie the liability is not revalued at the reporting date. In simple terms this means that each year the
liability will increase with the finance cost charged to the statement of profit or loss and decrease by the cash repaid.

Note: Attempt Questions 3 & 4 from Concept test questions at the end of this chapter.

Financial liabilities at FVTPL

Financial liabilities are only classified as FVTPL if they are held for trading or the entity so chooses.

Financial liabilities that are classified as FVTPL are initially measured at fair value and any transaction costs are
immediately written off to the statement of profit or loss.

By accounting for a financial liability at FVTPL, the financial liability is also increased by a finance cost and reduced
by cash repaid but is then revalued at each reporting date with any gains and losses immediately recognised in the
statement of profit or loss. The measurement of the new fair value at the year-end will be its market value or, if not
known, the present value of the future cash flows, using the current market interest rates. The interest rate used
subsequently to calculate the finance cost will be this new current rate until the next revaluation.

Note: Attempt Question 5 from Concept test questions at the end of this chapter.

Points to remember

Effective interest rate method

Total finance cost: $

Interest paid xx
Issuance cost xx
Discount xx
Premium xx
Total finance cost (Allocate over loan term xx
using effective interest rate)

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 Years Opening Finance cost charged Interest paid Rollover Closing
balance balance
Y1 Xx Issue cost, discount & Nominal value x Discount, issue cost Xx
premium Par value & premium
Calculation of fair value of financial instrument

 Fair value = Present value of future cash flows at current market interest for similar financial instruments
 Use market rate of relevant year or date
 Future cash flows will be used.
Classification of Financial Liabilities

Financial liabilities are either classified as:

 Financial liabilities at amortised cost; or
 Financial liabilities as at fair value through profit or loss (FVTPL).

Financial liabilities are measured at amortised cost unless either:

 The financial liability is held for trading and is therefore required to be measured at FVTPL (e.g. derivatives
not designated in a hedging relationship), or
 The entity elects to measure the financial liability at FVTPL (using the fair value option).
Measurement of Financial Liabilities

1) At Amortised cost:
Initial measurement: Fair value (Cash received) - Issue cost
Subsequent measurement: At amortised cost using effective interest rate method

Examples of items at amortised cost are

 Trade payables
 Loan payables
 Bank borrowings

2) At Fair value option:

Fair value Gain/Loss will be split
 Gain/Loss due to own credit risk will be charged to OCI
 Gain/Loss due to other credit risk will be charged to P&L

3) At FVTPL:
Initial measurement: Fair value (Cash received)
Transaction cost is charged to P&L
Subsequent measurement:

 Fair value will be calculated by PV(FCF) by using current market interest rate
 Any Gain or loss will be charged to P&L

Examples of items at FVTPL are

 Held for trading liability
 Derivatives standing at loss
 Contingent liability arising at business combination

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Summary

COMPOUND INSTRUMENTS

Convertible bonds are basically debt instruments but they also contain an option to convert into equity shares and
this means that a convertible bond contains both debt and equity elements. The option to convert will be exercisable
by the holder of the bond who has the option to require settlement of the debt in equity shares rather than being
repaid in cash. So, a compound instrument is a financial instrument that has characteristics of both equity and
liabilities.

For accounting purposes it will be necessary on initial recognition to split out the debt and equity elements so that
they can be separately accounted for. The fair value of the option is highly subjective, but the fair value of the debt
element is more easily measured by discounting the future cash flows. The assumption is then made that the fair
value of the option is the balancing figure.

The issuer of a compound financial instrument must classify it as a financial liability or equity instrument on initial
recognition according to its substance.

IAS 32 requires compound financial instruments be split into their component parts:

- A financial liability (the debt)

- An equity instrument (the option to convert into shares).

These must be shown separately in the financial statements.

For example, a convertible bond:

 The value of a convertible bond consists of a liability component - the bond - and
 An equity component - the value of the right to convert in due course to equity.

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Accounting for a convertible loan

 Calculate fair value of liability component first

- Based on present value of future cash flows assuming non-conversion

- Apply discount rate equivalent to interest on similar non-convertible debt instrument

 Equity = remainder
 The double entry passed is as follows:
Dr. Cash/Bank
Cr. Liability
Cr. Equity option
The liability component will be amortised like a loan as follows:

Opening Finance cost Interest paid Rollover balance Closing balance

balance
(Opening bal. x (Nominal value x Nominal (Difference between finance cost
Effective rate) interest rate) and interest paid)
Finance cost is charged to statement of profit or loss.

The economic effect of issuing convertible bonds is substantially the same as the simultaneous issue of a debt
instrument with an early settlement provision and warrants to purchase shares.

 If preference shares are irredeemable they are classified as equity

 If preference shares are redeemable they are classified as a financial liability
 Offset of a financial asset and liability is only allowed where there is a legally enforceable right and the
entity intends to settle net or simultaneously
Issue and finance costs

 Interest, dividends, loss or gains relating to a financial instrument claimed as a liability are reported in the
statement of profit or loss while distributions to holders of equity instruments are debited directly to equity
(in the SOCIE)
 Examples are: Issue cost of ordinary shares are deducted from share premium or retained earnings,
ordinary dividends are deducted from retained earnings, issue cost of equity option is deducted from the
value of equity option.

Note: Attempt Question 6 from Concept test questions at the end of this chapter.

DERECOGNITION OF FINANCIAL ASSETS

Financial assets are decrecognised when:

 Contractual rights related to financial assets expire e.g. cash received from receivable
 Financial assets are transferred to another party and substantial risks and rewards are transferred

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FACTORING OF RECEIVABLES/DEBTS:

This is where debts or receivables are factored the original creditor sells the debts to the factor.

If the seller has to pay interest on the difference between the amounts advanced to him and the amounts that the
factor has received, and if the seller bears the risk of non-payment by the debtor, then the indications would be that
the transaction is, in effect, a loan.

Required accounting:

 Where the seller has retained no significant benefits and risks relating to the debts and has no obligation
to repay amounts received from the factors, the receivables should be removed from its statement of
financial position
 No liability should be shown in respect of the proceeds received from the factor
 A profit or loss should be recognized, calculated as the difference between the carrying amount of the debts
and the proceeds received.
 Where the seller does retain significant benefits and risks a gross asset should be shown in the statement
of financial position of the seller within assets, and a corresponding liability in respect of the proceeds
received from the factor should be shown within liabilities.
 The interest element of the factor’s charges should be recognized as it accrues and included in profit or loss
with other interest charges.

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 CONCEPT TEST QUESTIONS

Question 1

Included within the financial assets of Zinet Co at 31 March 20X9 are the following two recently purchased
investments in publically-traded equity shares:

 Investment 1 – 10% of the issued share capital of Haruka Co. This shareholding was acquired as a long-term
investment as Zinet Co wishes to participate as an active shareholder of Haruka Co.
 Investment 2 – 10% of the issued share capital of Lukas Co. This shareholding was acquired for speculative
purposes and Zinet Co expects to sell these shares in the near future.
Neither of these shareholdings gives Zinet Co significant influence over the investee companies.

Wherever possible, the directors of Zinet Co wish to avoid taking any fair value movements to profit or loss, so as to
minimise volatility in reported earnings.

How should the fair value movements in these investments be reported in Zinet Co’s financial statements for the
year ended 31 March 20X9?

A In profit or loss for both investments

B In other comprehensive income for both investments
C In profit or loss for investment 1 and in other comprehensive income for investment 2
D In other comprehensive income for investment 1 and in profit or loss for investment 2

Solution

Option D

Question 2

Dravid issues 10,000 $1 ordinary shares for cash consideration of $2.50 each. Issue costs are $1,000.

Required

Explain and illustrate how the issue of shares is accounted for in the financial statements of Dravid.

Solution

The entity has raised finance (received cash) by issuing financial instruments. Ordinary shares have been issued, thus
the entity has no obligation to repay the monies received; rather it has increased the ownership interest in its net
assets. As such, the issue of ordinary share capital creates equity instruments. The issue costs are written off against
share premium. The issue of ordinary shares can thus be summed up in the following journal entry.

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 The gross cash received is 10,000 x $2.5 = $25,000 but the issue
Dr Cash $24,000
costs of $1,000 have to be paid

The 10,000 shares issued are recorded at their nominal value of

Cr Equity Share Capital $10,000
$1 each

The excess consideration received of $15,000 ($1.50 x 10,000) is

Cr Share Premium $14,000
recorded in share premium but net of the issue costs of $1,000

Question 3: Accounting for a financial liability at amortised cost

Laxman raises finance by issuing zero coupon bonds at par on the first day of the current accounting period with a
nominal value of $10,000. The bonds will be redeemed after two years at a premium of $1,449. The effective rate of
interest is 7%.

Required

Explain and illustrate how the loan is accounted for in the financial statements of Laxman.

Solution

Laxman is receiving cash that it is obliged to repay, so this financial instrument is classified as a financial liability.
There is no suggestion that the liability is being held for trading purposes nor that the option to have it classified as
FVTPL has been made, so, as is perfectly normal, the liability will be classified and accounted for at amortised cost
and initially measured at fair value less the transaction costs. The bonds are being issued at par, so there is neither
a premium nor discount on issue. Thus Laxman initially receives $10,000. There are no transaction costs and, if there
were, they would be deducted. Thus, the liability is initially recognised at $10,000.

In applying amortised cost, the finance cost to be charged to the statement of profit or loss is calculated by applying
the effective rate of interest (in this example 7%) to the opening balance of the liability each year. The finance cost
will increase the liability. The bond is a zero coupon bond meaning that no actual interest is paid during the period
of the bond. Even though no interest is paid there will still be a finance cost in borrowing this money. The premium
paid on redemption of $1,449 represents the finance cost. The finance cost is recognised as an expense in the
statement of profit or loss over the period of the loan. It would be inappropriate to spread the cost evenly as this
would be ignoring the compound nature of finance costs, thus the effective rate of interest is given. In the final year
there is a single cash payment that wholly discharges the obligation. The workings for the liability being accounted
for at amortised cost can be summarised and presented as follows.

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 Plus statement of profit or loss Closing balance,
finance charge @7% on the opening Less the being the liability
Opening balance balance cash paid on the statement of financial position

Year 1 $10,000 $700 (Nil) $10,700

Year 2 $10,700 $749 ($11,449) Nil

Question 4: Accounting for a financial liability at amortised cost

Broad raises finance by issuing $20,000 6% four-year loan notes on the first day of the current accounting period.
The loan notes are issued at a discount of 10%, and will be redeemed after three years at a premium of $1,015. The
effective rate of interest is 12%. The issue costs were $1,000.

Required

Explain and illustrate how the loan is accounted for in the financial statements of Broad.

Solution

Broad is receiving cash that is obliged to repay, so this financial instrument is classified as a financial liability. Again,
as is perfectly normal, the liability will be classified and accounted for at amortised cost and, thus, initially measured
at the fair value of consideration received less the transaction costs.

With both a discount on issue and transaction costs, the first step is to calculate the initial measurement of the
liability.

Cash received – the nominal value

($20,000 x 90%) $18,000
less the discount on issue

($1,000)
Less the transaction costs
_______

Initial recognition of the financial liability $17,000

In applying amortised cost, the finance cost to be charged to the statement of profit or loss is calculated by applying
the effective rate of interest (in this example 12%) to the opening balance of the liability each year. The finance cost
will increase the liability. The actual cash is paid at the end of the reporting period and is calculated by applying the
coupon rate (in this example 6%) to the nominal value of the liability (in this example $20,000). The annual cash
payment of $1,200 (6% x $20,000 = $1,200) will reduce the liability. In the final year there is an additional cash
payment of $21,015 (the nominal value of $20,000 plus the premium of $1,015), which extinguishes the remaining
balance of the liability. The workings for the liability being accounted for at amortised cost can be summarised and
presented as follows.

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 Plus statement of profit or
loss finance charge
Opening @12% on the opening Less the cash paid Closing balance, being the liability on
balance balance (6% x 20,000) the statement of financial position
Year 1 $17,000 $2,040 ($1,200) $17,840
Year 2 $17,840 $2,141 ($1,200) $18,781
Year 3 $18,781 $2,254 ($1,200) $19,835
$2,380 ($1,200)
Year 4 $19,835 Nil
______ ($21,015)
Total
$8,815
finance
______
costs
Because the cash paid each year is less than the finance cost, each year the outstanding liability grows and for this
reason the finance cost increases year on year as well. The total finance cost charged to income over the period of
the lo an comprises not only the interest paid, but also the discount on the issue, the premium on redemption and
the transaction costs.

Interest paid (4 years x $1,200) = $4,800

Discount on issue (10% x $20,000) = $2,000
Premium on redemption $1,015
$1,000
Issue costs
______
$8,815
Total finance costs
______
Question 5: Accounting for a financial liability at FVTPL

On 1 January 2011 Swann issued three year 5% $30,000 loans notes at nominal value when the effective rate of
interest is also 5%. The loan notes will be redeemed at par. The liability is classified at FVTPL. At the end of the first
accounting period market interest rates have risen to 6%.

Required

Explain and illustrate how the loan is accounted for in the financial statements of Swann in the year ended 31
December 2011.

Solution

Swann is receiving cash that is obliged to repay so this financial instrument is classified as a financial liability. The
liability is classified at FVTPL so, presumably, it is being held for trading purposes or the option to have it classified
as FVTPL has been made.

Initial measurement is at the fair value of $30,000 received and, although there are no transaction costs in this
example, these would be expensed rather than taken into account in arriving at the initial measurement.

With an effective rate of interest and the coupon rate both being 5%, at the end of the accounting period the carrying
value of the liability will still be $30,000. This is because the finance cost that will increase the liability is $1,500 (5%

82
x $30,000 – the effective rate applied to the opening balance), and the cash paid reducing the liability is also $1,500
(5% x $30,000 – the coupon rate applied to the nominal value).

As the liability has been classified as FVTPL this carrying value at 31 December 2011 now has to be revalued. The fair
value of the liability at this date will be the present value (using the new rate of interest of 6%) of the next remaining
two years' payments.

6% Present value of the future cash

Cash discount flow
flow factor
Payment due 31 December 2012 (interest only) $1,500 x 0.943 $1,415
Payment due 31 December 2013
$31,500
(the final interest payment and the repayment of the 0.890 $28,035
x
$30,000)
Fair value of the liability at 31 December 2011 $29,450
As Swann has classified this liability at FVTPL, it is revalued to $29,450. The reduction of $550 in the carrying value
of the liability from $30,000 is regarded as a profit, and this is recognised in the statement of profit or loss. If,
however, the higher discount rate used was not because general interest rates have risen, rather the credit risk of
the entity has risen, then the gain is recognised in other comprehensive income. This can all be summarised in the
following presentation.

Carrying
Plus statement of profit or Less cash paid value Fair value
Gain to
Opening loss finance charge (5% of the of the
statement of profit
balance @5% x liability at liability at
or loss
on the opening balance 30,000) year year end
end
1/1/2011 $30,000 $1,500 ($1,500) $30,000 $29,450 $550
Briefly consider the accounting in the remaining two years. The finance charge in the statement of profit or loss for
the year end 31 December 2012 will be the 6% x $29,450 = $1,767, and with the cash payment of $ 1,500 being
made, the carrying value of the liability will be $29,717 ($29,450 plus $ 1,767 less $1,500) at the year end.

If at 31 December 2012 the market rate of interest has fallen to, say, 4%, then the fair value of the liability at the
reporting date will be the present value of the last repayment due of $31,500 in one year's time discounted at 4%
(ie $31,500 x 0.962 = $30,288), which in turn means that as the fair value of the liability exceeds the carrying value,
a loss of $571 (ie $30,288 less $29,717) arises which is recognised in the statement of profit or loss.

In the final year ending 31 December 2013 the finance cost to the statement of profit or loss will be 4% x $30,288 =
$1,212, increasing the liability to $31,500 before the final cash payment of $31,500 is made, thus extinguishing the
liability. As you may know from your financial management studies, and as is demonstrated here, when interest
rates rise so the fair value of bonds fall and when interest rates fall then the fair value of bonds rises.

83
Question 6

Graham Gooch issues a 3% $200,000 two-year convertible bond at par. The effective rate of interest of the
instrument is 8%. The terms of the convertible bond is that the holder of the bond, on the redemption date, has the
option to convert the bond to equity shares at the rate of 10 shares with a nominal value of $1 per $100 debt rather
than being repaid in cash. Transaction costs can be ignored. Graham Gooch will account for the financial liability
arising using amortised cost.

Required

Explain the accounting for the issue of the convertible bond.

Solution

A convertible bond creates both an equity and a debt instrument. On initial recognition the debt element will be
measured at fair value – i.e. the present value of the future cash flow, with the equity element representing the
balancing figure. Transaction costs have been ignored, but would have to split proportionately between the debt
and equity elements. The value ascribed to the equity element is the balancing figure.

Present
Cash
Discount value of
flow
factor the
(3% x
@ 8% future
$200,000)
cash flow

Year 1 $6,000 x 0.926 $5,556

$176,542
Year 2 $206,000 x 0.857
________
Fair value of the
$182,098
debt element
Fair value of the $17,902
equity element (balancing figure) ________
Proceeds of the issue $200,000
In journal entry terms the initial issue of the convertible bond can be summarised as follows:

Dr Cash $200,000

Cr Financial liability $182,098

Cr Equity $17,902

The Cr to equity can be reported in a reserve entitled ‘Other components of equity’. Equity is not subsequently
remeasured. The liability on the other hand will be accounted for using amortised cost charging income with a
finance cost at the rate of 8%.

84
 Statement of
Opening profit or loss Closing balance
Less cash
balance finance cost @ of the liability
8%

Year 1 $182,098 $14,568 ($6,000) $190,666

Year 2 $190,666 $15,334* ($6,000) $200,000

* includes rounding

At the end of Year 2 the liability can be extinguished by the payment of $200,000 in cash, or if the option is exercised
by the bond holder, then it is extinguished by the issue of 20,000 $1 ordinary shares at nominal value with a share
premium of $180,000 also being recorded.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16
MCQ. 7, Q.1(i)
March/June 16
Q.3 (iii)
Dec. 15
Q.1 (v)
June 15
Q.3
Dec. 14
Financial instruments MCQ.11
June 14
Q.2(iv)
Dec. 12
Q.2 (v)
Dec. 11
Q.2 (v), Q.5
Dec. 11
Q.2 (ii)
June 11

85
 IAS 37 – PROVISONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

Objective

The objective of this IAS is to ensure that appropriate recognition criteria and measurement bases are applied to
provisions, contingent liabilities and contingent assets.

PROVISIONS

Definitions

 A provision is a liability of uncertain timing or amount.

 An obligating event is an event that creates a legal or constructive obligation that results in an enterprise
having no realistic alternative to settling that obligation.
 A legal obligation is an obligation that derives from:
(a) A contract (through its explicit or implicit terms);
(b) Legislation; or
(c) Other operation of law.
 A constructive obligation is an obligation that derives from an enterprise’s action where:
(a) By an established pattern of past practice, published policies or a sufficiently specific current statement,
the enterprise has indicated to other parties that it will accept certain responsibilities; and
(b) As a result, the enterprise has created a valid expectation on the part of those other parties that it will
discharge those responsibilities.
 An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it.
 A restructuring is a program that is planned and controlled by management, and materially changes either:
(a) The scope of a business undertaken by an enterprise; or
(b) The manner in which that business is conducted.
Recognition

A provision shall be recognized when:

a) An entity has a present obligation (legal or constructive) as a result of a past event;
b) It is possible than an outflow of resources embodying economic benefits will be required to settle the
obligation; and
c) A reliable estimate can be made of amount of the obligation.
If these conditions are not met, no provision shall be recognized.

Present obligation

In rare cases it is not clear whether there is a present obligation. In the cases, a past event is deemed to give rise to
a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation
exists at the reporting date.

86
Past event

A past event that leads to a present obligation is called an obligating event. For an event to be an obligating event,
it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This is the
case only:

a) Where the settlement of the obligation can be enforced by law; or

b) In the case of a constructive obligation, where the event (which may be an action of the entity) creates valid
expectations in other parties that the entity will discharge the obligation.
Measurement

The amount recognized as a provision shall be the best estimate of the expenditure required to settle the present
obligation at the reporting date. This means that:

 Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured
at the most likely amount.
 Provisions for large populations of events (warranties, customer refunds) are measured at a probability-
weighted expected value.
 Both measurements are at discounted present value using a pre-tax discount rate that reflects the current
market assessments of the time value of money and the risks specific to the liability.
In reaching its best estimate, the enterprise should take into account the risks and uncertainties that surround the
underlying events. Expected cash outflows should be discounted to their present values, where the effect of the
time value of money is material.

Reimbursement

If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the
reimbursement should be recognized as a reduction of the required provision when, and only when, it is virtually
certain that reimbursement will be received if the enterprise settles the obligation. The amount recognized should
not exceed the amount of the provision.

In SOFP, reimbursement should be shown as an asset and provision should be shown at gross amount however, in
statement of profit or loss they can be netted off.

Re-measurement of provisions

 Review and adjust provisions at each reporting date

 If outflow is no longer probable, reverse the provision to statement of profit or loss.
Application of recognition and measurement rules

Some specific requirements on applying recognition and measurement rules are as follows:

 Future operating losses

Provisions shall not be recognized for future operating losses.
 Onerous contracts
If an entity has a contract that is onerous, the present obligation under the contract shall be recognized and
measured as a provision.

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Restructuring

The following are examples of events that may fall under the definition of restructuring:

 Sale or termination of a line of business

 Closure of business locations
 Changes in management structure
 Fundamental re-organization of company
Restructuring provisions should be accrued as follows:

Sale of operation: Accrue provision only after a binding sale agreement. If the binding sale agreement is after
reporting date, disclose but do not accrue
Closure or re-organization: Accrue only after a detailed formal plan is adopted and announced publicly. A board
decision is not enough.
Restructuring provision on acquisition (merger): Accrue provision for terminating employees, closing facilities, and
eliminating product lines only if announced at acquisition and, then only if a detailed formal plan is adopted 3 months
after acquisition.
A management or board decision to restructure taken before the reporting date does not give rise to a constructive
obligation at the reporting date unless the entity has, before the reporting date:

a) Stated to implement the restructuring plan; or

b) Announced the main features the restructuring plan to those affected by it in a sufficiently specific manner
to raise a valid expectation in them that the entity will carry out the restructuring.
If an entity starts to implement a restructuring plan, or announces its main features to those affected, only after the
reporting date, disclosure is required under IAS 10 Events after the Reporting Date, if the restructuring is material
and non-disclosure could influence the economic decisions of users taken on the basis of the financial statements.

Restructuring provisions should include only direct expenditures caused by the restructuring, not costs that
associated with the ongoing activities of the enterprise such as: -

a) retraining or relocating continuing staff;

b) marketing; or
c) investment in new systems and distribution networks

88
CONTINGENT LIABILITIES

Definition

A contingent liability is:

(a) A possible obligation that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the
enterprise; or
(b) A present obligation that arises from past events but is not recognized because:
(i) It is not probably that an outflow of resources embodying economic benefits will be required to
settle the obligation; or
(ii) The amount of the obligation cannot be measured with sufficient reliability.
Accounting treatment

 An enterprise should not recognize a contingent liability.

 A contingent liability is disclosed in financial statements, unless the possibility of an outflow of resources
embodying economic benefits is remote.
Where an enterprise is jointly and severally liable for an obligation, the part of the obligation that is expected to be
met by other parties is treated as a contingent liability.

The enterprise recognizes a provision for the part of the obligation for which an outflow of resources embodying
economic benefits is probable, except in the extremely rare circumstances where no reliable estimate can be made.

Contingent liabilities may develop in a way not initially expected. Therefore, they are assessed continually to
determine whether an outflow of resources embodying economic benefits has become probable. If it becomes
probable that an outflow of future economic benefits will be required for an item previously dealt with as a
contingent liability, a provision is recognized in the financial statements of the period in which the change in
probability occurs (except in the extremely rare circumstances where no reliable estimate can be made.)

Question 1

The following two issues relate to Spiko Co’s mining activities:

 Issue 1: Spiko Co began operating a new mine in January 20X3 under a five-year government licence which
required Spiko Co to landscape the area after mining ceased at an estimated cost of $100,000.
 Issue 2: During 20X4, Spiko Co’s mining activities caused environmental pollution on an adjoining piece of
government land. There is no legislation which requires Spiko Co to rectify this damage, however, Spiko Co
does have a published environmental policy which includes assurances that it will do so. The estimated cost
of the rectification is $1,000,000.
In accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, which of the following
statements is correct in respect of Spiko Co’s financial statements for the year ended 31 December 20X4?

A A provision is required for the cost of both issues 1 and 2

B Both issues 1 and 2 require disclosure only
C A provision is required for the cost of issue 1 but issue 2 requires disclosure only
D Issue 1 requires disclosure only and issue 2 should be ignored
Solution
Option A
CONTINGENT ASSETS

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Definition

A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the
enterprise.

Accounting treatment

 An enterprise should not recognize a contingent asset.

 A contingent asset is disclosed in financial statements, where an inflow of economic benefits is probable.
Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an
inflow of economic benefits to the enterprise. An example is a claim that an enterprise is pursuing through legal
processes, where the outcome is uncertain.

Contingent assets are not recognized in financial statements since may result in the recognition of income that may
never be realized. However, when the realization of income is virtually certain, then the related asset is not a
contingent asset and its recognition is appropriate.

Contingent assets are assessed continually to ensure that developments are appropriately reflected in the financial
statements. If it has become virtually certain that an inflow of economic benefits will arise, the asset and the related
income are recognized in the financial statements of the period in which the change occurs. If an inflow of economic
benefits has become probable, an enterprise discloses the contingent asset.

90
Examples of Provisions

Situation Accrue a Provision?

Restructuring by sale of an operation Accrue a provision only after a binding sale agreement

Restructuring by closure or re-organization Accrue a provision only after a detailed formal plan is adopted
and announced publicly. A Board decision is not enough

Warranty Accrue a provision (past event was the sale of defective goods)

Land contamination Accrue a provision if the company's policy is to clean up even if

there is no legal requirement to do so (past event is the
obligation and public expectation created by the company's
policy)

Offshore oil rig must be removed and sea bed Accrue a provision when installed, and add to the cost of the
restored asset

Abandoned leasehold, four years to run Accrue a provision

ACCA firm staff training for recent changes in tax No provision (there is no obligation to provide the training)
law

A chain of retail stores is self-insured for fire loss No provision until a an actual fire (no past event)

Self-insured restaurant, people were poisoned, Accrue a provision (the past event is the injury to customers)
lawsuits are expected but none have been filed
yet

Major overhaul or repairs No provision (no obligation)

Onerous (loss-making) contract Accrue a provision

Question 2 (IAS 16 + IAS 37)

On 1 October 20X4, Kalatra Co commenced drilling for oil from an undersea oilfield. Kalatra Co is required to
dismantle the drilling equipment at the end of its five-year licence. This has an estimated cost of $30m on 30
September 20X9. Kalatra Co’s cost of capital is 8% per annum and $1 in five years’ time has a present value of 68
cents.

What is the provision which Kalatra Co would report in its statement of financial position as at 30 September 20X5
in respect of its oil operations?

A $32,400,000
B $22,032,000
C $20,400,000
D $1,632,000
Solution

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Option B

Dismantling provision at 1 October 20X4 is $20·4 million (30,000 x 0·68) discounted

This will increase by an 8% finance cost by 30 September 20X5 = $22,032,000

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 4
Spec. exam Sept. 16 MCQ.5
June 15 MCQ.16
Dec. 14 MCQ.17
IAS 37
June 14 Q.5(ii)
Dec. 13 Q.2(iii), Q.4(c)
Dec. 12 Q.5
Dec. 11 Q.4

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 IFRS 16 - LEASES

Objective

IFRS 16 establishes principles for the recognition, measurement, presentation and disclosure of leases, with the
objective of ensuring that lessees and lessors provide relevant information that faithfully represents those
transactions.

Scope

IFRS 16 Leases applies to all leases, including subleases, except for:

 leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
 leases of biological assets held by a lessee (see IAS 41 Agriculture);
 licences of intellectual property granted by a lessor (see IFRS 15 Revenue from Contracts with Customers);
and
 rights held by a lessee under licensing agreements for items such as films, videos, plays, manuscripts,
patents and copyrights within the scope of IAS 38 Intangible Assets

Key definitions

Interest rate implicit in the lease

The interest rate that yields a present value of (a) the lease payments and (b) the unguaranteed residual value equal
to the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

Lease term

The non-cancellable period for which a lessee has the right to use an underlying asset, plus:

a) Periods covered by an extension option if exercise of that option by the lessee is reasonably certain;
and
b) Periods covered by a termination option if the lessee is reasonably certain not to exercise that option

Lessee’s incremental borrowing rate

The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the
funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

LEASE – IMPORTANCE OF IFRS 16

A lease is an agreement whereby the lessor (the legal owner of an asset) conveys to the lessee (the user of the asset)
the right to use an asset for an agreed period of time in exchange for consideration (return for a payment or series
of payments).

The approach of IAS 17 was to distinguish between two types of lease. Leases that transfer substantially all the risks
and rewards of ownership of an asset were classified as finance leases. All other leases were classified as operating
leases. The lease classification set out in IAS 17 was subjective and there was a clear incentive for the preparers of

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lessee’s financial statements to ‘argue’ that leases should be classified as operating rather than finance leases in
order to enable leased assets and liabilities to be left out of the financial statements.

It was for this reason that IFRS 16 was introduced.

IFRS 16 - ASSETS

IFRS 16 defines a lease as 'A contract, or part of a contract, that conveys the right to use an asset for a period of time
in exchange for consideration'. In order for such a contract to exist the user of the asset needs to have the right to:

 Obtain substantially all of the economic benefits from the use of the asset.
 The right to direct the use of the asset.

An ‘identified asset’

One essential feature of a lease is that there is an ‘identified asset’. This normally takes place through the asset being
specified in a contract, or part of a contract.

A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time
in exchange for consideration.

Control is conveyed where the customer has both the right to direct the identified asset’s use and to obtain
substantially all the economic benefits from that use.

An asset is typically identified by being explicitly specified in a contract, but an asset can also be identified by being
implicitly specified at the time it is made available for use by the customer.

For the asset to be ‘identified’ the supplier of the asset must not have the right to substitute the asset for an
alternative asset throughout its period of use. The fact that the supplier of the asset has the right or the obligation
to substitute the asset when a repair is necessary does not preclude the asset from being an ‘identified asset’.

A capacity portion of an asset is still an identified asset if it is physically distinct (e.g. a floor of a building). A capacity
or other portion of an asset that is not physically distinct (e.g. a capacity portion of a fiber optic cable) is not an
identified asset, unless it represents substantially all the capacity such that the customer obtains substantially all the
economic benefits from using the asset.

Example – identified assets

Under a contract between a local government authority (L) and a private sector provider (P), P provides L with 20
trucks to be used for refuse collection on behalf of L for a six-year period. The trucks, which are owned by P, are
specified in the contract. L determines how they are used in the refuse collection process. When the trucks are not
in use, they are kept at L’s premises. L can use the trucks for another purposes if it so chooses. If a particular truck
needs to be serviced or repaired, P is required to substitute a truck of the same type. Otherwise, and other than on
default by L, P cannot retrieve the trucks during the six-year period.

Conclusion: The contract is a lease. L has the right to use the 20 trucks for six years which are identified and explicitly
specified in the contract. Once delivered to L, the trucks can be substituted only when they need to be serviced or
repaired.

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The right to direct the use of the asset

IFRS 16 states that a customer has the right to direct the use of an identified asset if either:

 The customer has the right to direct how and for what purpose the asset is used throughout its period of
use, or
 The relevant decisions about use are pre-determined and the customer has the right to operate the asset
throughout the period of use without the supplier having the right to change these operating instructions.

Example – the right to direct the use of an asset

A customer (C) enters into a contract with a road haulier (H) for the transportation of goods from London to
Edinburgh on a specified truck. The truck is explicitly specified in the contract and H does not have substitution rights.
The goods will occupy substantially all of the capacity of the truck. The contract specifies the goods to be transported
on the truck and the dates of pickup and delivery.

H operates and maintains the truck and is responsible for the safe delivery of the goods. C is prohibited from hiring
another haulier to transport the goods or operating the truck itself.

Conclusion: This contract does not contain a lease.

There is an identified asset. The truck is explicitly specified in the contract and H does not have the right to substitute
that specified truck.

C does have the right to obtain substantially all of the economic benefits from use of the truck over the contract
period. Its goods will occupy substantially all of the capacity of the truck, thereby preventing other parties from
obtaining economic benefits from use of the truck.

However, C does not have the right to control the use of the truck because C does not have the right to direct its
use. C does not have the right to direct how and for what purpose the truck is used. How and for what purpose the
truck will be used (i.e. the transportation of specified goods from London to Edinburgh within a specified timeframe)
is predetermined in the contract. C has the same rights regarding the use of the truck as if it were one of many
customers transporting goods using the truck.

Separating components of a contract

For a contract that contains a lease component and additional lease and non-lease components, such as the lease
of an asset and the provision of a maintenance service, lessees shall allocate the consideration payable on the basis
of the relative stand-alone prices, which shall be estimated if observable prices are not readily available.

As a practical expedient, a lessee may elect, by class of underlying asset, not to separate non-lease components from
lease components and instead account for all components as a lease.

Lessors shall allocate consideration in accordance with IFRS 15 Revenue from Contracts with Customers.

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ACCOUNTING FOR LEASES

With a very few exceptions (discussed later) IFRS 16 basically abolishes the distinction between an operating lease
and a finance lease in the financial statements of lessees. Lessees will recognise a right of use asset and an associated
liability at the inception of the lease.

IFRS 16 basically requires that the ‘right of use asset’ and the lease liability should initially be measured at the
present value of the minimum lease payments. The discount rate used to determine present value should be the
rate of interest implicit in the lease.

Recording the asset

The ‘right of use asset’ would include the following amounts, where relevant:

 Any payments made to the lessor at, or before, the commencement date of the lease, less any lease
incentives received.
 Any initial direct costs incurred by the lessee.
 An estimate of any costs to be incurred by the lessee in dismantling and removing the underlying asset, or
restoring the site on which it is located (unless the costs are incurred to produce inventories, in which case
they would be accounted for in accordance with IAS 2 – Inventories). Costs of this nature are recognised
only when an entity incurs an obligation for them. IAS 37 – Provisions, Contingent Liabilities and Contingent
Assets would be applied to ascertain if an obligation existed.

Depreciation

The right of use asset is subsequently depreciated. Depreciation is over the shorter of the useful life of the asset and
the lease term, unless the title to the asset transfers at the end of the lease term, in which case depreciation is over
the useful life.

Lease liability

The lease liability is effectively treated as a financial liability which is measured at amortised cost, using the rate of
interest implicit in the lease as the effective interest rate.

Example – accounting for leases

A lessee enters into a 20-year lease of one floor of a building, with an option to extend for a further five years. Lease
payments are $80,000 per year during the initial term and $100,000 per year during the optional period, all payable
at the end of each year. To obtain the lease, the lessee incurred initial direct costs of $25,000.

At the commencement date, the lessee concluded that it is not reasonably certain to exercise the option to extend
the lease and, therefore, determined that the lease term is 20 years. The interest rate implicit in the lease is 6% per
annum. The present value of the lease payments is $917,600.

At the commencement date, the lessee incurs the initial direct costs and measures the lease liability $917,600.

The carrying amount of the right of use asset after these entries is $942,600 ($917,600 + $25,000) and consequently
the annual depreciation charge will be $47,130 ($942,600 x 1/20).

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The lease liability will be measured using amortised cost principles. In order to help us with the example in the
following section, we will measure the lease liability up to and including the end of year two. This is done in the
following table:

Finance
Balance Balance
cost
b/fwd Rental c/fwd
(6%)
Year $ $ $
$

1 917,600 55,056 (80,000) 892,656

2 892,656 53,559 (80,000) 866,215
At the end of year one, the carrying amount of the right of use asset will be $895,470 ($942,600 less $47,130
depreciation).

The interest cost of $55,056 will be taken to the statement of profit or loss as a finance cost.

The total lease liability at the end of year one will be $892,656. As the lease is being paid off over 20 years, some of
this liability will be paid off within a year and should therefore be classed as a current liability.

To find this figure, we look at the remaining balance following the payment in year two. Here, we can see that the
remaining balance is $866,215. This will represent the non-current liability, being the amount of the $892,656 which
will still be outstanding in over a year. The current liability element is therefore $26,441. This represents the $80,000
paid in year two less year two’s finance costs of $53,559 (or $892,656-$866,215).

Points to remember

Upon lease commencement a lessee recognises a right-of-use asset and a lease liability.

The right-of-use asset is initially measured at the amount of the lease liability plus any initial direct costs incurred
by the lessee. Adjustments may also be required for lease incentives, payments at or prior to commencement and
restoration obligations or similar.

After lease commencement, a lessee shall measure the right-of-use asset using a cost model, unless:
ii) The right-of-use asset is an investment property and the lessee fair values its investment property
under IAS 40; or
iii) The right-of-use asset relates to a class of PPE to which the lessee applies IAS 16’s revaluation
model, in which case all right-of-use assets relating to that class of PPE can be revalued.
Under the cost model a right-of-use asset is measured at cost less accumulated depreciation and accumulated
impairment.

The lease liability is initially measured at the present value of the lease payments payable over the lease term,
discounted at the rate implicit in the lease if that can be readily determined. If that rate cannot be readily
determined, the lessee shall use their incremental borrowing rate.

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Variable lease payments

Variable lease payments are the payments that depend on an index or a rate are included in the initial measurement
of the lease liability and are initially measured using the index or rate as at the commencement date. Amounts
expected to be payable by the lessee under residual value guarantees are also included.

Variable lease payments that are not included in the measurement of the lease liability are recognised in profit or
loss in the period in which the event or condition that triggers payment occurs, unless the costs are included in the
carrying amount of another asset under another Standard.

The lease liability is subsequently remeasured to reflect changes in:

 The lease term (using a revised discount rate);

 The assessment of a purchase option (using a revised discount rate);
 The amounts expected to be payable under residual value guarantees (using an unchanged discount rate);
or
 Future lease payments resulting from a change in an index or a rate used to determine those payments
(using an unchanged discount rate).

The re-measurements are treated as adjustments to the right-of-use asset.

Lease modifications may also prompt re-measurement of the lease liability unless they are to be treated as separate
leases.

Question

On 1 October 20X4, Flash Co acquired an item of plant under a five-year lease agreement. The plant had a cash
purchase cost of $25m. The agreement had an implicit finance cost of 10% per annum and required an immediate
deposit of $2m and annual rentals of $6m paid on 30 September each year for five years.

What is the current liability for the leased plant in Flash Co’s statement of financial position as at 30 September
20X5?

A $19,300,000
B $4,070,000
C $5,000,000
D $3,850,000
Solution

Option B

25,000 – 2,000 = 23,000 + 2,300 (10% int) – 6,000 (pmt) = 19,300

19,300 + 1,930 (10% int) – 6,000 (pmt) = 15,230

Current liability = 19,300 – 15,230 = $4,070

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A SIMPLIFIED APPROACH FOR SHORT-TERM OR LOW-VALUE LEASES – EXCEPTION

A short-term lease is a lease that, at the date of commencement, has a term of 12 months or less. A lease that
contains a purchase option cannot be a short-term lease. Lessees can elect to treat short-term leases by recognising
the lease rentals as an expense over the lease term rather than recognising a ‘right of use asset’ and a lease liability.
The election needs to be made for relevant leased assets on a ‘class-by-class’ basis. A similar election – on a lease-
by-lease basis – can be made in respect of ‘low value assets’.

The assessment of whether an underlying asset is of low value is performed on an absolute basis. Leases of low-
value assets qualify for the simplified accounting treatment explained above regardless of whether those leases are
material to the lessee. The assessment is not affected by the size, nature or circumstances of the lessee. Accordingly,
different lessees are expected to reach the same conclusions about whether a particular underlying asset is of low
value.

An underlying asset can be of low value only if:

(a) The lessee can benefit from use of the underlying asset on its own or together with other resources that are
readily available to the lessee; and

(b) The underlying asset is not highly dependent on, or highly interrelated with, other assets.

A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that,
when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value
assets because a new car would typically not be of low value.

Examples of low-value underlying assets can include tablet and personal computers, small items of office furniture
and telephones.

SALE AND LEASEBACK TRANSACTIONS

Introduction

The treatment of sale and leaseback transactions depends on whether or not the ‘sale’ constitutes the satisfaction
of a relevant performance obligation under IFRS 15 – Revenue from Contracts with Customers. The relevant
performance obligation would be the effective ‘transfer’ of the asset to the lessor by the previous owner (now the
lessee).

Transaction constituting a sale

If the transaction does constitute a ‘sale’ under IFRS 15 then the treatment is as follows:

 The seller-lessee shall recognise only the amount of any gain or loss that relates to the rights transferred to
the buyer-lessor.
 The buyer-lessor shall account for the purchase of the asset applying applicable Standards, and for the lease
applying the lessor accounting requirements in IFRS 16 (these being essentially unchanged from the
predecessor standard).

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If the fair value of the consideration for the sale of an asset does not equal the fair value of the asset, or if the
payments for the lease are not at market rates, an entity shall make the following adjustments to measure the sale
proceeds at fair value:

 Any below-market terms shall be accounted for as a prepayment of lease payments; and
 Any above-market terms shall be accounted for as additional financing provided by the buyer-lessor to the
seller-lessee.

Example – sale and leaseback

Entity X sells a building to entity Y for cash of $5 million. Immediately before the transaction, the carrying amount of
the building in the financial statements of entity X was $3.5 million. At the same time, X enters into a contract with
Y for the right to use the building for 20 years, with annual payments of $200,000 payable at the end of each year.
The terms and conditions of the transaction are such that the transfer of the building by X satisfies the requirements
for determining when a performance obligation is satisfied in IFRS 15, Revenue from Contracts with Customers.
Accordingly, X and Y account for the transaction as a sale and leaseback.

The fair value of the building at the date of sale is $4.5 million. Because the consideration for the sale of the building
is not at fair value, X and Y make adjustments to measure the sale proceeds at fair value. The amount of the excess
sale price of $500,000 ($5 million – $4.5 million) is recognised as additional financing provided by Y to X.

The annual interest rate implicit in the lease is 5%. The present value of the annual payments (20 payments of
$200,000, discounted at 5%) amounts to $2,492,400, of which $500,000 relates to the additional financing and
$1,992,400 ($2,492,200 – $500,000) relates to the lease (as adjusted for the fair value difference already identified).
The annual payment that would be required to be made 20 times in arrears to repay additional financing of $500,000
when the rate of interest is 5% per annum would be $40,122 ($500,000/12.462 (the cumulative discount factor for
5% for 20 years)). Therefore the residual would be regarded as a ‘lease rental’ at an amount of $159,878 ($200,000
– $40,122).

Given the IFRS 15 treatment as a ‘sale’ B would almost certainly regard the lease of the building as an operating
lease. This means that B would recognise the ‘lease rentals’ of $159,878 as income.

Transaction not constituting a ‘sale’

In these circumstances the seller does not ‘transfer’ the asset and continues to recognise it, without adjustment.
The ‘sales proceeds’ are recognised as a financial liability and accounted for by applying IFRS 9, Financial Instruments.
In the same circumstances, the buyer recognizes a financial asset equal to the ‘sales proceeds’.

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SUMMARY

The requirements of IFRS 16 will have significant impacts on key accounting ratios of lessees. The greater recognition
of leased assets and lease liabilities on the statement of financial position will reduce return on capital employed
and increase gearing. Initial measures of profit are likely to be reduced, as in the early years of a lease the
combination of depreciation of the right of use asset and the finance charge associated with the lease liability will
exceed the lease rentals (normally charged on a straight-line basis).

Disclosure

The objective of IFRS 16’s disclosures is for information to be provided in the notes that, together with information
provided in the statement of financial position, statement of profit or loss and statement of cash flows, gives a basis
for users to assess the effect that leases have.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 8, 21-25
Spec. exam Sept. 16 MCQ.3
June 15 Q.3(iii), (iv)
LEASES Dec. 14 Q.19
Dec.13 Q.2 (ii), Q.5
June 12 Q.2 (ii)
Dec. 11 Q.2 (ii)

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 IFRS 13 – FAIR VALUE MEASUREMENTS

NEED FOR FAIR VALUE GUIDANCE & IFRS 13:

IFRS 13 provides a single source of guidance for all fair value measurements, clarifying the definition of fair value
and enhancing disclosures requirements about reported fair value estimates.

IFRS 13, Fair Value Measurement was issued in May 2011 and defines fair value, establishes a framework for
measuring fair value and requires significant disclosures relating to fair value measurement. The International
Accounting Standards Board (IASB) wanted to enhance disclosures for fair value in order that users could better
assess the valuation techniques and inputs that are used to measure fair value. There are no new requirements as
to when fair value accounting is required but rather it relies on guidance regarding fair value measurements in
existing standards.

FAIR VALUE DEFINITION

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.

From the above definition, it can be inferred that fair value is an exit price. Consequently, fair value is focused on
the assumptions of the market place, is not entity specific and so takes into account any assumptions about risk. This
means that fair value is measured using the same assumptions used by market participants and takes into account
the same characteristics of the asset or liability. Such conditions would include the condition and location of the
asset and any restrictions on its sale or use.

An entity cannot argue that prices are too low relative to its own valuation of the asset and that it would be unwilling
to sell at low prices. The prices to be used are those in ‘an orderly transaction’. An orderly transaction is one that
assumes exposure to the market for a period before the date of measurement to allow for normal marketing
activities to take place and to ensure that it is not a forced transaction. If the transaction is not ‘orderly’ then there
will not have been enough time to create competition and potential buyers may reduce the price that they are willing
to pay. Similarly if a seller is forced to accept a price in a short period of time, the price may not be representative.
Therefore, it does not follow that a market in which there are few transactions is not orderly. If there has been
competitive tension, sufficient time and information about the asset, then this may result in an acceptable fair value.

Unit of account

IFRS 13 does not specify the unit of account that should be used to measure fair value. This means that it is left to
the individual standard to determine the unit of account for fair value measurement. A unit of account is the single
asset or liability or group of assets or liabilities. The characteristic of an asset or liability must be distinguished from
a characteristic arising from the holding of an asset or liability by an entity. An example of this is where an entity
sells a large block of shares, and it has to sell them at a discount price to the market price. This is a characteristic of
holding the asset rather than a characteristic of the asset itself and should not be taken into account when fair
valuing the asset.

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MARKETS – PRINCIPAL MARKET

Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the
principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market
for the asset or liability. The principal market is the one with the greatest volume and level of activity for the asset
or liability that can be accessed by the entity.

IFRS 13 provides a new framework to estimate fair value in a consistent manner across standards. For a fair value
measurement, an entity has to determine:

 The particular asset or liability that is the subject of the measurement

 For an asset, the valuation premise that is appropriate for the measurement
 The most advantageous market for the asset or liability and
 The valuation technique appropriate for measurement
MARKETS – THE MOST ADVANTAGEOUS MARKET

It is assumed that transactions take place in the most advantageous market to which the entity has access. This
means that the entity is in a position to receive the maximum amount on sale of the asset or pay the minimum
amount to transfer a liability after considering transaction and transport costs.

While transaction and transport costs are relevant to identify the market, they are not considered in determining
the fair value.

MEASUREMENT ASSUMPTIONS

Fair value measurement of an asset or liability should use the assumptions that market participants would use in
pricing the asset or liability. These assumptions include:

 Buyers and sellers are independent of each other

 They have knowledge about the asset or liability
 They are capable of entering into a transaction
 They are willing to enter into a transaction, rather than being forced or otherwise compelled.
VALUATION TECHNIQUES

An entity uses valuation techniques appropriate in the circumstances and for which sufficient data are available to
measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs.

Where fair value is determined using a valuation technique, IFRS 13 prescribes that the technique should be one of
the following.

i. Market approach: uses price and other relevant market information for identical or comparable assets
or liabilities
ii. Income approach: converts future amounts to a single discounted present value amount or
iii. Cost approach: amount that would currently be required to replace the service capacity of the asset
When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use of
unobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the
fair value measurement process.

FAIR VALUE HIERARCHY

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IFRS 13 seeks to increase consistency and comparability in fair value measurements and related disclosures through
a 'Fair Value Hierarchy'. The hierarchy categorises the inputs used in valuation techniques into three levels.

Level 1 Inputs

Level 1 inputs are unadjusted quoted prices in active markets for items identical to the asset or liability being
measured. As with current IFRS, if there is a quoted price in an active market, an entity uses that price without
adjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity
needs to be able to access the market at the measurement date. Active markets are ones where transactions take
place with sufficient frequency and volume for pricing information to be provided. An alternative method may be
used where it is expedient. The standard sets out certain criteria where this may be applicable. For example where
the price quoted in an active market does not represent fair value at the measurement date. An example of this may
be where a significant event takes place after the close of the market such as a business reorganisation or
combination.

The determination of whether a fair value measurement is based on level 2 or level 3 inputs depends on (i) whether
the inputs are observable inputs or unobservable and (ii) their significance.

Level 2 Inputs

Level 2 inputs are inputs other than the quoted prices in determined in level 1 that are directly or indirectly
observable for that asset or liability. They are likely to be quoted assets or liabilities for similar items in active markets
or supported by market data. For example interest rates, credit spreads or yields curves. Adjustments may be needed
to level 2 inputs and, if this adjustment is significant, then it may require the fair value to be classified as level 3.

Level 3 Inputs

Finally, level 3 inputs are unobservable inputs. These inputs should be used only when it is not possible to use Level
1 or 2 inputs. The entity should maximise the use of relevant observable inputs and minimise the use of unobservable
inputs.

However, situations may occur where relevant inputs are not observable and therefore these inputs must be
developed to reflect the assumptions that market participants would use when determining an appropriate price for
the asset or liability.

The general principle of using an exit price remains and IFRS 13 does not preclude an entity from using its own data.
For example cash flow forecasts may be used to value an entity that is not listed. Each fair value measurement is
categorised based on the lowest level input that is significant to it.

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ASSET -SPECIFIC VALUATIONS

For a fair value measurement of an asset, it is assumed that the asset will be sold to a market participant who will
use it at its highest and best use.

LIABILITY or EQUITY – SPECIFIC VALUATION

Fair value measurement of a liability, or owner’s own equity assumes that the liability is transferred to a market
participant at the measurement date. In many cases there is no observable market to provide pricing information
and the highest and best use is not applicable. In this case, the fair value is based on the perspective of a market
participant who holds the identical instrument as an asset.

Where there is no observable market price for the transfer of a liability, an entity would be required to measure the
fair value of the liability using the same methodology that the counterparty would use to measure the fair value of
the corresponding asset.

If there is no corresponding asset, then a corresponding valuation technique may be used. This would be the case
with a decommissioning activity.

The fair value of a liability reflects the non-performance risk based on the entity’s own credit standing plus any
compensation for risk and profit margin that a market participant might require to undertake the activity.
Transaction price is not always the best indicator of fair value at recognition because entry and exit prices are
conceptually different.

Valuation concepts

IFRS 13 also sets out certain valuation concepts to assist in the determination of fair value. For non-financial assets
only, fair value is determined based on the highest and best use of the asset as determined by a market participant.

Highest and best use is a valuation concept that considers how market participants would use a non-financial asset
to maximise its benefit or value. The maximum value of a non-financial asset to market participants may come from
its use in combination with other assets and liabilities or on a standalone basis.

In determining the highest and best use of a non-financial asset, IFRS 13 indicates that all uses that are physically
possible, legally permissible and financially feasible should be considered. As such, when assessing alternative uses,
entities should consider the physical characteristics of the asset, any legal restrictions on its use and whether the
value generated provides an adequate investment return for market participants.

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RULES IN BUSINESS COMBINATION:

IFRS 3 sets out general principles for arriving at the fair values of a subsidiary's assets and liabilities only if they
satisfy the following criteria:

 In the case of an asset other than an intangible asset, it is probable that any associated future economic
benefits will flow to the acquirer, and its fair value can be measured reliably. Vice versa for liabilities
 In the case of an intangible asset or a contingent liability, its fair value can be measured reliably.
 The acquiree's identifiable assets and liabilities might include assets and liabilities not previously recognised
in the acquiree's financial statements
 An acquirer should not recognise liabilities for future losses or other costs expected to be incurred as a
result of the business combination.
 The acquiree may have intangible assets which can only be recognised separately from goodwill if they are
identifiable. They must be able to be capable of being separated from the entity.
 The acquirer should measure the cost of a business combination as the total of the fair values at the date
of acquisition
 If part of the consideration is payable at a later date, this deferred consideration is discounted to present
value at the date of exchange.
 In case of equity instruments as cost of investment, the published price at the date of exchange normally
provides the best evidence of the instrument's fair value.
 Costs attributable to the combination, for example professional fees and administrative costs, should not
be included: they are recognised as an expense when incurred.
 If an asset or liability has been recognised at fair value at acquisition, it must be recorded in the subsidiary’s
statement of financial position at fair value consequently also
 Some fair value adjustments are made on depreciable assets such as buildings, the assets with fair value
adjustment must be depreciated at its fair value so there will be an adjustment, which flows through to
profit or loss for this additional depreciation.

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 IAS-20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF
GOVERNMENT ASSISTANCE

Objective:

To prescribe the accounting for, and disclosure of, government grants and other forms of government assistance.

Scope:

IAS 20 applies to all government grants and other forms of government assistance. However, it does not cover
government assistance that is provided in the form of benefits in determining taxable income. It does not cover
government grants covered by IAS 41 Agriculture, either. The benefit of a government loan at a below-market rate
of interest is treated as a government grant.

Definitions:

Government refers to government, government agencies and similar bodies whether local, national or international.

Government assistance is provision of economic benefits by government to a specific entity or range of entities
which meet specific criteria. Government assistance for the purpose of this Standard does not include benefits
provided only indirectly through action affecting general trading conditions, such as the provision of infrastructure
in development areas or the imposition of trading constraints on competitors.

Government grants are transfer of resources to an entity, from government, in return for compliance with certain
conditions.

It is the assistance by government in the form of transfers of resources to an entity in return for past or future
compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of
government assistance which cannot reasonably have a value placed upon them and transactions with government
which cannot be distinguished from the normal trading transactions of the entity (subsidies, subvention, or
premiums).

ACCOUNTING TREATMENT

Recognition

A government grant is recognized only when there is reasonable assurance that

 The entity will comply with any conditions attached to the grant
 The grant will be received.

The grant is recognised as income over the period necessary to match them with the related costs, for which they
are intended to compensate, on a systematic basis.

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Non-monetary grants

Non-monetary grants such as land or other resources, are usually accounted for at fair value, although recording
both the asset and the grant at a nominal amount is also permitted.

Assistance without conditions

Even if there are no conditions attached to the assistance specifically relating to the operating activities of the entity
(other than the requirement to operate in certain regions or industry sectors), such grants should not be credited to
equity.

Compensation of already incurred costs

A grant receivable as compensation for costs already incurred or for immediate financial support, with no future
related costs, should be recognised as income in the period in which it is receivable.

GRANT RELATED TO ASSET

Grant related to depreciable assets are recognized over the useful life of the assets in the proportion of depreciation
charge.

Grant related to non-depreciable assets are also recognized over the period in which related expenses are made.

If grants are received as a package of financial or fiscal aids to which a number of conditions are attached then
reasons giving rise to costs and expenses should be identified and it may be appropriate to allocate part of grant on
one basis and part on another basis.

Presentation of grant related to asset

A grant relating to assets may be presented in one of two ways:

 As deferred income, or
 By deducting the grant from the asset's carrying amount.

GRANT RELATED TO INCOME

Such grants are recognized over the period and matched with the related expenses.

Presentation of grant related to income

A grant relating to income may be reported separately as 'other income' or deducted from the related expense.

Repayment:

 If the conditions of a grant are breached, it may need to be repaid.

 A government grant that becomes repayable shall be accounted for as a revision to an accounting estimate
(IAS –8).
 Repayment of a grant related to income shall be applied first against any un-amortized deferred credit and
if repayment exceeds the deferred credit the rest will be recognized immediately as expense.

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  Repayment of grants related to assets shall be recorded by increasing the carrying amount of the asset or
reducing the deferred income balance by the amount payable. The cumulative additional depreciation that
would have been recognized to date as an expense in the absence of the grant shall be recognized
immediately as an expense.
Question 1

On 1 January 20X6, Gardenbugs Co received a $30,000 government grant relating to equipment which cost $90,000
and had a useful life of six years. The grant was netted off against the cost of the equipment. On 1 January 20X7,
when the equipment had a carrying amount of $50,000, its use was changed so that it was no longer being used in
accordance with the grant. This meant that the grant needed to be repaid in full but by 31 December 20X7, this had
not yet been done.

Which journal entry is required to reflect the correct accounting treatment of the government grant and the
equipment in the financial statements of Gardenbugs Co for the year ended 31 December 20X7?

A Dr Property, plant and equipment $10,000

Dr Depreciation expense $20,000
Cr Liability $30,000

B Dr Property, plant and equipment $15,000

Dr Depreciation expense $15,000
Cr Liability $30,000

C Dr Property, plant and equipment $10,000

Dr Depreciation expense $15,000
Dr Retained earnings $5,000
Cr Liability $30,000

D Dr Property, plant and equipment $20,000

Dr Depreciation expense $10,000
Cr Liability $30,000

Solution

Option A

The repayment of the grant must be treated as a change in accounting estimate. The carrying amount must be
increased as the netting off method has been used. The resulting extra depreciation must be charged immediately
to profit or loss.

Original As if no grant Adjustment

Cost 90,000 90,000
Grant (30,000)
60,000
60,000
Depreciation (10,000) (1 yr) (30,000) (2 yr) Dr Depn exp 20,000
Carrying amount 50,000 (1/1X7)) 60,000 (31/12X7)) Dr PPE 10,000
Cr Liability 30,000

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Disclosure:

The following must be disclosed:

 Accounting policy adopted for grants, including method of statement of financial position presentation
 Nature and extent of grants recognized in the financial statements
 Unfulfilled conditions and contingencies attaching to recognized grant

GOVERNMENT ASSISTANCE

Government grants do not include government assistance whose value cannot be reasonably measured, such as
technical or marketing advice.

The government grants are not recognized because no value can be assigned to them or they are not distinguishable
from the other transactions of the entity if material shall be disclosed.

Question 2

Which of the following statements about IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance are true?

(i) A government grant related to the purchase of an asset must be deducted from the carrying amount
of the asset in the statement of financial position
(ii) A government grant related to the purchase of an asset should be recognised in profit or loss over the
life of the asset
(iii) Free marketing advice provided by a government department is excluded from the definition of
government grants
(iv) Any required repayment of a government grant received in an earlier reporting period is treated as
prior period adjustment

A (i) and (ii)

B (ii) and (iii)
C (ii) and (iv)
D (iii) and (iv)
Solution

Option B

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 3
June 15 MCQ.15
IAS 20
June 14 Q.5(iii)
Dec. 12 Q.5

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 IAS 10 - EVENTS AFTER REPORTING DATE

Objective:

To prescribe:

 When an entity should adjust its financial statements for events after the reporting period; and
 The disclosures that an entity should give about the date when the financial statements were authorized
for issue and about events after the reporting period.
The Standard also requires that an entity should not prepare its financial statements on a going concern basis if
events after the reporting period indicate that the going concern assumption is not appropriate.

Definitions:

Event after the reporting period occurs between the end of the reporting period and the date that the financial
statements are authorized for issue. These include:

 Adjusting events provide evidence of conditions that existed at the end of the reporting period.
 Non-adjusting events are those that are indicative of conditions that arose after the reporting period.
Accounting treatment:

 Adjust financial statements for adjusting events

 Do not adjust for non-adjusting events
 If an entity declares dividends after the reporting period, the entity shall not recognize those dividends as
a liability at the end of the reporting period. That is a non-adjusting event.
 An entity shall not prepare its financial statements on a going concern basis if management determines
after the reporting period either that it intends to liquidate the entity or to cease trading.
Adjusting events – examples

Adjusting events, as is evident by the name, require adjustments in the financial statements. Following are some
examples:

 Invoices received in respect of goods or services received before the year end
 The resolution after the reporting date of a court case giving rise to a liability
 Evidence of impairment of assets, such as news that a major customer is going into liquidation or the sale
of inventories below cost
 Discovery of fraud or errors showing that financial statements were incorrect
 Determination of employee bonuses/profit shares
 The tax rates applicable to the financial year are announced
 The auditors submit their fee
 The sale of a non-current asset at a loss indicates that it was impaired at the reporting date
 The bankruptcy of a customer indicates that their debt was irrecoverable at the reporting date
 The sale of inventory at less than cost indicates that it should have been valued at NRV in the accounts
 The determination of cost or proceeds of assets bought/sold during the accounting period indicates at what
amount they should be recorded in the accounts

111
Non-adjusting events – examples

Usually non-adjusting events do not require adjustments. However, if the event is of such importance that its non-
disclosure will affect the economic decision making of users it should be disclosed in the notes to the accounts. Some
examples of non-adjusting events are as follows:

 Business combinations
 Discontinuance of an operation
 Major sale/purchase of assets
 Destruction of major assets in natural disasters
 Major restructuring
 Major share transactions
 Unusual changes in asset prices/foreign exchange rates
 Commencing major litigation
 A purchase or sale of a non-current asset
 The destruction of assets due to fire or flood
 The announcement of plans to discontinue an operation
 An issue of shares
Question

Each of the following events occurred after the reporting date of 31 March 2015, but before the financial statements
were authorised for issue.

Which would be treated as a NON-adjusting event under IAS 10 Events After the Reporting Period?

A. A public announcement in April 2015 of a formal plan to discontinue an operation which had been
approved by the board in February 2015
B. he settlement of an insurance claim for a loss sustained in December 2014
C. Evidence that $20,000 of goods which were listed as part of the inventory in the statement of financial
position as at 31 March 2015 had been stolen
D. A sale of goods in April 2015 which had been held in inventory at 31 March 2015. The sale was made at a
price below its carrying amount at 31 March 2015
Solution

Option A

A board decision to discontinue an operation does not create a liability. A provision can only be made on the
announcement of a formal plan (as it then raises a valid expectation that the discontinuance will be carried out). As this
announcement occurs during the year ended 31 March 2016, this a non-adjusting event for the year ended 31 March 2015.

Dividends

If an entity declares dividends to holders of equity instruments after the reporting period but before the financial
statements, the entity shall not recognise those dividends as a liability at the end of the reporting period. This is
because no obligation exists at that time. Such dividends are disclosed in the notes.

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Going concern

An entity shall not prepare its financial statements on a going concern basis if management determines after the
reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative
but to do so.

Disclosure:

Non-adjusting events should disclose the nature and financial effect of the event if its non-disclosure would affect
the judgment of users in making decisions.

Companies must disclose the following

 When the financial statements were authorized for issue

 Who gave that authorization
 Who has the power to amend the financial statements after issuance
PAST EXAMS ANALYSIS
Topic Exam Attempt Question

IAS 10 June 15 MCQ.3

113
 IAS 12 – INCOME TAXES

Objective

The objective of IAS 12 is to prescribe the accounting treatment for income taxes.

Definitions

Accounting profit

This is the net profit (or loss) for the reporting period before deducting tax expense.

Taxable Profit

This is the profit (or loss) for a period, determined in accordance with the local tax authority's rules, upon which
income taxes are payable.

TAX EXPENSE

Tax in the statement of profit or loss may consist of three elements:

 Current tax expense

 Adjustments to tax charges of prior periods (over/under provisions)
 Transfers to/from deferred tax.
CURRENT TAX

This is the amount of income tax payable (or recoverable) in respect of the taxable profit (or loss) for the period.

Accounting for Current Tax

In most jurisdictions, tax is paid several months after the end of the accounting period. At the period end, an
estimated amount is accrued based on the year’s profits:

Dr Income tax expense (P&L) estimated tax charge

Cr Tax payable (liability in SOFP) estimated tax charge

When the tax is actually paid some months later, it is recorded by:

Dr Tax payable (SFP) amount paid

Cr Cash amount paid.

Since the amount paid is likely to differ from the estimated tax charge originally accrued, a balance is left on the tax
payable account:

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 Tax payable

Cash (tax paid) X Income tax (estimated tax charge) X

Overprovision c/f X Under provision c/f X

An overprovision arises where the actual tax paid is less than the estimated tax charge. This reduces the following
year’s tax charge in the statement of profit or loss.

An underprovision arises where the actual tax paid is more than the estimated charge. This increases the following
year’s tax charge in the statement of profit or loss.

Summary

 Current taxes include tax payable for current period and adjustment of under/over provision of prior
periods
 Current taxes are to be treated as an expense
 If the tax expense and the provision at the end of the year are greater than the payment, the shortfall in
the payment will be disclosed as a current tax liability and vice versa.
DEFERRED TAX

In Paper FR, deferred tax normally results in a liability being recognised within the Statement of Financial Position.
IAS 12 defines a deferred tax liability as being the amount of income tax payable in future periods in respect of
taxable temporary differences. So, in simple terms, deferred tax is tax that is payable in the future. However, to
understand this definition more fully, it is necessary to explain the term ‘taxable temporary differences’.

Tax Base

This is the amount attributed to an asset or liability for tax purposes.

Tax base-Asset

The tax base of an asset is the amount that will be deductible for tax purposes against any future taxable benefits
derived from the asset.

Tax base-Liability

The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect
of that liability in future periods.

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Accounting for Deferred Tax

Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary
differences.

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:

 Deductible temporary differences

 The carry forward of unused tax losses
 The carry forward of unused tax credits
Temporary differences are differences between the carrying amount of an asset or liability in the SOFP and its tax
base.

Temporary differences may be of two types:

i. Taxable temporary differences are temporary differences that will result in taxable amounts in determining
taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.

IAS 12 requires that a deferred tax liability is recorded in respect of all taxable temporary differences that exist at
the year-end – this is sometimes known as the full provision method.

All of this terminology can be rather overwhelming and difficult to understand, so consider it alongside an example.
Depreciable non-current assets are the typical example behind deferred tax in Paper FR.

Within financial statements, non-current assets with a limited economic life are subject to depreciation. However,
within tax computations, non-current assets are subject to capital allowances (also known as tax depreciation) at
rates set within the relevant tax legislation. Where at the year-end the cumulative depreciation charged and the
cumulative capital allowances claimed are different, the carrying value of the asset (cost less accumulated
depreciation) will then be different to its tax base (cost less accumulated capital allowances) and hence a taxable
temporary difference arises.

Examples

A taxable temporary difference occurs when:

 Depreciation or amortisation is accelerated for tax purposes

 Development costs capitalised in the statement of financial position deducted against taxable profit when
the expenditure was incurred
 Interest income is included in the statement of financial position when earned, but included in taxable profit
when the cash is actually received
 Prepayments in the statement of financial position deducted against taxable profits when the cash expense
was incurred
 Revaluation/Fair value adjustment of assets with no adjustment of the tax base.
 Deferred tax on impairment where these adjustments are ignored for tax purposes until the asset is sold.
ii. Deductible temporary differences 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.

A deferred tax asset (DTA) shall be recognised for all deductible temporary differences to the extent it is probable
that taxable profit will be available against which the deductible temporary difference can be utilised.

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  Provisions, accrued product warranty costs for which the taxation laws do not permit the deduction until
the company actually pays the claims. This is a deductible difference as its taxable profits for the current
period will be higher than those in future, when they will be lower.
Measurement of deferred tax assets and liabilities

 Measurement shall be at the tax rates expected to apply to the period when the asset is realised or liability
is settled.
 The rates used shall be those enacted or substantially enacted by the end of the reporting period.
 Measurement depends upon the expectations about the manner in which the recovery of tax asset or
settlement of tax liability will take place.
 In the case of deferred tax assets and liabilities, the values are not to be discounted.
 Deferred tax expense is recognized as an expense in statement of profit or loss. If the tax relates to items
that are credited or charged directly to equity, then this current tax and deferred tax shall also be charged
or credited directly to equity.
The movement in the deferred tax liability in the year is recorded in the statement of profit or loss where:

 An increase in the liability, increases the tax expense

 A decrease in the liability, decreases the tax expense.

The closing figures are reported in the Statement of Financial Position as the deferred tax liability.

The statement of profit or loss

As IAS 12 considers deferred tax from the perspective of temporary differences between the carrying value and tax
base of assets and liabilities, the standard can be said to take a valuation approach. However, it will be helpful to
consider the effect on the statement of profit or loss.

THE PAPER FR EXAM

Deferred tax is consistently tested in the published accounts question of the Paper FR exam. Here are some hints on
how to deal with the information in the question.

 The deferred tax liability given within the trial balance or draft financial statements will be the opening
liability balance.
 In the notes to the question there will be information to enable you to calculate the closing liability for the
statement of financial position or the increase/decrease in the liability.

It is important that you read the information carefully. You will need to ascertain exactly what you are being told
within the notes to the question and therefore how this relates to the working that you can use to calculate the
figures for the answer.

Consider the following sets of information – all of which will achieve the same ultimate answer in the published
accounts.

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Revaluations of non-current assets

Revaluations of non-current assets (NCA) are a further example of a taxable temporary difference. When an NCA is
revalued to its current value within the financial statements, the revaluation surplus is recorded in equity (in a
revaluation reserve) and reported as other comprehensive income. While the carrying value of the asset has
increased, the tax base of the asset remains the same and so a temporary difference arises.

Presentation

Current tax assets and current tax liabilities should be offset on the SOFP only if the entity has the legal right and the
intention to settle on a net basis.

Deferred tax assets and deferred tax liabilities should be offset on the SOFP only if the entity has the legal right to
settle on a net basis.

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 IAS 12 – INCOME TAXES

CONCEPT TEST QUESTIONS

Question 1

Hill, a limited liability company, shows an overprovision of $3,400 on its tax liability account at the end of the
year ended 31 December 20X8 before accounting for that year’s tax charge.

It estimates tax on profits for the year to be $67,900.

What amounts should be shown in the financial statements for the year ended 31 December 20X8 in respect of
tax?
Statement of profit or loss Statement of financial position
a) $67,900 tax charge $67,900 tax payable
b) $64,500 tax charge $64,500 tax payable
c) $64,500 tax charge $67,900 tax payable
d) $71,300 tax charge $67,900 tax payable
Solution

Option C

Question 2

A non-current asset costing $2,000 was acquired at the start of year 1. It is being depreciated straight line over four
years, resulting in annual depreciation charges of $500. Thus a total of $2,000 of depreciation is being charged. The
capital allowances granted on this asset are:

$
Year 1 800
Year 2 600
Year 3 360
Year 4 240
Total capital allowances 2,000
Table 1 shows the carrying value of the asset, the tax base of the asset and therefore the temporary difference at
the end of each year.

As stated above, deferred tax liabilities arise on taxable temporary differences, ie those temporary differences that
result in tax being payable in the future as the temporary difference reverses. So, how does the above example result
in tax being payable in the future?

Entities pay income tax on their taxable profits. When determining taxable profits, the tax authorities start by taking
the profit before tax (accounting profits) of an entity from their financial statements and then make various
adjustments. For example, depreciation is considered a disallowable expense for taxation purposes but instead tax
relief on capital expenditure is granted in the form of capital allowances. Therefore, taxable profits are arrived at by

119
adding back depreciation and deducting capital allowances from the accounting profits. Entities are then charged
tax at the appropriate tax rate on these taxable profits.

Table 1: The carrying value, the tax base of the asset and therefore the temporary difference at the end of each
year (Example 1)

Carrying Tax base

value (Cost -
(Cost - accumulated
accumulated capital Temporary
depreciation) allowances) difference
Year $ $ $
1 1,500 1,200 300
2 1,000 600 400
3 500 240 260
4 Nil Nil Nil
In the above example, when the capital allowances are greater than the depreciation expense in years 1 and 2, the
entity has received tax relief early. This is good for cash flow in that it delays (ie defers) the payment of tax. However,
the difference is only a temporary difference and so the tax will have to be paid in the future. In years 3 and 4, when
the capital allowances for the year are less than the depreciation charged, the entity is being charged additional tax
and the temporary difference is reversing. Hence the temporary differences can be said to be taxable temporary
differences.

Notice that overall, the accumulated depreciation and accumulated capital allowances both equal $2,000 – the cost
of the asset – so over the four-year period, there is no difference between the taxable profits and the profits per the
financial statements.

At the end of year 1, the entity has a temporary difference of $300, which will result in tax being payable in the
future (in years 3 and 4). In accordance with the concept of prudence, a liability is therefore recorded equal to the
expected tax payable.

Assuming that the tax rate applicable to the company is 25%, the deferred tax liability that will be recognised at the
end of year 1 is 25% x $300 = $75. This will be recorded by crediting (increasing) a deferred tax liability in the
Statement of Financial Position and debiting (increasing) the tax expense in the statement of profit or loss.

By the end of year 2, the entity has a taxable temporary difference of $400, ie the $300 bought forward from year
1, plus the additional difference of $100 arising in year 2. A liability is therefore now recorded equal to 25% x $400
= $100. Since there was a liability of $75 recorded at the end of year 1, the double entry that is recorded in year 2 is
to credit (increase) the liability and debit (increase) the tax expense by $25.

At the end of year 3, the entity’s taxable temporary differences have decreased to $260 (since the company has now
been charged tax on the difference of $140). Therefore in the future, the tax payable will be 25% x $260 = $65. The
deferred tax liability now needs reducing from $100 to $65 and so is debited (a decrease) by $35. Consequently,
there is now a credit (a decrease) to the tax expense of $35.

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At the end of year 4, there are no taxable temporary differences since now the carrying value of the asset is equal
to its tax base. Therefore the opening liability of $65 needs to be removed by a debit entry (a decrease) and hence
there is a credit entry (a decrease) of $65 to the tax expense. This can all be summarised in the following working.

The movements in the liability are recorded in the statement of profit or loss as part of the taxation charge

1 2 3 4
Year
$ $ $ $
Opening deferred tax liability 0 75 100 65
Increase/(decrease) in the year 75 25 (35) (65)
Closing deferred tax liability 75 100 65 0
The closing figures are reported in the Statement of Financial Position as part of the deferred tax liability.

Proforma

Example 1 provides a proforma, which may be a useful format to deal with deferred tax within a published accounts
question.

The movement in the deferred tax liability in the year is recorded in the statement of profit or loss where:

 An increase in the liability, increases the tax expense

 A decrease in the liability, decreases the tax expense.

The closing figures are reported in the Statement of Financial Position as the deferred tax liability.

The statement of profit or loss

As IAS 12 considers deferred tax from the perspective of temporary differences between the carrying value and tax
base of assets and liabilities, the standard can be said to take a valuation approach. However, it will be helpful to
consider the effect on the statement of profit or loss.

Continuing with the previous example, suppose that the profit before tax of the entity for each of years 1 to 4 is
$10,000 (after charging depreciation). Since the tax rate is 25%, it would then be logical to expect the tax expense
for each year to be $2,500. However, income tax is based on taxable profits not on the accounting profits.

The taxable profits and so the actual tax liability for each year could be calculated as in Table 2.

The income tax liability is then recorded as a tax expense. As we have seen in the example, accounting for deferred
tax then results in a further increase or decrease in the tax expense. Therefore, the final tax expense for each year
reported in the statement of profit or loss would be as in Table 3.

It can therefore be said that accounting for deferred tax is ensuring that the matching principle is applied. The tax
expense reported in each period is the tax consequences (ie tax charges less tax relief) of the items reported within
profit in that period.

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Example 1: Proforma

$
Opening deferred tax liability X As given in the trial balance
Increase/(decrease) in the year
This is taken to the taxation charge in the
Tax rate % x increase / decrease in year-end taxable X/(X)
Statement of profit or loss
temporary differences
Closing deferred tax liability This is reported in the Statement of Financial
X
Tax rate % x year-end taxable temporary differences Position
Table 2: Taxable profit and actual tax liability calculation

Year Year Year Year

1 2 3 4
$ $ $ $

Profit before tax 10,000 10,000 10,000 10,000

Depreciation 500 500 500 500

Capital allowances (800) (600) (360) (240)

Taxable profits 9,700 9,900 10,140 10,260

Tax liability
@ 25% of
2,425 2,475 2,535 2,565
taxable profits
Table 3: Final tax expense for each reported Statement of profit or loss year

Year Year Year Year

1 2 3 4
$ $ $ $

Income tax 2,425 2,475 2,535 2,565

Increase/(decrease) due to deferred tax

75 25 (35) (65)

Total tax expense (2,500) (2,500) (2,500) (2,500)

Question 3

The trial balance shows a credit balance of $1,500 in respect of a deferred tax liability.

The notes to the question could contain one of the following sets of information:

1. At the year-end, the required deferred tax liability is $2,500.

2. At the year-end, it was determined that an increase in the deferred tax liability of $1,000 was required.
3. At the year-end, there are taxable temporary differences of $10,000. Tax is charged at a rate of 25%.
4. During the year, taxable temporary differences increased by $4,000. Tax is charged at a rate of 25%.

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Table 4:– published accounts question

$
Situation 1

Opening deferred tax liability 1,500 Provided in trial balance

Increase in the year to be

taken to IS as an increase
in tax expense 1,000 Balancing figure

Closing deferred tax liability

to be reported in SFP 2,500 Provided in information
Situation 2

Opening deferred tax liability 1,500 Provided in trial balance

Increase in the year to be

taken to IS as an increase
in tax expense 1,000 Provided in information

Closing deferred tax liability

to be reported in SFP 2,500 Balancing figure
Situation 3

Opening deferred tax liability 1,500 Provided in trial balance

Increase in the year to be

taken to IS as an increase
in tax expense 1,000 Balancing figure

Closing deferred tax liability Calculated from information

to be reported in SFP 2,500 (25% x $10,000)
Situation 4

Opening deferred tax liability 1,500

Provided in trial balance
Increase in the year to be
taken to IS as an increase
Calculated from information (25% x $4,000)
in tax expense 1,000

Closing deferred tax liability

Balancing figure
to be reported in SFP 2,500
Situations 1 and 2 are both giving a figure that can be slotted straight into the deferred tax working. In situations 3
and 4 however, the temporary differences are being given. These are then used to calculate a figure which can be
slotted into the working. In all situations, the missing figure is calculated as a balancing figure. Table 4 shows the
completed workings.

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Revaluations of non-current assets

Table 5: Revalued asset at the end of year 2

Carrying Tax base

value (Cost -
(Cost - accumulated
accumulated capital Temporary
depreciation) allowances) difference
Year 2 $ $ $
Opening balance 1,500 1,200 300
Depreciation charge / capital allowance (500) (600) 100
Revaluation 1,500 - 1,500
Closing balance 2,500 600 1,900
The carrying value will now be $2,500 while the tax base remains at $600. There is, therefore, a temporary difference
of $1,900, of which $1,500 relates to the revaluation surplus. This gives rise to a deferred tax liability of 25% x $1,900
= $475 at the year-end to report in the Statement of Financial Position. The liability was $75 at the start of the year
(earlier question) and thus there is an increase of $400 to record.

However, the increase in relation to the revaluation surplus of 25% x $1,500 = $375 will be charged to the revaluation
reserve and reported within other comprehensive income. The remaining increase of $25 will be charged to the
Statement of profit or loss as before.

The overall double entry is:

 Dr Tax expense in Other comprehensive income $25

 Dr Revaluation reserve in equity $375
 Cr Deferred tax liability in SFP $400
PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 29, 30, 31(iv)
March/June 16 Q.3 (v)
Dec. 15 Q.1 (vi)
June 15 Q.3 (vi)
Dec. 14 Q.2 (iii)
June 14 Q.2 (vi)
IAS 12
Dec. 13 Q.2 (iv)
June 13 Q.2 (iv)
Dec. 12 Q.2 (vi)
June 12 Q.2 (iv)
Dec. 11 Q.2 (vi)
June 11 Q.2 (iv)

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 IFRS 15 – REVENUE FROM CONTRACTS WITH CUSTOMERS

IFRS 15 specifies how and when an IFRS reporter will recognise revenue.

THE FIVE-STEP MODEL FRAMEWORK

The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of promised good or services
to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for
those goods and services. The standard introduces a five-step model for the recognition of revenue.

The five-step model applies to revenue earned from a contract with a customer with limited exceptions, regardless
of the type of revenue transaction or the industry.

STEP 1: IDENTIFY THE CONTRACT WITH THE CUSTOMER

Step one in the five-step model requires the identification of the contract with the customer. A contract with a
customer will be within the scope of IFRS 15 if all the following conditions are met:

 The contract has been approved by the parties to the contract;

 Each party’s rights in relation to the goods or services to be transferred can be identified;
 The payment terms for the goods or services to be transferred can be identified;
 The contract has commercial substance; and
 It is probable that the consideration to which the entity is entitled to in exchange for the goods or services
will be collected.

Contracts may be in different forms (written, verbal or implied). If a contract with a customer does not meet these
criteria, the entity can continually reassess the contract to determine whether it subsequently meets the criteria.

Two or more contracts that are entered into around the same time with the same customer may be combined and
accounted for as a single contract, if they meet the specified criteria. The standard provides detailed requirements
for contract modifications. A modification may be accounted for as a separate contract or as a modification of the
original contract, depending upon the circumstances of the case.

STEP 2: IDENTIFY THE PERFORMANCE OBLIGATIONS IN THE CONTRACT

Step two requires the identification of the separate performance obligations in the contract. This is often referred
to as ‘unbundling’, and is done at the beginning of a contract. The key factor in identifying a separate performance
obligation is the distinctiveness of the good or service, or a bundle of goods or services.

At the inception of the contract, the entity should assess the goods or services that have been promised to the
customer, and identify as a performance obligation:

 A good or service (or bundle of goods or services) that is distinct; or

 A series of distinct goods or services that are substantially the same and that have the same pattern of
transfer to the customer.

A series of distinct goods or services is transferred to the customer in the same pattern if both of the following
criteria are met:

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  Each distinct good or service in the series that the entity promises to transfer consecutively to the customer
would be a performance obligation that is satisfied over time; and
 A single method of measuring progress would be used to measure the entity’s progress towards complete
satisfaction of the performance obligation to transfer each distinct good or service in the series to the
customer.

A good or service is distinct if both of the following criteria are met:

 The customer can benefit from the good or services on its own or in conjunction with other readily available
resources; and
 The entity’s promise to transfer the good or service to the customer is separately identifiable from other
promises/elements in the contract.

IFRS 15 requires that a series of distinct goods or services that are substantially the same with the same pattern of
transfer, to be regarded as a single performance obligation. A good or service which has been delivered may not be
distinct if it cannot be used without another good or service that has not yet been delivered. Similarly, goods or
services that are not distinct should be combined with other goods or services until the entity identifies a bundle of
goods or services that is distinct.

IFRS 15 provides indicators rather than criteria to determine when a good or service is distinct within the context of
the contract. This allows management to apply judgment to determine the separate performance obligations that
best reflect the economic substance of a transaction.

Factors for consideration as to whether a promise to transfer the good or service to the customer is separately
identifiable include, but are not limited to:

 The entity does not provide a significant service of integrating the good or service with other goods or
services promised in the contract.
 The good or service does not significantly modify or customise another good or service promised in the
contract.
 The good or service is not highly interrelated with or highly dependent on other goods or services promised
in the contract.

STEP 3: DETERMINE THE TRANSACTION PRICE

Step three requires the entity to determine the transaction price, which is the amount of consideration that an
entity expects to be entitled to in exchange for the promised goods or services. When making this determination,
an entity will consider past customary business practices. This amount excludes amounts collected on behalf of a
third party – for example, government taxes. An entity must determine the amount of consideration to which it
expects to be entitled in order to recognise revenue.

Additionally, an entity should estimate the transaction price, taking into account non-cash consideration,
consideration payable to the customer and the time value of money if a significant financing component is present.
The latter is not required if the time period between the transfer of goods or services and payment is less than one
year. In some cases, it will be clear that a significant financing component exists due to the terms of the arrangement.

In other cases, it could be difficult to determine whether a significant financing component exists. This is likely to be
the case where there are long-term arrangements with multiple performance obligations such that goods or services

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are delivered and cash payments received throughout the arrangement. For example, if an advance payment is
required for business purposes to obtain a longer-term contract, then the entity may conclude that a significant
financing obligation does not exist.

If an entity anticipates that it may ultimately accept an amount lower than that initially promised in the contract due
to, for example, past experience of discounts given, then revenue would be estimated at the lower amount with the
collectability of that lower amount being assessed. Subsequently, if revenue already recognised is not collectable,
impairment losses should be taken to profit or loss.

Where a contract contains elements of variable consideration, the entity will estimate the amount of variable
consideration to which it will be entitled under the contract.

However, a different, more restrictive approach is applied in respect of sales or usage-based royalty revenue arising
from licences of intellectual property. Such revenue is recognised only when the underlying sales or usage occur.

STEP 4: ALLOCATE THE TRANSACTION PRICE TO THE PERFORMANCE OBLIGATIONS IN THE CONTRACTS

Step four requires the allocation of the transaction price to the separate performance obligations. Where a
contract has multiple performance obligations, an entity will allocate the transaction price to the performance
obligations in the contract by reference to the relative standalone selling prices of the goods or services promised.
This allocation is made at the inception of the contract. It is not adjusted to reflect subsequent changes in the
standalone selling prices of those goods or services.

The best evidence of standalone selling price is the observable price of a good or service when the entity sells that
good or service separately. If that is not available, an estimate is made by using an approach that maximises the use
of observable inputs – for example, expected cost plus an appropriate margin or the assessment of market prices
for similar goods or services adjusted for entity-specific costs and margins or in limited circumstances a residual
approach. The residual approach is different from the residual method that is used currently by some entities, such
as software companies.

When a contract contains more than one distinct performance obligation, an entity should allocate the transaction
price to each distinct performance obligation on the basis of the standalone selling price.

This will be a major practical issue as it may require a separate calculation and allocation exercise to be performed
for each contract. For example, a mobile telephone contract typically bundles together the handset and network
connection and IFRS 15 will require their separation.

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STEP 5: RECOGNISE REVENUE WHEN (OR AS) THE ENTITY SATISFIES A PERFORMANCE OBLIGATION

Step five requires revenue to be recognised as each performance obligation is satisfied. This differs from IAS 18
where, for example, revenue in respect of goods is recognised when the significant risks and rewards of ownership
of the goods are transferred to the customer.

Revenue is recognised as control is passed. An entity satisfies a performance obligation by transferring control of a
promised good or service to the customer, which could occur over time or at a point in time.

Control of an asset is defined as the ability to direct the use of and obtain substantially all of the remaining benefits
from the asset. The benefits related to the asset are the potential cash flows that may be obtained directly or
indirectly. These include, but are not limited to:

 Using the asset to produce goods or provide services;

 Using the asset to enhance the value of other assets;
 Using the asset to settle liabilities or to reduce expenses;
 Selling or exchanging the asset;
 Pledging the asset to secure a loan; and
 Holding the asset.

A performance obligation is satisfied at a point in time unless it meets one of the following criteria, in which case, it
is deemed to be satisfied over time. So, an entity recognises revenue over time if one of the following criteria is met:

 The customer simultaneously receives and consumes the benefits provided by the entity’s performance as
the entity performs.
 The entity’s performance creates or enhances an asset that the customer controls as the asset is created or
enhanced.
 The entity’s performance does not create an asset with an alternative use to the entity and the entity has
an enforceable right to payment for performance completed to date.

Revenue is recognised in line with the pattern of transfer. Whether an entity recognises revenue over the period
during which it manufactures a product or on delivery to the customer will depend on the specific terms of the
contract.

If an entity does not satisfy its performance obligation over time, it satisfies it at a point in time. Revenue will
therefore be recognised when control is passed at a certain point in time. Factors that may indicate the point in time
at which control passes include, but are not limited to:

 The entity has a present right to payment for the asset;

 The customer has legal title to the asset;
 The entity has transferred physical possession of the asset;
 The customer has the significant risks and rewards related to the ownership of the asset; and
 The customer has accepted the asset.

As a consequence of the above, the timing of revenue recognition may change for some point-in-time transactions
when the new standard is adopted.

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CONTRACT COSTS

The incremental costs of obtaining a contract must be recognised as an asset if the entity expects to recover those
costs.

Costs incurred to fulfill a contract are recognised as an asset if and only if all of the following criteria are met:

 The costs relate directly to a contract (or a specific anticipated contract);

 The costs generate or enhance resources of the entity that will be used in satisfying performance
obligations in the future; and
 The costs are expected to be recovered.

The asset recognised in respect of the costs to obtain or fulfill a contract is amortised on a systematic basis that is
consistent with the pattern of transfer of the goods or services to which the asset relates.

PRINCIPLES OF REVENUE RECOGNITION

Sale on return basis

 In case of sale on return basis, an estimate should be made of the amount of goods expected to be returned.
 The most likely amount of return can be determined by past experience or by assigning probability to
estimated figures
 For the goods expected to be returned, sale is not recognized. A refund liability is recorded with the amount.
 The right to receive inventory with a corresponding adjustment to cost of sales
 If the item is ultimately not returned, then it will be recognized as sale at the point of confirmation of no
return.

Warranty

 In case of option to purchase warranty separately (extended), warranty is distinct and should be recognized
as a separate performance obligation
If a customer does not have the option to purchase a warranty separately, an entity shall account for the warranty
in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Asset Principal versus agent
considerations

 When another party is involved in providing goods or services to a customer, the entity shall determine
whether the nature of its promise is a performance obligation to provide the specified goods or services
itself (ie the entity is a principal) or to arrange for the other party to provide those goods or services (ie the
entity is an agent).
 An entity is a principal if the entity controls a promised good or service before the entity transfers the good
or service to a customer. However, an entity is not necessarily acting as a principal if the entity obtains legal
title of a product only momentarily before legal title is transferred to a customer.
 When an entity that is a principal satisfies a performance obligation, the entity recognises revenue in the
gross amount of consideration to which it expects to be entitled in exchange for those goods or services
transferred.
 An entity is an agent if the entity’s performance obligation is to arrange for the provision of goods or
services by another party. When an entity that is an agent satisfies a performance obligation, the entity
recognises revenue in the amount of any fee or commission to which it expects to be entitled in exchange
for arranging for the other party to provide its goods or services.

Indicators that an entity is an agent are as follows:

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 a. Another party is primarily responsible for fulfilling the contract;
b. The entity does not have inventory risk before or after the goods have been ordered by a customer,
during shipping or on return;
c. The entity does not have discretion in establishing prices for the other party’s goods or services and,
therefore, the benefit that the entity can receive from those goods or services is limited;
d. The entity’s consideration is in the form of a commission; and
e. The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the
other party’s goods or services.
Repurchase agreements

A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in
the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was
originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the
asset that was originally sold is a component.

Repurchase agreements generally come in three forms:

a. An entity’s obligation to repurchase the asset (a forward);

b. An entity’s right to repurchase the asset (a call option); and
c. An entity’s obligation to repurchase the asset at the customer’s request (a put option).
Forward & Call option

 In case of forward and call option, the customer does not obtain control
 If entity can or must repurchase at an amount less than original selling price of asset, then it will be
accounted for as lease
 If entity can or must repurchase at an amount equal to or more than original selling price of asset, then
accounting done as financing arrangement —recognize the asset and a financial liability
Put option
 If repurchase price lower than original selling price then see does customer have significant economic
incentive to exercise right
 If yes then account for as lease. If no, then recognize as sale of product with right of return
 If repurchase price is equal or greater than original selling price following two options arise
 If repurchase price is more than expected market value then accounting done as financing arrangement —
recognize the asset and a financial liability
 If Repurchase price is less than expected market value and no significant economic incentive to exercise
right then record as sale of product with right of return
Bill and hold arrangement

 Bill-and-hold arrangements are those whereby an entity bills a customer for the sale of a particular product,
but the entity retains physical possession until it is transferred to the customer at a later date.
 In assessing whether revenue can be recognized in a bill-and-hold transaction, entities must first determine
whether control has transferred to the customer (as with any other sale under IFRS 15) through review of
the indicators for the transfer of control. One indicator is physical possession of the asset; however, physical
possession may not coincide with control in all cases (e.g., in bill-and-hold arrangements).
 In determining whether control has transferred in such arrangements, the specific criteria included in IFRS
15 for bill-and-hold transac-tions must all be met in order for revenue to be recognized.

o The reason for the bill-and-hold arrangement must be substantive (e.g., the customer has
requested the arrangement).
o The product must be identified separately as belonging to the customer.
o The product currently must be ready for physical transfer to the customer.

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 o The entity cannot have the ability to use the product or to direct it to another customer.

 An entity that has transferred control of the goods and met the bill-and-hold criteria to recognize revenue
will also need to consider whether it is providing other services (e.g., custodial services). If so, a portion of
the transaction price should be allocated to each of the separate performance obligations (i.e., the goods
and the custodial service).
Consignment arrangements

When an entity delivers a product to another party (such as a dealer or a distributor) for sale to end customers, the
entity shall evaluate whether that other party has obtained control of the product at that point in time. A product
that has been delivered to another party may be held in a consignment arrangement if that other party has not
obtained control of the product.

Accordingly, an entity shall not recognise revenue upon delivery of a product to another party if the delivered
product is held on consignment.

Indicators that an arrangement is a consignment arrangement include, but are not limited to, the following:

a. The product is controlled by the entity until a specified event occurs, such as the sale of the product to
a customer of the dealer or until a specified period expires;
b. The entity is able to require the return of the product or transfer the product to a third party (such as
another dealer); and
c. The dealer does not have an unconditional obligation to pay for the product (although it might be
required to pay a deposit).
PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 26 - 28
March/June 16 Q.3 (i), (ii)
IFRS 15
Dec. 12 Q.2(i)
Dec. 11 Q.2 (i)
Dec. 15 Q.1 (i)
June 14 Q.2(i)
Substance over form Dec. 13 Q.4(b)
June 13 Q.2(i)
June 11 Q.2 (vi)

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 STATEMENT OF CASH FLOWS - IAS 7

Objective

The objective of IAS 7 – Statement of cashflows is to ensure that enterprises provide information about the historical
changes in cash and cash equivalents by means of a cash flows statement which classifies cash flows during the
period according to operating, investing and financing activities for a period.

Purpose of Statement of Cash flows

The fundamental purpose of being in business is to generate profit, as this will increase the owners' wealth.
Profitability relates to the long term performance of the business and indicates that over the long term a business
will generate cash. In the short term, the business' viability is determined by its ability to generate cash. However as
a statement of profit or loss is prepared on an accruals basis, the profit for the year is unlikely to correlate with the
movement in the company's bank balance. Items such as depreciation, provision movements and impairment of
goodwill will mean that profits and cash flows may differ dramatically.

Users need to know about the cash generating ability and financial adaptability of an enterprise, i.e. can the business
generate cash and can it alter the timing of its cash flows. If the entity can answer positively, users will be confident
about the entity's prospects.

Cash flows are either receipts (ie cash inflows and so are represented as a positive number in a statement of cash
flows) or payments (ie cash out flows and so are represented as a negative number using brackets in a statement of
cash flows).

Cash flows are usually calculated as a missing figure. For example, when the opening balance of an asset, liability or
equity item is reconciled to its closing balance using information from the statement of profit or loss and/or
additional notes, the balancing figure is usually the cash flow.

DEFINITIONS

The standard gives the following definitions, the most important of which are cash and cash equivalents.
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
and which are subject to insignificant risk of changes in value (Investments with a maturity of three months or less
from the date of acquisition).
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 financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash
equivalents.
Financing activities are activities that result in changes in the size and composition of the equity capital and
borrowings of the entity.

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Presentation of Statement of Cash Flows

The format and content of the statement of cash flows are prescribed by IAS 7 Statements of cash flow. It requires
that cash flows are listed under one of three headings:

 Cash flows from operating activities

 Cash flows from investing activities, or
 Cash flows from financing activities.
CASH FLOWS FROM OPERATING ACTIVITIES

This is perhaps the key part of the Statement of Cash Flows because it shows whether, and to what extent, companies
can generate cash from their operations. It is these operating cash flows which must, in the end pay for all cash
outflows relating to other activities, i.e. paying loan interest, dividends and so on Most of components of cash flows
from operating activities will be those items which determine the net profit of loss of the entity, i.e. they relate to
the main revenue-producing activities of the entity.

The standard gives the following as examples of cash flows from operating activities.

 Cash receipts from the sale of goods and the rendering of services
 Cash receipts from royalties, fees, commissions and other revenue
 Cash payments to suppliers for goods and services
 Cash payments to and on behalf of employees
 Cash payments/refunds of income taxes unless they can be specifically identified with financing of investing
activates
 Cash receipts and payments from contracts held for dealing for trading purposes.

Depreciation / amortisation / loss on disposal of non-current assets is added back as they are non-cash expenses.

Interest expense is added back as it is not part of cash generated from operations.

Note: If profit before interest and tax (operating profit) is used as the first item then an adjustment for interest
payable is not necessary.

Increase in inventories and trade receivables are deducted because this is part of the profit not yet realized into
cash but tied up in the respective assets. On the contrary, the decrease of inventories and receivables are added in
operating profit, because this shows the realized profits i.e. the realization of cash.

The decrease in trade payables is deducted as it results in a cash outflow since cash is leaving the business to
reduce the amount owing. On the contrary; the increase in trade payables are added, as the increase in payables
means more cash inflow towards organization.
The actual amount paid for interest, tax and dividends will result in a cash outflow.

A working may be necessary determine the actual payment.

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Calculation of interest/income taxes paid

The cash flow should be calculated by reference to:

 The charge to profits for the item (shown in the statement of profit or loss); and
 Any opening or closing payable balance shown on the statement of financial position.
A T account working may be useful:

e.g. Interest payable

$ $

Interest accrual b/f X

Cash paid (ß) X Interest charge (P&L) X

Interest accrual c/f X

–––– ––––

X X

–––– ––––

If there is no opening or closing should be statement of financial position payable amount, it follows that the charge
to profits is the cash outflow.

Calculation of dividends paid

The cash flow should again be calculated by reference to the charge to profits and the opening or closing dividend
payable shown in the statement of financial position.

Note that the charge to profits for dividends is not shown in the statement of profit or loss. It can, however, be
derived using an accumulated profits T account working.

CASH FLOWS FROM INVESTING ACTIVITIES

The cash flows classified under this heading show the extent of new investment in assets which will generate future
profit and cash flows. The standard gives the following examples of cash flows arising from investing activities.

 Cash payments to acquire property, plant and equipment, intangibles and other long term assets, including
those relating to capitalized development costs and self-constructed property, plant and equipment.
 Cash receipts from sales of property, plant and equipment, intangibles and other long-term assets
 Cash payments to acquire shares or debentures of other entities.
 Cash receipts from sales of shares or debentures of other entities
 Cash advances and loans made to other parties
 Cash receipts from the repayment of advances and loans made to other parties
 Interest received
 Dividends received

Below is a format which can be used to calculate the amount paid to acquire non-current assets: This applies if
there are no details of cost and accumulated depreciation in the Statement of Financial Position.

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Calculation of purchase of property, plant and equipment and proceeds of sale of equipment

These amounts are often the trickiest to calculate within a statement of cash flows. It is therefore recommended
that T account workings are used.

The following T accounts will be required for each class of assets:

 Cost account
 Accumulated depreciation account
 Disposals account (where relevant).
Data provided in the source financial statements should then be entered into these T accounts and the required cash
flows found – often as balancing figures.

If there is evidence of a revaluation, remember to include the uplift in value on the debit side of the carrying value
T account.

In some cases, insufficient detail is provided to produce separate cost and accumulated depreciation accounts.
Instead, a carrying value account should be used:

Carrying value (CV)

$ $

CV b/f X

Additions at cost X

(= cash to purchase PPE) Disposals at CV X

Revaluation X Depreciation charge for year X

Carrying value c/f X

–– ––

X X

–– ––

Calculation of interest and dividends received

Again, the calculation should take account of both the income receivable shown in the statement of profit or loss
and any relevant receivables balance from the opening and closing statement of financial positions.

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A T account working may be useful:

e.g. Interest receivable

$ $

Interest receivable b/f X

Interest income (P&L) X Cash received (ß) X

Interest receivable c/f X

–––– ––––

X X

–––– ––––

Cash flows from financing activities

This sections of the Statement of Cash Flows shows the share of cash which the entity’s capital providers have
claimed during the period. This is an indicator of likely future interest and dividend payments. The standard gives
the following examples of cash flows which might arise under these headings.

 Cash proceeds from issuing shares

 Cash payments to owners to acquire or redeem the entities shares
 Cash proceeds from issuing debentures , loans notes , bonds, mortgages and other short or long-term
borrowings
 Cash repayments of amounts borrowed
 Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease
Calculation of proceeds of issue of shares

This cash inflow is derived by comparison of the sum brought forward and sum carried forward balances on two
accounts:

 Share capital
 Share premium.
Calculation of proceeds of issue of loans/repayment of loans

This cash flow is derived by simply subtracting the brought forward balance from the carried forward.

Net increase in cash and cash equivalents

This is the overall increase in cash and cash equivalents during the year.

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METHODS FOR PREPARATION OF STATEMENT OF CASHFLOWS

Cash flows from operating activities are those that normally arise from transactions relating to trading activities.

Cash flows from operating activities can be calculated in two ways, using the direct method or the indirect method.
Direct method is not a part of Financial Reporting (F7) syllabus.

Indirect Method (Operating activities)

The indirect method starts with profit before tax. The profit before tax is then reconciled to the cash that it has
generated. This means that the figures at the start of the cash flow statement are not cash flows at all. In that initial
reconciliation, expenses that have been charged against profit that are not cash out flows; for example depreciation
and losses, have to be added back, and non-cash income; for example investment income and profits are deducted.
The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement
profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase
in the levels of inventory and receivables will have not impacted on profit but will have had an adverse impact on
the cash flow of the business. Thus in the reconciliation process the increases in inventory and trade receivables are
deducted. Conversely decreases in inventory and trade receivables are deducted. The opposite is applicable for trade
payables. Finally the payments for interest and tax are presented.

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 Statement of Cash flows (Proforma)

$'m $'m
Net cash inflow from operating activities
Profit before tax X
Adjustments for:
Add back interest expense (Finance cost) X
Deduct investment income (X)
Add back depreciation X
Add back Loss on disposal of PP&E* X
Add back Goodwill impairment X
Add back increase in provisions* X
Deduct amortisation of government grants (X)
Operating profit before working capital changes X
(Increase) in inventory (X)
(Increase) in receivables (X)
Increase in payables X
Cash generated from operations X
Interest paid (X)
Tax paid (X)
Dividends paid (might be shown in Financing instead) (X)
Net cash flow from operating activities X/(X)
Cash flows from investing activities
Purchase of PP&E (X)
Purchase of non-current investments (X)
Receipts from sale PP&E X
Receipts from sale of investments X
Dividends received X
Interest received X
Receipt of government grant X
Cash used for investing activities X/(X)
Cash flows from Financing activities
Issue of ordinary share capital X
Issue of loan notes X
Payment of finance lease liabilities (X)
Cash from financing activities X/(X)
Net increase/(Decrease) in cash and cash equivalents
Opening balance for cash & cash equivalents X
Closing balance for cash and cash equivalents X
*Reverse treatment for profit on disposal and decrease in provision.

ANALYSING A STATEMENT OF CASH FLOWS

A key part of the Financial Reporting exam is the ability to analyse a set of financial statements. The statement of
cash flows is one of the primary financial statements, and Financial Reporting exam requires that candidates must
be able to explain the performance of an entity based on all of the financial statements including the cash flows
given. To do this, candidates need to understand the different sections of the statement and the implications for the
business.

One of the first things to note is to not simply comment on the overall movement in the total cash and cash
equivalents figure in the year. An increase in this figure does not necessarily mean that the entity has performed

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well in the year. A situation could easily arise where an entity is struggling to generate cash in a period and is forced
to sell its owned premises and rent them back in order to continue. This may mean that the entity’s overall cash
position increases in the period, but is clearly not a sign that the entity has performed well. This would be a significant
concern, as the entity cannot simply sell premises again in the future. There will also be fewer assets owned the
entity in the future, meaning that its ability to secure future borrowing may be limited. Any candidate simply
commenting that the entity has performed well as the overall cash figure has increased is unlikely to score any marks,
as they have not really understood the reasons behind the movement.

A good analysis will examine the statement of cash flows in detail and look for the reasons behind the movement,
commenting on how the entity’s performance is reflected here. The statement of cash flows contains three sections,
namely cash flows from operating activities, investing activities and financing activities, each of which give us useful
information about an entity’s performance.

Operating activities

The first key figure to address is likely to be cash generated from operations. This shows how much cash the business
can generate from its core activities, before looking at one-off items such as asset purchases/sales and raising money
through debt or equity. The cash generated from operations figure is effectively the cash profit from operations. The
cash generated from operations figure should be compared to the profit from operations to show the quality of the
profit.

The closer these two are together, the better the quality of profit. If the profit from operations is significantly larger
than the cash generated from operations, it shows that the business is not able to turn that profit into cash, which
could lead to problems with short-term liquidity.

When examining cash generated from operations, examine the movements in working capital which have led to this
figure. Large increases in receivables and inventories could mean problems for the cash flow of the business and
should be avoided if possible. This could mean that the company has potential irrecoverable debts, or may be that
a large customer has been taken on with increased payment terms. Either way, the company should have enough
cash to pay the payables on time.

Look for large increases in payables. If a company has positive cash generated from operations, but a significant
increase in the payables balance compared to everything else, it may be that the company is delaying paying its
suppliers in order to improve its cash flow position at the end of the year.

The cash generated from operations figure should be a positive figure. This ensures that the business generates
enough cash to cover the day to day running of the company. The cash generated from operations should also be
sufficient to cover the interest and tax payments, as the company should be able to cover these core payments
without taking on extra debt, issuing shares or selling assets.

Any cash left over after paying the tax and interest liabilities is thought of as ‘free cash’, and attention should be paid
as to where this is spent. Ideally, a dividend would be paid out of this free cash, so that a firm does not have to take
out longer sources of finance to make regular payments to its shareholders. Other good ways of using this free cash
would be to invest in further non-current assets (as this should generate returns into the future) and paying back
loans (as this will reduce further interest payments).

139
Investing activities

This section of the cash flow focuses on the cash flows relating to non-current assets,

For example, sales of assets can be a good thing if those assets are being replaced. However, as stated earlier, if a
company is selling off its premises and is now renting somewhere, this makes the financial position significantly
weaker, and banks will be less willing to lend as there are less assets to secure a loan against.

The sale of assets should not be used to finance the operating side of the business or to pay dividends. This is poor
cash management, as a company will not be able to continue selling assets in order to survive. This is an indication
that a company is shrinking and not growing.

Whilst purchases or sales of non-current assets may be relatively irregular transactions, the presence of interest
received, or dividends received may well be recurring cash flows arising from investments the entity holds.

Financing activities

The sources of financing any increases in assets should also be considered. If this can be financed out of operations,
then this is the best scenario as it shows the company is generating significant levels of excess cash. Funding these
out of long term sources (ie loans or shares) is also fine, as long-term finances are sensible to use for long term
assets.

However, when raising long term finance, it is also useful to consider the future consequences. For example, taking
out loans will lead to higher interest charges going forward. This will increase the level of gearing in the entity,
meaning that finance providers may charge higher interest rates due to the increased risk. It may also mean that
loan providers are reluctant to provide further finance if the entity already has significant levels of debt.

Raising funds from issuing shares will not lead to interest payments and will not increase the level of risk associated
with the entity. It must also be noted that issuing shares will lead to more shareholders and possibly higher total
dividend payments in the future.

In summary, a well-rounded answer will absorb all of the information contained within a statement of cash flows,
using this to produce a thorough discussion of an entity’s performance. Candidates who are able to do this should
perform well on these tasks, and are more likely to have demonstrated a much greater understanding of
performance than simply commenting whether the overall cash balance has gone up (or down).

140
Question

Top Trades Co has been trading for a number of years and is currently going through a period of expansion. An
extract from the statement of cash flows for the year ended 31 December 20X7 for Top Trades Co is presented as
follows:

$’000
Net cash from operating activities 995
Net cash used in investing activities (540)
Net cash used in financing activities (200)
Net increase in cash and cash equivalents 255
Cash and cash equivalents at the beginning of the period 200
Cash and cash equivalents at the end of the period 455
Which of the following statements is correct according to the extract of Top Trades Co’s statement of cash flows?

A The company has good working capital management

B Net cash generated from financing activities has been used to fund the additions to non-current assets
C Net cash generated from operating activities has been used to fund the additions to non-current assets
D Existing non-current assets have been sold to cover the cost of the additions to non-current assets

Solution
Option C
ddThis Shari ng Buttons

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 11
June 15 Q.3(e)
Dec. 14 MCQ.9
Dec. 13 Q.3(a)
IAS 7
June 13 Q.3(a)
June 12 Q.3 (a)
Dec. 11 Q.3 (a)
June 11 Q.3 (a)

141
 IFRS 5 – NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS

OBJECTIVE

The objective of this standard is to specify the accounting for Non-current assets held for sale, and presentation and
disclosure of discontinued operations.

Non-Current Assets Held For Sale

HELD FOR SALE

This term refers to a non-current asset whose carrying amount will be recovered principally through a sale
transaction rather than through continuing use.

DISCONTINUED OPERATION

A discontinued operation includes the following criteria (Discussed in detail after measurement):

 Is a separately identifiable component

 Must represent a major line of the entity’s business
 Is part of a plan to dispose of a major line of business or a geographical area
 Is a subsidiary acquired with a view to resell
DISPOSAL GROUP

This is a group of assets and possibly some liabilities that an entity intends to dispose of in a single transaction.

CLASSIFICATION OF NON-CURRENT ASSETS AS HELD FOR SALE

For an asset to be classified as held for sale:

a) It must be available for immediate sale in its present condition allowing for terms that are usual or
customary;

b) Its sale must be highly probable {expected within 1 year of reclassification);

c) It must be genuinely sold, not abandoned.

Immediate sale

The application of the phrase does make allowance for conditions considered 'usual and customary' in selling the
asset, e.g. allowance would be made for searches and surveys when selling property.

No allowance is made for conditions imposed by the seller of the asset or disposal group.

142
Highly probable

For a sale to be highly probable it must be significantly more likely than probable. In addition the standard sets out
the following criteria to be satisfied:

 Management, at a level that has the authority to sell the assets or disposal group, is committed to a plan to
sell;
 An active program to locate a buyer and complete the sale must have begun. This will include making it
known to those that might be interested that the asset or disposal group is available for sale;
 The asset or disposal group must be actively marketed at a price that is reasonable compared to its current
fair value.
This should take account of local conditions in the market. Thus, if it is customary to price above fair value in
the expectation of low bids, or vice versa, this is acceptable. The term actively marketed requires that the entity
is making positive efforts to sell, not just to locate a buyer, e.g. by engaging a selling agent.

 The sale of the asset is expected to be recorded as completed within time, ear from the date of
classification.
(If the sale is not completed within one year and this is due to events beyond entity's control, it is still possible
for the asset to be continued to be classified as held for sale provided the entity is still committed to selling the
asset).

 The actions required to complete the plan should indicate that it is not likely that there will be significant
changes made to the plan or that the plan will be withdrawn.
MEASUREMENT

Non-current assets or disposal groups that meet the criteria to be classified as held for sale are measured at the
lower of:

 Fair value less costs to sell; and

 Carrying amount (in accordance with the relevant Standard).
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.

Costs to sell are "the incremental costs directly attributable to the disposal of an asset (or disposal group)". Examples
would include lawyer's or estate agent's fees.

The costs must be incremental; internal costs cannot be included in costs to sell.

Measurement on initial classification as held for sale

IFRS 5 requires that immediately before the initial classification of an asset (or disposal group) as held for sale, the
carrying amount of the asset (or all the assets and liabilities in a disposal group) should be measured in accordance
with the relevant IFRS.

Initial classification as held for sale may lead to a write down to fair value less costs to sell.

Note:

 Any impairment loss on initial or subsequent write-down of the asset or disposal group to fair value less
cost to sell is to be recognised in the statement of profit or loss.

143
  Any subsequent increase in fair value less cost to sell can be recognised in the statement of profit or loss to
the extent that it is not in excess of the cumulative impairment loss that has been recognised in accordance
with the IFRS 5 or previously in accordance with IAS 36.
 Any impairment loss recognised for disposal group should be applied in the order set out in IAS 36. The
standard sets out how to allocate the impairment loss among the constituent parts of the disposal group
(or cash generating unit). The loss itself is still charged to the statement of profit or loss.
SUBSEQUENT REMEASUREMENT

 Whilst a non-current asset/disposal group is classified as held for sale it should not be depreciated or
amortised.
 At each reporting date where a non-current asset or disposal group continues to be classified as held for
sale it should be re-measured at fair value less costs to sell at that date.
 This may give rise to further impairments or a reversal of previous impairment losses. In either case
recognise in the statement of profit or loss.
Question

As at 30 September 2013 Dune’s property in its statement of financial position was:

Property at cost (useful life 15 years) $45 million

Accumulated depreciation $6 million

On 1 April 2014, Dune decided to sell the property. The property is being marketed by a property agent at a price of
$42 million, which was considered a reasonably achievable price at that date. The expected costs to sell have been
agreed at $1 million. Recent market transactions suggest that actual selling prices achieved for this type of property
in the current market conditions are 10% less than the price at which they are marketed.

At 30 September 2014 the property has not been sold.

At what amount should the property be reported in Dune’s statement of financial position as at 30 September
2014?

A $36 million
B $37·5 million
C $36·8 million
D $42 million
Solution

Option C

At 30 September 2014:

Carrying amount = $37·5 million (45,000 – 6,000 b/f – 1,500 for 6 months; no further depreciation when classified
as held for sale).

Recoverable amount = $36·8 million ((42,000 x 90%) – 1,000).

Therefore included at $36·8 million (lower of carrying amount and fair value less cost to sell).

144
DISCONTINUED OPERATIONS – Detailed explanation

As mentioned earlier, discontinued operation is a component of an entity that:

i.) either has been disposed of, or

ii.) is classified as held for sale, and that component

a) Represents a separate major line of business or geographical area of operations, or

b) Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of
operations, or

c) It is a subsidiary acquired exclusively with a view to resale.

Component:

The standard defines this term as "operations and cash flows that can be clearly distinguished, operationally and for
financial reporting purposes, from the rest of the entity”.

A component will have been a single Cash Generating Unit (CGU) or a collection of CGUs while held for use in the
business.

A component can be distinguished operationally and for financial reporting purposes if:

 Its operating assets and liabilities can be directly attributed to it;

 Its income (gross revenue) can be directly attributed to it;
 At least a majority of its operating expenses can be directly attributed to it.
Classification as discontinued operation

A component of the reporting entity is classified as discontinued at:

 The date of its disposal (sale/termination); or

 Or when the operation meets the IFRS criteria to be classified as held for sale.
In order to have been classified as a discontinued operation by the reporting date the disposal or reclassification as
'held for sale' must have taken place by that reporting period end.

If an operation is to be terminated, but it is not actually closed by the reporting date then it will not be classified as
discontinued at the year end.

Major line of business or geographical segment

A separate business segment or geographical segment as defined in IFRS 8 – Operating Segments, would normally
meet this condition.

Single plan

If a component is not itself a separate major line of business or geographical area of operations then it must be "part
of a single co-ordinated plan" to dispose of such a line of business or geographical area of operations. The single plan
might relate to a disposal in one transaction or piecemeal.

145
PRESENTATION

 Non-current assets that meet the criteria are presented separately on the Statement of Financial Position
within current assets.
 If the held for sale item is a disposal group then related liabilities are also reported separately within current
liabilities.
 Discontinued operations and operations held for sale must be disclosed separately in the statement of
financial position at the lower of their carrying value less costs to sell.
PAST EXAMS ANALYSIS
Topic Exam Attempt Question

June 15 MCQ.17

Dec.14 MCQ. 14
IFRS 5
June 13 Q.2(ii) Q.2(a)

June 11 Q.4 (b)

146
 IAS 21 — THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES

Objective of IAS 21

The objective of IAS 21 is to prescribe how to include foreign currency transactions (As per scope of F7)

Key definitions

Functional currency:

The currency of the primary economic environment in which the entity operates.

Presentation currency:

The currency in which financial statements are presented.

Foreign currency:

It is a currency other than the functional currency of the entity.

Exchange difference:

The difference resulting from translating a given number of units of one currency into another currency at different
exchange rates.

Closing rate:

It is the spot exchange rate at the end of the reporting period.

Exchange difference:

It is the difference resulting from translating a given number of units of one currency into another currency at
different exchange rates.

Exchange rate:

It is the ratio of exchange for two currencies.

Monetary items:

They are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of
units of currency.

Spot exchange rate:

It is the exchange rate for immediate delivery.

147
Foreign currency transactions

A foreign currency transaction should be recorded initially at the rate of exchange at the date of the transaction (use
of averages is permitted if they are a reasonable approximation of actual).

At each subsequent reporting date:

 Foreign currency monetary amounts should be reported using the closing rate
 Non-monetary items carried at historical cost should be reported using the exchange rate at the date of the
transaction
 Non-monetary items carried at fair value should be reported at the rate that existed when the fair values
were determined
 Exchange differences arising when monetary items are settled or when they are translated at different rates
from initial recognition or previous financial statements are reported in profit or loss in the period
 If a gain or loss on a non-monetary item is recognised in other comprehensive income (for example, a
property revaluation under IAS 16), any foreign exchange component of that gain or loss is also recognised
in other comprehensive income.

Question

When a single entity makes purchases or sales in a foreign currency, it will be necessary to translate the transactions
into its functional currency before the transactions can be included in its financial records.

In accordance with IAS 21 The Effect of Changes in Foreign Currency Exchange Rates, which of the following foreign
currency exchange rates may be used to translate the foreign currency purchases and sales?

(1) The rate which existed on the day that the purchase or sale took place

(2) The rate which existed at the beginning of the accounting period

(3) An average rate for the year, provided there have been no significant fluctuations throughout the year

(4) The rate which existed at the end of the accounting period

A (2) and (4)

B (1) only
C (3) only
D (1) and (3)
Solution
Option D

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

IAS 21 Spec. exam Sept. 16 MCQ.6

148
 IAS 33 – EARNINGS PER SHARE

INTRODUCTION

Earnings Per Share (EPS) is an unusual accounting ratio in that it has a whole standard devoted to its calculation and
presentation. The importance attached to this ratio derives from the fact that it is used as a basis for a number of
significant statistics used by investors.

USES OF EPS

The uses of EPS as a financial indicator include:

 The assessment of management performance over time.

 Trend analysis of EPS to give an indication of earnings performance.
 An indicator of dividend payouts. The higher the EPS the greater the expectation of an increased dividend
compared to previous periods.
 An important component in determining the entity's price/earnings (P/E) ratio.
Scope and Objective

The objective of the standard is to prescribe principles for the determination and presentation of earning per share
in order to improve performance comparisons between different entities in the same period and over time for the
same entity.

IAS 33 only applies to entities whose securities are publicly traded or that are in the process of issuing securities to
the public. This is because entities, whose securities are not traded, do not have a readily observable market price
which would make it difficult to calculate a P/E ratio.

DEFINITIONS

Ordinary shares: an equity instrument that is subordinate to all other classes of equity shares.

Potential ordinary shares: a financial instrument or other contract that may entitle its holder to ordinary shares.

Examples of potential ordinary shares include:

 Convertible debt
 Convertible preference shares
 Share warrants
 Share options
Warrants or options: financial instruments that give the holder the right to purchase ordinary shares.

Dilution: a reduction in EPS or an increase in loss per share resulting from the assumption that convertible
instruments are converted, the options or warranties are exercised, or that ordinary shares are issued upon the
satisfaction of specified conditions.

Anti-dilution: an increase in EPS or a reduction in loss per share resulting from the assumption that convertible
instruments are converted, the options or warranties are exercised, or that ordinary shares are issued upon the
satisfaction of specified conditions.

149
BASIC EPS

The basic EPS should be calculated by dividing the net profit or loss attributable to ordinary equity shareholders by
the weighted average number of ordinary shares outstanding during the period.

The net profit is profit after tax and preference dividends.

Note: Attempt Question 1 from Concept test questions at the end of this chapter.

CHANGES IN THE CAPITAL STRUCTURE

Most of the complications in the computation of EPS arise from changes in the share capital. The underlying principle
is that EPS should be comparable from period to period.

Thus in arriving at the denominator in the EPS calculation, the shares in issue at the beginning of the period may
need to be adjusted for shares bought back or issued during the period multiplied by a time weighting factor.

It is necessary to time apportion and come up with a weighted average number of shares outstanding; because
where capital has been invested through the issue of shares part-way through the year, additional earnings will only
have been generated from the date at which the investment took place. If earnings for the year were apportioned
over shares in issue at the year end the resultant EPS would not fairly reflect performance for the current period in
comparison to a previous period when there may have been no such change in equity. Similar logic applies where
shares have been bought back in the year.

The four most common reasons for adjusting shares in issue at the beginning of the period are:

 Issue of new shares during the period (fully or partly paid)

 Bonus issues
 Rights issues;
 Potential ordinary shares (resulting in calculation of diluted EPS)

Issue of new shares during the period (Fully paid)

Shares should be included in the weighted average calculation from the date consideration is receivable

Note: Attempt Question 2 from Concept test questions at the end of this chapter.

Issue of new shares during the period (Partly paid)

The general principle under IAS 33 that shares should be included in the weighted average calculation from the date
consideration is receivable does not apply to shares that are issued in partly paid form. Partly paid shares are treated
as fractions of shares; based on payments received to date as a proportion of the total subscription price. These
shares are included in the averaging calculation only to the extent that they participate in dividends for the period.
Dividend entitlement of such shareholders is usually restricted to an amount based on this fraction.

The weighted average number of shares should be restricted based on this fraction. If the actual receipts to date
were only applied to the issue of fully paid shares, then the number of fully paid shares would be smaller than was
actually the case for partly paid shares being issued.

150
Note: Attempt Question 3 from Concept test questions at the end of this chapter.

Bonus issue, share split and share consolidation

Where a company issues new shares by way of a capitalisation of reserves (a bonus issue) during the period, the
effect is to increase only the number of shares outstanding after the issue. There is no effect on earnings as there is
no inflow of funds as a result of the issue.

As shareholders rights are not affected; each individual will hold the same proportion of outstanding shares as before
the issue. IAS 33 requires that the bonus shares are treated as if they had occurred at the beginning of the period.
The EPS from the previous period should also be recalculated using the new number of shares in issue to allow
comparison with the current year's EPS, as if the issue had taken place at the beginning of that period as well.

When calculating the prior period EPS comparator then multiply last year's EPS by the factor:

Number of Shares before bonus issue

Number of Shares after bonus issue

When calculating the weighted average number of shares then the bonus factor to apply is the inverse of the above,
i.e.

Number of Shares after bonus issue

Number of Shares before bonus issue

Similar considerations apply where ordinary shares are split into shares of smaller nominal value (a share of $1 is
split into four share of 25c each) or consolidated into shares of higher nominal value (four shares of 25c each are
consolidated into one share of $1). In both these situations, the number of shares outstanding before the event is
adjusted for the proportionate change in the number of shares outstanding after the event.

Note: Attempt Question 4 from Concept test questions at the end of this chapter.

RIGHTS ISSUE

With a rights issue additional capital is raised by the issue of the shares. Existing shareholders are offered the right
to purchase new shares from the company, usually at a discount to the current market price.

Note: Attempt Question 5 from Concept test questions at the end of this chapter.

Then when dealing with a rights issue at a discount, calculation of EPS should mark adjustment for the two elements:

 A bonus issue (reflecting the fact that the cash received would not pay for all the/shares issued if based on
fair values, rather than being discounted).
 An assumed issue at full price (reflecting the fact that new shares are issued in return for cash);
Consequently the number of shares outstanding at the beginning of the year should be adjusted for the bonus factor
to give a deemed number of shares in issue before the rights issue. This should be weighted for the period up to the
date of the rights issue.

151
The bonus factor is equal to: Fair Value before rights issue

Theoretical ex - rights Price after rights issue

Additionally the number of shares actually in issue after the rights issue is weighted for the period after the rights
issue.

As in the section on bonus issues, the prior period EPS should be adjusted for the bonus factor. This is achieved by
taking the reciprocal of the bonus factor (turn fraction Upside down) and multiplying by last year's EPS.

Note: Attempt Question 6 from Concept test questions at the end of this chapter.

DILUTED EARNINGS PER SHARE

An entity may have in issue at the reporting date a number of financial instruments that give rights to ordinary shares
at a future date. IAS 33 refers to these as potential ordinary shares. Examples of potential ordinary shares include:

 Convertible debt;
 Convertible preference shares;
 Share warrants
 Share options
Where these rights are exercised they will increase the number of shares. Earnings may also be affected. The overall
effect will tend towards lowering (or diluting) the EPS.

This will tend to be the case because holders of these rights will only take them if it is to their benefit which tends
to be prejudicial to existing shareholders

So that existing shareholders can see the potential dilution of their present earnings, IAS 33 requires that a diluted
EPS is calculated.

The calculation is performed as if the potential ordinary shares had been in issue throughout the period. If the rights
were granted during the reporting the period, then time apportion.

The diluted EPS is:

Earnings as per basic EPS + Adjustment for dilutive potential ordinary shares

Weighted Average number of shares per basic EPS + Adjustment for dilutive potential ordinal

152
CONVERTIBLE FINANCIAL INSTRUMENTS
CALCULATION OF EARNINGS

The basic earnings figure should be adjusted to reflect any changes in profit that would arise when the potential
ordinary shares outstanding are actually issued. Adjust:

1. Profits

There will be a saving of interest. Interest is a tax-deductible expense and so the post- tax effects will be
brought into the adjusted profits.

There will be a saving of preference dividend. There is no associated tax effect.

Therefore, the numerator should be adjusted for the after-tax effects of dividends and interest charged in
relation to dilutive potential ordinary shares and for any other changes in income that would result from
the conversion of the potential ordinary shares.

2. The number of shares

The denominator should include shares that would be issued on the conversion.

The potential ordinary shares are deemed to be converted to ordinary shares at the start of the period
unless they were issued during the reporting period.

Note: Attempt Question 7 from Concept test questions at the end of this chapter.

2) Adjust the number of shares.

The maximum number of shares that the convertible loan stock holders could take up, after the current balance
sheet date, is 120 on 31 December 20X6.

Weighted average number of shares in issue 200,000,000

Dilution (4,000,000 x 120/100) 4,800,000

Fully diluted number of shares 204,800,000

Fully diluted EPS (50,28SXX)/204,800,000) = 24.6c

SHARE WARRANTS AND OPTIONS

A share option or warrant gives the holder the right to purchase or subscribe for ordinary shares. IAS 33 requires
that the assumed proceeds from these shares should be considered to have been received from the issue of shares
at fair value. These would have no effect on EPS.

The difference between the number of shares that would have been issued at fair value and the number of shares
actually issued is treated as an issue of ordinary shares for no consideration. This bonus element has a dilutive effect
with regard to existing shareholders.

Note: Attempt Question 8 from Concept test questions at the end of this chapter.

153
 CONCEPT CHECK QUESTIONS

Question 1

Box, has its shares listed on a recognised stock exchange. Its profit after tax for 20X4 was $30million. The company's
issued share capital of $37.5million is made up of $0.10 ordinary shares. There has been no change in issued share
capital for a number of years.

Solution

Basic EPS = $30,000,000 x 100 = 8 cents

375,000,000

Question 2 - Issue of fully paid shares during the period

Strudel whose shares are listed on a recognised stock exchange, had a profit after tax of $40million. The company
had 80million ordinary shares of $1.00 each in issue at the beginning of the year ended 31 December 20X4. On 1 July
20X4 a further 8 million ordinary shares were issued.

Required: calculate Strudel's basic EPS for the year ended 31 December 20X4.

Solution - Strudel

Date/Event Shares Calculation Weighted

issued Average (millions)
(millions)

1 Jan 20X4 - Balance at beginning of year 80 80m x 6/12* 40

1 July 20X4 - Issue at full price 8
1 July 20X4 - new issue for cash 88 88 x 6/12* 44
84
*Note: The time weighting factor is earlier of the time to the next issue or the time to the year end.
OR
Date/Event Shares Calculation Weighted
issued Average (millions)
(millions)
1 Jan 20X4 - Balance at beginning of year 80 80m x 12/12 80

1 July 20X4 - new issue for cash 8 8 x 6/12 4

31 Dec' 20X4 - Balance at end of year 88 84
Basic EPS = $40m / 84m x 100 = 47.6 cents

154
Question 3 - Issue of partly paid shares during the period

Strudel whose shares are listed on a recognised stock exchange, had a profit after tax of $40million. The company
had 80million ordinary shares of $l.00 each in issue at the beginning of the year ended 31 December 20X4. On 1 July
20X4 a further 8 million ordinary shares were issued for consideration of $2.00, of which $1.50 was paid when the
shares were issued. The partly paid shares are entitled to participate in dividends for the period in proportion to the
amount paid.

Required: Calculate Strudel's basic EPS for the year ended 31 December 20X4.

Solution - Strudel

The issue of 8 million for which $1.50 has been paid is equivalent to the issue of: 8m x 1.50/2.00 = 6 million shares
at the full subscription price.

Date/Event Shares Calculation Weighted

issued Average
(millions) (millions)
1 Jan 20X4 - Balance at beginning of year 80 80m x 6/12 40
1 July 20X4 - new shares deemed to be 6
issued @ $2.00 (8m x 1.50/2.00) =
1 July 20X4 - Equivalent shares in issue 86 86m x 6/12 43
following $1.50 actually paid for 8m
Shares
83

OR -

Date/Event Shares Calculation Weighted

Issued Average
(millions) (millions)
1 Jan 20X4 - Balance at beginning of year 80 80m x 12/12 80
1 July 20X4 - new issue for cash 8 (8 x 1.50/2.00) x 6/12 3

31 Dec' 20X4 - Balance at end of year 88 83

Basic EPS = $40m / 83m x 100 = 48.2 cents

155
Question 4 - Bonus issue

JZ had profit after tax of $28.Om. The company had twenty million ordinary shares in issue at 1 January 20X2. The
company had a ' 1 for 4' bonus issue on 1 May 20X2. JZ's basic EPS for 20X1 was 114 pence.

Required: Calculate JZ's EPS for 20X2 and 20X1.

Solution - JZ

Bonus factor for adjusting number of shares = 5/4

Date/Event Shares Calculation Weighted

issued Average

(millions) (millions)

1 Jon 20X2 - Balance at beginning of year 20 (20m x 4/12) x 5/4 = 8.33

1 May 20X2 - bonus issue 5

Actual shares in issue after BI 25 (25m x 8/12) = 16.67

25

Note: in this case as there were no issues before the bonus issue the weighted average number of shares could have
been quickly calculated as:

20 million x 5/4 = 25 million shares

Basic EPS for 20X2 = $28m / 25m x 100 = 112 cents

Comparator for 20X1 restated = 114 x 4/5 = 91.2 cents

Question 5

Suppose a company had thirty-six shares in issue with a market price of $10 each. The company then had a 1 for 4
rights issue at $5 each. The market price just before the rights issue is $10 per share.

Market capitalisation before RI (36 x $10) = $360

Market capitalisation after RI [(36 x $10) + (9 x $5) = $405

Theoretical Ex-rights price ($405/45) = $9.00

Comparison of the market price before and after the issue indicates the bonus element implicit in the rights issue; a
bonus issue would drag the share price down.

Share price ratio = $10:$9. This means that the rights issue could be thought of as a combination of a 7 for 9' bonus
issue, followed by an issue at the full market price after the BI.

156
Proof:

Nine new shares were issued as a result of rights issue raising 9 x $5 = $45.

Alternatively:

Shares issued under a 1 for 9 bonus issue (36/9) = 4. The issue at full market price must then relate to the remaining
5 shares.

This raises 5 x $9 = $45

Thus a shareholder would be indifferent between:

a '1 for 4* RI at $5, and

a '1 for 9' BI followed by an issue at full market price of $9.

Question 6 - Rights issue

Blaze has it shares listed on a recognised stock market. Its profits after tax for 20X2 and 2J)X1 were $8,000,000 and
$6,000,000 respectively. Shares outstanding at 1 January 20X2 were 1,000,000 ordinary shares of $1 each. The
company had a 'one for four' rights issue. The last date to exercise rights was l April 20X2 and the exercise price was
$6.00. The fair value of one share immediately before the last date to exercise rights was $11.00.

Required: Calculate Blaze's EPS for 20X2 and 20X1.

Solution - Blaze

1) First Calculate theoretical ex-rights price:

Event- Number Price Market Value

$ $

Before Rights Issue 4 11.00 44.00

Rights Issue 1 6.00 6.00

After rights issue 5 10.00* 50.00

* Theoretical Ex-rights price = ($50.00/5)

Bonus Factor (for adjusting number of shares) = 11.00/10.00 = 1.1

157
2) Calculate weighted average number of shares in issue

Date/Event Shares Calculation Weighted

issued Average

1,000,000 275,000
1 Jan 20X4 - Balance at beginning of year (1,000,000 x 1.1) x 3/12
250,000
1 April 20X4 - rights issue (1 for 4)

1,250,000 (1,250,000 x 9/12)

937,500
1 April 20X4 - actual shares following RI

1,212,500

Basic EPS for 20X2 = $8.0m / 1,212,500 = $6.60

Comparator for 20X1 - original = $6.00m / 1,000,000 = $6.00

Comparator for 20X1 – restated = $6.00 x 1.00/1.10 = $5.45

Question 7

Throughout the year ended 31 December 20X5 Ace had in issue $4million 10% convertible u loan stock. The terms
for conversion for every $100 of loan stock are as follows:

31 December 20X5 125 ordinary shares

31 December 20X6 120 ordinary shares

31 December 20X7 115 ordinary shares

Profit attributable to ordinary shares for the year amounted to $50 million. The weighted average number of shares
in issue for the year was 200 million. Tax is charged at 30%.

Required: Calculate the diluted EPS.

Solution - Ace

1) Calculation of revised Earnings: $'000

Basic Earnings 50,000

Add back interest saved on 10% convertible loan stock ($4m x 10%) 400

Deduct tax on additional earnings (400 x 30%) (120)

50,280

158
2) Adjust the number of shares.

The maximum number of shares that the convertible loan stock holders could take up, after the current balance
sheet date, is 120 on 31 December 20X6.

Weighted average number of shares in issue 200,000,000

Dilution (4,000,000 x 120/100) 4,800,000
Fully diluted number of shares 204,800,000

Fully diluted EPS (50,28SXX)/204,800,000) = 24.6c

Question 8

Buick has in issue options to subscribe for 3,000,000 $1 ordinary shares at $4 per share. The average fair value of
one share during the year was $6 per share.

Profits attributable to ordinary shareholders amounted to $20million.

The weighted average number of shares in issue during the year was 100 million.

Required: Calculate the basic and diluted EPS.

Solution

Basic EPS ($20,000,000 / 100,000,000) x 100 = 20c

Diluted EPS:

Increase in number of shares 3,000,000

Number of shares that would have been issued at fair value (2,000,000)
3,000,000 x $4/$6 =
________
Shares issued for no consideration 1,000,000
Diluted EPS ($20,000,000 / 101,000,000) = 19.8c

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 Q.1 (c)
Spec. exam Sept. 16 MCQ.7
June 15 Q3.(d)
Dec. 14 MCQ.2, 13
IAS 33
June 14 Q.2(d)
June 13 Q.2(b)
June 12 Q.2 (b)
June 11 Q.4(b)

159
 CONSOLIDATED FINANCIAL STATEMENTS

A group is formed when one company, known as the parent, acquires control over another company, known as its
subsidiary.

The subsidiary and the holding company are considered separate legal entities. Group accounts are presented as if
the parent company and its subsidiary were one single entity – an application of the substance over form concept.

DEFINITIONS

Group of Companies arises when one company (Parent) takes control of another company (subsidiary).
Subsidiary is a company controlled by another company.
Parent is a company that controls one or more subsidiaries.
Non-Controlling Interest is a collective representation of the shareholders that normally own 49% or less of equity.
Consolidated Financial Statements means F/S of whole Group presented as a single set of accounts.
CONTROL

According to IFRS 10 Consolidated Financial Statements, an investor controls investee when it is exposed, or has
rights, to variable returns from its involvement with the investee and has the ability to affect those returns through
its power over the investee.

Existence of parent subsidiary relationship

Parent subsidiary relationship exists when:

 The parent holds more than one half of the voting power of the entity
 The parent has power over more than one half of the voting rights by virtue of an agreement with other
investors (common control)
 The parent has the power to govern the financial and operating policies of the entity under the articles of
association of the entity
 The parent has the power to appoint or remove a majority of the board of directors
 The parent has the power to cast the majority of votes at meetings of the board
Question 1

Which of the following will be treated as a subsidiary of Poulgo Co as at 31 December 20X7?

(1) The acquisition of 60% of Zakron Co’s equity share capital on 1 March 20X7. Zakron Co’s activities are
significantly different from the rest of the Poulgo group of companies
(2) The offer to acquire 70% of Unto Co’s equity share capital on 1 November 20X7. The negotiations were
finally signed off during January 20X8
(3) The acquisition of 45% of Speeth Co’s equity share capital on 31 December 20X7. Poulgo Co is able to
appoint three of the ten members of Speeth Co’s board
A 1 only
B 2 and 3
C 3 only
D 1 and 2

Solution

160
Option A

EXEMPTION FROM PREPARING GROUP ACCOUNTS

A parent need not present consolidated financial statements if the following stipulations hold:

 The parent itself is a wholly-owned subsidiary or it is a partially owned subsidiary of another entity Its
securities are not publicly traded
 The parent’s debt or equity instruments are not traded in a public market
 The parent did not file its financial statements with a securities commission or other regulatory organisation
 The ultimate parent publishes consolidated financial statements that comply with International Financial
Reporting Standards.
Question 2

Petre owns 100% of the share capital of the following companies. The directors are unsure of whether the
investments should be consolidated.

In which of the following circumstances would the investment NOT be consolidated?

A Petre has decided to sell its investment in Alpha as it is loss-making; the directors believe its exclusion from
consolidation would assist users in predicting the group’s future profits

B Beta is a bank and its activity is so different from the engineering activities of the rest of the group that it would
be meaningless to consolidate it

C Delta is located in a country where local accounting standards are compulsory and these are not compatible with
IFRS used by the rest of the group

D Gamma is located in a country where a military coup has taken place and Petre has lost control of the
investment for the foreseeable future

Solution

Option D

161
GENERAL RULES

 Same accounting policies should be used for both the holding company and the subsidiaries. Adjustments
must be made where there is a difference
 The reporting dates of parent and subsidiary will be the same in most cases. In case of difference, the
subsidiary will be allowed to prepare another set of accounts for consolidation purposes (if the difference
is of more than three months).
Accounting for subsidiaries in separate financial statements of the holding company

The holding company will usually produce its own separate financial statements. Investments in subsidiaries and
associates have to be accounted for at cost or in accordance with IFRS 9. Where subsidiaries are classified as held
for sale then the provisions of IFRS 5 have to be complied with.

Question 3

Consolidated financial statements are presented on the basis that the companies within the group are treated as if
they are a single economic entity.

Which of the following are requirements of preparing consolidated financial statements?

(1) All subsidiaries must adopt the accounting policies of the parent in their individual financial statements
(2) Subsidiaries with activities which are substantially different to the activities of other members of the
group should not be consolidated
(3) All entity financial statements within a group should normally be prepared to the same accounting
year end prior to consolidation
(4) Unrealised profits within the group must be eliminated from the consolidated financial statements

A (1) and (3)

B (2) and (4)
C (3) and (4)
D (1) and (2)

Solution

Option C

Unrealised profits are discussed later in the chapter.

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ.2
Spec. exam Sept. 16 MCQ.9
Consolidation rules
June 15 MCQ.8
Dec.14 MCQ.10
Spec. exam Sept. 16 MCQ.2
IFRS 3
June 11 Q.1 (b)

162
 CONSOLIDATED STATEMENT OF FINANCIAL POSITION

At the date of acquisition, the investment by the parent company in the subsidiary company is cancelled of against
the equity (share capital, state premium and retained earnings of subsidiary company. Any excess remaining is
known as goodwill.

All assets and liabilities of subsidiary company are than added on a line by line basis with the assets and liabilities of
the parent company.

In the consolidated statement of financial position, the share capital and share premium will ALWAYS be of Parent
Co. only.

If the parent contacts less than 100% of a subsidiary, the remaining investment is known as non-controlling interest
and a portion of equity shall now be attributable to NCI.

Types of consideration

There are five different ways in which consideration may be paid at the acquisition of subsidiary co. A sum of all of
these is called the COST OF INVESTMENT.

Consideration might be paid in the following ways:

 By cash
 By share for share exchange
 By deferred consideration
 By contingent consideration
 By loan notes
 By Cash

The consideration is calculated by multiplying the number of shares acquired with per share cash paid i.e. Total no.
of shares of subsidiary co. x % holding x cash paid per share.

 By Share for share exchange

The consideration is calculated by multiplying the number of shares issued by Parent Co. with per share price of
Parent Co. at the date of acquisition. i.e. No. of shares issued by Parent co. x Parent co. per share price

 By Deferred consideration: Deferred consideration is recorded at present value at the date of acquisition.

Initial recognition:

Dr. Cost of investment

Cr. Provision for deferred consideration

Subsequent recognition Unwinding of discount

Dr. Consolidates retained earnings

Cr. Provision for deferred consideration

163
  Contingent consideration: At times, the parent Co. agrees to pay the consideration only if some specified
conditions are met such conditions are contingent events and IFRS 3 requires to measure such
consideration at fair value.

Initial recognition:

Dr. Cost of investment

Cr. Provision for contingent consideration

Subsequent recognition

Fair value of contingent considered is re-assessed at every subsequent reporting date. Increase/ Decrease in fair
value is charged to consolidated retained earnings.

In case of increase in fair value, following double entry will be passed.

Dr. Consolidates retained earnings

Cr. Provision for contingent consideration

 By loan notes

The consideration is calculated by recording the loan notes issued to shareholders of subsidiary co. at the date of
acquisition.

The loan notes are issued to shareholders of subsidiary co. so these are NOT subsequently adjusted as inter-company
loan.

Fair Value Adjustment

All items in subsidiary co. financial statements are brought at their fair value at the date of acquisition for a valid
calculation of goodwill. Gain or loss on fair value adjustment is included in the calculation of goodwill.

Additional depreciation due to fair value adjustment is deducted from retained earnings.

Goodwill in consolidated Statement of Financial Position:

Acquisition-date fair value of consideration transferred by parent X

Plus: Fair (or full) value of the N-CI at date of acquisition X

Less: Fair value of subsidiary's identifiable net assets at date of acquisition (X)

Equals: Total Goodwill X

164
Format for detailed working of Full Goodwill calculation

Cost of investment by Parent Co. X

Fair value of NCI at the date of acquisition X XX

Fair value of net assets of subsidiary co.

Share capital X
Share premium X
Pre-acquisition retained earnings X
Pre-acquisition revaluation reserve X
Fair value adjustment X/(X) (XX)
GOODWILL XX/(XX)
Negative goodwill is called Bargain Purchase Gain. It is charged to current year statement of profit or loss as income.

Impairment of Goodwill

Under this approach the goodwill appearing in the consolidated Statement of Financial Position is the total goodwill.
The accounting treatment will be:

Dr Group retained Earnings X

Dr Non-controlling interest X

Cr Goodwill X

INTRA-GROUP BALANCES:

Intra-group balances shall be removed from consolidated statement of financial position (CSOFP) only if the balances
reconcile.

Dr. Payables
Cr. Receivables

If balances do not reconcile then there can be two possible reasons for it. It is either due to cash in transit or goods
in transit.

Make the adjustments for in transit items to bring their values at the same level in parent and subsidiary co.

• Cash in transit
DR Cash
CR Receivables

• Goods in transit
DR Inventories
CR Payables

165
Intra-Group unrealized profits

These are the profits on inventory arising as a result of inter-company/intra group sale and the goods are still unsold
at the year end.

Downstream transactions: If P Co has sold goods to S Co and these goods remain the in inventory at the year end,
the profit recognized by the parent Co. Shall be eliminated (No impact on NCI)

Dr. Consolidated Reserves

Cr. Inventory

Upstream transaction: If the S Co. has sold goods to the P.Co. the profits have been earned by the S.Co. and shall
be eliminated not only from group reserve but also from NCI

Dr. Consolidated Reserves

Dr. NCI
Cr. Inventories

Question

Patula Co acquired 80% of Sanka Co on 1 October 20X5. At this date, some of Sanka Co’s inventory had a carrying
amount of $600,000 but a fair value of $800,000. By 31 December 20X5, 70% of this inventory had been sold by
Sanka Co.

The individual statements of financial position at 31 December 20X5 for both companies show the following:

Patula Co Sanka Co

$’000 $’000

Inventories 3,250 1,940

What will be the total inventories figure in the consolidated statement of financial position of Patula Co as at 31
December 20X5?

A $5,250,000
B $5,330,000
C $5,130,000
D $5,238,000

Solution

Option A

3,250 + 1,940 + ((800 – 600) x 30%) = 5,250,000

Intra-group loans: The portion of loan given by the P.Co to its subsidiary is an intra-group receivable, payable
and shall be eliminated as such.

Dr. Loan liability

Cr. Loan Asset

166
Any interest receivable payable on such loans shall also be eliminated but only to the extent related to the parent

Dr. Interest payable

Cr. Interest receivable

If the P.Co has not recorded interest receivable on loans given to the sub Co. the first treatment is to record the
interest receivable.

Dr. Interest receivable

Cr. Consolidated reserves

After this an intra-group interest receivable payables exists which shall be eliminated

Dr. Interest payable

Cr. Interest receivable

If P.Co. has recorded the receivable but subsidiary company has not included a payable in its own financial
statements, first treatment is to record the interest payable.

After this an intra-group interest receivable, payable asset which shall be eliminated.

Intra-group dividends: If the parent Co has not recorded the dividend recoverable the first treatment is to record
the receivables.

Dr. Dividend receivable

Cr. Consolidated reserve

After this an intra-group, dividends receivable/payable exists which shall be eliminated:

Dr. Consolidated reserves

Dr. NCI
Cr. Dividend payable

Redeemable Preference Shares: Treat like any other long-term loans i.e. eliminate as an inter-company loan and
adjust for any interest accrual.

Full or fair value of NCI: IFRS-3, allows/requires goodwill to be stated at full value i.e. a part of goodwill shall now
be attributable to NCI.

Now goodwill impairment shall be charged not only to be parent company but also to NCI

Dr. NCI
Dr. Consolidated Reserves
Cr. Goodwill

Format for calculation of NCI

Fair value of NCI at the date of acquisition* X

Subsidiary Co. share of post-acquisition retained earnings X
Share of post-acquisition revaluation reserve X
Unrealised profit (Upstream transaction) (X)
Impairment of Goodwill (Share) (X)
Additional depreciation on fair value adjustment (X)
Non- controlling Interest XX

167
*If fair value of NCI is not available in question, it can be calculated by multiplying NCI no. of shares with Subsidiary
Co. per share price at the date of acquisition

Question

Rooney Co acquired 70% of the equity share capital of Marek Co, its only subsidiary, on 1 January 20X6. The fair
value of the non-controlling interest in Marek Co at acquisition was $1·1m. At that date the fair values of Marek Co’s
net assets were equal to their carrying amounts, except for a building which had a fair value of $1·5m above its
carrying amount and 30 years remaining useful life.

During the year to 31 December 20X6, Marek Co sold goods to Rooney Co, giving rise to an unrealised profit in
inventory of $550,000 at the year end. Marek Co’s profit after tax for the year ended 31 December 20X6 was $3·2m.

What amount will be presented as the non-controlling interest in the consolidated statement of financial position
of Rooney Co as at 31 December 20X6?

A $1,895,000
B $1,495,000
C $1,910,000
D $1,880,000

Solution

Option D

$ $
FV of NIC at acquisition 1,100
Profit for year x 30% 3,200
Depn on FVA (1.5m/30) (50)
Unrealized profit (550)
2,600x30% 780
1,880

Question

Pact acquired 80% of the equity shares of Sact on 1 July 2014, paying $3·00 for each share acquired. This represented
a premium of 20% over the market price of Sact’s shares at that date.

Sact’s shareholders’ funds (equity) as at 31 March 2015 were:

$ $
Equity shares of $1 each 100,000
Retained earnings at 1 April 2014 80,000
Profit for the year ended 31 March 2015 40,000 120,000
––––––– ––––––––
220,000
––––––––
The only fair value adjustment required to Sact’s net assets on consolidation was a $20,000 increase in the value of
its land.

168
Pact’s policy is to value non-controlling interests at fair value at the date of acquisition. For this purpose the market
price of Sact’s shares at that date can be deemed to be representative of the fair value of the shares held by the
non-controlling interest.

What would be the carrying amount of the non-controlling interest of Sact in the consolidated statement of
financial position of Pact as at 31 March 2015?

Solution

$56,000

Market price of Sact’s shares at acquisition was $2·50 (3·00 – (3·00 x 20/120)), therefore NCI at acquisition was
$50,000 (100,000 x 20% x $2·50). NCI share of the post-acquisition profit is $6,000 (40,000 x 9/12 x 20%). Therefore
non-controlling interest as at 31 March 2015 is $56,000.

CONSOLIDATD RETAINED EARNINGS

Format for calculation of consolidated retained earnings

Parent Co. total retained earnings X

Subsidiary Co. share of post-acquisition retained earnings X
Unrealised profit (X)
Impairment of Goodwill (Share) (X)
Additional depreciation on fair value adjustment (X)
Unwinding of present value of deferred consideration (X)
Increase/ Decrease in fair value of contingent consideration (X)/X
Any other adjustment as per question (X)/X
Consolidated Retained Earnings XX
Question

Wilmslow acquired 80% of the equity shares of Zeta on 1 April 2014 when Zeta’s retained earnings were $200,000.
During the year ended 31 March 2015, Zeta purchased goods from Wilmslow totalling $320,000. At 31 March 2015,
one quarter of these goods were still in the inventory of Zeta. Wilmslow applies a mark-up on cost of 25% to all of
its sales.

At 31 March 2015, the retained earnings of Wilmslow and Zeta were $450,000 and $340,000 respectively.

What would be the amount of retained earnings in Wilmslow’s consolidated statement of financial position as at
31 March 2015?

A $706,000
B $542,000
C $498,000
D $546,000

Solution

Option D

169
Retained earnings:
$
Wilmslow 450,000
Post acq Zeta ((340 – 200) x 80%) 112,000
URP in inventory (320,000 x ¼ x 25/125) (16,000)
––––––––
546,000
––––––––

Question

On 1 October 20X5, Anita Co purchased 75,000 of Binita Co’s 100,000 equity shares when Binita Co’s retained
earnings amounted to $90,000.

On 30 September 20X7, extracts from the statements of financial position of the two companies were:
Anita Co Binita Co
$’000 $’000
Equity shares of $1 each 125 100
Retained earnings 300 150
–––– ––––
Total 425 250
–––– ––––

What is the total equity attributable to the owners of Anita Co that should appear in Anita Co’s consolidated
statement of financial position as at 30 September 20X7?

A $125,000
B $470,000
C $345,000
D $537,500

Solution

Option B

Retained earnings = 300 + ((150 – 90) x 75%) = 345

Total equity = 125 + 345 = 470

PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept./Dec. 17 Q. 32
March/June 17 Q. 32
Sept. 16 MCQ. 10,12,13,14
March/June 16 Q.1
Spec. exam Sept. 16 MCQ.10,15
Dec. 15 Q.3a
Consolidated SOFP
June 15 MCQ.5,11,12,14
Dec. 14 MCQ.16 Q.3(a),(c)
Dec. 13 Q.1(a)
June 13 Q.1
June 12 Q.1
Dec. 11 Q.1

170
 CONSOLIDATED STATEMENT PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME

The basic idea of preparing consolidated statement of profit or loss is to show the results of the group as if it were a
single entity.

The majority of figures are simple aggregations of the results of the parent and all the subsidiaries (line by line) down
to profit after tax.

In aggregating the results of the parent and subsidiaries, intra-group transactions such as dividend income, interest
income and unrealised profits are eliminated.

Any non-controlling interest is ignored until profit after tax. Their interest in profits after tax is then subtracted as a
one-liner to leave profits attributable to members of the parent.

P group plc - Pro-forma Consolidated statement of profit or loss

For year ended 30 November 20X6

$'m
Sales revenue (P+S less intra-group sales) X
Cost of Sales (P+S less intra-group purchases plus unrealised profit in inventory) (X)
Gross Profit X
Distribution Costs (P+S) (X)
Administrative Expenses (P+S) (X)
Group operating Profit X
Interest and similar income receivable (P+S less intra group interest income) X
Interest expenses (P+S less intra-group interest expense) (X)
X
Share of Profits of Associate (PAT) X
Profit before tax X
Income tax expense (P+S) (X)
Profit for the period X
Profit attributable to :
Owners of the parent X
Non-controlling interest X
X
OTHER ADJUSTMENTS

 If the subsidiary is acquired during the current accounting period it is necessary to apportion the profit for
the period between its pre-acquisition and post-acquisition elements. This is dealt with by determining on
a line-by-line basis the post-acquisition figures of the subsidiary.
 After profit after tax in consolidated statement of profit or loss, total profits are divided between profits
attributable to group and profit attributable to NCI
 Any dividends receivable by the parent must be cancelled against dividends paid from the subsidiary
undertaking.
 Where group companies trade with each other one will record a sale and the other an equal amount as a
purchase. These items must be removed from the consolidated statement of profit or loss by cancelling
from both sales and cost of sales.

171
Question

Parket Co acquired 60% of Suket Co on 1 January 20X7. The following extract has been taken from the individual
statements of profit or loss for the year ended 31 March 20X7:

Parket Co Suket Co

$’000 $’000

Cost of sales 710 480

Parket Co consistently made sales of $20,000 per month to Suket Co throughout the year. At the year end, Suket Co
held $20,000 of this in inventory. Parket Co made a mark-up on cost of 25% on all sales to Suket Co.

What is Parket Co’s consolidated cost of sales for the year ended 31 March 20X7?

A $954,000
B $950,000
C $774,000
D $766,000

Solution

Option C

710,000 + (480,000 x 3/12) – (20,000 x 3) + (20,000 x 25/125) = $774,000

 The unrealized profit adjustment is to increase cost of sales. In case of upstream transaction, the unrealized
profit is deducted from profit attributable to NCI also.
 Investment in loans means an intra-group finance cost as well as inter-group dividends.
 These will cancel out in basically the same way as for dividends.
 Impairment of goodwill is treated as an administration expense unless otherwise stated
 There is no impact of fair value adjustment on acquisition at the statement of profit or loss. However, any
additional depreciation related to such fair value adjustment must be charged by adding to cost of sales
and deducting from profit after tax of subsidiary while calculating profit attributable to NCI
PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept. 16 MCQ. 5
Spec. exam Sept. 16 MCQ.8
June 15 Q.1
Dec. 14 Q.3(b)
Consolidated P&L
June 14 Q.1
Dec. 13 Q.1(b)
Dec. 12 Q.1
June 11 Q.1

172
 INVESTMENTS IN ASSOCIATES & DISPOSAL OF SUBSIDIARY

IAS 28 – INVESTMENTS IN ASSOCIATES

SCOPE

This Standard shall be applied in accounting for investments in associates.

DEFINITIONS

The following terms are used in this Standard with the meanings specified:-

 An associate is an entity, including an unincorporated entity such as a partnership, over which the investor
has significant influence and that is neither a subsidiary nor an interest in a joint venture.
 The equity method is a method of accounting whereby the investment is initially recognized at cost and
adjusted thereafter for the post-acquisition change in the investor’s share of net assets of the investee. The
profit or loss of the investor includes the investor’s share of the profit or loss of the investee.
 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. Investments of 20% to 50% in voting power
of companies lead to existence of significant influence. Significant influence by an investor is usually
evidenced in one or more of the following ways:-

a. Representation on the board of directors or equivalent governing body of the investee.

b. Participating in policy making process, including participation in decisions about dividends or other
distributions.
c. Material transactions between the investor and the investee
d. Interchange of managerial personnel; or
e. Provision of essential technical information.
ACCOUNTING OF ASSOCIATE

Associate should be accounted for in consolidated financial statement using equity method; i.e. investment is

 Initially recorded at cost;

 Adjusted for post-acquisition change in net assets (investor share); Or post acquisition profits/losses
(investor share);
 The profit or loss of the investor includes the investor’s share of the profit or loss of the investee.
 Dividend paid or distributions made will reduce the investment.
 On acquisition any difference between the cost of investment and investor’s share of net fair value of
associate’s identifiable assets, liabilities and contingent liabilities is accounted for in accordance with IFRS-
3.
 Goodwill relating to an associate is included in the carrying value of investment
 Any excess of the investor’s share of net fair value of the associate’s assets, liabilities and contingent
liabilities over the cost of investment is excluded from the carrying value of investment and is included in
the statement of profit or loss of the year of acquisition.
 Adjustments in investor’s share of profit and loss after acquisition are made in respect of depreciation based
on Fair Value.
 If different reporting dates, adjust the effect of significant events between reporting dates;
 The investor’s financial statements shall be prepared using uniform accounting policies for like transactions
and events in similar circumstances.

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  If the investor’s share of losses exceeds or equals its interest in associate, the investor will discontinue the
recognition of further losses. Additional losses can only be recognized if there exist any legal or constructive
obligation
 Impairment test will be applied on the entire amount of investment under IAS -36 and the impairment loss
will be recognized.
 In case of trading between group and associate, the profits or losses resulting from these transactions are
recognized in the investor’s financial statements only to the extent of un-related investor’s interest in
associate.
 No netting-off is done between receivables and payables
EXCEPTIONS TO THE EQUITY METHOD

An investment in an associate shall be accounted for using the equity method except when:

1) There is an evidence that the investment is acquired and held exclusively with a view to its disposal within twelve
months from acquisition date (Then apply IFRS -5).
2) All of the following apply:
a. The investor is a wholly-owned subsidiary its other owners do not object if the investor does not apply the
equity method;
b. The investor’s debt or equity instruments are not traded in a public market
c. The investor did not file its financial statements with securities commission, and
d. The ultimate parent of the investor produces consolidated financial statements.
Some noteworthy points include:

 Investment described in 1 above shall be classified as held for trading and accounted for in accordance
with IFRS-5.
EQUITY METHOD

Statement of profit or loss

 Dividend income from associates (reported in the investor's books) is replaced by the profit after tax of the
associate.
STATEMENT OF FINANCIAL POSITION

Initially the Investments in Associates is shown at cost (same as in the individual accounts), identifying any goodwill
included in the cost.

In subsequent years the Investor's accounts will show:

 The investment at cost

 Plus group share of associate's post acquisition reserves.
 Less any impairment of investment to date.

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On the bottom of the statement of financial position consolidated reserves will reflect the other side of these
adjustments.

Method $
Cost of Investment X
Plus group share of post-acquisition reserves X
Less impairment of investment (X)
INVESTMENT IN ASSOCIATES X
Question

Johnson paid $1·2 million for a 30% investment in Treem’s equity shares on 1 August 2014. Treem’s profit after tax
for the year ended 31 March 2015 was $750,000. On 31 March 2015, Treem had $300,000 goods in its inventory
which it had bought from Johnson in March 2015. These had been sold by Johnson at a mark-up on cost of 20%.
Treem has not paid any dividends.

On the assumption that Treem is an associate of Johnson, what would be the carrying amount of the investment
in Treem in the consolidated statement of financial position of Johnson as at 31 March 2015?

A $1,335,000
B $1,332,000
C $1,300,000
D $1,410,000
Solution

Option A

$’000
Investment at cost 1,200
Share of post-acq profit 150 (750 x 8/12 x 30%)
URP in inventory (15) (300 x 20/120 x 30%)
––––––
1,335
––––––

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 DISPOSAL OF INVESTMENT

Subsidiaries are consolidated until the date control is lost therefore profits need to be time-apportioned.

 Disposal occurs when control is lost over subsidiary. Financial Reporting (F7) syllabus includes only full
disposal i.e. all the holding is sold (say, 70% to nil)
 The effective date of disposal is when control is lost
 Following is the accounting treatment for full disposal
 In case of Statement of profit or loss and other comprehensive income, consolidate results and
non-controlling interests to the date of disposal.
 Show the group profit or loss on disposal
 In case of Statement of financial position, there will be no non-controlling interests and no
consolidation as there is no subsidiary at the date the statement of financial position is being
prepared.
Parent company's accounts

In the parent's individual financial statements the profit or loss on disposal of a subsidiary will be calculated as:

$
Sales proceeds X
Less: Carrying amount (cost in P's own statement of financial position) (X)
Profit (loss) on disposal X/(X)
Group accounts – Gain/loss on disposal of subsidiary

In the group financial statements the profit or loss on disposal will be calculated as:

$ $
Proceeds X
Less: Amounts recognised prior to disposal:
Net assets of subsidiary X
Goodwill X
Non-controlling interest _(X)_
Profit / loss X/(X)

 If the disposal is mid-year:

- A working will be required to calculate both net assets and the non-controlling interest at the disposal
date.
- Any dividends declared or paid in the year of disposal and prior to the disposal date must be deducted
from the net assets of the subsidiary if they have not already been accounted for.
 Goodwill recognised prior to disposal is original goodwill arising less any impairment to date.

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 PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Spec. exam Sept. 16 MCQ.11
Dec. 15 Q.3b
Associates
June 15 MCQ.18
Dec. 11 Q.1

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 INTERPRETATION OF FINANCIAL STATEMENTS AND RATIO ANALYSIS

Ratio analysis is a technique whereby complicated information is summarised to a common denominator so that a
meaningful comparison of the company's performance and financial position can be made.

Financial statements provide important financial information for people who do not have access to the internal
accounts. For example, current and potential shareholders can see how much profit a company has made, the value
of its assets, and the level of its cash reserves. Although these figures are useful they do not mean a great deal by
themselves. If the user is to make any real sense of the figures in the financial statements, they need to be properly
analysed using accounting ratios and then compared with either the previous year’s ratios, or measured against
averages for the industry.

ANALYSIS AND INTERPRETATION

Calculation of key ratios from Explanation of ratios to

financial statements establish strengths and
weaknesses

PURPOSE
Depends on USER

Management Lender / analyst Investors / analyst

Cost control Lending Buy/Hold/Sell shares
Profitability analysis Security Quality of management
Investment decisions Credit worthiness

Comparison required with:

Previous years
Predetermined forecasts
Industry averages

LIMITATIONS

Availability of information Consistency Historic cost accounting

Cost/difficulty of obtaining Changes in accounting policies Inherent limitations of HCA in
Information between years periods of price level
changes
Different policies used by different
companies
The scenario of a performance appraisal question can take many forms.

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Vertical or trend analysis

A company's performance may be compared to its previous period's performance. Past results may be adjusted for
the effects of price changes. This is referred to as trend or vertical analysis. A weakness of this type of comparison is
that there are no independent benchmarks to determine whether the chosen company's current year results are
good or bad. Just because a company's results are better than its results in the previous financial period - it does not
mean the results are good. It may be that its results in the prior year were particularly poor.

Horizontal analysis

To try to overcome the problem of vertical analysis, it is common to compare a company's performance for a
particular period with the performance of an equivalent company for the same period. This introduces an
independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in
the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a
comparator may have performed particularly well or particularly poorly.

Industry average comparison

This type of analysis compares a company's results (ratios) to a compilation of the average of many other similar
types of company. Such schemes are often operated on a subscription basis whereby subscribing companies
calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from
all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single
company.

The context of the analysis needs to be kept in mind. A student may be asked to compare two companies as a basis
for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be
asking for advice on how their investment in a company has performed. A bank may be considering offering a loan
to a company and requires advice. It may be that the chief executive asks for the chief accountant’s opinion on your
company's results

WHAT IS THE OBJECTIVE OF FINANCIAL STATEMENTS?

To provide information about the financial position, performance and financial adaptability of an enterprise that is
useful to a wide range of users for assessing the stewardship of management and for making economic decisions

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 PROVIDE USEFUL INFORMATION ON

Financial Performance Financial

Position adaptability

Statement of  Statement of profit or Statement of Resources, solvency &

Financial Position loss Financial Position financial structure

 Statement of Statement of profit Performance &

Changes in equity or loss Distributions

 Statement of Cash Statement of Realised gains/losses &

flows changes in equity unrealized gains losses
(reserve movements)

Cash flows Amounts of cash flow

statement Timings of cash flow
Quality of profits
Who are these users and what information do they want?

Shareholders (investment decisions) Profit and dividend prospects

Loan creditors (lending decisions) Creditworthiness and liquidity

Employees (safety of employment) Wage bargaining and future prospects

Suppliers (credit decisions) Ability to pay on time and short term liquidity

Note that most users will be interested in what has happened in the past, and what may happen in the future!

OVERVIEW

DIVISION OF RATIOS

PERFORMANCE LIQUIDITY EFFICIENCY STOCK MARKET

ROCE%  SHORT Inventory t/o in days ROE%

TERM

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 Profit margin% Current ratio Debtors t/o in days EPS
Creditors t/o in days Dividend yield%
Gross profit% Acid-test ratio

Net profit%  LONG TERM Asset turnover

Gearing Dividend cover

Interest cover
Calculating a ratio is easy, and usually is little more than dividing one number by another. Indeed, the calculations
are so basic that they can be programmed into a spreadsheet. The real skill comes in interpreting the results and
using that information. Saying

That a ratio has increased because the top line in the calculation has increased (or the bottom line decreased) is
rather pointless: this is simply translating the calculation into words. Use the mnemonic RATIO to remind yourself
to keep asking the following questions:

¤ Reason – why has this change occurred?

¤ Accident – is the change real or simply an accident of timing?

¤ Test – what can be done to test our conclusions? What other work should we do?

¤ Implications – what does this change mean? Liquidity crisis? Poor management etc?

¤ Other information – is this consistent with other information?

EXAM TECHNIQUE:

• RATIO ANALYSIS-----------use appendices to show calculations / always show formula used

• COMMENTS (cause) & CONSEQUENCES (effect)

3 steps

- The gearing ratio has moved from......}

- The gearing ratio measures.................} What is the overall picture?

- The move may be due to................}

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 STYLE OF REPORT

FORMAT STRUCTURE BE CONCISE

Formal: External Use sub-headings: Keep it simply and short

Introduction Avoid
Informal: Internal Separate paragraphs
Conclusion
INTERPRETATION OF RATIOS

Ratios can generally be broken down into several key areas: profitability, liquidity, gearing and investment.

PROFITABILITY

Profitability ratios, as their name suggests, measure the organisation’s ability to deliver profits. Profit is necessary to
give investors the return they require, and to provide funds for reinvestment in the business. Three ratios are
commonly used.

Return on capital employed (ROCE)

Profit before interest and tax

Shareholders' equity + debt

This ratio is generally considered to be the primary profitability ratio as it shows how well a business has generated
profit from its long term financing. An increase in ROCE is generally considered to be an improvement.

So, Return on capital employed (sometimes known as return on investment or ROI) measures the return that is being
earned on the capital invested in the business. It measures how efficiently and effectively management has
deployed the resources available to it, irrespective of how those resources have been financed.

Candidates are sometimes confused about which profit and capital figures to use. What is important is to compare
like with like. Operating profit (profit before interest) represents the profit available to pay interest to debt investors
and dividends to shareholders. It is therefore compared with the long-term debt and equity capital invested in the
business (non-current liabilities + total equity). By similar logic, if we wished to calculate return on ordinary
shareholders funds (the return to equity holders), we would use profit after interest and tax divided by total equity).

A return on capital is necessary to reward investors for the risks they are taking by investing in the company. As
mentioned earlier, generally, the higher the ROCE figure, the better it is for investors. It should be compared with
returns on offer to investors on alternative investments of a similar risk.

Movements in return on capital employed are best interpreted by examining profit margins and asset turnover in
more detail (often referred to as the secondary ratios) as ROCE is made up of these component parts. For example,
an improvement in ROCE could be due to an improvement in margins or more efficient use of assets.

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Asset turnover

Revenue
Total assets - current liabilities

Asset turnover shows how efficiently management have utilised assets to generate revenue. When looking at the
components of the ratio a change will be linked to either a movement in revenue, a movement in net assets, or both.

There are many factors that could both improve and deteriorate asset turnover. For example, a significant increase
in sales revenue would contribute to an increase in asset turnover or, if the business enters into a sale and lease
back agreement, then the asset base would become smaller, thus improving the result.

In other words, this ratio measures the ability of the organisation to generate sales from its capital employed. A
possible variant is non-current asset turnover (revenue ÷ non-current assets). Generally the higher the better, but
in later studies you will consider the problems caused by overtrading (operating a business at a level not sustainable
by its capital employed). Commonly a high asset turnover is accompanied with a low return on sales and vice versa.
Retailers generally have high asset turnovers accompanied by low margins.

Profit margins

Gross profit
Revenue

The gross profit margin looks at the performance of the business at the direct trading level. Typically variations in
this ratio are as a result of changes in the selling price/sales volume or changes in cost of sales. For example, cost of
sales may include inventory write downs that may have occurred during the period due to damage or obsolescence,
exchange rate fluctuations or import duties.

Gross margin focuses on the organisation’s trading activities. Once again, in simple terms, the higher the better, with
poor performance often being explained by prices being too low or costs being too high.

Changes in the gross profit percentage ratio can be caused by a number of factors. For example, a decrease may
indicate greater competition in the market and therefore lower selling prices and a lower gross profit or,
alternatively, an increase in the cost of purchases. An increase in the gross profit percentage may indicate that the
company is in a position to exploit the market and charge higher prices for its products or that it is able to source its
purchases at a lower cost.

Operating profit
Revenue

The operating profit margin (or net profit margin) is generally calculated by comparing the profit before interest and
tax of a business to revenue, but, beware in the exam as sometimes the examiner specifically requests the calculation
to include profit before tax.

Analysing the operating profit margin enables you to determine how well the business has managed to control its
indirect costs during the period. In the exam when interpreting operating profit margin it is advisable to link the
result back to the gross profit margin. For example, if gross profit margin deteriorated in the year then it would be
expected that operating margin would also fall.

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However, if this is not the case, or the fall is not so severe, it may be due to good indirect cost control or perhaps
there could be a one-off profit on disposal distorting the operating profit figure.

The relationship between the gross and the net profit percentage gives an indication of how well a company is
managing its business expenses. If the net profit percentage has decreased over time while the gross profit
percentage has remained the same, this might indicate a lack of internal control over expenses.

LIQUIDITY

This measures the ability of the organisation to meet its short-term financial obligations. Liquidity refers to the
amount of cash a company can generate quickly to settle its debts. A reasonable level of liquidity is essential to the
survival of a company, as poor cash control is one of the main reasons for business failure.

The two commonly used ratios are Current ratio and Quick ratio.

Current ratio

Current assets
Current liabilities

The current ratio compares liabilities that fall due within the year with cash balances and assets that should turn into
cash within the year. It assesses the company’s ability to meet its short-term liabilities. The current ratio considers
how well a business can cover the current liabilities with its current assets.

Therefore, this ratio compares a company’s liquid assets (ie cash and those assets held which will soon be turned
into cash) with short-term liabilities (payables/creditors due within one year). The higher the ratio the more liquid
the company. As liquidity is vital, a higher current ratio is normally preferred to a lower one.

Traditionally textbooks tell us that this ratio should exceed 2.0:1 for a company to be able to safely meet its current
liabilities should they fall due. However this ideal will vary from industry to industry. For example, a business in the
service industry would have little or no inventory and therefore could have a current ratio of less than 1. This does
not necessarily mean that it has liquidity problems so it is better to compare the result to previous years or industry
averages. Many companies operate safely at below the 2:1 level.

A current ratio of less than one is often considered alarming as there might be going concern worries, but you have
to look at the type of business before drawing conclusions. In a supermarket business, inventory will probably turn
into cash in a stable and predictable manner, so there will always be a supply of cash available to pay the liabilities.

A very high current ratio is not necessarily good. It could indicate that a company is too liquid. Cash is often described
as an ’idle asset‘ because it earns no return, and carrying too much cash is considered wasteful. A high ratio could
also indicate that the company is not making sufficient use of cheap short-term finance and its ratio may suggest
that funds are being tied up in cash or other liquid assets, and may not be earning the highest returns possible.

Quick ratio (sometimes referred to as acid test ratio)

Current assets - inventory

Current liabilities

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A stricter test of liquidity is the acid test ratio (also known as the quick ratio) which excludes inventory/stock as a
current asset. This approach can be justified because for many companies inventory/stock cannot be readily
converted into cash. In a period of severe cash shortage, a company may be forced to sell its inventory/stock at a
discount to ensure sales.

The quick ratio excludes inventory as it takes longer to turn into cash and therefore places emphasis on the business's
'quick assets' and whether or not these are sufficient to cover the current liabilities. Here the ideal ratio is thought
to be 1:1 but as with the current ratio, this will vary depending on the industry in which the business operates.

When assessing both the current and the quick ratios, look at the information provided within the question to
consider whether or not the company is overdrawn at the year-end. The overdraft is an additional factor indicating
potential liquidity problems and this form of finance is both expensive (higher rates of interest) and risky (repayable
on demand).

In practice a company’s current ratio and acid test should be considered alongside the company’s operating
cashflow. A healthy cashflow will often compensate for weak liquidity ratios.

Caution should always be exercised when trying to draw definite conclusions on the liquidity of a company, as both
the current ratio and the acid test ratio use figures from the Statement of financial position. The Statement of
financial position is only a ‘snapshot’ of the financial position at the end of a specific period. It is possible that the
Statement of financial position figures are not representative of the liquidity position during the year. This may be
due to exceptional factors, or simply because the business is seasonal in nature and the Statement of financial
position figures represent the cash position at just one particular point in the cycle.

Receivables collection period (in days)

Receivables x 365
Credit sales

The receivables/debtors collection period (in days or months) provides an indication of how successful (or efficient)
the debt collection process has been. For liquidity purposes the faster money is collected the better. Therefore, it is
preferable to have a short credit period for receivables as this will aid a business's cash flow. However, some
businesses base their strategy on long credit periods. When too high, it may be that some irrecoverable (bad) debts
have not been provided for, or an indication of worsening credit control. It may also be deliberate, e.g. the company
has decided to offer three-months' credit in the current year, instead of two as in previous years. It may do this to
try to stimulate higher sales and be more competitive than similar entities offering shorter credit periods.

If the receivables days are shorter compared to the prior period it could indicate better credit control or potential
settlement discounts being offered to collect cash more quickly whereas an increase in credit periods could indicate
a deterioration in credit control or potential bad debts. However, too much pressure on customers to pay quickly
may damage a company’s ability to generate sales.

Payables collection period (in days)

Payables x 365
Credit purchases*

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*(or use cost of sales if purchases figure is not available)

Payable days measures the average amount of time taken to pay suppliers. Because the purchases figure is often
not available to analysts external to the business, the cost of sales figure is often used to approximate purchases.

An increase in payables days could indicate that a business is having cash flow difficulties and is therefore delaying
payments using suppliers as a free source of finance. If the payables’ period is too long, it may be an indication of
poor liquidity (perhaps at the overdraft limit), and there may be a danger of further or renewed credit being refused
by suppliers. It is important that a business pays within the agreed credit period to avoid conflict with suppliers. If
the payables days are reducing this indicates suppliers are being paid more quickly. This could be due to credit terms
being tightened or taking advantage of early settlement discounts being offered.

Inventory days

Closing (or average) inventory x 365

Cost of sales

It measures how long a company carries inventory before it is sold. Therefore, the inventory/stock turnover period
indicates the average number of days that inventory/stock is held for. A company needs to carefully plan and manage
its inventory/stock levels. Ideally, it must avoid tying up too much capital in inventory/stock, yet the inventory/stock
levels must always be sufficient to meet customer demand.

Generally the lower the number of days that inventory is held the better as holding inventory for long periods of
time constrains cash flow and increases the risk associated with holding the inventory. The longer inventory is held
the greater the risk that it could be subject to theft, damage or obsolescence. However, a business should always
ensure that there is sufficient inventory to meet the demand of its customers. Too little inventory can result in
production stoppages and dissatisfied customers.

If the holding period is long, it may be an indication of obsolete stock or poor sales achievement. Sales may have
fallen (perhaps due to an economic recession), but the company has been slow to cut back on production, or an
unnecessary build up of inventory levels.

A change in the inventory/stock turnover period can be a useful indicator of how well a company is doing. Inventory
turnover can also be calculated using the following formula. It shows the above inventory days in terms of inventory
turnover times.

Inventory turnover:

Cost of sales____________

(Average or closing) inventory

Liquidity problems may also be caused by 'overtrading'. In some ways this is a symptom of the success of the
business. It is usually a lack of adequate financing and may be solved by an injection of capital.

GEARING/ CAPITAL GEARING

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Company directors often spend a great deal of time and money to make this ratio appear in line with acceptable
levels.

Current and potential investors will be interested in a company’s financing arrangements. The extent to which a
company is financed by outside parties is referred to as gearing. The level of gearing in a company is an important
factor in assessing risk. A company that has borrowed money obviously has a commitment to pay future interest
charges and make capital repayments. This can be a financial burden and possibly increase the risk of insolvency.
Most companies will be geared to some extent.

The gearing ratio measures the company’s commitments to its long-term lenders against the long-term capital in
the company. The level of gearing will be influenced by a number of factors, for example the attitude of the owners
and managers to risk, the availability of equity funds, and the type of industry in which the company operates.

Its main importance is that as borrowings rise, risk increases (in many ways) and as such, further borrowing is difficult
and expensive. Many companies have limits to the amount of borrowings they are permitted to have. These may be
in the form of debt covenants imposed by lenders or they may be contained in a company's Articles, such as a
multiple of shareholders funds.

Measures of gearing

Gearing is basically a comparison of debt to equity. Preference shares are usually treated as debt for this purpose.
There are two alternatives:

Debt or Debt
Equity Debt + equity

Also known as leverage. Capital gearing looks at the proportions of owner’s capital and borrowed capital used to
finance the business. Many different definitions exist; the two most commonly used ones are given above. When
necessary in the exam, you will be told which definition to use.

A large proportion of borrowed capital is risky as interest and capital repayments are legal obligations and must be
met if the company is to avoid insolvency. The payment of an annual equity dividend on the other hand is not a legal
obligation. Despite its risks, borrowed capital is attractive to companies as lenders accept a lower rate of return
than equity investors due to their secured positions. Also interest payments, unlike equity dividends, are corporation
tax deductible.

Levels of capital gearing vary enormously between industries. Companies requiring high investment in tangible
assets are commonly highly geared. Consequently, it is difficult to generalise about when capital gearing is too high.
However, most accountants would agree that gearing is too high when the proportion of debt exceeds the
proportion of equity.

The gearing ratio is of particular importance to a business as it indicates how risky a business is perceived to be based
on its level of borrowing. As borrowing increases so does the risk as the business is now liable to not only repay the
debt but meet any interest commitments under it. In addition, to raise further debt finance could potentially be
more difficult and more expensive.

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If a company has a high level of gearing it does not necessarily mean that it will face difficulties as a result of this.
For example, if the business has a high level of security in the form of tangible non-current assets and can
comfortably cover its interest payments () a high level of gearing should not give an investor cause for concern.

Interest cover

Interest cover = Profit before interest and tax

Interest

This is sometimes known as income gearing. It looks at how many times a company’s operating profits exceed its
interest payable. The higher the figure, the more likely a company is to be able to meet its interest payments.
Anything in excess of four is usually considered to be safe.

As mentioned above, the interest cover ratio measures the amount of profit available to cover the interest payable
by the company. The lower the level of interest cover the greater the risk to lenders that interest payments will not
be met. If interest payments and capital repayments are not paid when they fall due there can be serious
consequences for a company. In the event of a default, a lender may have the right to seize the assets on which the
loan is secured and sell them to repay the amount outstanding. Where lenders do not have security on their loan,
they could still apply to the courts for the winding up of a company so that assets can be liquidated and debts repaid.

INVESTMENT RATIOS

Earnings per share

Profit after tax and preference dividends

Number of equity shares in issue

The earnings per share ratio of a company represents the relationship between the earnings made during an
accounting period (and available to shareholders) and the number of shares issued. For ordinary shareholders, the
amount available will be represented by the net profit after tax (less any preference dividend where applicable).

Many investment analysts regard the earnings per share ratio as a fundamental measure of a company’s
performance. The trend in earnings per share over time is used to help assess the investment potential of a
company’s shares. However, an attempt should be made to take into account the effect of a company increasing its
retained earnings. Most companies retain a significant proportion of the funds they generate, and hence their
earnings per share will increase even if there is no increase in profitability.

In isolation, this ratio is meaningless for inter-company comparisons. Its major usefulness is as part of the P/E ratio,
and as a measure of profit trends.

Price/earnings ratio

Market price of equity share

EPS

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This is calculated by dividing a company's market price by its EPS. Say the price of a company's shares is $2.40, and
its last reported EPS was 20c. It would have a P/E ratio of 12. The mechanics of the movement of a company's P/E
ratio are complex, but if this company's EPS improved to 24c in the following year, it would not mean that its P/E
ratio would be calculated as 10 ($2.40/24c). It is more likely that its share price would increase such that it
maintained or even improved its P/E ratio. If the share price increased to say $2.88, the P/E ratio would remain at
12 ($2.88/24c). This demonstrates the real importance of EPS in the way it has a major influence on a company's
share price.

The price earnings ratio compares the benefits derived from owning a share with the cost of purchasing such a share.
It provides a clear indication of the value placed by the capital market on those earnings and what it is prepared to
pay for participation. It reflects the capital market assessment of both the amount and the risk of these earnings,
albeit subject to overall market and economic considerations.

Earning yield

________EPS____________

Market price per equity share

This is a relatively 'old' ratio which has been superseded by the P/E ratio. It is in fact its reciprocal. Earnings yield is
the EPS/share price x 100. In the above example, a P/E ratio of 12 would be equivalent to an earnings yield of 8.3%.

Dividend yield

Ordinary dividends appropriated in period

Market price of equity shares

This is similar to the above except that the dividend per share is substituted for the EPS. It is a crude measure of the
return to shareholders, but it does ignore capital growth which is often much higher than the return for dividends.

The dividend yield compares the amount of dividend per share with the market price of a share, and provides a
direct measure of the return on investment in the shares of a company. Investors are able to use this ratio to assess
the relative merits of different investment opportunities.

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Dividend cover

Profit after tax and preference dividends

Ordinary dividends appropriated in period

This is the number of times the current year's dividend could have paid out of the current year's profit available to
ordinary shareholders. It is a measure of security. A high figure indicates high levels of security. In other words,
profits in future years could fall substantially and the company would still be able to pay the current level of
dividends. An alternative view of a high dividend cover is that it indicates that the company operates a low dividend
distribution policy.

The dividend cover ratio focuses on the security of the current rates of dividends, and therefore provides a measure
of the likelihood that those dividends will be maintained in the future. It does this by measuring the proportion
represented by current rates of dividends of the profits from which such dividends can be declared without drawing
on retained earnings. The higher the ratio, the more profits can decline without dividends being affected.

LIMITATIONS OF RATIO ANALYSIS

1. It is an oversimplification of a harsh business world

2. Ratios are based on highly subjective accounting figures
3. Historical cost accounts do not take into account the impact of inflation
4. Ratios do not make allowances for external factors: economic or political
5. Users are more interested in future prospects rather than past events

Specific problems IN FR Exam

When marking this style of question there are some common weaknesses that are identified by examiner, some of
which are highlighted below:

 Limited knowledge of ratio calculations

 Appraisal not linked to scenario
 Poor understanding of the topic
 Limited understanding of what accounting information represents
 Lack of commercial awareness
 Discursive elements often not attempted
 Inability to come to a conclusion
 Poor English.

The majority of questions that feature performance appraisal have an accompanying scenario to the question
requirement. A weak answer will make no attempt to refer to this information in the appraisal and, therefore, will
often score few marks. It is important that you carefully consider this information and incorporate it into your
appraisal because it has been provided for a reason. Do not simply list all the possibilities of why a ratio may have
changed; link the reason to the scenario that you have been provided with.

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Exam approach
In an exam there is a (time) limit to the amount of ratios that may be calculated. A structured approach is useful
where the question does not specify which ratios to calculate:

 Limit calculations to important areas and avoid duplication (e.g. inventory turnover and inventory holding
periods)
 It is important to come to conclusions, as previously noted, candidates often get carried away with the ratio
calculations and fail to comment on them
 Often there are some 'obvious' conclusions that must be made (e.g. liquidity has deteriorated dramatically,
or a large amount of additional non-current assets have been purchased without a proportionate increase
in sales).

COMPREHENSIVE EXAMPLE

Superlit Co is a public listed company. During the year ended 31 October 20X4 the directors decided to cease
operations of one of its activities and put the assets of the operation up for sale (the discontinued activity has no
associated liabilities). The directors have been advised that the cessation qualifies as a discontinued operation and
has been accounted for accordingly.

Extracts from Superlit Co’s financial statements are set out below.

Note: the statement of profit or loss figures down to the profit for the period from continuing operations are those
of the continuing operations only.

Statements of profit or loss for the year ended 31 October 20X4

$million
Revenue 56
Cost of sales (40)
Gross profit 16
Operating expenses (5.8)
10.2
Finance costs (1.2)
Profit before taxation 9
Income tax expense (2)
Profit for the period from continuing operations 7
Profit/(Loss) from discontinued operations (3)
Profit for the period 4
Analysis of discontinued operations:

$million
Revenue 15
Cost of sales (17)
Gross profit/(loss) (2)
Operating expenses (0.8)
Profit/(loss) before taxation (2.8)
Tax (expense)/relief 0.6
(2.2)
Loss on measurement to fair value of disposal group (1)
Tax relief on disposal group 0.2
Profit/(Loss) from discontinued operations (3)

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 Statement of financial position as at 31 October 20X4
$million $million
Property, plant and equipment 35
Current assets
Inventory 2.5
Trade receivables 4
Assets held for sale (at fair value) 12 18.5
Total assets 53.5

Equity and liabilities

Equity shares of $1 each 20
Retained earnings 9 29
Non-current liabilities
5% loan notes 16
Current liabilities
Bank overdraft 2.3
Trade payables 4.3
Current tax payable 1.9 8.5
Total equity and liabilities 53.5
The relevant data and ratios for the continuing operations for the year ended 31 October 20X3 are as follows:

Return on capital employed (ROCE) 34.6%

Sales $42 million
Profit before tax (Discontinued operations) $1 million
Gross profit percentage 28.3%
Operating expense percentage of sales revenue 11.5%
Profit before interest and tax margin 17.7%
Asset turnover 1.92
Current ratio 1.01
Current ratio (excluding held for sale) Not applicable
Quick ratio (excluding held for sale) 0.65
Inventory (closing) turnover 11.1
Receivables (in days) 39.6
Payables/cost of sales (in days) 59
Gearing 27.8%
Required:

Analyse the financial performance and position of Superlit Co for the two years ended 31 October 20X4.

Note: Your analysis should be supported by appropriate ratios and refer to the effects of the discontinued operation.

(20 marks)

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Profitability

An important feature of the company’s performance in the year to 31 October 20X4 is the evaluation of the effect
of discontinued operation. When using an entity’s recent results as a basis for assessing how the entity may perform
in the future, emphasis should be placed on the results from continuing operations as it is these that will form the
basis of future results. For this reason most of the ratios calculated in the appendix are based on the results from
continuing operations and ratio calculations involving net assets/capital employed generally exclude the value of the
assets held for sale.

On this basis, it can be seen that the overall efficiency of Superlit (measured by its ROCE) has declined considerably
from 34·6% to 30·9% (a fall of 10·7%). The fall in the asset turnover (from 1·92 to 1·7 times) appears to be mostly
responsible for the overall decline in efficiency. In effect the company’s assets are generating less sales per $1
invested in them. The other contributing factors to overall profitability are the company’s profit margins. Superlit
has achieved an impressive increase in sales revenues of nearly 33.3% (14m on 42m) whilst being able to maintain
its gross profit margin at 28.6% (no significant change from 20X3). This has led to a substantial increase in gross
profit, but this has been eroded by an increase in operating expenses. As a percentage of sales, operating expenses
were 10·4% in 20X4 compared to 11·5% in 20X3 (they appear to be more of a variable than a fixed cost). This has led
to a modest improvement in the profit before interest and tax margin which has partially offset the deteriorating
asset utilization.

The decision to sell the activities which are classified as a discontinued operation is likely to improve the overall
profitability of the company. In the year ended 31 October 20X3 the discontinued operation made a pre-tax profit
of $1 million. This poor return acted to reduce the company’s overall profitability (the continuing operations yielded
a return of 34·6%). The performance of the discontinued operation continued to deteriorate in the year ended 31
October 20X4 making a pre-tax operating loss of $3 million which creates a negative return on the relevant assets.
Despite incurring losses on the measurement to fair value of the discontinued operation’s assets, it seems the
decision will benefit the company in the future as the discontinued operation showed no sign of recovery.

Liquidity and solvency

Superficially the current ratio of 2·17 in 20X4 seems reasonable, but the improvement from the alarming current
ratio in 20X3 of 1·01 is more illusory than real. The ratio in the year ended 31 October 20X4 has been distorted
(improved) by the inclusion of assets of the discontinued operation under the heading of ‘held for sale’. These have
been included at fair value less cost to sell (being lower than their cost – a requirement of IFRS 5). Thus the carrying
amount should be a realistic expectation of the net sale proceeds, but it is not clear whether the sale will be cash
(they may be exchanged for shares or other assets) or how Superlit intends to use the disposal proceeds. What can
be deduced is that without the assets held for sale being classified as current, the company’s liquidity ratio would
be much worse than at present (at below 1 for both years). Against an expected norm of 1, quick ratios (acid test)
calculated on the normal basis of excluding inventory (and in this case the assets held for sale) show an alarming
position; a poor figure of 0·65 in 20X3 has further deteriorated in 20X4 to 0·47. Without the proceeds from the sale
of the discontinued operation (assuming they will be for cash) it is difficult to see how Superlit would pay its creditors
(and tax liability), given a year end overdraft of $2.3 million.

Further analysis of the current ratios shows some interesting changes during the year. Despite its large overdraft
Superlit appears to be settling its trade payables quicker than in 20X3. At 59 days in 20X3 this was rather a long time
and the reduction in credit period may be at the insistence of suppliers – not a good sign. Perhaps to relieve liquidity
pressure, the company appears to be pushing its customers to settle early. It may be that this has been achieved by

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the offer of early settlement discounts, if so the cost of this would have impacted on profit. The company has
increased its inventory turnover; given that margins have been held, this reflects an improved performance.

Gearing

The gearing has increased to 35.6% from 29.6% reflecting additional borrowing. This shows a consequent increase
in finance costs. Despite the increase in finance costs the borrowing is acting in the shareholders’ favour as the
overall return on capital employed (at 30·9%) is well in excess of the 6% interest cost.

Summary

Overall the company’s performance has deteriorated in the year ended 31 October 20X4. Management’s action in
respect of the discontinued operation is a welcome measure to try to halt the decline, but more needs to be done.
The company’s liquidity position is giving cause for serious concern and without the prospect of realising $12 million
from the assets held for sale it would be difficult to envisage any easing of the company’s liquidity pressures.

Appendix:

Return on capital employed (ROCE) – Note 1 10.2/(29+16-12) 30.9%

Gross profit percentage 16/56 28.6%
Operating expense percentage of sales revenue 5.8/56 10.4%
Profit before interest and tax margin 10.2/55 18.5%
Asset turnover 56/(29+16-12) 1.7
Current ratio 18.5/8.5 2.17
Current ratio (excluding held for sale) 6.5/8.5 0.76
Quick ratio (excluding held for sale) 4/8.5 0.47
Inventory (closing) turnover 39/2.5 15.6
Receivables (in days) 4/56*365 26.1
Payables/cost of sales (in days) 4.3/40*365 39.2
Gearing 16/(16+29) 35.6%
Note 1: The return has been taken as the profit before interest and tax from continuing operations. The capital
employed is the normal equity plus loan capital (as at the year-end), but less the value of the assets held for sale.
This is because the assets held for sale have not contributed to the return from continuing operations.

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 PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Sept./ Dec. 17 Q. 31
March/June 17 Q. 31
Sept. 16 Q.2
March/June 16 Q. 2
Spec. exam Sept. 16 MCQ. 12,14
Dec. 15 Q.2
June 15 MCQ.7,20 Q.2
Interpretation of ratios Dec. 14 Q.1
June 14 Q.3
Dec. 13 Q.3(b)
June 13 Q.3(b)
Dec. 12 Q.3
June 12 Q.3 (b)
Dec. 11 Q.2 (iii), Q.3 (b)
June 11 Q.3 (b)

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 NOT-FOR-PROFIT AND PUBLIC SECTOR ENTITIES

It would be simplistic to assume that any organisation that does not pursue profit as an objective is a not-for-profit
organisation. This is an incorrect assumption, as many such organisations do make a profit every year and overtly
include this in their formal plans. Quite often, they will describe their profit as a ‘surplus’ rather than a profit, but as
either term can be defined as an excess of income over expenditure, the difference may be considered rather
semantic.

Not-for-profit organisations are distinguished from profit maximising organisations by three characteristics.

 First, most not-for-profit organisations do not have external shareholders providing risk capital for the
business.
 Second, and building on the first point, they do not distribute dividends, so any profit (or surplus) that is
generated is retained by the business as a further source of capital.
 Third, their objectives usually include some social, cultural, philanthropic, welfare or environmental
dimension, which in their absence, would not be readily provided efficiently through the workings of the
market system.

Not-for-profit and public sector entities are not expected to show a profit but must ensure that they have managed
their funds efficiently. Not-for-profit and public sector entities do not exist to make profits, but they do have a diverse
range of stakeholders, many of whom have a legitimate interest in the body’s financial stewardship. The corporate
objectives of businesses are very different from those of not-for-profit and public sector entities. Companies exist
largely to make profits.

TYPES OF NOT-FOR-PROFIT ORGANISATION

Not-for-profit organisations exist in both the public sector and the private sector. Most, but not all, public sector
organisations do not have profit as their primary objective and were established in order to provide what economists
refer to as public goods. These are mainly services that would not be available at the right price to those who need
to use them (such as medical care, museums, art galleries and some forms of transportation), or could not be
provided at all through the market (such as defence and regulation of markets and businesses). Private sector
examples include most forms of charity and self-help organisations, such as housing associations that provide
housing for low income and minority groups, sports associations (many football supporters’ trusts are set up as
industrial and provident societies), scientific research foundations and environmental groups.

CORPORATE FORM

Not-for-profit organisations can be established as incorporated or unincorporated bodies. The common business
forms include the following:

 In the public sector, they may be departments or agents of government

 Some public sector bodies are established as private companies limited by guarantee, including the
Financial Services Authority (the UK financial services regulator)
 In the private sector they may be established as cooperatives, industrial or provident societies (a specific
type of mutual organisation, owned by its members), by trust, as limited companies or simply as clubs or
associations.

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A cooperative is a body owned by its members, and usually governed on the basis of ‘one member, one vote’. A trust
is an entity specifically constituted to achieve certain objectives. The trustees are appointed by the founders to
manage the funds and ensure compliance with the objectives of the trust. Many private foundations (charities that
do not solicit funds from the general public) are set up as trusts.

FORMATION, CONSTITUTION, AND OBJECTIVES

Not-for-profit organisations are invariably set up with a purpose or set of purposes in mind, and the organisation
will be expected to pursue such objectives beyond the lifetime of the founders. On establishment, the founders will
decide on the type of organisation and put in place a constitution that will reflect their goals. The constitutional base
of the organisation will be dictated by its legal form.

As with any type of organisation, the objectives of not-for-profit organisations are laid down by the founders and
their successors in management.

Unlike profit maximisersa, however, the broad strategic objectives of not-for-profit organisations will tend not to
change over time.

The purposes of the latter are most often dictated by the underlying founding principles. Within these broad
objectives, however, the focus of activity may change quite markedly. For example, during the 1990s the British
Know-How Fund, which was established by the UK government to provide development aid, switched its focus away
from the emerging central European nations in favour of African nations.

It is important to recognise that although not-for-profit organisations do not maximise profit as a primary objective,
many are expected to be self-financing and, therefore, generate profit in order to survive and grow. Even if their
activities rely to some extent on external grants or subventions, the providers of this finance invariably expect the
organisation to be as financially self-reliant as possible.

MANAGEMENT

The management structure of not-for-profit organisations resembles that of profit maximisers, though the terms
used to describe certain bodies and officers may differ somewhat.

While limited companies have a board of directors comprising executive and non-executive directors, many not-for-
profit organisations are managed by a Council or Board of Management whose role is to ensure adherence to the
founding objectives. In recent times there has been some convergence between how companies and not-for-profit
organisations are managed, including increasing reliance on non-executive officers (notably in respect of the scrutiny
or oversight role) and the employment of ‘career’ executives to run the business on a daily basis.

ACCOUNTING

In practice, the accounting policies adopted by not-for-profit and public sector entities are increasingly similar. Not-
for-profit and public sector entities include government agencies, healthcare agencies, schools, colleges and
charities.

Even though not-for-profit entities do not report to shareholders, they must be able to account for the funds
received and the way they have been allocated. Their objective is to provide goods and services to various recipients
and not make a profit

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A public sector entity such as local government will have the aim of providing services to its local community such
as fire services, refuse collection, libraries, theatres and sports facilities. A charity will have the aim of providing
assistance to a particular cause, for example poverty aid in developing countries, child protection, animal rescue

PERFORMANCE MEASUREMENT

As the performance of not-for-profit organisations cannot be properly assessed by conventional accounting ratios,
such as ROCE, ROI, etc, it often has to be assessed with reference to other measures. The performance of a public
sector or not-for-profit entity will be in terms of measuring whether its stated Key performance indicators have been
achieved. One measure of performance for public sector entities is the 3 Es – economy, efficiency and effectiveness
mentioned above. Therefore, most not-for-profit organisations rely on measures that estimate the performance of
the organisation in relation to:

 Effectiveness – the extent to which the organisation achieves its objectives

 Economy – the ability of the organisation to optimise the use of its productive resources (often assessed
in relation to cost containment)
 Efficiency – the ‘output’ of the organisation per unit of resource consumed.

Another performance consideration is whether the entity has achieved value for money. Therefore, many service-
orientated organisations use ‘value for money’ indicators that can be used to assess performance against objectives.
Where the organisation has public accountability, performance measures can also be published to demonstrate that
funds have been used in the most cost-effective manner. It is important within an exam question to read the clues
given by the examiner regarding what is important to the organisation and what are its guiding principles, and to
use these when assessing the performance of the organisation. Charities must focus on demonstrating that they
have made proper use of the funds received and whether they have achieved their stated aims.
PAST EXAMS ANALYSIS

Topic Exam Attempt Question

Not-for-profit entities Dec. 14 MCQ.15

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