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HENNIE vAN GREUNING
international
financial
reporting standards
A practical guide
fourth edition
International Financial
Reporting Standards
A Practical Guide
International Financial
Reporting Standards
A Practical Guide
Fourth Edition
Hennie van Greuning
THE WORLD BANK
Washington, D.C.
© 2006 The International Bank for Reconstruction and Development / The World Bank
1818 H Street, NW
Washington, DC 20433
Telephone 202-473-1000
Internet www.worldbank.org
E-mail feedback@worldbank.org
All rights reserved.
1 2 3 4 09 08 07 06
The findings, interpretations, and conclusions expressed herein are those of the author(s) and
do not necessarily reflect the views of the Board of Executive Directors of the World Bank or
the governments they represent.
The World Bank does not guarantee the accuracy of the data included in this work. The
boundaries, colors, denominations, and other information shown on any map in this work
do not imply any judgment on the part of the World Bank concerning the legal status of any
territory or the endorsement or acceptance of such boundaries.
ISBN-10: 0-8213-6768-4
ISBN-13: 978-0-8213-6768-1
eISBN: 0-8213-6769-2
DOI: 10-1596/978-0-8213-6768-1
Rights and Permissions
The material in this work is copyrighted. Copying and/or transmitting portions or all of this
work without permission may be a violation of applicable law. The World Bank encourages
dissemination of its work and will normally grant permission promptly.
For permission to photocopy or reprint any part of this work, please send a request with
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MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, www.copyright.com.
All other queries on rights and licenses, including subsidiary rights, should be addressed to
the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax
202-522-2422, e-mail pubrights@worldbank.org.
Library of Congress Cataloging-in-Publication Data has been requested.
Contents
Foreword
Acknowledgments
Introduction
PRESENTATION
Framework
IFRS 1
IAS 1
IAS 7
IAS 8
Framework for the Preparation and Presentation of Financial Statements
First-Time Adoption of IFRS
Presentation of Financial Statements
Cash Flow Statements
Accounting Policies, Changes in Accounting Estimates, and Errors
IFRS 3
IAS 27
IAS 28
IAS 31
IFRS 2
IFRS 4
IAS 2
IAS 11
IAS 12
IAS 16
IAS 17
IAS 18
IAS 19
IAS 20
IAS 21
IAS 23
IAS 36
GROUP STATEMENTS
Business Combinations
Consolidated and Separate Financial Statements
Investments in Associates
Interests in Joint Ventures
BALANCE SHEET AND INCOME STATEMENT
Share-Based Payment
Insurance Contracts
Inventories
Construction Contracts
Income Taxes
Property, Plant, and Equipment
Leases
Revenue
Employee Benefits
Accounting for Government Grants and Disclosure of Government Assistance
The Effects of Changes in Foreign Exchange Rates
Borrowing Costs
Impairment of Assets
PART I
Chapter 1
2
3
4
5
PART II
Chapter 6
7
8
9
PART III
Chapter 10
11
12
13
14
15
16
17
18
19
20
21
22
vii
viii
ix
1
3
11
15
31
41
47
49
60
68
74
81
83
91
96
105
114
124
136
149
157
166
171
178
185
v
vi
Table of Contents
Chapter 23
24
25
26
27
PART IV
Chapter 28
29
30
31
32
33
34
35
36
37
38
IAS 37
IAS 38
IAS 39
IAS 40
IAS 41
IFRS 5
IAS 10
IAS 14
IAS 24
IAS 26
IAS 29
IAS 32
IAS 33
IAS 34
IFRS 6
IFRS 7
Provisions, Contingent Liabilities, and Contingent Assets
Intangible Assets
Financial Instruments: Recognition and Measurement
Investment Property
Agriculture
DISCLOSURE
Noncurrent Assets Held for Sale and Discontinued Operations
Events After the Balance Sheet Date
Segment Reporting
Related-Party Disclosures
Accounting and Reporting by Retirement Benefit Plans
Financial Reporting in Hyperinflationary Economies
Financial Instruments: Presentation
Earnings per Share
Interim Financial Reporting
Exploration for and Evaluation of Mineral Resources
Financial Instruments: Disclosures
About the Author
192
198
203
218
224
233
235
240
243
248
252
256
261
264
273
278
284
299
Foreword
The publication of this fourth edition coincides with an acceleration in the convergence in
accounting standards that has been a feature of the international landscape in this field since | Hennie |
the global financial crisis of 1998. The events of that year prompted several international
organizations, including the World Bank and the International Monetary Fund, to launch a
cooperative initiative to strengthen the global financial architecture and to seek a longer-term
solution to the lack of transparency in financial information. International convergence in
accounting standards under the leadership of the International Accounting Standards Board
(IASB) and the Financial Accounting Standards Board (FASB) in the United States has now
progressed to the point where more than 100 countries currently subscribe to IFRS.
The rush towards convergence continues to produce a steady stream of revisions to account-
ing standards by both the IASB and FASB. For accountants, financial analysts, and other spe-
cialists, there is already a burgeoning technical literature explaining in detail the background
and intended application of these revisions. But until publication of the present work, a con-
solidated and simplified reference has been lacking.
This book, already translated into 13 languages in its earlier editions, seeks to fill this gap.
Each chapter briefly summarizes and explains a new or revised IFRS, the issue or issues the
standard addresses, the key underlying concepts, the appropriate accounting treatment, and
the associated requirements for presentation and disclosure. The text also covers financial
analysis and interpretation issues to better demonstrate the potential effect of the accounting
standards on business decisions. Simple examples in most chapters help further clarify the
material. It is our hope that this approach, in addition to providing a handy reference for
practitioners, will help relieve some of the tension experienced by nonspecialists when faced
with business decisions influenced by the new rules. The book should also assist national
regulators in comparing IFRS to country-specific practices, thereby encouraging even wider
local adoption of these already broadly accepted international standards.
Kenneth G. Lay, CFA
Deputy Treasurer
The World Bank
Washington, D.C.
June 2006
vii
Acknowledgments
The author is grateful to Mr. Ken Lay, deputy treasurer of the World Bank, who has sup-
ported this revised edition as a means to assist our client countries with a publication that
may facilitate understanding of International Financial Reporting Standards as well as
emphasizing the importance of financial analysis and interpretation of the information pro-
duced through application of these standards.
The Stalla Review for the CFA® Exam made a significant contribution to the previous edition
by providing copyright permission to adapt material and practice problems from their text-
books and questions database. Stalla Review is part of Becker Professional Review, a leading
provider of test preparation for the CPA, CFA®, and CMA exams. Two individuals from The
Stalla Review were very helpful—Frank Stalla and Peter Olinto.
I am grateful to the International Accounting Standards Committee Foundation for the use
of their examples in chapter 27 (IAS 41–Agriculture). In essence, this entire publication is a
tribute to the output of the International Accounting Standards Board. Deloitte Touche
Tohmatsu also allowed the use of two examples from their publications.
Jason Mitchell of the World Bank Treasury enhanced the introductory paragraphs of each
chapter by ensuring that the publication followed a consistent line of reasoning. Other col-
leagues in the World Bank Treasury shared their insights into the complexities of applying cer-
tain standards to the treasury environment. I benefited greatly from hours of conversation
with many colleagues, including Hamish Flett and Richard Williams.
Despite the extent and quality of the inputs that I have received, I am solely responsible for
the contents of this publication.
Hennie van Greuning
June 2006
viii
| Hennie |
Introduction
This text, based on three earlier publications that have already been translated into thirteen
languages, is an important contribution to expanding awareness and understanding of IFRS
around the world, with easy-to-read summaries of each Standard, and examples that illus-
trate accounting treatments and disclosure requirements.
TARGET AUDIENCE
A conscious decision has been taken to focus on the needs of executives and financial ana-
lysts in the private and public sectors who might not have a strong accounting background.
This publication summarizes each IFRS and IAS so managers and analysts can quickly obtain
a broad and basic overview of the key issues. A conscious decision was taken to exclude
detailed discussion of certain topics, in order to maintain the overall objective of providing a
useful tool to managers and financial analysts.
In addition to the short summaries, most chapters contain simple examples that emphasize
the practical application of some key concepts in a particular Standard. The reader without a
technical accounting background is therefore provided with the tools to participate in an
informed manner in discussions relating to the appropriateness or application of a particular
Standard in a given situation. The reader can also evaluate the effect that the application of
the principles of a given financial reporting standard will have on the financial results and
position of a division or of an entire enterprise.
STRUCTURE OF THIS PUBLICATION
Each chapter follows a common outline to facilitate discussion of each Standard.
1. Problems Addressed identifies the main objectives and the key issues of the Standard.
2. Scope of the Standard identifies the specific transactions and events covered by a
Standard. In certain instances, compliance with the requirements of a Standard is limit-
ed to a specified range of enterprises.
3. Key Concepts explains the usage and implications of key concepts and definitions.
4. Accounting Treatment lists the specific accounting principles, bases, conventions,
rules, and practices that should be adopted by an enterprise for compliance with a par-
ticular Standard. Recognition (initial recording) and measurement (subsequent valua-
tion) is specifically dealt with where appropriate.
ix
x
Introduction
5. Presentation and Disclosure describes the manner in which the financial and nonfi-
nancial items should be presented in the financial statements, as well as aspects that
should be disclosed in these financial statements—keeping in mind the needs of vari-
ous users. Users of financial statements include investors; employees; lenders; suppli-
ers or trade creditors; governments; tax and regulatory authorities; and the public.
6. Financial Analysis and Interpretation discusses items of interest to the financial ana-
lyst in chapters where such a discussion is deemed appropriate. It must be emphasized
that none of the discussion in these sections should be interpreted as a criticism of
IFRS. Where analytical preferences and practices are highlighted, it is to alert the reader
to the challenges still remaining along the road to convergence of international account-
ing practices and unequivocal adoption of IFRS.
7. Examples are included at the end of most chapters. These examples are intended as
further illustration of the concepts contained in the IFRS.
The author hopes that managers in the client countries of the World Bank will find this for-
mat useful in establishing accounting terminology, especially where certain terms are still in
the exploratory stage. Feedback in this regard is welcome.
CONTENT INCLUDED
All of the accounting Standards issued by the International Accounting Standards Board
(IASB) until 31 May 2006 are included in this publication. The IASB texts are the ultimate
authority—this publication constitutes a summary.
PARTI
Presentation
1
Framework for the
Preparation and Presentation
of Financial Statements
1.1
PROBLEMS ADDRESSED
An acceptable coherent framework of fundamental accounting principles is essential for prepar- | Hennie |
ing financial statements. The major reasons for providing the framework are to:
•
identify the essential concepts underlying the preparation and presentation of financial
statements;
• guide standards setters in developing accounting standards;
• assist preparers, auditors, and users to interpret the International Financial Reporting
Standards (IFRS); and
• provide principles as not all issues are covered by the IFRS.
1.2
SCOPE OF THE FRAMEWORK
The existing framework deals with the:
• objectives of financial statements,
• qualitative characteristics of financial statements,
• elements of financial statements,
• recognition of the elements of financial statements,
• measurement of the elements of financial statements, and
• concepts of capital and capital maintenance.
A future framework which is currently under discussion might deal with:
• objectives of financial reporting and qualitative characteristics of financial reporting
information,
initial and subsequent measurement
• elements of financial statements, recognition and measurement attributes
•
• the reporting entity
• presentation and disclosure (including reporting boundaries)
The framework is not a standard, but is used extensively by the IASB and by its interpreta-
tions committee, the IFRIC (International Financial Reporting Interpretations Committee).
3
4
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
1.3
KEY CONCEPTS
OBJECTIVES OF FINANCIAL STATEMENTS
1.3.1 The objective of financial statements is to provide information about the financial
position (balance sheet), performance (income statement), and changes in financial posi-
tion (cash flow statement) of an entity; this information should be useful to a wide range of
users for the purpose of making economic decisions, focusing on users who cannot dictate
the information they should be getting.
1.3.2 Fair presentation is achieved through the provision of useful information (full disclo-
sure) in the financial statements, whereby transparency is secured. If one assumes that fair
presentation is equivalent to transparency, a secondary objective of financial statements can
be defined: to secure transparency through full disclosure and provide a fair presentation of
useful information for decision making purposes.
QUALITATIVE CHARACTERISTICS
1.3.3 Qualitative characteristics are the attributes that make the information provided in
financial statements useful to users:
• Relevance. Relevant information influences the economic decisions of users, helping
them to evaluate past, present, and future events or to confirm or correct their past
evaluations. The relevance of information is affected by its nature and materiality.
• Reliability. Reliable information is free from material error and bias and can be depend-
ed upon by users to represent faithfully that which it either purports to represent or
could reasonably be expected to represent. The following factors contribute to reliability:
faithful representation
substance over form
neutrality
prudence
completeness
• Comparability. Information should be presented in a consistent manner over time and
in a consistent manner between entities to enable users to make significant compar-
isons.
• Understandability. Information should be readily understandable by users who have a
basic knowledge of business, economic activities, and accounting, and who have a will-
ingness to study the information with reasonable diligence.
1.3.4 The following are the underlying assumptions of financial statements (see Figure 1.1
at end of chapter):
• Accrual basis. Effects of transactions and other events are recognized when they occur
(not when the cash flows). These effects are recorded and reported in the financial
statements of the periods to which they relate.
• Going concern. It is assumed that the entity will continue to operate for the foreseeable
future.
1.3.5 The following are constraints on providing relevant and reliable information:
• Timeliness. Undue delay in reporting could result in loss of relevance but improve reli-
ability.
| Hennie |
• Benefit versus cost. Benefits derived from information should exceed the cost of pro-
viding it.
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
5
1.3.6 Balancing of qualitative characteristics. To meet the objectives of financial statements
and make them adequate for a particular environment, providers of information must
achieve an appropriate balance among qualitative characteristics.
1.3.7 The application of the principal qualitative characteristics and the appropriate
accounting standards normally results in financial statements that provide fair presentation.
1.3.8 Balancing qualitative characteristics: The aim is to achieve a balance among charac-
teristics in order to meet the objective of financial statements.
1.4
ACCOUNTING TREATMENT
ELEMENTS OF FINANCIAL STATEMENTS
1.4.1 The following elements of financial statements are directly related to the measure-
ment of the financial position:
• Assets. Resources controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity
• Liabilities. Present obligations of an entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of economic benefits
• Equity. Assets less liabilities (commonly known as shareholders’ funds)
1.4.2 The following elements of financial statements are directly related to the measurement
of performance:
• Income. Increases in economic benefits in the form of inflows or enhancements of
assets, or decreases of liabilities that result in an increase in equity (other than increases
resulting from contributions by owners). Income embraces revenue and gains.
• Expenses. Decreases in economic benefits in the form of outflows or depletion of
assets, or incurrences of liabilities that result in decreases in equity (other than decreas-
es because of distributions to owners).
INITIAL RECOGNITION OF ELEMENTS
1.4.3 A financial statement element (assets, liabilities,equity, income and expenses) should
be recognized in the financial statements if:
• It is probable that any future economic benefit associated with the item will flow to or
from the entity; and
• The item has a cost or value that can be measured with reliability.
SUBSEQUENT MEASUREMENT OF ELEMENTS
1.4.4 The following bases are used to different degrees and in varying combinations to mea-
sure elements of financial statements:
• Historical cost.
• Current cost.
• Realizable (settlement) value.
• Present value (fair market value).
Fair value has to be used in the measurement of financial instruments, but is available as a
choice for property, plant and equipment, intangible assets, and agricultural products.
6
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
CAPITAL MAINTENANCE CONCEPTS
1.4.5 Concepts of capital and capital maintenance include:
• Financial capital. Capital is synonymous with net assets or equity; it is defined in
terms of nominal monetary units. Profit represents the increase in nominal money capi-
tal over the period.
• Physical capital. Capital is regarded as the operating capability; it is defined in terms of
productive capacity. Profit represents the increase in productive capacity over the period.
1.5
PRESENTATION AND DISCLOSURE: THE CASE FOR TRANSPARENT
FINANCIAL STATEMENT PREPARATION
1.5.1 The provision of transparent and useful information on market participants and their
transactions is essential for an orderly and efficient market, and it is one of the most impor-
tant preconditions for imposing market discipline. Left to themselves, markets cannot gen-
erate sufficient levels of disclosure. Market forces would normally balance the marginal ben-
efits and marginal costs of additional information disclosure and the end result might not be
what the market participants really need.
1.5.2 Financial and capital market liberalization trends of the 1980s, which brought increas-
ing volatility in financial markets, increased the need for information as a means to ensure | Hennie |
financial stability. In the 1990s, as financial and capital market liberalization increased, there
was mounting pressure for the provision of useful information in both the financial and pri-
vate sectors; minimum disclosure requirements now dictate the quality and quantity of infor-
mation that must be provided to the market participants and to the general public. Because
the provision of information is essential to promote the stability of the markets, regulatory
authorities also view the quality of information as a high priority. Once the quality of infor-
mation required by market participants and regulatory authorities is improved, entities
would do well to improve their own internal information systems to develop a reputation for
providing good quality information.
1.5.3 The public disclosure of information is predicated on the existence of good account-
ing standards and adequate disclosure methodology. This public disclosure normally
involves publication of relevant qualitative and quantitative information in annual financial
reports, which are often supplemented by interim financial statements and other relevant
information. The provision of information involves cost; therefore, when determining dis-
closure requirements, the usefulness of information for the public must be evaluated against
the cost to be borne by the entity.
1.5.4 The timing of disclosure is also important. Disclosure of negative information to a
public not yet sufficiently sophisticated to interpret the information can damage the entity in
question. When information is of inadequate quality or the users are not deemed capable to
properly interpret the information, or both, public disclosure requirements should be care-
fully phased in and progressively tightened. In the long run, a full disclosure regime is ben-
eficial, even if some problems are experienced in the short term, because the cost to the finan-
cial system of not being transparent is ultimately higher than the cost of being transparent.
TRANSPARENCY AND ACCOUNTABILITY
1.5.5 Transparency refers to the principle of creating an environment where information on
existing conditions, decisions, and actions are made accessible, visible, and understandable
to all market participants. Disclosure refers to the process and methodology of providing the
information and making policy decisions known through timely dissemination and open-
ness. Accountability refers to the need for market participants, including the authorities, to
justify their actions and policies and accept responsibility for their decisions and results.
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
7
1.5.6 Transparency is necessary for the concept of accountability to take hold among the
major groups of market participants: borrowers and lenders; issuers and investors; and
national authorities and international financial institutions.
1.5.7 Transparency and accountability have become strongly debated topics in discussions
of economic policy over the past decade. Policymakers had become accustomed to secrecy.
Secrecy was viewed as a necessary ingredient for the exercise of authority, with an added
benefit of hiding the incompetence of policymakers. However, secrecy also prevents policies
from having the desired effects. The changed world economy and financial flows, which
brought increasing internationalization and interdependence, have put the transparency
issue at the forefront of economic policymaking. National governments, including central
banks, increasingly recognize that transparency (that is, the openness of policy) improves the
predictability and, hence, the efficiency of policy decisions. Transparency forces institutions
to face up to the reality of a situation and makes officials more responsible, especially if they
know they will have to justify their views, decisions, and actions afterwards. Timely policy | Hennie |
adjustments are therefore encouraged.
1.5.8 In part, the case for greater transparency and accountability rests on the need for private
sector agents to understand and accept policy decisions that will affect their behavior. Greater
transparency improves the economic decisions made by other agents in the economy.
Transparency is also a means of fostering accountability, internal discipline, and better gover-
nance. Transparency and accountability improve the quality of decisionmaking in policymaking
institutions as well as in institutions whose own decisions depend on understanding and pre-
dicting the future decisions of policymaking institutions. If actions and decisions are visible and
understandable, monitoring costs are lowered. The general public will be better able to monitor
public sector institutions; shareholders and employees will be better able to monitor corporate
management; creditors will be better able to monitor borrowers, and depositors will be better
able to monitor banks. Therefore, poor decisions will not go unnoticed or unquestioned.
1.5.9 Transparency and accountability are mutually reinforcing. Transparency enhances
accountability by facilitating monitoring, and accountability enhances transparency by pro-
viding an incentive for agents to ensure that the reasons for their actions are properly dis-
seminated and understood. Together, transparency and accountability will impose a disci-
pline that improves the quality of decisionmaking in the public sector, and will lead to more
efficient policy by improving the private sector’s understanding of how policymakers could
react to various events in the future.
1.5.10 Transparency and accountability are not ends in themselves. They are designed to
assist in increasing economic performance and can improve the working of the international
financial markets by enhancing the quality of decision making and risk management of all
market participants, including official authorities. But they are not a panacea. In particular,
transparency does not change the nature or risks inherent in financial systems. It might not
prevent financial crises, but it could moderate market participants’ response to adverse
events. Transparency then helps market participants to anticipate and qualify bad news and
thereby lessens the probability of panic and contagion.
1.5.11 One must also note that there is a dichotomy between transparency and confiden-
tiality. The release of proprietary information might give competitors an unfair advantage, a
fact that deters market participants from full disclosure. Similarly, monitoring bodies fre-
quently obtain confidential information from entities. The release of such information could
have significant market implications. Under such circumstances, entities might be reluctant
to provide sensitive information without the condition of client confidentiality. However,
unilateral transparency and full disclosure contributes to a regime of transparency, which
will ultimately benefit all market participants, even if in the short term a transition to such a
regime creates discomfort for individual entities.
8
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
TRANSPARENCY AND THE CONCEPTUAL ACCOUNTING FRAMEWORK
1.5.12 As stated in §1.3.1, the objective of financial statements is to provide information
about the financial position (balance sheet), performance (income statement), and changes
in financial position (cash flow statement) of an entity that is useful to a wide range of users
in making economic decisions. The transparency of financial statements is secured through
full disclosure and by providing fair presentation of useful information necessary for mak-
ing economic decisions to a wide range of users. In the context of public disclosure, financial
statements should be easily understandable for users to interpret. Whereas more information
is better than less, the provision of information is costly. Therefore, the net benefits of pro- | Hennie |
viding more transparency should be carefully evaluated by standard setters.
1.5.13 The adoption of internationally accepted financial reporting standards is a necessary
measure to facilitate transparency and contribute to proper interpretation of financial state-
ments.
1.5.14 In the context of fair presentation, no disclosure is probably better than disclosure of
misleading information. Figure 1.1 shows how transparency is secured through the
International Financial Reporting Standards (IFRS) framework.
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
9
Figure 1.1 Transparency in Financial Statements Achieved through Compliance with IASB Framework
OBJECTIVE OF FINANCIAL STATEMENTS
To provide a fair presentation of:
• Financial position
• Financial performance
• Cash flows
TRANSPARENCY AND FAIR PRESENTATION
• Fair presentation achieved through providing useful information (full disclosure)
which secures transparency
• Fair presentation equates transparency
SECONDARY OBJECTIVE OF FINANCIAL STATEMENTS
To secure transparency through a fair presentation of useful information (full disclosure)
for decision making purposes
ATTRIBUTES OF USEFUL INFORMATION
Existing Framework
• Relevance
• Reliability
• Comparability
• Understandability
Constraints
• Timeliness
• Benefit vs. Cost
• Balancing the qualitative characteristics
Alternative Views
• Relevance
• Predictive Value
• Faithful Representation
• Free from Bias
• Verifiable
UNDERLYING ASSUMPTIONS
Accrual basis
Going concern
10
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
EXAMPLE: FRAMEWORK FOR THE PREPARATION AND PRESENTATION
OF FINANCIAL STATEMENTS
EXAMPLE 1.1
Chemco Inc. is engaged in the production of chemical products and selling them locally. The
corporation wishes to extend its market and export some of its products. It has come to the
attention of the financial director that compliance with international environmental require-
ments is a significant precondition if it wishes to sell products overseas. Although the cor-
poration has during the past put in place a series of environmental policies, it is clear that it
is also common practice to have an environmental audit done from time to time, which will
cost approximately $120,000. The audit will encompass the following:
• Full review of all environmental policy directives
• Detailed analysis of compliance with these directives
• Report containing in-depth recommendations of those physical and policy changes that
would be necessary to meet international requirements
The financial director of Chemco Inc. has suggested that the $120,000 be capitalized as an
asset and then written off against the revenues generated from export activities so that the
matching of income and expense will occur.
EXPLANATION
The costs associated with the environmental audit can be capitalized only if they meet the def-
inition and recognition criteria for an asset. The IASB’s Framework does not allow the recog-
nition of items in the balance sheet that do not meet the definition or recognition criteria.
In order to recognize the costs of the audit as an asset, it should meet both the
• definition of an asset, and
• recognition criteria for an asset.
In order for the costs associated with the environmental audit to comply with the definition
of an asset (see §1.4.1), the following should be valid:
(i) The costs must give rise to a resource controlled by Chemco Inc.
(ii) The asset must arise from a past transaction or event, namely the audit.
(iii) The asset must be expected to give rise to a probable future economic benefit that will
flow to the corporation, namely the revenue from export sales.
The requirements in terms of (i) and (iii) are not met. Therefore, the entity cannot capitalize
these costs due to the absence of fixed orders and detailed analyses of expected economic
benefits.
In order to recognize the costs as an asset in the balance sheet, it has to comply with the
recognition criteria (see §1.4.3), namely:
| Hennie |
• The asset should have a cost that can be measured reliably.
• The expected inflow of future economic benefits must be probable.
In order to properly measure the carrying value of the asset, the corporation must be able to
demonstrate that further costs will be incurred that would give rise to future benefits.
However, the second requirement poses a problem because of insufficient evidence of the
probable inflow of economic benefits and would therefore again disqualify the costs once
again for capitalizing as an asset.
2 First-Time Adoption
of IFRS (IFRS 1)
2.1
PROBLEMS ADDRESSED
Specific issues occur with the first time adoption of IFRS. IFRS 1 aims to ensure that the enti-
ty’s first financial statements (including interim financial reports for that specific reporting
period) under IFRS provide a suitable starting point, are transparent to users, and are com-
parable over all periods presented.
2.2
SCOPE OF THE STANDARD
This Standard applies when an entity adopts IFRS for the first time by an explicit and unre-
served statement of compliance with IFRS.
The Standard specifically covers:
identification of the basis of reporting,
• comparable (prior period) information that is to be provided,
•
• retrospective application of IFRS information,
• formal identification of the reporting and the transition date.
The IFRS requires an entity to comply with each individual standard effective at the report-
ing date for its first IFRS-compliant financial statements. Subject to certain exceptions and
exemptions, IFRS should be applied retrospectively. Therefore, the comparative amounts,
including the opening balance sheet for the comparative period, should be restated from
national generally accepted accounting principles (GAAP) to IFRS.
2.3
KEY CONCEPTS
2.3.1 The reporting date is the balance sheet date of the first financial statements that
explicitly state that they comply with IFRS (for example, December 31, 2005).
2.3.2 The transition date is the date of the opening balance sheet for the prior year com-
parative financial statements (for example, January 1, 2004, if the reporting date is December
31, 2005).
11
12
Chapter 2 First-Time Adoption of IFRS (IFRS 1)
2.4
ACCOUNTING TREATMENT
OPENING BALANCE SHEET
2.4.1 The opening IFRS balance sheet as at the transition date should
• recognize all assets and liabilities whose recognition is required by IFRS; but
• not recognize items as assets or liabilities whose recognition is not permitted by IFRS.
2.4.2 With regard to event-driven fair values, if fair value had been used for some or all
assets and liabilities under a previous GAAP, these fair values can be used as the IFRS
“deemed costs” at date of measurement.
2.4.3 When preparing the opening balance sheet:
• Recognize all assets and liabilities whose recognition is required by IFRS. Examples of
changes from national GAAP are derivatives, leases, pension liabilities and assets, and
deferred tax on revalued assets. Adjustments required are debited or credited to equity.
• Remove assets and liabilities whose recognition is not permitted by IFRS. Examples of
changes from national GAAP are deferred hedging gains and losses, other deferred
costs, some internally generated intangible assets, and provisions. Adjustments
required are debited or credited to equity.
• Reclassify items that should be classified differently under IFRS. Examples of changes
from national GAAP are financial assets, financial liabilities, leasehold property, com-
pound financial instruments, and acquired intangible assets (reclassified to goodwill).
Adjustments required are reclassifications between balance sheet items.
• Apply IFRS in measuring assets and liabilities by using estimates that are consistent
with national GAAP estimates and conditions at the transition date. Examples of
changes from national GAAP are deferred taxes, pensions, depreciation, or impairment
of assets. Adjustments required are debited or credited to equity.
| Hennie |
2.4.4 Derecognition criteria of financial assets and liabilities are applied prospectively
from the transition date. Therefore, financial assets and financial liabilities which have been
derecognized under national GAAP are not reinstated. However:
• All derivatives and other interests retained after derecognition and existing at transi-
tion date must be recognized.
• All special purposed entities (SPE) controlled as at transition date must be consolidated.
Derecognition criteria can be applied retrospectively provided that the information needed
was obtained when initially accounting for the transactions.
2.4.5 Cumulative foreign currency translation differences on translation of financial state-
ments of a foreign operation can be deemed to be zero at transition date. Any subsequent
gain or loss on disposal of operation excludes pretransition date translation differences.
ASSETS
2.4.6 With regard to property plant and equipment, the following amounts can be used as
IFRS deemed cost:
• Fair value at transition date
• Pretransition date revaluations, if the revaluation was broadly comparable to either
• fair value, or
• (depreciated) cost adjusted for a general or specific price index
Chapter 2 First-Time Adoption of IFRS (IFRS 1)
13
2.4.7 With regard to investment property, the following amounts can be used as IFRS
“deemed cost” under the cost model:
• Fair value at transition date
• Pretransition date revaluations, if the revaluation was broadly comparable to either
• fair value, or
• (depreciated) cost adjusted for a general or specific price index
If a fair value model is used no exemption is granted.
2.4.8 With regard to intangible assets, the following amounts can be used as deemed cost,
provided that there is an active market for the assets:
• Fair value at transition date
• Pretransition date revaluations if the revaluation was broadly comparable to either
• fair value, or
• (depreciated) cost adjusted for general or specific price index
2.4.9 With regard to defined benefit plans, the full amount of the liability or asset must be
recognized, but deferrals of actuarial gains and losses at transition date can be set to zero. For
posttransition date actuarial gains and losses, one could apply the corridor approach or any
other acceptable method of accounting for such gains and losses.
2.4.10 Previously recognized financial instruments can be designated as trading or avail-
able for sale—from the transition date, rather than initial recognition.
2.4.11 Financial instruments comparatives for IAS 32 and IAS 39 need not be restated in
the first IFRS financial statements. Previous national GAAP should be applied to compara-
tive information for instruments covered by IAS 32 and IAS 39. The major adjustments to
comply with IAS 32 and IAS 39 must be disclosed, but need not be quantified. Adoption of
IAS 32 and IAS 39 should be treated as a change in accounting policy.
2.4.12 If the liability portion of a compound instrument is not outstanding at the transition
date an entity need not separate equity and liability components, thereby avoiding reclassi-
fications within equity.
2.4.13 Hedge accounting should be applied prospectively from the transition date, provid-
ed that hedging relationships are permitted by IAS 39 and that all designation, documenta-
tion, and effectiveness requirements are met from the transition date.
BUSINESS COMBINATIONS
2.4.14 It is not necessary to restate pretransition date business combinations. If any are restat-
ed, all later combinations must be restated. If information related to prior business combinations
are not restated, the same classification (acquisition, reverse acquisition, and uniting of interests)
must be retained. Previous GAAP carrying amounts are treated as deemed costs for IFRS pur-
poses. However, those IFRS assets and liabilities which are not recognized under national GAAP
must be recognized, and those which are not recognized under IFRS must be removed.
2.4.15 With regard to business combinations and resulting goodwill, if pretransition date | Hennie |
business combinations are not restated, then
• goodwill for contingent purchase consideration resolved before transition date should
be adjusted,
• any non-IFRS acquired intangible assets (not qualifying as goodwill) should be reclassified,
• an impairment test should be carried out on goodwill, and
• any existing negative goodwill should be credited to equity.
14
Chapter 2 First-Time Adoption of IFRS (IFRS 1)
2.4.16 Foreign currency translation and pretransition date goodwill and fair value adjust-
ments should be treated as assets and liabilities of the acquirer, not the acquiree. They are not
restated for postacquisition changes in exchange rates—either pre- or posttransition date.
EXEMPTIONS
2.4.17 Exemptions in respect of the retrospective application of IFRS, relate to the following:
• Business combinations prior to the transition date
• Fair value or revalued amounts, which can be taken as deemed costs
• Employee benefits
• Cumulative foreign currency translation differences, goodwill, and fair value adjustments
• Financial instruments, including hedge accounting
2.5
PRESENTATION AND DISCLOSURE
2.5.1 A statement should be made to the effect that the financial statements are being pre-
pared in terms of IFRS for the first time.
2.5.2 Prior information that cannot be easily converted to IFRS should be dealt with as follows:
• Any previous GAAP information should be prominently labeled as not being prepared
under IFRS.
• Where the adjustment to the opening balance of retained earnings cannot be reasonably
determined, that fact should be stated.
2.5.3 Where IFRS 1 permits a choice of transitional accounting policies, the policy selected
should be stated.
2.5.4 The way in which the transition from previous GAAP to IFRS has affected the report-
ed financial position, financial performance, and cash flows should be explained.
2.5.5 With regard to reporting date reconciliations from national GAAP (assume
December 31, 2005), the following must be disclosed:
• Equity reconciliation at the transition date (January 1, 2004) and at the end of the last
national GAAP period (December 31, 2004)
• Profit reconciliation for the last national GAAP period (December 31, 2004)
2.5.6 With regard to interim reporting reconciliations (assume interim report to June 30,
2005 and reporting date to be December 31, 2005), the following must be disclosed:
• Equity reconciliation at the transition date (January 1, 2004), at the prior year compara-
tive date (June 30, 2004), and at the end of last national GAAP period (December 31,
2004)
• Profit reconciliation for the last national GAAP period (December 31, 2004) and for the
prior year comparative date (June 30, 2004)
2.5.7 Impairment losses are disclosed as follows:
• Recognized or reversed on transition to IFRS
• IAS 36 disclosures as if recognized or reversed in period beginning on transition date
2.5.8 Use of fair values as deemed costs is as follows:
• Disclosed aggregate amounts for each line item
• Disclosed adjustment from national GAAP for each line item
3 Presentation of Financial
Statements (IAS 1)
3.1
PROBLEMS ADDRESSED
The objective of this Standard is to prescribe the basis for presentation of general purpose
financial statements and what is necessary for these statements to be in accord with IFRS. The
key issues are to ensure comparability both with the entity’s financial statements of previous
periods and with the financial statements of other entities. It also enables informed users to
rely on a formal definable structure and facilitates financial analysis.
3.2
SCOPE OF THE STANDARD
IAS 1 outlines:
• what constitutes a complete set of financial statements (namely balance sheet, income
statement, statement of changes in equity, cash flow statement and accounting policies
and notes),
• overall requirements for the presentation of financial statements including guidelines
for their structure,
• the distinction between current and non-current elements, and
• minimum requirements for financial statement content.
IAS 1 is currently under discussion in a new Exposure Draft, issued in March 2006, with first | Hennie |
comments due in July 2006. Performance reporting and the reporting of comprehensive
income are major issues to be dealt with and voluntary name changes are suggested for key
financial statements.
3.3
KEY CONCEPTS
3.3.1 Fair presentation. The financial statements should present fairly the financial posi-
tion, financial performance, and cash flows of the entity. Fair presentation requires the faith-
ful representation of the effects of transactions, other events, and conditions in accordance
with the definitions and recognition criteria for assets, liabilities, income, and expenses set
out in the Framework. The application of this IFRS is presumed to result in fair presentation.
3.3.2 Departure from the requirements of an IFRS is allowed only in the extremely rare cir-
cumstances in which the application of the IFRS would be so misleading as to conflict with
15
16
Chapter 3 Presentation of Financial Statements (IAS 1)
the objectives of financial statements. In such circumstances, the entity should disclose the
reasons for and the financial effect of the departure from the IFRS.
3.3.3 Current assets are:
• Assets expected to be realized or intended for sale or consumption in the entity’s nor-
mal operating cycle
• Assets held primarily for trading
• Assets expected to be realized within 12 months after the balance sheet date
• Cash or cash equivalents, unless restricted in use for at least 12 months
3.3.4 Current liabilities are:
• Liabilities expected to be settled in the entity’s normal operating cycle
• Liabilities held primarily for trading
• Liabilities due to be settled within 12 months after the balance sheet date
3.3.5 Noncurrent assets and liabilities are expected to be settled more than 12 months after
the balance sheet date.
3.3.6 The portion of noncurrent interest-bearing liabilities to be settled within 12 months
after the balance sheet date can be classified as noncurrent liabilities if
• the original term is greater than 12 months,
• it is the intention to refinance or reschedule the obligation, or
• the agreement to refinance or reschedule the obligation is completed on or before the
balance sheet date.
3.4
ACCOUNTING TREATMENT
3.4.1 Financial statements should provide information about an entity’s financial position,
performance, and cash flows, that is useful to a wide range of users for economic decision-
making.
3.4.2 Departure from the requirements of an IFRS is allowed only in the extremely rare cir-
cumstances in which the application of the IFRS would be so misleading as to conflict with the
objectives of financial statements. In such circumstances, the entity should disclose the reasons
for and the financial effect of the departure from the IFRS.
3.4.3 The presentation and classification of items should be consistent from one period to
another unless a change would result in a more appropriate presentation, or a change is
required by the IFRS.
3.4.4 A complete set of financial statements comprises the following:
• Balance sheet
• Income statement
• Statement of changes in equity
• Cash flow statement
• Accounting policies and notes
Entities are encouraged to furnish other related financial and nonfinancial information in
addition to the financial statements.
Chapter 3 Presentation of Financial Statements (IAS 1)
17
3.4.5 Fair presentation. The financial statements should present fairly the financial position,
financial performance, and cash flows of the entity.
• The following aspects should be addressed with regard to compliance with the IFRS:
• Compliance with the IFRS should be disclosed.
• Compliance with all requirements of each standard is compulsory.
• Disclosure does not rectify inappropriate accounting treatments.
• Premature compliance with an IFRS should be mentioned.
3.4.6 Financial statements should be presented on a going concern basis unless manage-
ment intends to liquidate the entity or cease trading. If not presented on a going concern
basis, the fact and rationale for not using it should be disclosed. Uncertainties related to | Hennie |
events and conditions that cast significant doubt on the entity’s ability to continue as a going
concern should be disclosed.
3.4.7 The accrual basis for presentation should be used, except for the cash flow statement.
3.4.8 Aggregation of immaterial items of a similar nature and function is allowed. Material
items should not be aggregated.
3.4.9 Assets and liabilities should not be offset unless allowed by the IFRS (see Chapter 35
[IAS 32]). However, immaterial gains, losses, and related expenses arising from similar trans-
actions and events can be offset.
3.4.10 With regard to comparative information, the following aspects are presented:
• Numerical information in respect of the previous period
• Relevant narrative and descriptive information
3.5
PRESENTATION AND DISCLOSURE
3.5.1 Identification and period to which the statements relate, including:
• Financial statements should be clearly distinguished from other information.
• Each component should be clearly identified.
• The following should be prominently displayed:
• Name of reporting entity
• Own statements distinct from group statements
• Reporting date or period
• Reporting currency
• Level of precision.
3.5.2 The balance sheet provides information about the financial position of the entity. It
should distinguish between major categories and classifications of assets and liabilities.
3.5.3 Current or noncurrent distinction. The balance sheet should normally distinguish
between current and noncurrent assets, and between current and noncurrent liabilities.
Disclose amounts to be recovered or settled within 12 months.
3.5.4 Liquidity based presentation. Where a presentation based on liquidity provides more
relevant and reliable information (for example, in the case of a bank or similar financial insti-
18
Chapter 3 Presentation of Financial Statements (IAS 1)
tution), assets and liabilities should be presented in the order in which they can or might be
required to be liquidated.
3.5.5. Current assets are:
• Assets expected to be realized or intended for sale or consumption in the entity’s nor-
mal operating cycle
• Assets held primarily for trading
• Assets expected to be realized within 12 months after the balance sheet date
• Cash or cash equivalents unless restricted in use for at least 12 months
3.5.6 Current liabilities are:
• Liabilities expected to be settled in the entity’s normal operating cycle
• Liabilities held primarily for trading
• Liabilities due to be settled within 12 months after the balance sheet date
3.5.7 Long-term interest-bearing liabilities to be settled within 12 months after the balance
sheet date can be classified as noncurrent liabilities if:
• The original term of the liability is greater than 12 months
• It is the intention to refinance or reschedule the obligation
• The agreement to refinance or reschedule the obligation is completed on or before the
balance sheet date
3.5.8 Capital disclosures encompass the following:
• The entity’s objectives, policies, and processes for managing capital
• Quantitative data about what the entity regards as capital
• Whether the entity complies with any capital (adequacy) requirements
• Consequences of noncompliance with capital requirements where applicable
• For each class of share capital:
• Number of shares authorized
• Number of shares issued and fully paid
• Number of shares issued and not fully paid
• Par value per share, or that it has no par value
• Reconciliation of shares at beginning and end of year
• Rights, preferences, and restrictions attached to that class
• Shares in the entity held by entity, subsidiaries, or associates
• Reserved for issue under options and sales contracts
Chapter 3 Presentation of Financial Statements (IAS 1)
19
3.5.9 Minimum information on the face of the balance sheet:
Assets
Liabilities
Trade and other payables
Provisions
Financial liabilities
Current tax liabilities
Deferred tax liabilities
Reserves
Minority interest
Parent shareholders’ equity
Liabilities included in disposal groups
held for sale
Property, plant, and equipment | Hennie |
Investment property
Intangible assets
Financial assets
Investments accounted for by the
equity method
Biological assets
Deferred tax assets
Inventories
Trade and other receivables
Current tax assets
Cash and cash equivalents
Assets held for sale (see IFRS 5)
Assets included in disposal groups
held for sale (see IFRS 5)
3.5.10 Other information on the face of the balance sheet or in notes:
• Nature and purpose of each reserve
• Shareholders for dividend not formally approved for payment
• Amount of cumulative preference dividend not recognized.
3.5.11 Information about performance of the entity should be provided in the income state-
ment. Minimum information on the face of the income statement includes:
• Revenue
• Finance costs
• Share of profits or losses of associates and joint ventures
• Tax expense
• Discontinued operations
• Profit or loss
• Profit or loss attributable to minority interest
• Profit or loss attributable to equity shareholders of parent
3.5.12 Other information on the face of the income statement or in notes includes:
• Analysis of expenses based on nature or their function (see Example at end of chapter)
• If classified by function, disclosure of the following:
• Depreciation charges for tangible assets
• Amortization charges for intangible assets
• Employee benefits expense
• Dividends recognized and the related amount per share
• Extraordinary Items. IFRS no longer allow the presentation of any items of income
or expense as extraordinary items.
20
Chapter 3 Presentation of Financial Statements (IAS 1)
3.5.13 The statement of changes in equity reflects information about the increase or
decrease in net assets or wealth.
3.5.14 Minimum information on the face of the changes in equity statement includes:
• Profit or loss for the period
• Each item of income or expense recognized directly in equity
• Total of above two items showing separately amounts attributable to minority share-
holders and parent shareholders
• Effects of changes in accounting policy
• Effects of correction of errors
3.5.15 Other information on the face of the changes in equity statement or in notes
includes:
• Capital transactions with owners and distributions to owners
• Reconciliation of the balance of accumulated profit or loss at beginning and end of the
year
• Reconciliation of the carrying amount of each class of equity capital, share premium,
and each reserve at beginning and end of the period
3.5.16 For a discussion of the cash flow statement refer to IAS 7 (Chapter 4).
3.5.17 Accounting policies and notes include information that must be provided in a sys-
tematic manner and cross-referenced from the face of the financial statements to the notes:
Disclosure of accounting policies
• Measurement bases used in preparing financial statements
• Each accounting policy used even if it is not covered by the IFRS
• Judgments made in applying accounting policies that have the most significant effect
on the amounts recognized in the financial statements
Estimation Uncertainty
• Key assumptions about the future and other key sources of estimation uncertainty that
have a significant risk of causing material adjustment to the carrying amount of assets
and liabilities within the next year
3.5.18 Other disclosures include the following:
• Domicile of the entity
• Legal form of the entity
• Country of incorporation
• Registered office or business address, or both
• Nature of operations or principal activities, or both
• Name of the parent and ultimate parent
3.6
FINANCIAL ANALYSIS AND INTERPRETATION
3.6.1 Financial analysis is the discipline whereby analytical tools are applied to financial
statements and other financial data in order to interpret trends and relationships in a consis-
tent and disciplined manner. In essence, the analyst is in the business of converting data into
information, and thereby assisting in a diagnostic process that has as its objective the screen-
ing and forecasting of information.
Chapter 3 Presentation of Financial Statements (IAS 1)
21
3.6.2 The financial analyst who is interested in assessing the value or creditworthiness of an | Hennie |
entity is required to estimate its future cash flows, assess the risks associated with those esti-
mates, and determine the proper discount rate that should be applied to those estimates. The
objective of the IFRS financial statements is to provide information which is useful to users in
making economic decisions. However, IFRS financial statements do not contain all the informa-
tion that an individual user might need to perform all of the above tasks, because they largely
portray the effects of past events and do not necessarily provide nonfinancial information. IFRS
financial statements do contain data about the past performance of an entity (its income and
cash flows), as well as its current financial condition (assets and liabilities) that are useful in
assessing future prospects and risks. The financial analyst must be capable of using the financial
statements in conjunction with other information in order to reach valid investment conclusions.
3.6.3 The notes to financial statements are an integral part of the IFRS financial reporting
process. They provide important detailed disclosures required by IFRS, as well as other infor-
mation provided voluntarily by management. The notes include information on such topics
as the following:
• Specific accounting policies that were used in compiling the financial statements
• Terms of debt agreements
• Lease information
• Off-balance sheet financing
• Breakdowns of operations by important segments
• Contingent assets and liabilities
• Detailed pension plan disclosure
3.6.4 Supplementary schedules can be provided in financial reports to present additional
information that can be beneficial to users. These schedules include such information as the
5-year performance record of a company, a breakdown of unit sales by product line, a listing
of mineral reserves, and so forth.
3.6.5 The management of publicly traded companies in certain jurisdictions, such as the
United States, is required to provide a discussion and analysis of the company’s operations
and prospects. This discussion normally includes:
• A review of the company’s financial condition and its operating results
• An assessment of the significant effects of currently known trends, events, and uncer-
tainties on the company’s liquidity, capital resources, and operating results
• The capital resources available to the firm and its liquidity
• Extraordinary or unusual events (including discontinued operations) that have a mate-
rial effect on the company
• A review of the performance of the operating segments of the business that have a sig-
nificant impact on the business or its finances
The publication of such a report is encouraged, but is currently not required by IFRS.
3.6.6 Ratio analysis is used by analysts and managers to assess company performance and
status. Ratios are not meaningful when used on their own, which is why trend analysis (the
monitoring of a ratio or group of ratios over time) and comparative analysis (the comparison
of a specific ratio for a group of companies in a sector, or for different sectors) is preferred by
financial analysts. Another analytical technique of great value is relative analysis, which is
achieved through the conversion of all balance sheet (or income statement items) to a per-
centage of a given balance sheet (or income statement) item.
3.6.7 Although financial analysts use a variety of subgroupings to describe their analysis,
the following classifications of risk and performance are often used:
22
Chapter 3 Presentation of Financial Statements (IAS 1)
• Liquidity. An indication of the entity’s ability to repay its short-term liabilities, mea-
sured by evaluating components of current assets and current liabilities
• Solvency. The risk related to the volatility of income flows often described as business
risk (resulting from the volatility related to operating income, sales, and operating
leverage) and financial risk (resulting from the impact of the use of debt on equity
returns as measured by debt ratios and cash flow coverage)
| Hennie |
• Operational efficiency. Determination of the extent to which an entity uses its assets
and capital efficiently, as measured by asset and equity turnover
• Growth. The rate at which an entity can grow as determined by its retention of profits
and its profitability measured by return on equity (ROE)
• Profitability. An indication of how a company’s profit margins relate to sales, average
capital, and average common equity. Profitability can be further analyzed through the
use of the Du Pont analysis
3.6.8 Some have questioned the usefulness of financial statement analysis in a world where
capital markets are said to be efficient. After all, they say, an efficient market is forward look-
ing, whereas the analysis of financial statements is a look at the past. However, the value of
financial analysis is that it enables the analyst to gain insights that can assist in making for-
ward-looking projections required by an efficient market. Financial ratios serve the following
purposes:
• They provide insights into the microeconomic relationships within a firm that help ana-
lysts project earnings and free cash flow (which is necessary to determine entity value
and creditworthiness).
• They provide insights into a firm’s financial flexibility, which is its ability to obtain the
cash required to meet financial obligations or to make asset acquisitions, even if unex-
pected circumstances should develop. Financial flexibility requires a firm to possess
financial strength (a level and trend of financial ratios that meet or exceed industry
norms); lines of credit; or assets that can be easily used as a means of obtaining cash,
either by their outright sale or by using them as collateral.
• They provide a means of evaluating management’s ability. Key performance ratios,
such as the return on equity, can serve as quantitative measures for ranking manage-
ment’s ability relative to a peer group.
3.6.9 Financial ratio analysis is limited by:
• The use of alternative accounting methods. Accounting methods play an important
role in the interpretation of financial ratios. It should be remembered that ratios are
usually based on data taken from financial statements. Such data are generated via
accounting procedures that might not be comparable among firms, because firms have
latitude in the choice of accounting methods. This lack of consistency across firms
makes comparability difficult to analyze and limits the usefulness of ratio analysis. The
various accounting alternatives currently found (but not necessarily allowed by IFRS)
include the following:
• First-in-first-out (FIFO) or last-in-first-out (LIFO) inventory valuation methods
• Cost or equity methods of accounting for unconsolidated associates
• Straight-line or accelerated consumption pattern methods of depreciation
• Capitalized or operating lease treatment
The use of IFRS seeks to make the financial statements of different entities compara-
ble and so overcome these difficulties.
• The homogeneity of a firm’s operating activities. Many firms are diversified with
divisions operating in different industries. This makes it difficult to find comparable
industry ratios to use for comparison purposes. It is better to examine industry-specific
ratios by lines of business.
Chapter 3 Presentation of Financial Statements (IAS 1)
23
• The need to determine whether the results of the ratio analysis are consistent. One
set of ratios might show a problem and another set might prove that this problem is
short–term in nature, with strong long-term prospects.
• The need to use judgment. The analyst must use judgment when performing ratio
analysis. A key issue is whether a ratio for a firm is within a reasonable range for an
industry, with this range being determined by the analyst. Although financial ratios are
used to help assess the growth potential and risk of a business they cannot be used
alone to directly value a company or determine its creditworthiness. The entire opera-
tion of the business must be examined, and the external economic and industry setting | Hennie |
in which it is operating must be considered when interpreting financial ratios.
3.6.10 Financial ratios mean little by themselves. Their meaning can only be gleaned by
using them in the context of other information. In addition to the items mentioned in 3.6.9
above, an analyst should evaluate financial ratios based on:
• Experience. An analyst with experience obtains a feel for the right ratio relationships.
• Company goals. Actual ratios can be compared with company objectives to determine
if the objectives are being attained.
• Industry norms (cross-sectional analysis). A company can be compared with others in
its industry by relating its financial ratios to industry norms or a subset of the compa-
nies in an industry. When industry norms are used to make judgments, care must be
taken, because:
• Many ratios are industry specific, but not all ratios are important to all industries.
Table 3.1 Manipulation of earnings via accounting methods that distort the principles of IFRS
Financial Statement Item
Aggressive Treatment
(bending the intention of IFRS)
Revenue
Inventory
Aggressive accruals
FIFO-IFRS treatment
Depreciation
Straight line (usual under IFRS) with
Warranties or bad debts
Amortization period
Discretionary expenses
Contingencies
Management compensation
Prior period adjustments
Change in auditors
Costs
higher salvage value
High estimates
Longer or increasing
Deferred
Footnote only
Accounting earnings as basis
Frequent
Frequent
Capitalize
“Conservative” Treatment
Installment sales or cost recovery
LIFO (where allowed—not allowed per
IFRS anymore)
Accelerated consumption pattern-
methods (lower salvage value)
Low estimates
Shorter or decreasing
Incurred
Accrue
Economic earnings as basis
Infrequent
Infrequent
Expense
• Differences in corporate strategies can affect certain financial ratios. (It is a good
practice to compare the financial ratios of a company with those of its major com-
petitors. Typically, the analyst should be wary of companies whose financial ratios
are too far above or below industry norms.)
• Economic conditions. Financial ratios tend to improve when the economy is strong
and to weaken during recessions. Therefore, financial ratios should be examined in
light of the phase of the economy’s business cycle.
24
Chapter 3 Presentation of Financial Statements (IAS 1)
• Trend (time-series analysis). The trend of a ratio, which shows whether it is improving
or deteriorating, is as important as its current absolute level.
3.6.11 The more aggressive the accounting methods, the lower the quality of earnings; the
lower the quality of earnings, the higher the risk assessment; the higher the risk assessment,
the lower the value of the company being analyzed (Table 3.1).
Table 3.2 Ratio categories
1. Liquidity
2. Solvency (Business and Financial Risk Analysis)
Enumerator
Denominator
Enumerator
Denominator
Current
Current assets
Current
liabilities
Business risk (coeff
of variation)
Standard deviation
of operating income
income
Quick
Cash + marketable
Current
securities +
receivables
liabilities
Cash
Cash + marketable
Current
Business risk
(coefficient of
variation) – net
income
Standard deviation
of net income
Mean net
income
securities
liabilities
Sales variability
Standard deviation
Mean sales
Average
receivables
Receivables
turnover
Average
inventory
Inventory
turnover
Average
trade
payables
Payables
turnover
Receivables Net annual sales
turnover
365
Average
receivables
collection
period
Inventory Cost of goods sold
turnover
Average
inventory
processing
period
Payables
turnover
Payables
payment
period
Cash
conversion
cycle
365
Cost of goods sold
365
Average receivables
collection period +
average inventory
processing period
payables payment
period
Operating
leverage
Financial risk
of sales
Mean of absolute value
Percentage
of % change in
Operating expenses
(%) change
in sales
Volatility caused
by firm’s use
of debt
Debt-equity
Total long-term debt
Total equity
Long-term
debt ratio
Total long-term debt
Total long-term
Total debt ratio
Total debt
Interest coverage
EBIT (Earnings before
interest and taxes)
Fixed financial | Hennie |
cost coverage
EBIT
Fixed charge
coverage
EBIT + lease payments
Cash flow to
interest expense
Net income + depreciation
expense + increase in
deferred taxes
Cash flow coverage
of fixed financial
cost coverage
Traditional cash flow +
interest expense +
one-third of lease
payments
Cash flow to
long-term debt
Cash flow to
total debt
Net income + depreciation
expense + increase in
deferred taxes
Net income + depreciation
expense + increase in
deferred taxes
capital
Total capital
Interest expense
Interest expense
+ one-third of
lease payments
Interest payments
+ lease payments
+ preferred
dividends /
(1 – tax rate)
Interest expense
Interest expense +
one-third of
lease payments
Book value of
long-term debt
Total debt
Chapter 3 Presentation of Financial Statements (IAS 1)
25
3.6.12 Table 3.2 provides an overview of some of the ratios that can be calculated using
each of the classification areas discussed above.
3.6.13 When performing an analysis for specific purposes, various elements from different
ratio classification groupings can be combined as seen in Table 3.3.
3. Operational Efficiency (Activity)
5. Profitability
Enumerator
Denominator
Enumerator
Denominator
Total asset
turnover
Fixed asset
turnover
Equity
turnover
Net sales
Net sales
Net sales
Average net
net assets
Average total
fixed assets
Average
equity
4. Growth
Sustainable
growth rate
Enumerator
Denominator
Retention rate
of earning
reinvested
(RR) * (ROE)
RR (retention Dividends
declared
rate)
Operating
income
after taxes
Return on
equity – ROE
Net income –
preferred
dividends
Average
common
equity
Payout ratio
Common
dividends
declared
Net income –
preferred
dividends
Gross profit margin
Gross profit
Operating profit margin Operating profit
Net sales
Net sales
(EBIT)
Net profit margin
Net income
Net sales
Return on total capital
Net income +
Average total capital
interest expense
Return on total equity
Net income
Average total equity
Return on common
equity
Net income –
Average common
preferred dividends
equity
Net income
Equity
Du Pont 1:
ROE (y/e figures)
* Total asset
turnover
* Equity (financial
leverage) multiplier
Du Pont 2:
ROE (y/e figures) =
operating profit margin
Sales
Assets
EBIT
* Total asset turnover
Sales
– Interest expense rate
Interest expense
* Financial leverage
(equity) multiplier
Assets
* Tax retention rate
1-t
Assets
Equity
Sales
Assets
Assets
Equity
2
6
Table 3.3 Combining Ratios for Specific Analytical Purposes
Purpose of
analysis
Stock / equity
valuation
Liquidity
Solvency (Business and
financial risk analysis)
Operational
efficiency (activity)
Ratio Used
Debt/equity
Interest coverage
Business risk (coefficient of variation of
operating earnings)
Business risk (coefficient of variation)
– net income
Sales variability
Systematic risk (Beta)
Sales / Earnings growth rates
Cash flow growth rate
Growth
Profitability
External Liquidity
Dividend payout
rate
Return on equity
– ROE
Market price to book
value
RR (retention rate)
Return on common
equity
Market price to cash
flow
Market price to sales
Risk measurement
Current ratio
Total debt ratio
Dividend payout
rate
Asset size
Market value of
stock outstanding
Working capital
to total assets
Cash flow to total debt
Interest coverage
Cash flow to total debt
Business risk (coefficient of variation of
operating earnings / operating profit
margins)
Credit analysis
for bond ratings
Long-term debt ratio
Equity turnover
Total debt ratio
Working capital
to sales ratio
Cash flow to total debt
Total asset turnover
Cash flow coverage of fixed financial cost
Cash flow to interest expense
Interest coverage
Variability of sales / net income and ROA
Net profit margin
(ROE)
Market value of
stock outstanding
Return on Assets
Par value of bonds
Operating profit
margin
Return on equity – ROE
Forecasting
bankruptcy
Current
Cash flow to total debt
Total asset turnover
Return on Assets
Market value of stock
to book value of debt
Cash
Cash flow to LT debt
Working capital
to sales ratio
Total debt ratio
Total debt to total assets
Other—not
used above
Quick (acid test)
Operating leverage
Fixed asset turnover
Sustainable
growth rate
Receivables
turnover
Financial risk (volatility caused by firm’s
use of debt)
| Hennie |
Fixed financial cost coverage
Fixed charge coverage
Average
receivables
collection period
Inventory
turnover
Average inventory
processing period
Payables turnover
Payables payment
period
Cash conversion
cycle
Return on Assets
EBIT to total assets
Retained earnings
to total assets
Gross profit margin
Operating profit
margin
Return on total capital
Return on total capital
including leases
Du Pont 1
Du Pont 2
Number of securities
traded per day
Bid / Asked spread
Percentage of
outstanding securities
traded per day
2
7
28
Chapter 3 Presentation of Financial Statements (IAS 1)
EXAMPLE: PRESENTATION OF FINANCIAL STATEMENTS
EXAMPLE 3.1
Elrali Inc. is a manufacturing entity. The following is a summary of the income and expens-
es for the year ending March 31, 20X7:
Gross turnover
Cost of sales of finished goods
Materials used
Labor
Variable production overhead costs allocated
Fixed production overhead costs allocated
Packing materials
Cost of finished goods manufactured
Opening inventories finished goods
Closing inventories finished goods
Distribution costs
Administrative expenses
Other operating expenses
Investment income
Rental income
Finance costs
Write-down of cost of materials to net realizable value
Over-recovery of fixed production overhead costs
Abnormal spillage of materials
Income tax expense
$
7,500,000
3,995,100
910,100
1,200,000
800,000
845,000
310,000
4,065,100
70,000
(140,000)
718,800
929,100
587,100
124,800
60,100
234,000
25,000
41,000
15,000
319,700
Depreciation and amortization charges included in the fixed production overheads amount-
ed to $418,000, and those included in administrative expenses amounted to $205,000. Total
salaries and other staff costs included in administrative expenses amounted to $689,300.
Chapter 3 Presentation of Financial Statements (IAS 1)
29
EXPLANATION
The following income statements could be prepared based on the two alternative classifica-
tions of income and expenses allowed by IAS 1:
Elrali Inc. Income Statement for the Year Ending March 31, 20X7
1. CLASSIFICATION OF EXPENSES BY FUNCTION
Revenue
Cost of sales (Calculation a)
Gross profit
Other income (Calculation b)
Distribution costs
Administrative expenses
Other expenses
Finance costs
Profit before tax
Income tax expense
Profit for the period
$
7,500,000
(3,994,100)
3,505,900
184,900
(718,800)
(929,100)
(587,100)
(234,000)
1,221,800
(319,700)
902,100
Elrali Inc. Income Statement for the Year Ending March 31, 20X7
2. CLASSIFICATION OF EXPENSES BY NATURE
Revenue
Other income (Calculation b)
Changes in inventories of finished goods and work in progress
Work performed by the enterprise and capitalized (Calculation c)
Raw material and consumables used (Calculation d)
Staff costs (Calculation e)
Depreciation and amortization expenses (418 + 205)
Other expenses (Calculation f)
Finance costs
Profit before tax
Income tax expense
Profit for the period
$
7,500,000
184,900
70,000
(1,186,000)
(1,260,100)
(1,889,300)
(623,000)
(1,340,700)
(234,000)
1,221,800
(319,700)
902,100
Continued on next page
30
Chapter 3 Presentation of Financial Statements (IAS 1)
Example 3.1 (continued)
Calculations
a. Cost of sales
Amount given
Write-down to net realizable value
Over-recovery of fixed production overheads
Abnormal materials spillage
b. Other income
Investment income
Rental income
c. Work performed and capitalized
Variable production overheads
Fixed production overheads (845–41)
Depreciation separately disclosed
d. Raw materials consumed
Materials used
Packing material
Write-down to net realizable value
Abnormal spillage
e. Staff costs
Labor
Other staff costs
f. Other expenses
Distribution costs given
Administrative costs given
Operating costs given
Staff costs shown in calculation e
Depreciation separately shown
$
3,995,100
25,000
(41,000)
15,000
3,994,100
124,800
60,100
184,900
800,000
804,000
(418,000)
1,186,000
910,100
310,000
25,000
15,000
1,260,100
1,200,000
689,300
1,889,300
718,800
929,100
587,100
(689,300)
(205,000)
1,340,700
4 Cash Flow Statements (IAS 7)
4.1
PROBLEMS ADDRESSED
The cash flow statement is a separate financial statement that mainly provides users with
additional information so that they can evaluate the solvency and liquidity of the entity. | Hennie |
Other reasons why cash flows are relevant are that it allows users to identify the:
• movement in cash balances for the period,
• timing and certainty of cash flows,
• ability of the entity to generate cash and cash equivalents, and
• prediction of future cash flows (useful for valuation models).
4.2
SCOPE OF THE STANDARD
All entities are required to present a cash flow statement that reports cash flows during the
reporting period. Either the direct or the indirect method can be used. Cash and cash equiv-
alents must be defined. Cash flows must be classified as follows:
• Operating activities.
• Investing activities.
• Financing activities.
4.3
KEY CONCEPTS
4.3.1 An entity should present a cash flow statement that reports cash flows during the
reporting period, classified by operating, financing, and investing activities.
4.3.2 Cash flows are inflows and outflows of cash and cash equivalents.
4.3.3 Cash comprises
• cash on hand, and
• demand deposits (net of bank overdrafts repayable on demand).
4.3.4 Cash equivalents are short term, highly liquid investments (such as short-term debt secu-
rities) that readily convert to cash and that are subject to an insignificant risk of changes in value.
31
32
Chapter 4 Cash Flow Statements (IAS 7)
4.3.5 Operating activities are principal revenue-producing activities and other activities
that do not include investing or financing activities.
4.3.6 Investing activities are acquisition and disposal of long-term assets and other invest-
ments not included as cash equivalent investments.
4.3.7 Financing activities are activities that change the size and composition of the equity
capital and borrowings.
4.4
ACCOUNTING TREATMENT
4.4.1 Cash flows from operating activities are reported using either the direct or indirect
method:
• Direct method
• Major classes of gross cash receipts and gross cash payments (for example, sales cost
of sales, purchases, and employee benefits ) are disclosed.
• Indirect method
• Profit and loss for the period is adjusted for
• effects of noncash transactions,
• deferrals or accruals, and
• investing or financing cash flows.
4.4.2 Cash flows from investing activities are reported as follows:
• Major classes of gross cash receipts and gross cash payments are reported separately.
• The aggregate cash flows from acquisitions or disposals of subsidiaries and other busi-
ness units are classified as investing.
4.4.3 Cash flows from financing activities are reported by separately listing major classes
of gross cash receipts and gross cash payments.
4.4.4 The following cash flows can be reported on a net basis:
• Cash flows on behalf of customers
• Items for which the turnover is quick, the amounts large, and maturities short (for
example, purchase and sale of investments)
4.4.5 Interest and dividends paid should be treated consistently as either operating or
financing activities. Interest and dividends received are treated as investing inflows.
However, in the case of financial institutions, interest paid and dividends received are usu-
ally classified as operating cash flows.
4.4.6 Cash flows from taxes on income are normally classified as operating (unless specifi-
cally identified with financing or investing).
4.4.7 A foreign exchange transaction is recorded in the functional currency using the
exchange rate at the date of the cash flow.
4.4.8 Foreign operations’ cash flows are translated at exchange rates on dates of cash flows.
4.4.9 When entities are equity- or cost-accounted, only actual cash flows from them (for
example, dividends received) are shown in the cash flow statement.
4.4.10 Cash flows from joint ventures are proportionately included in the cash flow statement.
4.5
PRESENTATION AND DISCLOSURE
Chapter 4 Cash Flow Statements (IAS 7)
33
4.5.1 The following should be shown in aggregate in respect of both the purchase and sale
of a subsidiary or business unit:
• Total purchase or disposal consideration
• Purchase or disposal consideration paid in cash and equivalents | Hennie |
• Amount of cash and equivalents in the entity acquired or disposed
• Amount of assets and liabilities other than cash and equivalents in the entity acquired
or disposed.
4.5.2 The following should be disclosed:
• Cash and cash equivalents in the cash flow statement and a reconciliation with the
equivalent items in the balance sheet
• Details about noncash investing and financing transactions (for example, conversion of
debt to equity)
• Amount of cash and equivalents that are not available for use by the group
• Amount of undrawn borrowing facilities available for future operating activities and to
settle capital commitments (indicating any restrictions)
• Aggregate amount of cash flows from each of the three activities related to interest in
joint ventures
• Amount of cash flows arising from each of the three activities (operating, etc.) regard-
ing each reported business and geographical segment
• Distinction between the cash flows that represent an increase in operating capacity and
those that represent the maintenance of it.
4.6
FINANCIAL ANALYSIS AND INTERPRETATION
4.6.1 The IFRS statement of cash flows shows the sources of the cash inflows received by an
entity during an accounting period, and the purposes for which cash was used. The state-
ment is an integral part of the analysis of a business because it enables the analyst to deter-
mine the following:
• The ability of a company to generate cash from its operations
• The cash consequences of investing and financing decisions
• The effects of management’s decisions about financial policy
• The sustainability of a firm’s cash-generating capability
• How well operating cash flow correlates with net income
• The impact of accounting policies on the quality of earnings
• Information about the liquidity and long-term solvency of a firm
• Whether or not the going concern assumption is reasonable
• The ability of a firm to finance its growth from internally generated funds
4.6.2 Because cash inflows and outflows are objective facts, the data presented in the state-
ment of cash flows represent economic reality. The statement reconciles the increase or
decrease in a company’s cash and cash equivalents that occurred during the accounting peri-
od (an objectively verifiable fact). Nevertheless, this statement must be read while keeping
the following in mind:
• There are analysts who believe that accounting rules are developed primarily to pro-
mote comparability, rather than to reflect economic reality. Even if this view were to be
34
Chapter 4 Cash Flow Statements (IAS 7)
considered harsh, it is a fact that too much flexibility in accounting can present
problems for analysts who are primarily interested in assessing a company’s future
cash-generating capability from operations.
• As with income statement data, cash flows can be erratic from period to period, reflect-
ing random, cyclical, and seasonal transactions involving cash, as well as sectoral
trends. It can be difficult to decipher important long-term trends from less meaningful
short-term fluctuations in such data.
4.6.3 Financial analysts can use the IFRS cash flow statement to help them determine other
measures that they wish to use in their analysis, for example free cash flow, which is often
used by analysts to determine the value of a firm. Defining free cash flow is not an easy task,
because there are many different measures that are commonly called free cash flow.
4.6.4 Discretionary free cash flow is the cash that is available for discretionary purposes.
According to this definition, free cash flow is the cash generated from operating activities,
less the capital expenditures required to maintain the current level of operations. Therefore,
the analyst must identify that part of the capital expenditure included in investing cash flows
that relates to maintaining the current level of operations—a formidable task. Any excess
cash flow can be used for discretionary purposes (for example, to pay dividends, reduce
debt, improve solvency, or to expand and improve the business). IFRS therefore requires dis- | Hennie |
closure of expenditures into those expenditures that were required to maintain the current
level of operations and those that were undertaken to expand or improve the business.
4.6.5 Free cash flow available to owners measures the ability of a firm to pay dividends to
its owners. In this case, all of the cash used for investing activities (capital expenditures,
acquisitions, and long-term investments) is subtracted from the cash generated from operat-
ing activities. In effect, this definition states that the firm should be able to pay out as divi-
dends cash from operations that is left over after the firm makes the investments that man-
agement deems necessary to maintain and grow current operations.
4.6.6 Generally, the cash generated from operating activities is greater than net income for a
well-managed, financially healthy company; if it is not, the analyst should be suspicious of the
company’s solvency. Growth companies often have negative free cash flows because their
rapid growth requires high capital expenditures and other investments. Mature companies
often have positive free cash flows, whereas declining firms often have significantly positive
free cash flows because their lack of growth means a low level of capital expenditures. High
and growing free cash flows, therefore, are not necessarily positive or negative; much depends
upon the stage of the industry life cycle in which a company is operating. This is why the free
cash flow has to be assessed in conjunction with the income prospects of the firm.
4.6.7 Many valuation models use cash flow from operations, thus giving management an
incentive to record inflows as operating (normal and recurring), and outflows as either relat-
ed to investing or financing. Other areas where management discretionary choices could
influence the presentation of cash flows follow:
• Payment of taxes. Management has a vested interest in reducing current-year pay-
ments of taxes by choosing accounting methods on the tax return that are likely to
defer tax payments to the future.
• Discretionary expenses. Management can manipulate cash flow from operations by
timing the payment or incurring certain discretionary expenses such as research and
development, repairs and maintenance, and so on. Cash inflows from operations can
also be increased by the timing of the receipt of deposits on long-term contracts.
• Leasing. The entire cash out-flow of an operating lease reduces the cash flow from
operations; for a capital lease, the cash payment is allocated between operating and
financing, thus increasing cash flow from operations.
EXAMPLES: CASH FLOW STATEMENTS
Chapter 4 Cash Flow Statements (IAS 7)
35
EXAMPLE 4.1
During the year ending 20X1, ABC Company completed the following transactions:
1. Purchased a new machine for $13.0 million
2. Paid cash dividends totaling $8.0 million
3. Purchased Treasury stock (own shares) totaling $45.0 million
4. Spent $27.0 million on operating expenses, of which $10.0 million was paid in cash and
the remainder put on credit
Which of the following correctly classifies each of the above transaction items on the operat-
ing, investing, and financing activities on the statement of cash flows?
Transaction 1
Transaction 2
Transaction 3
Transaction 4
a.
Investing in flow
Operating outflow Financing outflow All expenses—
operating outflow
b.
Financing outflow Financing outflow Investing outflow
Cash paid (only)—
operating outflow
c.
Investing outflow
Financing outflow Financing outflow Cash paid (only)—
operating outflow
d.
Financing inflow
Operating outflow Financing inflow
Cash paid (only)—
operating outflow
EXPLANATION
Choice c. is correct. Each transaction had both the proper statement of cash flow activity and
the correct cash inflow or outflow direction.
Choice a. is incorrect. This choice incorrectly classifies the cash flow activities for transactions
1, 2, and 4.
Choice b. is incorrect. This choice incorrectly classifies the cash flow activities for transactions
1 and 3.
Choice d. is incorrect. This choice incorrectly classifies the cash flow activities for transactions | Hennie |
1, 2, and 3.
Note: Dividends are sometimes classified as an operating cash flow.
36
Chapter 4 Cash Flow Statements (IAS 7)
EXAMPLE 4.2
Gibson Entities had the following financial data for the year ended December 31, 2002:
Capital expenditures
Dividends declared
Net income
Common stock issued
Increase in accounts receivable
Depreciation and amortization
Proceeds from sale of assets
Gain on sale of assets
millions of $
75.0
1.2
17.0
33.0
12.0
3.5
6.0
0.5
Based on the above, what is the ending cash balance at December 31, 2002, assuming an open-
ing cash balance of $47.0 million?
a. $13.0 million
b. $17.8 million
c. $19.0 million
d. $43.0 million
EXPLANATION
Choice c. is correct. The answer is based on the following calculation:
Operating cash flow
Net income
Depreciation and amortization
Gain on sale of assets
Increase in accounts receivable
Operating cash flow
Investing cash flow
Capital expenditures
Proceeds from sale of assets
Investing cash outflow
Financing cash flow
Common stock issued
Financing cash inflow
Net change in cash (8 – 69 + 33)
Beginning cash
Ending cash
millions of $
17.0
3.5
(0.5)
(12.0)
8.0
(75.0)
6.0
(69.0)
33.0
33.0
(28.0)
47.0
19.0
Note that the dividends had only been declared, not paid.
Chapter 4 Cash Flow Statements (IAS 7)
37
EXAMPLE 4.3
The following are the abridged annual financial statements of Linco Inc.
Income Statement for the Year Ending September 30, 20X4
Revenue
Cost of sales
Gross profit
Administrative expenses
Operating expenses
Profit from operations
Finance cost
Profit before tax
Income tax expense
Profit for the period
$
850,000
(637,500)
212,500
(28,100)
(73,600)
110,800
(15,800)
95,000
(44,000)
51,000
Statement of Changes in Equity for the Year Ending September 30, 20X4
Share
capital ($)
Revaluation
reserve ($)
Accumulated
profit ($)
Total ($)
Balance—beginning
of the year
Revaluation of
buildings
Profit for
the period
Dividends paid
Repayment of
share capital
Balance—end
of the year
120,000
121,000
241,000
20,000
51,000
(25,000)
20,000
51,000
(25,000)
(20,000)
(20,000)
100,000
20,000
147,000
267,000
Continued on next page
38
Chapter 4 Cash Flow Statements (IAS 7)
Example 4.3 (continued)
Balance Sheet at September 30, 20X4
20X4 ($)
20X3 ($)
Noncurrent Assets
Property, plant, and equipment
Office buildings
Machinery
Motor vehicles
Long-term loans to directors
Current Assets
Inventories
Debtors
Prepaid Expenses
Bank
Total Assets
Equity and Liabilities
Capital and Reserves
Share Capital
Revaluation Reserve
Accumulated Profits
Noncurrent Liabilities
Long-Term Borrowings
Current Liabilities
Creditors
Bank
Taxation Due
Total Equity and Liabilities
250,000
35,000
6,000
64,000
355,000
82,000
63,000
21,000
–
166,000
521,000
100,000
20,000
147,000
267,000
220,000
20,000
4,000
60,000
304,000
42,000
43,000
16,000
6,000
107,000
411,000
120,000
–
121,000
241,000
99,000
125,000
72,000
43,000
40,000
155,000
521,000
35,000
–
10,000
45,000
411,000
Additional information
1. The following depreciation charges are included in operating expenses:
Machinery
Motor vehicles
$25,000
$ 2,000
2. Fully depreciated machinery with an original cost price of $15,000 was sold for $5,000
during the year. The profit is included in operating expenses.
3. The financial manager mentions that the accountants allege the company is heading for
a possible liquidity crisis. According to him, the company struggled to meet its short-
term obligations during the current year.
Chapter 4 Cash Flow Statements (IAS 7)
39
EXPLANATION
The cash flow statement would be presented as follows if the direct method were used for
its preparation:
Linco Inc. Cash Flow Statement for the Year Ending September 30, 20X4
Cash Flows from Operating Activities
Cash Receipts from Customers (Calculation E)
Cash Payments to Suppliers and Employees (Calculation F)
Net Cash Generated By Operations
Interest Paid
Taxation Paid (Calculation D)
Dividends Paid
Cash Flows from Investing Activities
Purchases of Property, Plant and Equipment (Calc. A, B, C)
Proceeds on Sale of Machinery
Loans to Directors
Cash Flows from Financing Activities
Decrease in Long-Term Loan (125–99)
Repayment of Share Capital
Net Decrease in Bank Balance for the Period
Bank Balance at Beginning of the Year | Hennie |
Overdraft at End of the Year
$
830,000
(725,200)
104,800
(15,800)
(14,000)
(25,000)
50,000
(54,000)
5,000
(4,000)
(53,000)
(26,000)
(20,000)
(46,000)
(49,000)
6,000
(43,000)
Commentary
1. The total increase in creditors was used to partially finance the increase in working capi-
tal.
2. The rest of the increase in working capital as well as the interest paid, taxation paid, and
dividends paid were financed by cash generated from operations.
3. The remaining balance of cash generated by operating activities and the proceeds on the
sale of fixed assets were used to finance the purchase of fixed assets.
4. The overdrawn bank account was used for the repayment of share capital and the
redemption of the long-term loan.
Continued on next page
40
Chapter 4 Cash Flow Statements (IAS 7)
Example 4.3 (continued)
Calculations
a. Office Buildings
Balance at Beginning of Year
Revaluation
Purchases (Balancing Figure)
Balance at End of the Year
b. Machinery
Balance at Beginning of Year
Depreciation
Purchases (Balancing Figure)
Balance at End of the Year
c. Vehicles
Balance at Beginning of Year
Depreciation
Purchases (Balancing Figure)
Balance at End of the Year
d. Taxation
Amount Due at Beginning of Year
Charge in Income Statement
Paid in Cash (Balancing Figure)
Amount Due at End of the Year
e. Cash Receipts from Customers
Sales
Increase in Debtors (63–43)
f. Cash Payments to Suppliers and Employees
Cost of Sales
Administrative Expenses
Operating Expenses
Adjusted for Noncash Flow Items:
Depreciation
Profit on Sale of Machinery
Increase in Inventories (82–42)
Increase in Creditors (72–35)
Increase in Prepaid Expenses (21–16)
$
220,000
20,000
10,000
250,000
20,000
(25,000)
40,000
35,000
4,000
(2,000)
4,000
6,000
10,000
44,000
(14,000)
40,000
850,000
(20,000)
830,000
637,500
28,100
73,600
(27,000)
5,000
40,000
(37,000)
5,000
725,200
5 Accounting Policies,
Changes in Accounting
Estimates, and Errors (IAS 8)
5.1
PROBLEMS ADDRESSED
This Standard prescribes the criteria for selecting and changing accounting policies, changes
in accounting estimates, and correction of errors. The Standard aims at enhancing the rele-
vance, reliability, and comparability of an entity’s financial statements.
5.2
SCOPE OF THE STANDARD
This Standard covers situations where the entity:
• is selecting and applying accounting policies,
• is accounting for changes in accounting policies,
• has changes in accounting estimates, and
• has corrections of prior-period errors.
5.3
KEY CONCEPTS
5.3.1 Accounting policies are specific principles, bases, conventions, rules, and practices
applied by an entity in preparing and presenting financial statements.
5.3.2 Changes in accounting estimates are adjustments of an asset’s or liability’s carrying
amount or the amount of the periodic consumption of an asset that result from the assess-
ment of the present status of, and expected future benefits and obligations associated with,
assets and liabilities. Changes in accounting estimates result from new information or new
developments and, accordingly, are not corrections of errors. For example, a change in the
method of depreciation results from new information about the use of the related asset and
is, therefore, a change in accounting estimate.
5.3.3 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 a misuse of, reliable
information that
• was available when prior period financial statements were authorized for issue, or
• could reasonably have been obtained and taken into account in the preparation and
presentation of those financial statements.
41
42
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
Such errors include the effects of
• mathematical mistakes,
• mistakes in applying accounting policies,
• oversights or misinterpretations of facts, or
• fraud.
5.3.4 Omissions or misstatements are material if they could, individually or collectively, influ-
ence users’ economic decisions that are taken (or made) on the basis of the financial statements.
5.3.5 Impracticable changes are requirements that an entity cannot apply after making | Hennie |
every reasonable effort to do so. The application of a change in accounting policy or retro-
spective correction of an error becomes impracticable when
• effects are not determinable;
• assumptions about management intent in prior period are required; and
• it is impossible to distinguish information about circumstances in a prior period and
information that was available in that period from other information.
5.4
ACCOUNTING TREATMENT
5.4.1 When a Standard or an Interpretation specifically applies to a transaction, other
event, or condition, the accounting policy or policies applied to that item should be deter-
mined (chosen) by applying the Standard or Interpretation, considering any implementation
guidance issued by the IASB for that Standard or Interpretation.
5.4.2 In the absence of specific guidance on accounting policies (that is, a Standard or an
Interpretation that specifically applies to a transaction, other event or condition), manage-
ment should use its judgment in developing and applying an accounting policy that results
in relevant and reliable information. In making the judgment, management should consider
the applicability in the following order:
• The requirements and guidance in Standards and Interpretations dealing with similar
and related issues
• The definitions, recognition criteria and measurement concepts for assets, liabilities,
income, and expenses in the Framework
To the extent that they do not conflict with the above, management may also consider:
• The most recent pronouncements of other standard-setting bodies that use a similar
conceptual framework
• Other accounting literature and accepted industry practices
5.4.3 Accounting policies are applied consistently for similar transactions, other events
and conditions (unless a Standard or Interpretation requires or permits categorization, for
which different policies may be appropriate).
5.4.4 A change in accounting policy is allowed only under one of the following conditions:
• The change is required by a Standard or Interpretation
• The change will provide reliable and more relevant information about the effects of
transactions, other events and conditions.
5.4.5 When a change in accounting policy results from application of a new Standard or
Interpretation:
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
43
• Any specific transitional provisions in the Standard or Interpretation should be followed.
• If there are no specific transitional provisions, they should be applied in same way as
voluntary change.
5.4.6 A voluntary change in accounting policies is applied as follows:
• Policies are applied retrospectively as though the new policy had always applied
unless it is impracticable to do so.
• Opening balances are adjusted at the earliest period presented.
• Policies are applied prospectively if it is impracticable to restate prior periods or to
adjust opening balances.
5.4.7 Carrying amounts of asset, liability, or equity should be adjusted when changes in
accounting estimates necessitate a change in assets, liabilities, or equity.
5.4.8 Other changes in accounting estimates should be included in the profit or loss in the
period of the change or in the period of change and future periods if the change affects both.
5.4.9 Financial statements do not comply with IFRS if they contain prior-period material
errors. In the first set of financial statements authorized for issue after their discovery an enti-
ty should correct material prior-period errors retrospectively by
• restating the comparative amounts for the prior period or periods presented in which
the error occurred, or
• restating the opening balances of assets, liabilities, and equity for the earliest prior peri-
od presented.
5.5
PRESENTATION AND DISCLOSURE
5.5.1 If an entity makes a voluntary change in accounting policies, it should disclose:
• Nature of change
• Reason or reasons why new policy provides reliable and more relevant information
• Adjustment in current and each prior period presented | Hennie |
• Adjustment to basic and diluted earnings per share
• Adjustment to periods prior to those presented
5.5.2 When initial application of a Standard or an Interpretation has or could have an effect
on the current period or any prior period, except that it is impracticable to determine the
amount of the adjustment, an entity should disclose:
• The title of the Standard or Interpretation
• That the change in accounting policy is made in accordance with its transitional provi-
sions (when applicable)
• The nature of the change in accounting policy
• A description of the transitional provisions (when applicable)
• The transitional provisions that might have an effect on future periods (when applicable)
5.5.3 In considering an impending change in accounting policy, an entity should disclose:
• Pending implementation of a new standard
• Known or reasonably estimable information relevant to assessing the possible impact
of new standards
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Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
5.5.4 With reference to a change in accounting estimates, an entity should disclose:
• Nature of the change in estimate
• Amount of the change and its effect on the current and future periods
If estimating the future effect is impracticable that fact should be disclosed.
5.5.5 In considering prior period errors, an entity should disclose:
• Nature of the error
• Amount of correction in each prior period presented and the line items affected
• Correction to basic and diluted earnings per share
• Amount of correction at beginning of earliest period presented
• Correction relating to periods prior to those presented
5.6
FINANCIAL ANALYSIS AND INTERPRETATION
5.6.1 Analysts find it useful to break reported earnings down into recurring and nonrecur-
ring income or losses. Recurring income is similar to permanent or sustainable income,
whereas nonrecurring income is considered to be random and unsustainable. Even so-called
nonrecurring events tend to recur from time to time. Therefore, analysts often exclude the
effects of nonrecurring items when performing a short-term analysis of an entity (such as
estimating next year’s earnings). They also might include them on some average (per year)
basis for longer-term analyses.
5.6.2 The analyst should be aware that, when it comes to reporting nonrecurring income,
IFRS do not distinguish between items that are and are not likely to recur. Furthermore, IFRS
do not permit any items to be classified as extraordinary items.
5.6.3 However, IFRS do require the disclosure of all material information that is relevant to
an understanding of an entity’s performance. It is up to the analyst to use this information
together with information from outside sources and management interviews to determine to
what extent reported profit reflects sustainable income and to what extent it reflects nonre-
curring items.
5.6.4 Analysts generally need to identify such items as:
• Changes in accounting policies
• Changes in estimates
• Errors
• Unusual or infrequent items
• Discontinued operations (see chapter 28)
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
45
EXAMPLES: ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES, AND ERRORS
EXAMPLE 5.1
Which of the following items is not included in an IFRS income statement for the current
period?
a. The effects of corrections of prior period errors
b. Income and gains or losses from discontinued operations
c. Income or losses arising from extraordinary items
d. Adjustments resulting from changes in accounting policies.
EXPLANATION
Choice a. is incorrect. An entity should 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 or periods presented in which
the error occurred, or
• restating the opening balances of assets, liabilities, and equity for the earliest prior peri-
od presented.
Choice b. is correct. Income and losses from discontinued operations (net of taxes) is shown | Hennie |
on a separate line of the income statement, called Income (Loss) from Discontinued
Operations (see IFRS 5).
Choice c. is incorrect. The items are included in the income statement but they are not shown
as extraordinary items. (Extraordinary items are not separately classified under IAS 1.)
Choice d. is incorrect. Adjustments from changes in accounting policies should be applied ret-
rospectively as if though the new policy had always applied. Opening balances are adjusted
at the earliest period where feasible, when amounts prior to that period cannot be restated.
46
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
EXAMPLE 5.2
Unicurio Inc. is a manufacturer of curios that are sold at international airports. The follow-
ing transactions and events occurred during the year under review:
a. As of the beginning of the year, the remaining useful life of the plant and equipment was
reassessed as 4 years rather than 7 years.
b. Bonuses of $12 million, compared with $2.3 million in the previous year, had been paid
to employees. The financial manager explained that a new incentive scheme was adopt-
ed whereby all employees shared in increased sales.
c. There was a $1.25 million profit on the nationalization of land.
d. During the year the corporation was responsible for the formation of the ECA
Foundation, which donates funds to welfare organizations. This foundation forms part
of the corporation’s social investment program. The company contributed $7 million to
the fund.
EXPLANATION
Each of the transactions and events mentioned above would be treated as follows in the
income statement for the current year:
1. A change in the useful life of plants and equipment is a change in accounting estimate
and is applied prospectively. Therefore, the carrying amount of the plant and equipment
is written off over 4 years rather than 7 years. All the effects of the change are included
in profit or loss. The nature and amount of the change should be disclosed.
2. The item is included in profit or loss. Given its nature and size, it may need to be dis-
closed separately.
3. The profit is included in profit or loss (that is, it is not an “extraordinary item”).
4. The contribution is included in profit or loss. It is disclosed separately if it is material.
PARTII
Group
Statements
6 Business Combinations (IFRS 3)
6.1
PROBLEMS ADDRESSED
Many business operations take place within the context of a group structure that involves
many interrelated companies and entities. This Standard prescribes the accounting treatment
for business combinations where control is established. It is directed principally to a group
of entities where the acquirer is the parent entity and the acquiree a subsidiary. The prime
objective of IFRS 3 is to specify the relevant accounting treatment for all business combina-
tions acquired, regardless of how control is achieved.
The IFRS framework for dealing with equity and other securities investments is outlined in
Table 6.1.
Table 6.1 Accounting treatment of various securities acquisitions
Percentage Ownership
Accounting Treatment
IFRS Reference
Acquisition of Securities
Less than 20%
Between 20–50%
More than 50%
Other
Fair value
Equity accounting
Consolidation and
business combinations
Joint ventures
Business combinations
IAS 39
IAS 28
IAS 27
IAS 31
IFRS 3
6.2
SCOPE OF THE STANDARD
IFRS 3 addresses the following points:
• The focus is on the accounting treatment at date of acquisition.
• All business combinations should be accounted for by applying the purchase method
of accounting.
• The initial measurement of the identifiable assets acquired as well as liabilities and con-
tingent liabilities assumed in a business should be at fair value.
• The recognition of liabilities for terminating or reducing the activities.
49
50
Chapter 6 Business Combinations (IFRS 3)
• The accounting for goodwill and intangible assets acquired in a business combination.
This IFRS does not apply to the following:
• Business combinations in which separate entities or businesses are brought together to
| Hennie |
form a joint venture
• Business combinations involving entities or businesses under common control
• Business combinations involving two or more mutual entities
• Business combinations in which separate entities or businesses are brought together to
form a reporting entity by contract alone without the obtaining of an ownership inter-
est (for example, a dual listed corporation)
6.3
KEY CONCEPTS
6.3.1 A business combination is the bringing together of separate entities into one eco-
nomic entity as a result of one entity obtaining control over the net assets and operations of
another entity.
6.3.2 The purchase method views a business combination from the perspective of the com-
bining entity that is identified as the acquirer. The acquirer purchases net assets and recog-
nizes the assets acquired and liabilities and contingent liabilities assumed, including those
not previously recognized by the acquiree.
6.3.3 Non-controlling interest is that portion of a subsidiary attributable to equity interests
that are not owned, directly or indirectly through subsidiaries, by the parent. It is disclosed
as equity in consolidated financial statements.
6.3.4 A subsidiary is an entity—including an unincorporated entity such as a partnership—
that is controlled by another entity, known as the parent.
6.3.5 Control is the power to govern the financial and operating policies of an entity or
business to obtain benefits from its activities.
6.3.6 Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
6.3.7 Goodwill is the future economic benefits arising from assets that are not capable of
being individually identified and separately recognized.
6.4
ACCOUNTING TREATMENT
6.4.1 This Standard requires an acquirer to be identified for every business combination
within its scope. The acquirer is the combining entity that obtains control of the other com-
bining entities or businesses.
6.4.2 An acquisition should be accounted for by use of the purchase method of accounting.
From the date of acquisition, an acquirer should incorporate into the income statement the
results of operations of the acquiree, and recognize in the balance sheet the identifiable assets,
liabilities, and contingent liabilities of the acquiree and any goodwill arising from the acqui-
sition. Applying the purchase method involves the following steps:
• Identifying an acquirer
• Measuring the cost of the business combination
Chapter 6 Business Combinations (IFRS 3)
51
• Allocating, at the acquisition date, the cost of the business combination to the assets
acquired and liabilities and contingent liabilities assumed
6.4.3 The cost of acquisition carried by the acquirer is the aggregate of the fair values of
assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer,
in exchange for control of the acquiree, at the date of exchange. It includes directly attribut-
able costs but not professional fees or the costs of issuing debt or equity securities used to set-
tle the consideration.
6.4.4 The identifiable assets, liabilities, and contingent liabilities acquired should be those
of the acquiree that existed at the date of acquisition.
6.4.5 Intangible assets should be recognized as acquired assets if they meet the definition of
an intangible asset in IAS 38.
6.4.6 If the initial accounting for a business combination can be determined only provision-
ally because either the fair values to be assigned or the cost of the combination can be deter-
mined only provisionally, the acquirer should account for the combination using those provi-
sional values. The acquirer should recognize any adjustments to those provisional values as
a result of completing the initial accounting within twelve months of the acquisition date.
6.4.7 The identifiable assets, liabilities, and contingent liabilities acquired should be mea-
sured at their fair values at the date of acquisition. Any minority interest should be stated at | Hennie |
the minority’s proportion of their fair values.
6.4.8 The excess of the cost of acquisition over the acquirer and non-controlling interest in the
fair value of the identifiable assets and liabilities acquired is described as goodwill and is rec-
ognized as an asset.
6.4.9 Goodwill should be tested for impairment annually. Goodwill is not amortized.
6.4.10 The excess of the acquirer’s interest in the fair value of the identifiable assets and lia-
bilities acquired over the cost of acquisition is a gain and is recognized in profit or loss. It is
not recognized on the balance sheet as negative goodwill. However, before any gain is rec-
ognized, the acquirer should reassess the cost of acquisition and the fair values attributed to
the acquiree’s identifiable assets, liabilities, and contingent liabilities.
6.5
PRESENTATION AND DISCLOSURE
6.5.1 The acquirer should disclose information that enables users of its financial statements
to evaluate the nature and financial effect of business combinations that were effected dur-
ing the period and before the financial statements are authorized for issue (in aggregate
where immaterial). This information includes:
• Names and descriptions of the combining entities or businesses
• Acquisition date
• Percentage of voting equity instruments acquired
• Cost of the combination and a description of the components of that cost, such as the
number of equity instruments issued or issuable; and the fair value of those instru-
ments as well as the basis for determining that fair value
• Details of any operations the entity has decided to dispose of as a result of the
combination
• Amounts recognized at the acquisition date for each class of the acquiree’s assets, liabil-
ities, and contingent liabilities
52
Chapter 6 Business Combinations (IFRS 3)
• Amount of any excess (negative goodwill) recognized in profit or loss, and the line
item in the income statement in which the excess is recognized
• A description of factors that contributed to goodwill
• A description of each intangible asset that was not recognized separately from goodwill
• The amount of the acquiree’s profit or loss since the acquisition date included in the
acquirer’s profit or loss for the period
• The revenue and profit and loss of the combined entity for the period as though the
acquisition date for all business combinations effected during the period had been the
beginning of that period
6.5.2 Information to enable users to evaluate the effects of adjustments that relate to prior
business combinations should be disclosed.
6.5.3 Disclosure is required of all information neccessary to evaluate changes in the carrying
amount of goodwill during the period
BUSINESS COMBINATIONS AFTER THE BALANCE SHEET DATE
As much of the disclosures (as is practicable) mentioned above should be furnished for all
business combinations effected after balance sheet date. If it is impracticable to disclose any
of this information, this fact should be disclosed.
6.6
FINANCIAL ANALYSIS AND INTERPRETATION
6.6.1 When one entity seeks to obtain control over the net assets (assets less liabilities) of
another, there are a number of ways that this control can be achieved from a legal perspec-
tive: merger, consolidation, tender offer, and so forth. Business combinations occur in one of
two ways.
• In an acquisition of net assets, some (or all) of the assets and liabilities of one entity
are directly acquired by another
• With an equity (stock) acquisition one entity (the parent) acquires control of more than
50 percent of the voting common stock of another entity (the subsidiary). Both entities
can continue as separate legal entities, producing their own independent set of finan-
cial statements, or they can be merged in some way.
Under IFRS 3, the same accounting principles apply to both these ways of carrying out the
combination.
6.6.2 Under the purchase method, the acquisition price must be allocated to all of the
acquired company’s identifiable tangible and intangible assets, liabilities, and contingent lia- | Hennie |
bilities. The assets and liabilities of the acquired entity are combined into the financial state-
ments of the acquiring firm at their fair values on the acquisition date. Because the acquirer’s
assets and liabilities, measured at their historical costs, are combined with the acquired com-
pany’s assets and liabilities, measured at their fair market value on the acquisition date, the
acquirer’s pre- and postmerger balance sheets might not be easily comparable.
6.6.3 The fair value of long-term debt acquired on a business combination is the present
value of the principal and interest payments over the remaining life of the debt which has
been discounted using current market interest rates. Therefore, the fair value of the acquiree’s
debt that was issued at interest rates below current rates will be lower than the amount rec-
ognized on the acquiree’s balance sheet. Conversely, the fair value of the acquiree’s debt will
be higher than the amount recognized on the acquiree’s financial statements if the interest
rate on the debt is higher than current interest rates.
Chapter 6 Business Combinations (IFRS 3)
53
6.6.4 The cost of acquisition is compared with the fair values of the acquiree’s assets, liabili-
ties, and contingent liabilities and any excess is recognized as goodwill. If the fair market value
of the acquiree’s assets, liabilities and contingent liabilities is greater than the cost of acquisition
(effectively resulting in negative goodwill), IFRS 3 requires that the excess be reported as a gain.
6.6.5 The purchase method of accounting can be summarized by the following steps:
1. The cost of acquisition is determined.
2. The fair value of the acquiree’s assets is determined.
3. The fair value of the acquiree’s liabilities and contingent liabilities is determined.
4. The fair market value of the acquired company’s net assets equals the difference
between the fair market values of the acquired firm’s assets and liabilities.
Fair Market Value
of Acquired Firm’s Net Assets
=
Fair Market Value
of Acquired Firm’s Assets
–
Fair Market Value
of Acquired Firm’s Liabilities
and Contingent Liabilities
5. Calculate the new goodwill arising from the purchase as follows:
Goodwill
=
Purchase
Price
–
Fair Market Value
of Acquired Firm’s Net Assets,
Liabilities, and Contingent Liabilities
6. The book value of the acquirer’s assets and liabilities should be combined with the fair
values of the acquiree’s assets, liabilities, and contingent liabilities.
7. Any goodwill should be recognized as an asset in the combined entity’s balance sheet.
8. The acquired company’s net assets should not be combined with the acquiring compa-
ny’s equity because the acquired company ceases to exist (separately in the combined
financial statements) after the acquisition. Therefore, the acquired firm’s net worth is
eliminated (replaced with the market value of the shares issued by the acquirer).
6.6.6 In applying the purchase method, the income statement and the cash flow statements
will include the operating performance of the acquiree from the date of the acquisition for-
ward. Operating results prior to the acquisition are not restated and remain the same as his-
torically reported by the acquirer. Consequently, the financial statements (balance sheet,
income statement, and cash flow statement) of the acquirer will not be comparable before
and after the merger, but will reflect the reality of the merger.
6.6.7 Despite the sound principles incorporated in IFRS 3, many analysts believe that the
determination of fair values involve considerable management discretion. Values for intan-
gible assets such as computer software might not be easily validated when analyzing pur-
chase acquisitions.
6.6.8 Management judgment can be particularly apparent in the allocation of excess pur-
chase price (after all other allocations to assets and liabilities). If, for example, the remaining
excess purchase price is allocated to goodwill, there will be no impact on the firm’s net | Hennie |
income, because goodwill is not amortized (but is tested for impairment). If the excess were
to be allocated to fixed assets, depreciation would rise, thus reducing net income and pro-
ducing incorrect financial statements.
54
Chapter 6 Business Combinations (IFRS 3)
6.6.9 Under the purchase method, the acquirer’s gross margin usually decreases in the year
of the combination (assuming the combination does not occur near the end of the year)
because the write-up of the acquired firm’s inventory will almost immediately increase the
cost of goods sold. However, in the year following the combination the gross margin might
increase, reflecting the fact that the cost of goods sold decreases after the higher-cost inven-
tory has been sold. Under some unique circumstances, for instance when an entity purchas-
es another for less than book value, the effect on the ratios can be the reverse of what is com-
monly found. Therefore, there are no absolutes in using ratios, and analysts need to assess
the calculated ratios carefully in order to determine the real effect.
6.6.10 This points to an important analytical problem. Earnings, earnings per share, the
growth rate of these variables, rates of return on equity, profit margins, debt-to-equity ratios,
and other important financial ratios have no objective meaning. There is no rule of thumb
that the ratios will always appear better under the purchase method or any other method that
might be allowed in non-IASB jurisdictions. The financial ratios must be interpreted in light
of the accounting principle that is employed to construct the financial statements, as well as
the substance of the business combination.
6.6.11 One technique an analyst can use in his or her review of a company is to examine
cash flow. Cash flow, being an objective measure (in contrast to accounting measures such as
earnings that are subjectively related to the accounting methods used to determine them), is
less affected by the accounting methods used. Therefore, it is often instructive to compare
companies, and to examine the performance of the same company over time, in terms of cash
flow.
6.6.12 Over the years, goodwill has become one of the most controversial topics in account-
ing. Goodwill cannot be measured directly. Its value is generally determined through
appraisals, which are based on appraiser assumptions. As such, the value of goodwill is sub-
jectively determined.
6.6.13 The subject of recognizing goodwill in financial statements has found both propo-
nents and opponents among professionals. The proponents of goodwill recognition assert
that goodwill is the “present value of excess returns that a company is able to earn.” This
group claims that determining the present value of these excess returns is analogous to deter-
mining the present value of future cash flows associated with other assets and projects.
Opponents of goodwill recognition claim that the prices paid for acquisitions often turn out
to be based on unrealistic expectations, thereby leading to future write-offs of goodwill.
6.6.14 Both arguments have merit. Many companies are able to earn excess returns on their
investments. As such, the prices of the common shares of these companies should sell at a
premium to the book value of their tangible assets. Consequently, investors who buy the
common shares of such companies are paying for the intangible assets (reputation, brand
name, and so forth).
6.6.15 There are companies that earn low returns on investment despite the anticipated
excess returns indicated by the presence of a goodwill balance. The common share prices of
these companies tend to fall below book value because their assets are overvalued. Therefore,
it should be clear that simply paying a price in excess of the fair market value of the acquired
firm’s net assets does not guarantee that the acquiring company will continue earning excess
returns.
6.6.16 In short, analysts should distinguish between accounting goodwill and economic | Hennie |
goodwill. Economic goodwill is based on the economic performance of the entity, whereas
accounting goodwill is based on accounting standards. Economic goodwill is what should
Chapter 6 Business Combinations (IFRS 3)
55
concern analysts and investors. So, when analyzing a company’s financial statements, it is
imperative that the analysts remove goodwill from the balance sheet. Any excess returns that
the company earns will be reflected in the price of its common shares.
6.6.17 Under IFRS 3, goodwill should be capitalized and tested for impairment annually.
Goodwill is not amortized. Impairment of goodwill is a noncash expense. However, the
impairment of goodwill does affect reported net income. When goodwill is charged against
income in the current period, current reported income decreases, but future reported income
should increase when the asset is written off or no longer impaired. This also leads to
reduced net assets and reduced shareholders’ equity on the one hand, but improved return
on assets, asset turnover ratios, return on equity, and equity turnover ratios on the other
hand.
6.6.18 Even when the marketplace reacts indifferently to these impairment write-offs, it is
an analyst’s responsibility to carefully review a company’s goodwill to determine whether or
not it has been impaired.
6.6.19 Goodwill can significantly impact the comparability of financial statements between
companies using different accounting methods. As such, an analyst should remove any dis-
tortion that goodwill, its recognition, amortization, and impairment might create by adjust-
ing the company’s financial statements. Adjustments should be made by:
• Computing financial ratios using balance sheet data that exclude goodwill
• Reviewing operating trends using data that exclude the amortization of goodwill or
impairment to goodwill charges
• Evaluating future business acquisitions by taking into account the purchase price paid
relative to the net assets and earnings prospects of the acquired firm
56
Chapter 6 Business Combinations (IFRS 3)
EXAMPLES: BUSINESS COMBINATIONS
EXAMPLE 6.1
H Ltd. acquired a 70 percent interest in the equity shares of F Ltd. for an amount of $750,000
on January 1, 20X1. The abridged balance sheets of both companies at the date of acquisition
were as follows:
Identifiable Assets
Investment in F Ltd.
Equity
Identifiable Liabilities
H Ltd.
$’000
8,200
750
8,950
6,000
2,950
8,950
F Ltd.
$’000
2,000
–
2,000
1,200
800
2,000
The fair value of the identifiable assets of F Ltd. amounts to $2,800,000 and the fair value of
its liabilities is $800,000. Demonstrate the results of the acquisition.
EXPLANATION
Fair Value of Assets Less Liabilities
Minority Interest
Fair Value of Net Acquisition
Cost of Acquisition
Gain
Minority
$’000
360
240
600
H Ltd.
$’000
2,000
600
1,400
(750)
650
The abridged consolidated balance sheet at the date of acquisition will appear as follows:
Assets
Shareholders’ Equity
Minority Interest
Liabilities
a = 8,200 + 2,800
b = 6,000 + 650 (gain included in profit or loss)
c = 2,950 + 800
$’000
11,000a
6,650b
600
3,750c
11,000
Chapter 6 Business Combinations (IFRS 3)
57
EXAMPLE 6.2
Big Company is buying Small for $100,000 plus the assumption of all of Small’s liabilities.
Indicate what cash balance and goodwill amount would be shown on the consolidated bal-
ance sheet.
Assume that Big Company is planning to fund the acquisition using cash of $10,000 and new
borrowings of $90,000 (long-term debt).
Preacquisition balance sheets
$
Big
20,000
40,000
20,000
80,000
120,000
–
200,000
22,000
3,000
25,000
$
Small
3,000
10,000
8,000
21,000
50,000
–
71,000
10,000
1,000
11,000
$
Small
(FMV)
3,000
15,000
8,000
26,000
60,000
–
86,000
10,000
1,000
11,000
Cash
Inventory
Accounts receivable
Current assets
Property, plant,
and equipment
Goodwill
Total assets
Accounts payable
Accrued liabilities
Current liabilities
Long-term Debt
25,000
10,000
10,000
Common stock
Paid-in capital
Retained earnings
Total equity
Total
Common stock
Par value
Market value
10,000
40,000
100,000
150,000
200,000
10
80
1,000
9,000
40,000
50,000
71,000
2
8
65,000
86,000
Continued on next page
58
| Hennie |
Chapter 6 Business Combinations (IFRS 3)
Example 6.2 (continued)
Postacquisition balance sheets (purchase method)
Cash
Inventory
Accounts
Receivable
Current assets
Investment in subsidiary
Property, plant,
and equipment
Goodwill
Total assets
Accounts payable
Accrued liabilities
Current liabilities
$
Big
10,000
40,000
20,000
80,000
100,000
120,000
–
290,000
22,000
3,000
25,000
$
Small
3,000
10,000
8,000
21,000
50,000
–
71,000
10,000
1,000
11,000
$
Small (FMV)
3,000
15,000
8,000
26,000
60,000
–
86,000
10,000
1,000
11,000
Long-term debt
115,000
10,000
10,000
Common stock
Paid-in capital
Retained earnings
Total equity
Total
Common stock
Par value
Market value
10,000
40,000
100,000
150,000
290,000
10
80
1,000
9,000
40,000
50,000
71,000
2
8
65,000
86,000
EXAMPLE 6.2.A
Using the purchase method, Big’s postacquisition consolidated balance sheet will reflect a cash
balance of:
a. $13,000
c. $23,000
b. $20,000
d. $33,000
EXPLANATION 2A
Choice a. is correct. In a purchase method business combination, add the cash balances of the
two companies together and deduct any cash paid out as part of the purchase. Here the two
companies have $20,000 + $3,000 = $23,000 less $10,000 paid as part of the purchase leaving
a balance of $13,000.
Chapter 6 Business Combinations (IFRS 3)
59
EXAMPLE 6.2.B
Using the information provided, complete the consolidated balance sheet.
EXPLANATION
Completed postacquisition balance sheets (purchase method)
Cash
Inventory
Accounts
Receivable
Current assets
Investment in
Subsidiary
Property, plant,
and equipment
Goodwill
Total assets
Accounts
Payable
Accrued
Liabilities
Current
Liabilities
$
Big
10,000
40,000
20,000
80,000
100,000
120,000
–
290,000
$
Small
3,000
10,000
8,000
21,000
50,000
–
71,000
$
Small
(FMV)
3,000
15,000
8,000
26,000
60,000
–
86,000
22,000
10,000
10,000
3,000
1,000
1,000
25,000
11,000
11,000
Long-term debt
115,000
10,000
10,000
Common stock
Paid-in capital
Retained
Earnings
Total equity
Total
Common stock
Par value
Market value
10,000
40,000
100,000
150,000
290,000
10
80
1,000
9,000
40,000
50,000
71,000
2
8
10,000
40,000
65,000
(65,000) (c)
86,000
25,000
$
$
Adjustments
Consolidated
–100,000
35,000 (b)
25,000
13,000
55,000
28,000
96,000
180,000
35,000
311,000
32,000
4,000
36,000
125,000
100,000
150,000
311,000
Note: The goodwill is the difference between the consideration, including debt assumed, and
the fair market value of assets. In this case, the fair market value of Small’s assets is $86,000.
The consideration paid is $121,000 – $10,000 (cash) + $90,000 (debt issued) + $21,000 (liabili-
ties assumed, including Small’s accounts payable, accrued liabilities, and long-term debt).
The net difference between the $121,000 paid and the fair market value of the assets of
$86,000 is the goodwill of $35,000.
7 Consolidated and Separate
Financial Statements (IAS 27)
7.1
PROBLEMS ADDRESSED
Users of the financial statements of a parent entity need information about the financial posi-
tion, results of operations, and changes in financial position of the group as a whole. Hence,
the main objective of IAS 27 is to ensure that consolidated financial statements incorporating
all subsidiaries, jointly controlled entities, and associates are provided by such parent enti-
ties.
7.2
SCOPE OF THE STANDARD
This Standard’s main requirements are:
• Necessary aspects for control to be established.
• The preparation and presentation of consolidated financial statements for a group of
entities under the control of a parent; and
• The accounting for investments in subsidiaries, jointly controlled entities, and associ-
ates when an entity elects to—or is required by local regulations to—present separate
financial statements.
7.3
KEY CONCEPTS
7.3.1 Consolidated financial statements are the financial statements of a group presented
as financial statements of a single economic entity.
7.3.2 Control is the power to govern the financial and operating policies of an entity in
order to obtain benefits from the entity’s activities. The existence of control is generally evi-
denced by one of the following:
• Ownership. Parent owning (directly or indirectly through subsidiaries) of more than 50
percent of the voting power
• Voting rights. Power over more than 50 percent of the voting rights by virtue of an
| Hennie |
agreement with other investors
• Policies. Power to govern the financial and operating policies of the entity under a
statute or agreement
60
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
61
• Board of directors. Power to appoint or remove the majority of the members of the
board of directors
• Voting rights of directors. Power to cast the majority of votes at meetings of the board
7.3.3 A group is a parent and all of the parent’s subsidiaries.
7.3.4 A parent is an entity that has one or more subsidiaries.
7.3.5 Minority interest is that portion of the profit or loss, and net assets of a subsidiary
attributable to equity interests that are not owned, directly or indirectly through subsidiaries,
by the parent.
7.3.6 Separate financial statements are those presented by a parent, an investor in an asso-
ciate, or a venturer in a jointly controlled entity in which the investments are accounted for
on the basis of the direct equity interest rather than on the basis of the reported results and
net assets of the investees.
7.3.7 A subsidiary is an entity—including an unincorporated entity such as a partnership—
that is controlled by another entity (known as the parent).
7.3.8 Cost method of accounting is the recognition of the investment at cost and that of
income only to the extent that the investor receives distributions from accumulated profits of
the investee arising after the date of acquisition. Distributions received in excess of such prof-
its are regarded as a recovery of investment and are recognized as a reduction of the cost of
the investment.
7.4
ACCOUNTING TREATMENT
7.4.1 A parent should present consolidated financial statements as if the group were a sin-
gle entity. Consolidated financial statements should include
• the parent and all its foreign and domestic subsidiaries (including those that have dis-
similar activities),
• special purpose entities if the substance of relationship indicates control,
• subsidiaries that are classified as “held for sale,” and
• subsidiaries held by venture capital entities, mutual funds, unit trusts, and similar entities.
7.4.2 The preparation of consolidated financial statements involves the combination of the
financial statements of the parent and its subsidiaries on a line-by-line basis by adding
together like items of assets, liabilities, equity, income, and expenses. Other basic procedures
include the following:
• The carrying amount of the parent’s investment and its portion of equity of each sub-
sidiary are eliminated in accordance with the procedures of IFRS 3.
• Minority interests in the net assets of consolidated subsidiaries are identified and pre-
sented separately as part of equity.
• Intragroup balances and intragroup transactions are eliminated in full.
• Minority interests in the profit or loss of subsidiaries for the period are identified but
are not deducted from profit for the period.
• Consolidated profits are adjusted for the subsidiary’s cumulative preferred dividends,
whether or not dividends have been declared.
• An investment is accounted for in terms of IAS 39 from the date that it ceases to be a
subsidiary and does not subsequently become an associate.
62
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
• The losses applicable to the minority interest might exceed the minority investor’s
interest in the equity of the subsidiary. The excess is charged against the majority inter-
est except to the extent that the minority has a binding obligation to, and is able to,
make good on the losses.
7.4.3 Consolidated financial statements should be prepared using uniform accounting poli-
cies for like transactions and events.
7.4.4 Investments in subsidiaries should be accounted for in a parent entity’s separate
financial statements (if any) either
• at cost, or
• as financial assets in accordance with IAS 39.
7.4.5 When the reporting dates of the parent and subsidiaries differ, adjustments are made
for significant transactions or events that occur between those dates. The difference should | Hennie |
be no more than 3 months.
7.4.6 Consolidated financial statements need not be presented in the case of a wholly
owned subsidiary or a virtually wholly owned subsidiary (with unanimous approval of
minority shareholders) if
• debt or equity instruments are not traded in a public market;
• it did not file—or is not filing—financial statements with securities commission; and
• its ultimate parent publishes IFRS-consolidated financial statements.
7.5
PRESENTATION AND DISCLOSURE
7.5.1 Consolidated financial statements should include:
• Nature of the relationship when the parent does not own (directly or indirectly) more
than 50 percent of the voting power
• Name of an entity in which more than 50 percent of the voting power is owned (direct-
ly or indirectly), but which, because of the absence of control, is not a subsidiary
7.5.2 Where the parent does not present consolidated financial statements, include:
• the fact that exemption from publishing consolidated financial statements has been
used;
• the name and country of incorporation of parent that publishes consolidated financial
statement;
• the list of subsidiaries, associates, and joint ventures; and
• the method used to account for subsidiaries, associates and joint ventures.
7.5.3 In the parent’s separate financial statements, the following should be stated:
• List of subsidiaries, associates, and joint ventures
• Method used to account for subsidiaries, associates and joint ventures
7.6
FINANCIAL ANALYSIS AND INTERPRETATION (See also Section 6.6)
7.6.1 IAS 27 requires that the financial statements of a parent company and the financial
statements of the subsidiaries that it controls be consolidated. Control of a subsidiary is pre-
sumed when the parent company owns more than 50 percent of the voting stock of a sub-
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
63
sidiary unless control does not exist in spite of the parent’s ownership of a majority of the vot-
ing stock of the subsidiary.
7.6.2 The process of consolidation begins with the balance sheets and income statements of
the parent and the subsidiary constructed as separate entities. The parent’s financial state-
ments recognize the subsidiary as an asset called an investment in subsidiary and any div-
idends received from the subsidiary as income from subsidiaries.
7.6.3 With the financial statements of the parent and subsidiary combined, the consolidat-
ed financial statements fully reflect the financial results and financial position of the parent
and subsidiary. Consolidation does, however, pose problems:
• Combined financial statements of entities in totally different businesses limits analysis
of operations and trends of both the parent and the subsidiary—a problem overcome
somewhat by segment information.
• Regulatory or debt restrictions might not be easily discernible on the consolidated
financial statements.
64
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
EXAMPLES: CONSOLIDATED FINANCIAL STATEMENTS AND ACCOUNTING
FOR INVESTMENTS IN SUBSIDIARIES
EXAMPLE 7.1
The following amounts of profit after tax relate to the Alpha group of entities:
Alpha Inc.
Beta Inc.
Charlie Inc.
Delta Inc.
Echo Inc.
$
150,000
40,000
25,000
60,000
80,000
Alpha Inc. owns 75 percent of the voting power in Beta Inc. and 30 percent of the voting
power in Charlie Inc.
Beta Inc. also owns 30 percent of the voting power in Charlie Inc. and 25 percent of the vot-
ing power in Echo Inc.
Charlie Inc. owns 40 percent of the voting power in Delta Inc.
Issues
What is the status of each entity in the group and how is the minority share in the group profit
after tax calculated?
EXPLANATION
Beta Inc. and Charlie Inc. are both subsidiaries of Alpha Inc. which owns, directly or indi-
rectly through a subsidiary, more than 50 percent of the voting power in the entities.
Charlie Inc. and Echo Inc. are deemed to be associates of Beta Inc., whereas Delta Inc. is deemed
to be an associate of Charlie Inc. unless it can be demonstrated that significant influence does | Hennie |
not exist.
The minority interest in the group profit after tax is calculated as follows:
$
$
Profit after tax of Charlie Inc.
Own
Equity accounted:
Delta Inc. (40% ¥ 60,000)
25,000
24,000
49,000
Minority interest of 40%
19,600
Profit after tax of Beta Inc.
Own
Equity accounted:
Charlie Inc. (30% ¥ 49,000)
Echo Inc. (25% ¥ 80,000)
Minority interest of 25%
40,000
14,700
20,000
74,700
18,675
38,275
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
65
EXAMPLE 7.2
A European parent company, with subsidiaries in various countries, follows the accounting
policy of FIFO costing for all inventories in the group. It has recently acquired a controlling
interest in a foreign subsidiary that uses LIFO because of the tax benefits.
How is this aspect dealt with on consolidation?
EXPLANATION
IAS 27 requires consolidated financial statements to be prepared using uniform accounting
policies However, it does not demand that an entity in the group change its method of
accounting in its separate financial statements to that method which is adopted for the group.
Therefore, on consolidation appropriate adjustments must be made to the financial state-
ments of the foreign subsidiary to convert the carrying amount of inventories to a FIFO-
based amount.
66
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
EXAMPLE 7.3
Below are the balance sheet and income statements of a parent company and an 80
percent–owned subsidiary. The table depicts the method and adjustments required to con-
struct the consolidated financial statements. All allocations that cannot be accounted for in
any other way are attributed to goodwill.
Parent Only ($)
Subsidiary Only ($)
Adjustments ($)
Consolidated ($)
Cash
Receivables
From Others
From Subsidiary
Inventories
Plant and Equipment
Investments
In Others
In Subsidiary
Total Assets
Accounts Payable
To Others
To Parent
Long-Term Debt
Minority Interest
Common Stock
Paid-in Capital
Retained Earnings
Total Liabilities and Capital
50
320
30
600
1,000
800
360
3,160
250
1,350
100
300
1,160
3,160
120
20
100
500
40
780
100
30
200
40
160
250
780
170
340
—
700
1,500
840
—
3,550
350
—
1,550
90 (4)
100 (5)
300 (5)
1,160 (5)
3,550
(30) (1)
(360) (2)(3)
(390)
(30) (1)
90 (2)(3)
(40) (2)(3)
(160) (2)(3)
(250) (2)(3)
(390)
EXPLANATION 7.3.A
(1) The Intercompany receivables or payables are eliminated against each other so they do
not affect the consolidated group’s assets and liabilities.
(2) Investment in Subsidiary
Less 80% of Subsidiary’s equity
.80 ($40 + $160 + $250)
Goodwill from Consolidation
$360
360
$ 0
(3) This represents the pro rata share of the book value of the subsidiary’s equity (its com-
mon stock, paid-in capital, and retained earnings) that is not owned by the parent: 20%
of $450 = $90.
(4) Note that the Minority Interest is an explicit item only on the consolidated balance
sheet.
(5) Note that the equity of the consolidated group is the same as the equity of the parent,
which is the public entity.
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
67
Parent Only ($)
Subsidiary Only ($)
Adjustments ($)
Consolidated ($)
Sales to Outside Entities
Receipts from Subsidiary
Total Revenues
Costs of Goods Sold
Other Expenses
Payments to Parent
Minority Interest (1)
Pretax Income
Tax Expense (30%)
Income from Operations
Net Income from
Unconsolidated Subsidiaries
Net Income
2,800
500
3,300
1,800
200
—
1,300
390
910
28
938
1,000
1,000
400
50
500
50
15
35
35
(500) (2)
(500)
(500) (2)
10 (3)
(10)
(3) (3)
(7) (3)(4)
(28) (4)
(35)
3,800
—
3,800
2,200
250
—
10
1,340
402
938
—
938 (5)
EXPLANATION 7.3.B
(1) Sometimes Minority Interest ($10) is shown after taxes, in which case it would be
reported as $7 and placed below the Tax Expense line.
(2) The receipts from or payable by the subsidiary ($500) are eliminated against each other
and do not appear on the consolidated income statement.
(3) The pro forma share of the pretax income of the subsidiary that does not accrue to the
parent is reported as a Minority Interest expense on the consolidated income statement.
It is computed as follows:
20% of $50 = $10
Note that the calculation could have also been done on an after-tax basis:
| Hennie |
20% of $35 = $7
(4) The net income of the subsidiary is eliminated against the net Minority Interest expense
and the Net Income from Unconsolidated Subsidiaries account on the parent-only
income statement. This elimination is accounted for using the following journal entries:
Minority Interest (net of taxes)
Parent’s Net Income from Unconsolidated Subsidiaries
Subsidiary Net Income
$7
$28
$35
(5) The consolidated net income of the parent (the public entity) equals the parent-only net
income computed using the equity method. This is because the parent-only statement
includes the parent’s share of the net income from the (unconsolidated) subsidiary, just
as for the consolidated income.
8 Investments in Associates (IAS 28)
8.1
PROBLEMS ADDRESSED
Associate entities are distinct from subsidiaries in that the influence and ownership of asso-
ciates by the parent entity is not as extensive as for subsidiaries (IAS 27). The main issue is
identifying the amount of influence needed for an entity to be classified as an associate.
Conceptually this is considered as significant influence and practically this is done through
the degree of ownership (see Table 6.1). A conjunct issue of IAS 28 is what the appropriate
accounting treatment should be for the parent’s investment in the associate.
8.2
SCOPE OF THE STANDARD
IAS 28 applies to each investment in an associate. The main requirements are:
• Identification and requirements for the significant influence test.
• Prescription of the equity method of accounting for associates (which captures the parent’s
interest in the in the earnings and the underlying assets and liabilities of the associate).
The Standard does not apply to joint ventures, or entities that are subsidiaries.
The following entities could account for investments in associates as (a) associates in accor-
dance with IAS 28 or (b) held for trading financial assets in accordance with IAS 39:
• Venture capital organizations.
• Mutual funds.
• Unit trusts and similar entities.
• Investment-linked insurance funds.
8.3
KEY CONCEPTS
8.3.1 Equity method of accounting is accounting whereby the investment is initially rec-
ognized at cost and adjusted thereafter for the postacquisition 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.
8.3.2 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 inter-
est in a joint venture.
68
Chapter 8 Investments in Associates (IAS 28)
69
8.3.3 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. If an investor
holds, directly or indirectly through subsidiaries, 20 percent or more of the voting power of
the investee it is presumed that the investor has significant influence, unless it can be clearly
demonstrated that this is not the case. Existence of significant influence is evidenced by, inter
alia, the following:
• Representation on the board of directors or governing body
• Participation in policymaking processes
• Material transactions between parties
• Interchange of managerial personnel
• Provision of essential technical information
8.3.4 Control is the power to govern the financial and operating policies of an entity to
obtain benefits from its activities.
8.3.5 Joint control is the contractually agreed sharing of control over an economic activity.
8.3.6 A subsidiary is an entity—including an unincorporated entity such as a partnership—
that is controlled by another entity (known as the parent).
8.3.7 Consolidated financial statements are the financial statements of a group presented
as those of a single economic entity.
8.3.8 Separate financial statements are those presented by a parent, an investor in an asso-
ciate, or a venturer in a jointly controlled entity, in which the investments are accounted for | Hennie |
on the basis of the direct equity interest rather than on the basis of the reported results and
net assets of the investees.
8.4
ACCOUNTING TREATMENT
8.4.1 An investment in an associate should be accounted for, in the consolidated financial
statements of the investor and in any separate financial statements, using the equity method:
8.4.2 Equity accounting should commence from the date that the investee meets the defin-
ition of an associate. Equity accounting should be discontinued when
• the investor ceases to have significant influence, but retains whole or part of the invest-
ment; and
• the associate operates under severe long-term restrictions that significantly impair its
ability to transfer funds.
8.4.3 The equity method is applied as follows:
• Initial measurement is applied at cost (excluding borrowing costs as per IAS 23).
• Subsequent measurement is adjusted for postacquisition change in the investor’s
share of
• the net assets of the associate share of profit or loss included in income statement, and
• the share of other changes included in equity.
8.4.4 Many procedures for the equity method are similar to consolidation procedures, such
as the following:
• Eliminating intragroup profits and losses arising from transactions between the
investor and the investee
70
Chapter 8 Investments in Associates (IAS 28)
• Identifying the goodwill portion of the purchase price
• Amortization of goodwill
• Adjustments for depreciation of depreciable assets, based on their fair values
• Adjustments for the effect of cross holdings
• Using uniform accounting policies
8.4.5 The investor computes its share of profits or losses after adjusting for the cumulative
preferred dividends, whether or not they have been declared. The investor recognizes losses
of an associate until the investment is zero. Further losses are only provided for to the extent
of guarantees given by the investor.
8.4.6 The same principles outlined with regard to consolidating subsidiaries should be fol-
lowed when equity accounting—namely, using the most recent financial statements and
using uniform accounting policies for the investor and the investee; if reporting dates differ,
make adjustments for significant events after the balance sheet date of the associate.
8.4.7 With regard to impairment of an investment, the investor applies IAS 39 to determine
whether it is necessary to recognize any impairment loss. If the application of IAS 39 indi-
cates that the investment may be impaired, the investor applies IAS 36 to determine the value
in use of the associate.
8.5
PRESENTATION AND DISCLOSURE
8.5.1 Balance sheet and notes should include:
• Investment in associates shown as a separate item on the face and classified as noncurrent
• An appropriate list and description of significant associates, including
• name,
• nature of the business, and
• proportion of ownership interest or proportion of voting power (if different from the
ownership interest).
• If the investor does not present consolidated financial statements and does not equity-
account the investment, a description of what the effect would have been had the equi-
ty method been applied should be disclosed.
• If it is not practicable to calculate adjustments when associate (associates) uses account-
ing policies other than those adopted by investor, the fact should be mentioned.
• The investor’s share of the contingent liabilities and capital commitments of an associ-
ate for which it is contingently liable.
8.5.2 Income statement and notes should include the investor’s share of:
profits and losses for the period
prior period items
The investor’s share of the profit or loss of such associates, and the carrying amount of those
investments, should be separately disclosed. The investor’s share of any discontinued opera-
tions of such associates should also be separately disclosed, as follows:
• Its share of the contingent liabilities of an associate incurred jointly with other investors
• Those contingent liabilities that arise because the investor is severally liable for all or
| Hennie |
part of the liabilities of the associate.
Chapter 8 Investments in Associates (IAS 28)
71
8.5.3 Accounting policies. Disclose the method used to account for:
associates
goodwill and negative goodwill
amortization period for goodwill
8.5.4 The fair value of investments in associates for which there are published price quota-
tions should be disclosed.
8.5.5 Summarized financial information of associates, including the aggregated amounts of
assets
liabilities
revenues
profit or loss, should be provided.
8.5.6 The following disclosures should also be made:
• The reasons for deviating from the significant influence presumptions
• The reporting date of the financial statements of an associate, when such financial
statements are used in applying the equity method and are as of a reporting date or for
a period that is different from that of the investor, and the reason for using a different
reporting date or different period
• The nature and extent of any significant restrictions (for example, resulting from bor-
rowing arrangements or regulatory requirements) on the ability of associates to transfer
funds to the investor in the form of cash dividends, or repayment of loans or advances
• The unrecognized share of losses of an associate, both for the period and cumulatively,
if an investor has discontinued recognition of its share of losses of an associate
8.6
FINANCIAL ANALYSIS AND INTERPRETATION
8.6.1 Under the equity method, the investment in an associate is initially recognized at cost
and the carrying amount is increased or decreased to recognize the investor’s share of the
profit or loss of the investee after the date of acquisition. The investor’s share of the profit or
loss of the investee is recognized in the investor’s profit or loss. Distributions received from
an investee reduce the carrying amount of the investment.
8.6.2 Adjustments to the carrying amount might also be necessary for changes in the
investor’s proportionate interest in the investee arising from changes in the investee’s equi-
ty that have not been recognized in the investee’s profit or loss. Such changes include those
arising from the revaluation of property, plant, and equipment and from foreign exchange
translation differences. The investor’s share of those changes is recognized directly in equity
of the investor.
72
Chapter 8 Investments in Associates (IAS 28)
EXAMPLE: ACCOUNTING FOR INVESTMENTS IN ASSOCIATES
EXAMPLE 8.1
Dolo Inc. acquired a 40 percent interest in the ordinary shares of Nutro Inc. on the date of
incorporation, January 1, 20X0, for an amount of $220,000. This enabled Dolo Inc. to exercise
significant influence over Nutro Inc. On December 31, 20X3, the shareholders’ equity of
Nutro Inc. was as follows:
Ordinary issued share capital
Reserves
Accumulated profit
$
550,000
180,000
650,000
1,380,000
The following abstracts were taken from the financial statements of Nutro Inc. for the year
ending December 31, 20X4:
Income statement
Profit after tax
Extraordinary item
Net profit for the period
Statement of changes in equity
Accumulated profits at beginning of the year
Net profit for the period
Dividends paid
Accumulated profits at end of the year
$
228,000
(12,000)
216,000
650,000
216,000
(80,000)
786,000
In November 20X4, Dolo Inc. sold inventories to Nutro Inc. for the first time. The total sales
amounted to $50,000 and Dolo Inc. earned a profit of $10,000 on the transaction. None of the
inventories had been sold by Nutro Inc. by December 31. The income tax rate is 30 percent.
Chapter 8 Investments in Associates (IAS 28)
73
EXPLANATION
The application of the equity method would result in the carrying amount of the investment
in Nutro Inc. being reflected as follows:
Original cost
Postacquisition profits accounted for at beginning of the year
[40% ¥ (180,000 + 650,000)]
Carrying amount on January 1, 20X4
Attributable portion of net profit for the period (Calculation a)
Dividends received (40% ¥ 80,000)
Calculation a
Attributable portion of net profit
Net profit (40% ¥ 216,000)
After-tax effect of unrealized profit [40% ¥ (70% ¥ 10,000)]
All
$
220,000
332,000
552,000
83,600
(32,000)
603,600
$
86,400
(2,800)
83,600
| Hennie |
9 Interests in Joint Ventures (IAS 31)
9.1
PROBLEMS ADDRESSED
Joint ventures occur where there is an arrangement to undertake an activity where control is
shared jointly. This is different from arrangements where a parent has sole control or there is
significant influence. The overall objective of IAS 31 is to provide users with information con-
cerning the investing owners’ (venturers’) interest in the earnings and the underlying net
assets of the joint venture.
9.2
SCOPE OF THE STANDARD
This IAS applies to all interests in joint ventures and the reporting of their assets, liabilities,
income, and expenses, regardless of the joint ventures’ structures or forms. The Standard
specifically outlines:
• The characteristics necessary to be classified as a joint venture.
• The distinction between jointly controlled operations, assets and entities and the specif-
ic accounting requirements for each.
The following entities may account for investments in joint ventures as joint ventures in
accordance with IAS 31 or as held for trading financial assets in accordance with IAS 39:
• Venture capital organizations.
• Mutual funds.
• Unit trusts and similar entities.
• Investment-linked insurance funds.
9.3
KEY CONCEPTS
9.3.1 A joint venture is a contractual arrangement whereby two or more parties undertake
an economic activity that is subject to joint control.
9.3.2 The following are characteristics of all joint ventures:
• Two or more venturers are bound by a contractual arrangement.
• A joint venture establishes joint control; that is, the contractually agreed sharing of con-
trol over a joint venture is such that not one of the parties can exercise unilateral control.
• A venturer is a party to a joint venture and has joint control over that joint venture.
74
Chapter 9 Interests in Joint Ventures (IAS 31)
75
9.3.3 The existence of a contractual arrangement distinguishes joint ventures from associ-
ates. It is usually in writing and deals with such matters as:
• Activity, duration, and reporting
• Appointment of a board of directors or equivalent body and voting rights
• Capital contributions by venturers
• Sharing by the venturers of the output, income, expenses, or results of the joint venture
9.3.4 IAS 31 identifies three forms of joint ventures, namely jointly controlled operations,
jointly controlled assets, and jointly controlled entities.
9.3.5 Jointly controlled operations involve the use of resources of the venturers; they do
not establish separate structures. An example is when two or more parties combine resources
and efforts to manufacture, market, and jointly sell a product.
9.3.6 Jointly controlled assets refer to some joint ventures that involve the joint control and
ownership of one or more assets acquired for and dedicated to the purpose of the joint ven-
ture (for example, factories sharing the same railway line). The establishment of a separate
entity is unnecessary.
9.3.7 Jointly controlled entities are joint ventures that are conducted through a separate
entity in which each venturer owns an interest. An example is when two entities combine
their activities in a particular line of business by transferring assets and liabilities into a joint
venture.
9.3.8 Proportionate consolidation is a method of accounting whereby a venturer’s share of
each of the assets, liabilities, income, and expenses of a jointly controlled entity is combined
line by line with similar items in the venturer’s financial statements or reported as separate
line items in the venturer’s financial statements.
9.3.9 Separate financial statements are those presented by a parent, an investor in an asso-
ciate, or a venturer in a jointly controlled entity, in which the investments are accounted for
on the basis of the direct equity interest rather than on the basis of the reported results and
net assets of the investees.
9.4
ACCOUNTING TREATMENT
9.4.1 In respect of its interests in jointly controlled operations, a venturer should recognize
in its separate and consolidated financial statements
| Hennie |
• the assets that it controls,
• the liabilities that it incurs,
• the expenses that it incurs, and
• its share of the income that it earns from the joint venture.
9.4.2 In respect of its interests in jointly controlled assets a venturer should recognize in its
separate and consolidated financial statements
• its share of the assets,
• any liabilities that it has incurred,
• its share of any liabilities incurred jointly with the other venturers in relation to the
joint venture,
76
Chapter 9 Interests in Joint Ventures (IAS 31)
• any income it receives from the joint venture,
• its share of any expenses incurred by the joint venture, and
• any expenses that it has incurred in respect of its interest in the joint venture.
9.4.3 An entity should account for its interest as a venturer in jointly controlled entities
using one of the following two treatments:
1. Proportionate consolidation, whereby a venturer’s share of each of the assets, liabili-
ties, income, expenses, and cash flows of a jointly controlled entity is combined with
similar items of the venturer or reported separately. The following principles apply:
• Two formats could be used, namely
• combining items line by line, or
• listing separate line items.
• The interests in the joint ventures are included in consolidated financial statements
for the venturer, even if it has no subsidiaries.
• Proportionate consolidation is commenced when the venturer acquires joint control.
• Proportionate consolidation ceases when the venturer loses joint control.
• Many procedures for proportionate consolidation are similar to consolidation proce-
dures, described in IAS 27.
• Assets and liabilities can only be offset if
• a legal right to set-off exists; and
• there is an expectation of realizing an asset or settling a liability on a net basis.
2. The equity method is an allowed alternative but is not recommended. The method
should be discontinued when joint control or significant influence is lost by the venturer.
9.4.4 The following general accounting considerations apply:
• Transactions between a venturer and a joint venture are treated as follows:
• The venturer’s share of unrealized profits on sales or contribution of assets to a joint
venture is eliminated.
• Full unrealized loss on sale or contribution of assets to a joint venture is eliminated.
• The venturer’s share of profits or losses on sales of assets by a joint venture to the
venturer is eliminated.
• An investor in a joint venture that does not have joint control should report its interest
in a joint venture in the consolidated financial statements in terms of IAS 39 or, if it has
significant influence, in terms of IAS 28.
• Operators or managers of a joint venture should account for any fees as revenue in
terms of IAS 18.
9.5
PRESENTATION AND DISCLOSURE
9.5.1 The following contingent liabilities (IAS 37) should be shown separately from others:
• Incurred jointly with other venturers
• Share of a joint venture’s contingent liabilities
• Contingencies for liabilities of other venturers
9.5.2 Amount of commitments shown separately include:
• Incurred jointly with other venturers
• Share of a joint venture’s commitments
Chapter 9 Interests in Joint Ventures (IAS 31)
77
9.5.3 Present a listing of significant joint ventures, including:
• Names
• A description of the interests in all joint ventures
• The proportion of ownership
9.5.4 A venturer that uses the line-by-line reporting format or the equity method should
disclose aggregate amounts of each of the current assets, long-term assets, current liabilities,
long-term liabilities, income, and expenses related to the joint ventures.
9.5.5 A venturer not issuing consolidated financial statements (because it has no sub-
sidiaries) should nevertheless disclose the above information.
9.6
FINANCIAL ANALYSIS AND INTERPRETATION
9.6.1 Entities can form joint ventures in which none of the entities own more than 50 per-
cent of the voting rights in the joint venture. This enables every member of the venturing | Hennie |
group to use the equity method of accounting for unconsolidated affiliates to report their
share of the activities of the joint ventures. They can also use proportionate consolidation—
and each one need not use the same method.
9.6.2 If they use the equity method, joint ventures enable firms to report lower debt-to-equity
ratios and higher interest coverage ratios, although this does not affect the return on equity.
9.6.3 Forming joint ventures also affects the cash flow reported by the sponsoring group of
firms. When the equity method of accounting for jointly controlled entities is used, monies
exchanged between a parent and the jointly controlled entities are reported as income or
expenses, whereas in consolidation accounting any cash flows that are internal to members
of the consolidated group are not reported separately.
78
Chapter 9 Interests in Joint Ventures (IAS 31)
EXAMPLES: FINANCIAL REPORTING OF INTERESTS IN JOINT VENTURES
EXAMPLE 9.1
Techno Inc. was incorporated after three independent engineering corporations decided to
pool their knowledge to implement and market new technology. The three corporations
acquired the following interests in the equity capital of Techno Inc. on the date of its incor-
poration:
• Electro Inc.
• Mechan Inc.
• Civil Inc.
30%
40%
30%
The following information was taken from the financial statements of Techno Inc. as well as
one of the owners, Mechan Inc.
Abridged income statement for the year ending June 30, 20X1
Mechan Inc.
($’000)
Techno Inc.
($’000)
Revenue
Cost of Sales
Gross profit
Other operating income
Operating costs
Profit before tax
Income tax expense
Net profit for the period
3,100
(1,800)
1,300
150
(850)
600
(250)
350
980
(610)
370
–
(170)
200
(90)
110
Mechan Inc. sold inventories with an invoice value of $600,000 to Techno Inc. during the year.
Included in Techno Inc.’s inventories June 30, 20X1, is an amount of $240,000, which is inven-
tory purchased from Mechan Inc. at a profit markup of 20 percent. The income tax rate is 30
percent.
Techno Inc. paid an administration fee of $120,000 to Mechan Inc. during the year. This
amount is included under “Other operating income.”
EXPLANATION
In order to combine the results of Techno Inc. with those of Mechan Inc. the following issues
would need to be resolved:
• Is Techno Inc. an associate or joint venture for financial reporting purposes?
• Which is the appropriate method for reporting the results of Techno in the financial
statements of Mechan?
• How are the above transactions between the entities to be recorded and presented for
financial reporting purposes in the consolidated income statement?
First issue
The existence of a contractual agreement, whereby the parties involved undertake an eco-
nomic activity subject to joint control, distinguishes a joint venture from an associate. No one
of the ventures should be able to exercise unilateral control. However, in the event that no
Chapter 9 Interests in Joint Ventures (IAS 31)
79
contractual agreement exists, the investment would be regarded as being an associate
because the investor holds more than 20 percent of the voting power and is therefore pre-
sumed to have significant influence over the investee.
Second issue
If Techno Inc. is regarded as a joint venture, the proportionate consolidation method or the
equity method must be used. However, if Techno Inc. is regarded as an associate, the equity
method would be used.
Third issue
It is assumed that Techno Inc. is a joint venture for purposes of this illustration.
Consolidated Income Statement for the Year Ending June 30, 20X1
Revenue (Calculation a)
Cost of sales (Calculation b)
Gross profit
Other operating income (Calculation c)
Operating costs (Calculation d)
Profit before tax
Income tax expense (Calculation e)
Net profit for the period
$’000
3,252
(1,820)
1,432
102
(870)
664
(281)
383
Remarks
• The proportionate consolidation method is applied by adding 40 percent of the income
statement items of Techno Inc. to those of Mechan Inc.
• The transactions between the corporations are then dealt with by recording the follow-
| Hennie |
ing consolidation journal entries:
Sales (40% ¥ 600)
Cost of sales
(Eliminating intra-group sales)
Cost of sales (40% ¥ 20/120 ¥ 240)
Inventories
(Eliminating unrealized profit in inventory)
Deferred taxation (B/S) (30% ¥ 16)
Income tax expense (I/S)
(Taxation effect on elimination of unrealized profit)
Dr
($’000)
240
Cr
($’000)
240
16
4.8
16
4.8
Note: The administration fee is eliminated by reducing other operating income with Mechan
Inc.’s portion of the total fee, namely $48,000, and reducing operating expenses accordingly.
The net effect on the consolidated profit is nil.
Continued on next page
80
Chapter 9 Interests in Joint Ventures (IAS 31)
Example 9.1 (continued)
Calculations
a. Sales
Mechan
Intragroup sales (40% ¥ 600)
Techno (40% ¥ 980)
b. Cost of sales
Mechan
Intragroup sales
Unrealized profit (40% ¥ 20/120 ¥ 240)
Techno (40% ¥ 610)
c. Other operating income
Mechan
Intragroup fee (40% ¥ 120)
d. Operating costs
Mechan
Techno (40% ¥ 170)
Intragroup fee (40% ¥ 120)
e.
Income tax expense
Mechan
Unrealized profit (30% ¥ 16 rounded up)
Techno (40% ¥ 90)
$’000
3,100
(240)
392
3,252
1,800
(240)
16
244
1,820
150
(48)
102
850
68
(48)
870
250
(5)
36
281
PARTIII
Balance Sheet
and Income
Statement
10 Share-Based Payment (IFRS 2)
10.1
PROBLEMS ADDRESSED
Share-based payments occur when an entity uses a transfer of shares instead of satisfying an
obligation using conventional cash. The standard covers situations where the entity makes
any share-based payment transaction, including transactions with employees or other parties
to be settled in cash, equity, or the entity’s equity instruments. The main issues relate to if and
when the share-based payment should be recognized and when these transactions should be
reflected as expenses in the income statement.
10.2
SCOPE OF THE STANDARD
This IFRS should be applied for all share-based payment transactions. IFRS 2 is therefore
broader than just employee share options, because it also deals with the issuance of shares
(and rights to shares) in return for services and goods. The Standard specifically covers:
• The criteria for defining a share-based payment.
• The distinction and accounting for the various types of share-based payments namely:
equity settled, cash settled and transactions in which the entity receives or acquires
goods or services and where there is an option to settle via equity instruments.
• That an entity should reflect in its profit and loss and financial position the effects of
share-based payment transactions; these transactions include expenses associated with
transactions in which employees receive share options.
10.3
KEY CONCEPTS
10.3.1 A share-based payment transaction is a transaction in which the entity receives
goods or services as consideration for equity instruments of the entity (including shares or
share options), or acquires goods or services by incurring liabilities to the supplier of those
goods or services for amounts that are based on the price of the entity’s shares or other equi-
ty instruments of the entity. Share-based payment transactions include transactions where
the terms of the arrangement provide either the entity or the supplier of those goods or ser-
vices with a choice of whether the entity settles the transaction in cash (or other assets) or
through the issuance of equity instruments
83
84
Chapter 10 Share-Based Payment (IFRS 2)
10.3.2 An equity-settled share-based payment transaction is a share-based payment trans-
action in which the entity receives goods or services (including shares or share options) as
consideration for the entity’s equity instruments. An equity instrument is a contract that evi-
dences a residual interest in the assets of an entity after deducting all of its liabilities. An equi-
ty instrument granted is the right to an equity instrument of the entity conferred by the enti-
ty on another party, under a share-based payment arrangement.
10.3.3 A cash-settled share-based payment transaction is a share-based payment transac-
tion in which the entity acquires goods or services by incurring a liability to transfer cash or | Hennie |
other assets to the supplier of those goods or services for amounts that are based on the price
or value of the entity’s shares or other equity instruments.
10.3.4 The grant date is the date at which the entity and another party (including an
employee) agree to a share-based payment arrangement. At grant date the entity confers on
the counterparty the right to cash, other assets, or the entity’s equity instruments, provided
that the specified vesting conditions are met.
10.3.5 Employees and others providing similar services are individuals who render per-
sonal or similar services to the entity.
10.3.6 Under a share-based payment arrangement, a counterparty’s right to receive the
entity’s cash, other assets, or equity instruments vests upon satisfaction of any specified vest-
ing conditions. Vesting conditions include service conditions. The vesting period is the peri-
od during which all the specified vesting conditions of a share-based payment arrangement
should be satisfied.
10.3.7 Fair value is the amount for which an asset could be exchanged; a liability settled; or
an equity instrument granted could be exchanged between knowledgeable, willing parties in
an arm’s length transaction.
10.3.8 Intrinsic value is the difference between the fair value of the shares to which the
counterparty has the right to subscribe or which it has the right to receive, and the price the
counterparty is required to pay for those shares.
10.3.9 Market condition is a condition that is related to the market price of the entity’s
equity instruments.
10.3.10 A share option is a contract that gives the holder the right but not the obligation to
subscribe to the entity’s shares at a fixed or determinable price for a specified period of time.
10.4
ACCOUNTING TREATMENT
10.4.1 Share-based payments could be
• cash settled, that is, by a cash payment based on the value of equity instruments;
• equity settled, that is, by the issue of equity instruments; or
• cash or equity settlement (by choice of the entity or supplier)
10.4.2 An entity should recognize the goods or services received or acquired in a share-
based payment transaction when it obtains the goods or as the services are received.
Chapter 10 Share-Based Payment (IFRS 2)
85
10.4.3 Share-based payment transactions should be measured at
• the fair value of the goods or services received in the case of all third party, nonem-
ployee transactions, unless it is not possible to measure the fair value of those goods or
services reliably; or
• the fair value of the equity instruments in all other cases, including all employee
transactions.
EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS
10.4.4 The fair value of the equity instruments issued or to be issued should be measured
• at grant date for transactions with employees and others providing similar services; and
• at the date on which the entity receives the goods or the counterparty renders the ser-
vices in all other cases.
10.4.5 The fair value of the equity instruments issued or to be issued should be based on
market prices, taking into account market vesting conditions (for example, market prices or
reference to an index) but not other vesting conditions (for example, service periods). Listed
shares should be measured at market price. Options should be measured
• on the basis of the market price of any equivalent traded options; or
• using an option pricing model in the absence of such market prices; or
• at intrinsic value when they cannot be measured reliably on the basis of market prices
or on the basis of an option pricing model.
10.4.6 In the rare cases where the entity is required to measure the equity instruments at
their intrinsic value, it remeasures the instruments at each reporting date until final settle-
ment and recognizes any change in intrinsic value in profit or loss.
10.4.7 The entity should recognize an asset (for example, inventory) or an expense (for
example, services received or employee benefits) and a corresponding increase in equity if | Hennie |
the goods or services were received in an equity-settled share-based payment transaction.
Therefore, an entity recognizes an asset or expense and a corresponding increase in equity
• on grant date if there are no vesting conditions or if the goods or services have already
been received;
• as the services are rendered if nonemployee services are rendered over a period; or
• over the vesting period for employee and other share-based payment transactions
where there is a vesting period.
10.4.8 If the equity instruments granted do not vest until the counterparty completes a
specified period of service, the amount recognized should be adjusted over any vesting peri-
od for changes in the estimate of the number of securities that will be issued but not for
changes in the fair value of those securities. Therefore, on vesting date the amount recog-
nized is the exact number of securities that can be issued as of that date, measured at the fair
value of those securities at grant date.
10.4.9 If the entity cancels or settles a grant of equity instruments during the vesting peri-
od (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied):
• The entity accounts for the cancellation or settlement as an acceleration of vesting by
recognizing immediately the amount that otherwise would have been recognized over
the remainder of the vesting period.
• The entity recognizes in equity any payment made to the employee on the cancellation
or settlement to the extent that the payment does not exceed the fair value at repur-
chase date of the equity instruments granted.
86
Chapter 10 Share-Based Payment (IFRS 2)
• The entity recognizes as an expense the excess of any payment made to the employee
on the cancellation or settlement over the fair value at repurchase date of the equity
instruments granted.
• The entity accounts for new equity instruments granted to the employee as replace-
ment equity instruments for the cancelled equity instruments as a modification of the
original grant of equity instruments. The difference between the fair value of the
replacement equity instruments and the net fair value of the cancelled equity instru-
ments at the date the replacement equity instruments are granted is recognized as an
expense.
CASH-SETTLED SHARE-BASED PAYMENT TRANSACTION
10.4.10 The entity should recognize an asset (for example, inventory) or an expense (for
example, services received or employee benefits) and a liability if the goods or services were
received in a cash-settled share-based payment transaction.
10.4.11 Until the liability is settled, the entity should remeasure the fair value of the liabil-
ity at each reporting date and at the date of settlement, with any changes in fair value recog-
nized in profit or loss for the period.
SHARE-BASED PAYMENT TRANSACTIONS WITH CASH ALTERNATIVES
10.4.12 For share-based payment transactions in which the terms of the arrangement pro-
vide either the entity or the counterparty with the choice of whether the entity settles the
transaction in cash (or other assets) or by issuing equity instruments, the entity should
account for that transaction, or the components of that transaction, as a cash-settled share-
based payment transaction if, and to the extent that, the entity has incurred a liability to set-
tle in cash or other assets, or as an equity-settled share-based payment transaction if, and to
the extent that, no such liability has been incurred.
10.5
PRESENTATION AND DISCLOSURE
10.5.1 An entity should disclose information that enables users of the financial statements
to understand the effect of share-based payment transactions on the entity’s profit or loss
for the period and on its financial position.
10.5.2 An entity should disclose information that enables users of the financial statements
to understand the nature and extent of share-based payment arrangements that existed dur-
ing the period.
10.5.3 An entity should provide a description of
| Hennie |
• each type of share-based payment arrangement that existed at any time during the
period; and
• the general terms and conditions of each arrangement, such as vesting requirements,
the maximum term of options granted, and the method of settlement (for example,
whether in cash or equity).
10.5.4 An entity should provide the number and weighted average exercise prices of share
options for each of the following groups of options:
• Outstanding at the beginning of the period
• Granted during the period
• Forfeited during the period
• Exercised during the period
Chapter 10 Share-Based Payment (IFRS 2)
87
• Expired during the period
• Outstanding at the end of the period
• Exercisable at the end of the period
10.5.5 For share options granted during the period, the weighted average fair value of
those options at the measurement date and information on how that fair value was measured
should be disclosed, including:
• The option pricing model used and the inputs to that model, including
• the weighted average share price,
• exercise price,
• expected volatility,
• option life,
• expected dividends,
• the risk-free interest rate, and
• any other inputs to the model, including the method used and the assumptions
made to incorporate the effects of expected early exercise
• How expected volatility was determined, including an explanation of the extent to
which expected volatility was based on historical volatility
• Whether and how any other features of the option grant were incorporated into the
measurement of fair value, such as a market condition.
10.5.6 An entity should disclose information that enables users of the financial statements
to understand how the fair value of the goods or services received or the fair value of the
equity instruments granted during the period was determined.
10.5.7 For share options exercised during the period an entity should disclose the weight-
ed average share price at the date of exercise.
10.5.8 For share options outstanding at the end of the period, an entity should disclose the
range of exercise prices and weighted average remaining contractual life.
10.6
FINANCIAL ANALYSIS AND INTERPRETATION
10.6.1 Share-based earnings complicate the analysis of various operating areas, in particu-
lar operating cash flow.
10.6.2 When an employee exercises such share options, the cash payment by the employ-
ees are typically classified as operating cash flows. This effect could be large and may not
necessarily be sustainable, especially if the options were to become out-of-the-money and
their exercise therefore no longer attractive.
10.6.3 The variables used to measure the fair value of an equity instrument issued under
IFRS 2 have a significant impact on that valuation, and the determination of these variables
requires significant professional judgment. A minor change in a variable, such as volatility or
expected life of an instrument, could have a quantitatively material impact on the fair value
of the instruments granted. In the end, the selection of variables must be based on entity-spe-
cific information.
10.6.4 One of the most difficult issues in applying IFRS 2 will be determining the fair value
of share-based payments. The determination of the fair value of share-based payment trans-
actions requires numerous estimates and the application of careful judgment. Measurement
88
Chapter 10 Share-Based Payment (IFRS 2)
difficulties may arise, since the final value of the share-based payment transaction is deter-
mined when the transaction is settled at some point in the future but must be estimated at
the date of grant.
10.6.5 The determination of the model an entity uses is an accounting policy choice and
should be applied consistently to similar share-based payment transactions. While improve-
ments to a model would be considered a change in estimate, IAS 8 should be applied when
an entity changes models (e.g., from Black-Scholes to a binomial model).
10.6.6 The major strength of the Black-Scholes model is that it is a generally accepted | Hennie |
method for valuing share options. It has gained wide acceptance from both regulators and
users. Nearly all companies with share option plans use the Black-Scholes model to compute
the fair value of their share options today. The consistent use of this model also enhances the
comparability between entities.
10.6.7 Another strength of Black-Scholes is that the formula required to calculate the fair
value is relatively straightforward and can be easily included in spreadsheets.
10.6.8 The binomial model is described as an "open form solution," as it can incorporate dif-
ferent values for variables (such as volatility) over the term of the option. The model can also
be adjusted to take account of market conditions and other factors.
10.6.9 Many factors should be considered when estimating expected volatility. For exam-
ple, the estimation of volatility might first focus on implied volatilities for the terms that were
available in the market and compare the implied volatility to the long-term average histori-
cal volatility for reasonableness. In addition to implied and historical volatility, IFRS 2 sug-
gests the following factors be considered in estimating expected volatility:
• The length of time an entity’s share have been publicly traded;
• Appropriate and regular intervals for price observations; and
• Other factors indicating that expected future volatility might differ from past volatility
(e.g., extraordinary volatility in historical share prices)
10.6.10 Typically, the shares underlying traded options are acquired from existing share-
holders and therefore have no dilutive effect. Capital structure effects of nontraded options,
such as dilution, can be significant and are generally anticipated by the market at the date of
grant. Nevertheless, except in the most unusual cases, they should have no impact on the
individual employee’s decision. The market’s anticipation will depend, among other matters,
on whether the process of share returns is the same or is altered by the dilution and the cash
infusion. In many situations the number of employee share options issued relative to the
number of shares outstanding is not significant, and the effect of dilution on share price can
therefore be ignored.
IFRS 2 suggests that the issuer consider whether the possible dilutive effect of the future exer-
cise of options granted has an effect on the fair value of those options at grant date by an
adjustment to option pricing models.
EXAMPLE: DISCLOSURE OF SHARE-BASED PAYMENT
Chapter 10 Share-Based Payment (IFRS 2)
89
EXAMPLE 10.1
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Share-based payments
On 1 January 20X5, the Group applied the requirements of IFRS 2 share-based payments. In
accordance with the transition provisions, IFRS 2 has been applied to all grants after 7
November 20X2 that were unvested as of 1 January 20X5.
The Group issues equity-settled and cash-settled share-based payments to certain employees.
Equity-settled share-based payments are measured at fair value at the date of grant. The fair
value determined at the grant date of the equity-settled share-based payments is expensed on a
straight-line basis over the vesting period, based on the Group’s estimate of shares that will
eventually vest. A liability equal to the portion of the goods or services received is recognized at
the current fair value determined at each balance sheet for cash-settled share-based payments.
Fair value is measured by use of the Black-Scholes pricing model. The expected life used in
the model has been adjusted, based on management’s best estimate, for the effects of non-
transferability, exercise restrictions, and behavioral considerations.
The Group also provides employees the ability to purchase the Group’s ordinary shares at 85
percent of the current market value. The Group records an expense, based on its best estimate
of the 15 percent discount related to shares expected to vest on a straight-line basis over the
vesting period.
Note: 20: Share-based payments.
| Hennie |
Equity-settled share option plan
The Group plan provides for a grant price equal to the average quoted market price of the
Group shares on the date of grant. The vesting period is generally 3 to 4 years. If the options
remain unexercised after a period of 10 years from the date of grant, the options expire.
Furthermore, options are forfeited if the employee leaves the Group before the options vest.
Outstanding at beginning of period
Granted during the period
Forfeited during the period
Exercised during the period
Expired during the period
Outstanding at the end of the period
Exercisable at end of period
Options
42,125
11,135
(2000)
(5,575)
(1,245)
44,440
23,575
20X4
Weighted average
exercise price in €
64.26
68.34
65.67
45.32
82.93
65.75
46.47
Options
44,440
12,120
(1000)
(8,300)
(750)
46,510
24,650
20X5
Weighted average
exercise price in €
65.75
69.68
66.53
53.69
82.93
66.33
52.98
Source: Deloitte Touche Tohmatsu, IFRS 2: Share-based payments, p.61–63
Continued on next page
90
Chapter 10 Share-Based Payment (IFRS 2)
Example 10.1 (continued)
The weighted average share price at the date of exercise for share options exercised during
the Period was €53.69. The options outstanding at 31 December 20X5 had a weighted aver-
age exercise price of €66.33, and a weighted average remaining contractual life of 8.64 years.
The inputs into the Black-Scholes model were as follows:
Weighted average share price
Weighted average exercise price
Expected volatility
Expected life
Risk free rate
Expected dividends
20X4
68.34
68.34
40%
3–8 years
3%
None
20X5
69.68
69.68
35%
4–9 years
3%
none
Expected volatility was determined by calculating the historical volatility of the Group’s
share price over the previous 9 years. The expected life used in the model has been adjusted,
based on management’s best estimate, for the effects of nontransferability, exercise restric-
tions, and behavioral considerations.
During 20X5, the Group repriced certain of its outstanding options. The strike price was
reduced from €82.93 to the then current market price of €69.22. The incremental fair value of
€125,000 will be expensed over the remaining vesting period (2 years). The Group used the
inputs noted above to measure the fair value of the old and new shares.
The Group recognized total expenses of €775,000 and €750,000 related to equity-settled share-
based payment transactions in 20X4 and 20X5, respectively.
Cash-settled share-based payments
The Group issues to certain employees share appreciation rights (SARs) that require the
Group to pay the intrinsic value of the SAR to the employee at the date of exercise. The
Group has recorded liabilities of €1,325,000 and €1,435,000 in 20X4 and 20X5 respectively. Fair
value of the SARs is determined using the Black-Scholes model using the assumptions noted
in the above table. The Group recorded total expenses of €325,000 and €110,000 in 20X4 and
20X5, respectively. The total intrinsic value at 20X4 and 20X5 was €1,150,000 and €1,275,000,
respectively.
Other share-based payment plans
The employee share purchase plans are open to almost all employees and provide for a pur-
chase price equal to the daily average market price on the date of grant, less 15 percent. The
shares can be purchased during a two-week period each year. The shares so purchased are
generally placed in the employee share savings plan for a 5-year period. Pursuant to these
plans, the Group issued 2,123,073 ordinary shares in 20X5 at a weighted average share prices
of €64.35.
11 Insurance Contracts (IFRS 4)
11.1
PROBLEMS ADDRESSED
Accounting practices for insurance contracts have been diverse, and have often differed from
practices in other sectors. The objective of this IFRS is to address improvements to account-
ing for insurance contracts by insurers, and disclosure that identifies and explains the
amounts related to insurance contracts. It helps users of financial statements to understand
the amount, timing, and uncertainty of future cash flows from insurance contracts.
11.2
| Hennie |
SCOPE OF THE STANDARD
Entities should apply this IFRS to:
• insurance contracts (including reinsurance contracts) that it issues,
• reinsurance contracts that it holds, and
• financial instruments that it issues with a discretionary participation feature.
It does not apply to financial assets and financial liabilities within the scope of IAS 39.
This IFRS does not address
• accounting aspects related to other assets and liabilities of an insurer,
• product warranties,
• residual value guarantee embedded in a finance lease, and
• financial guarantees.
IFRS 4 is the first international Standard to deal with insurance contracts, and is therefore a
stepping-stone to be used until all relevant conceptual and practical questions have been
investigated.
11.3
KEY CONCEPTS
11.3.1 An insurance contract is a contract under which one party (the insurer) accepts sig-
nificant insurance risk from another party (the insured).
11.3.2 Insurance liability is an insurer’s net contractual obligations under an insurance
contract.
91
92
Chapter 11 Insurance Contracts (IFRS 4)
11.3.3 Insurance risk is risk, other than financial risk, transferred from the insured to the
insurer. Financial risk is the risk of a possible future change in one or more of a specified
interest rate; financial instrument price; commodity price; foreign exchange rate; index of
prices or rates; credit rating, credit index, or other variable.
11.3.4 An insured event is an uncertain future event that is covered by an insurance con-
tract and that creates insurance risk.
11.3.5 An insurer is the party that has an obligation under an insurance contract to com-
pensate a policyholder in case an insured event occurs.
11.3.6 A policyholder is a party that has a right to compensation under an insurance con-
tract if an insured event occurs. A cedant is a policyholder under a reinsurance contract.
11.3.7 Guaranteed benefits are payments or other benefits to which a particular policy-
holder or investor has an unconditional right that is not subject to the contractual discretion
of the issuer. A guaranteed element is an obligation to pay guaranteed benefits, which
includes those benefits included in a contract with a discretionary participation feature.
11.3.8 Fair value is the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arm’s length transaction.
11.4
ACCOUNTING TREATMENT
11.4.1 IFRS 4 provides a temporary exemption from the IAS 8 hierarchy—the main reason
why the IFRS has been issued. It exempts an insurer from applying those criteria to its
accounting policies for
• insurance contracts that it issues (including related acquisition costs and related intan-
gible assets, and
• reinsurance contracts that it holds.
11.4.2 Insurers must, however,
• not recognize as a liability any provisions for possible future claims that arise from
insurance contracts that are not in existence at the reporting date, and
• should remove an insurance liability from its balance sheet only when the obligation is
discharged.
11.4.3 An insurer should assess at each reporting date whether or not its recognized insur-
ance liabilities are adequate, using current estimates of future cash flows under its insurance
contracts.
11.4.4 A liability adequacy test should consider current estimates of all contractual and
related cash flows, and recognize the entire deficiency in profit or loss. Where a liability ade-
quacy test is not required by its accounting policies, the insurer should
• determine the carrying amount of the relevant insurance liabilities less carrying
amount of related deferred acquisition costs, as well as intangible assets; and
• determine whether the amount is less than the carrying amount that would be required
if the relevant insurance liabilities were within the scope of IAS 37 and, if so, account
for the difference in profit or loss.
Chapter 11 Insurance Contracts (IFRS 4)
93
11.4.5 If a cedant’s reinsurance asset is impaired, the cedant should reduce its carrying | Hennie |
amount accordingly and recognize that impairment loss in profit or loss. A reinsurance asset
is impaired if
• there is objective evidence that the cedant might not receive all amounts due to it under
the terms of the contract, or
• an event has a measurable impact on the amounts that the cedant will receive from the
reinsurer.
11.4.6 An insurer might change its accounting policies for insurance contracts if the
change makes the financial statements more relevant (but not less reliable) to the users’ eco-
nomic decisionmaking needs. Greater reliability should not be at the expense of relevance.
11.4.7 When an insurer changes its accounting policies for insurance liabilities, it might
reclassify some or all of its financial assets at fair value through the income statement (prof-
it and loss account).
11.4.8 The following principles apply when considering a change in accounting policies:
• Current market interest rates. An insurer is permitted to change its accounting policies
so that it remeasures designated insurance liabilities to reflect current market interest
rates. Changes in those liabilities must be recognized in profit or loss. This allows an
insurer to change its accounting policies for designated liabilities without applying
those policies consistently to all similar liabilities, which IAS 8 would otherwise
require. If an insurer designates liabilities for this election, it should continue to apply
current market interest rates consistently in all periods to all these liabilities until they
are extinguished.
• Continuation of existing practices. An insurer might continue the following practices,
but the introduction of any of them is not allowed:
• Measuring insurance liabilities on an undiscounted basis
• Measuring contractual rights to future investment management fees at an amount
that exceeds their market comparable fair value
• Using nonuniform accounting policies for the insurance contracts of subsidiaries,
except as permitted by this IFRS
• Prudence. An insurer need not change its accounting policies for insurance contracts to
eliminate excessive prudence. However, if an insurer already measures its insurance
contracts with sufficient prudence, it should not introduce additional prudence.
• Future investment margins. An insurer need not change its accounting policies to
eliminate future investment margins. However, there is a presumption that an insurer’s
financial statements will become less relevant and reliable if it introduces an accounting
policy that reflects future investment margins in the measurement of insurance con-
tracts, unless those margins affect the contractual payments. Two examples of account-
ing policies that reflect those margins are
• using a discount rate that reflects the estimated return on the insurer’s assets and
• projecting the returns on those assets at an estimated rate of return, discounting
those projected returns at a different rate, and including the result in the measure-
ment of the liability.
• The insurer might make its financial statements more relevant by switching to a com-
prehensive investor-oriented basis of accounting that involves
• current estimates and assumptions,
• a reasonable adjustment to reflect risk and uncertainty,
• measurements that reflect both the intrinsic value and time value of embedded
options and guarantees, or
94
Chapter 11 Insurance Contracts (IFRS 4)
• a current market discount rate.
• Shadow accounting. An insurer is permitted to change its accounting policies so that a
recognized but unrealized gain or loss on an asset affects those measurements in the
same way that a realized gain or loss does. The related adjustment to the insurance lia-
bility or other balance sheet items should be recognized in equity if the unrealized
gains or losses are recognized directly in equity. This practice is sometimes called shad-
ow accounting.
11.4.9 An insurer need not separate and measure at fair value a policyholder’s embedded
derivatives, such as an option to surrender an insurance contract for a fixed amount or inter- | Hennie |
est rate, or both, even if the exercise price differs from the carrying amount of the host insur-
ance liability. IAS 39 does apply to certain put options.
11.4.10 Some insurance contracts contain both an insurance component and a deposit com-
ponent. In some cases, an insurer is required or permitted to unbundle those deposit com-
ponents. Unbundling is prohibited if an insurer cannot measure the deposit component sep-
arately.
11.4.11 An insurer should, at the acquisition date of a business combination, measure the
insurance contracts at fair value. The subsequent measurement of such assets should be con-
sistent with the measurement of the related insurance liabilities.
11.4.12 The issuer of an insurance contract that contains a discretionary participation fea-
ture as well as a guaranteed element could recognize all premiums received as revenue with-
out separating any portion that relates to the equity component. The resulting changes (in the
guaranteed element and in the portion of the discretionary participation feature classified as
a liability) should be recognized in profit or loss.
11.5
PRESENTATION AND DISCLOSURE
11.5.1 An insurer should disclose the following information to identify and explain the
amounts arising from insurance contracts in its financial statements:
• Its accounting policies for insurance contracts and the assets, liabilities, income, and
expenses related thereto
• Recognized assets, liabilities, income, and expenses
• Cash flows on the direct method—optional
11.5.2 If the insurer is a cedant, it should disclose
• gains and losses recognized in profit or loss on buying reinsurance,
• amortization of deferred gains and losses for the period,
• unamortized amounts at the beginning and end of the period,
• the process used to determine assumptions underlying measurement of recognized
profits and losses,
• the effect of changes in assumptions, and
• reconciliations of changes in insurance liabilities, reinsurance assets, and related
deferred acquisition costs.
11.5.3 An insurer should disclose information that helps users to understand:
• The amount, timing, and uncertainty of future cash flows from insurance contracts
• Risk management policies and objectives
Chapter 11 Insurance Contracts (IFRS 4)
95
• Material terms and conditions affecting the amount, timing, and uncertainty of the
insurer’s future cash flows
• Insurance risk, including
• the sensitivity of profit or loss and equity to changes in applicable variables,
• concentrations of insurance risk, and
• actual claims compared with previous estimates up to a maximum period of 10
years (“claims development”)
• Interest rate risk and credit risk detail required by IAS 32
• Exposures to interest rate risk or market risk under embedded derivatives that are con-
tained in a host insurance contract, where the embedded derivatives are not measured
at fair value
11.6
FINANCIAL ANALYSIS AND INTERPRETATION
11.6.1 Traditionally, insurance accounting has varied between countries because it is high-
ly regulated by national regulators. There is often a strong focus on prudence because stake-
holders have demanded certainty about insurance companies’ abilities to pay out cash on
contracts as required.
11.6.2 From the analyst’s perspective, all financial instruments should be measured, recog-
nized, and reported at their fair value. A fair value approach greatly improves the trans-
parency of financial information, while enabling users of financial statements to predict more
reliably the amounts, timing, and uncertainty of an entity’s future cash flows. Fair values
overcome the historical cost deficiency of not incorporating sensitivity to financial risk expo-
sures, such as interest rate risk and credit risk.
11.6.3 Many insurance firms currently manage their financial assets and financial liabilities
using fair value techniques to determine which products to underwrite, which investment
strategies to adopt, and how best to manage overall risks. Moreover, those firms actively | Hennie |
acquiring insurance firms or blocks of insurance business analyze and determine the fair
value of those targets as part of their decisionmaking process. In addition, current and
prospective investors of those insurance firms pursue similar information for making their
investment decisions.
11.6.4 Fair value accounting reflects better economic reality by showing the volatility inher-
ent in the values of financial instruments, given changes in market conditions and operations
of the entity. Historic cost-based accounting facilitates the smoothing of these effects, thus
obscuring this volatility and masking the actual economic impact of various positions held
in financial instruments. Fair value accounting therefore unmasks, but does not create, the
real volatility.
11.6.5 One would expect less volatility or distortion of results, once all financial instruments
are recognized at fair value, assuming that a firm is effectively managing its risks and expo-
sures to those risks. At present, however, there is still a distortion in reported financial perfor-
mance because of an accounting model where some financial assets are marked-to-market and
others are not, and where financial liabilities are not measured using fair value techniques.
12 Inventories (IAS 2)
12.1
PROBLEMS ADDRESSED
The objective of IAS 2 is to prescribe the accounting treatment of inventories. This Standard
deals with the calculation of the cost of inventory, the type of inventory method adopted and
the allocation of cost to assets and expenses, and valuation aspects associated with any write-
downs to net realizable value.
12.2
SCOPE OF THE STANDARD
This Standard deals with all inventories of assets that are:
• Held for sale in the ordinary course of business.
• In the process of production for sale.
• In the form of materials or supplies to be consumed in the production process.
• In the rendering of services.
In the case of a service provider, inventories include the costs of the service for which the
related revenue has not yet been recognized (for example, the work in progress of auditors,
architects, and lawyers).
IAS 2 does not apply to the measurement of inventories held by producers of agricultural
and forest products, agricultural produce after harvest, and minerals and mineral products
to the extent that they are measured at net realizable value in accordance with well-estab-
lished practices in those industries. Living plants, animals and harvested agricultural pro-
duce derived from those plants and animals are also excluded (see IAS 41, chapter 27).
Although IAS 2 excludes construction contracts (IAS 11) and financial instruments (IAS 39)
the principles in this standard are still applied when deciding how to implement certain fea-
tures of the excluded standards (see example 12.5).
12.3
KEY CONCEPTS
12.3.1 Inventories should be measured at the lower of cost and net realizable value.
12.3.2 Cost of inventories comprises all costs of purchase, costs of conversion, and other
costs incurred in bringing the inventories to their present location and condition.
96
Chapter 12 Inventories (IAS 2)
97
12.3.3 The net realizable value (NRV) is the estimated selling price less the estimated costs
of completion and costs necessary to make the sale.
12.3.4 When inventories are sold, the carrying amount of the expenses should be recog-
nized as an expense in the period in which the related revenue is recognized (see Chapter 17).
12.3.5 The amount of any write-down of inventories to net realizable value and all losses
of inventories should be recognized as an expense in the period of the write-down or loss.
12.4
ACCOUNTING TREATMENT
MEASUREMENT TECHNIQUES
12.4.1 The cost of inventories that are not ordinarily interchangeable and those produced and
segregated for specific projects are assigned by specific identification of their individual costs.
12.4.2 The cost of other inventories is assigned by using either of the following cost formu-
las:
• Weighted average cost
• FIFO
| Hennie |
12.4.3 The following techniques can be used to measure the cost of inventories if the results
approximate cost:
Standard cost:
• Normal levels of materials, labor, and actual capacity should be taken into account.
• The standard cost should be reviewed regularly in order to ensure that it approximates
actual costs.
Retail method:
• Sales value should be reduced by gross margin to calculate cost.
• Average percentage should be used for each homogeneous group of items.
• Marked-down prices should be taken into consideration.
COST AND NRV
12.4.4 Cost of inventories comprises:
• Purchase costs, such as the purchase price and import charges
• Costs of conversion
• direct labor
• production overheads, including variable overheads and fixed overheads allocated
at normal production capacity
• Other costs, such as design and borrowing costs
12.4.5 The cost of inventories excludes:
• Abnormal amounts of wasted materials, labor, and overheads
• Storage costs, unless they are necessary prior to a further production process
• Administrative overheads
• Selling costs
98
Chapter 12 Inventories (IAS 2)
12.4.6 NRV is the estimated selling price less the estimated costs of completion and costs
necessary to make the sale. These estimates are based on the most reliable evidence at the
time the estimates are made. The purpose for which the inventory is held should be taken
into account at the time of the estimate. Inventories are usually written down to NRV based
on the following principles:
• Items are treated on an item-by-item basis.
• Similar items are normally grouped together.
• Each service is treated as a separate item.
12.5
PRESENTATION AND DISCLOSURE
The financial statements should disclose the following:
• Accounting policies, including the cost formulas used
• Total carrying amount of inventories and amount per category
• Amount of inventories carried at fair value less costs to sell
• Amount of any write-downs and reversals of any write-down
• Circumstances or events that led to the reversal of a write-down
• Inventories pledged as security for liabilities
• Amount of inventories recognized as an expense
12.6
FINANCIAL ANALYSIS AND INTERPRETATION
12.6.1 The accounting method used to value inventories should be selected based on the
order in which products are sold, relative to when they are put into inventory. Therefore,
whenever possible, the costs of inventories are assigned by specific identification of their
individual costs. In many cases, however, it is necessary to use a cost formula—for example,
first-in, first out (FIFO)—that represents fairly the inventory flows. IAS 2 does not allow the
use of last-in, first-out (LIFO), because it does not faithfully represent inventory flows. The
International Accounting Standards Board (IASB) has noted that the use of LIFO is often tax
driven and concluded that tax considerations do not provide a conceptual basis for selecting
an accounting treatment; and that it is therefore not acceptable to allow an inferior treatment
purely because of tax considerations.
12.6.2 Analysts and managers often use ratio analysis to assess company performance and
condition. The valuation of inventories can influence performance and cash flow through the
events or manipulations in the presentation of data presented in Table 12.1.
Table 12.1 Impact of inventory valuation on financial analysis
Valuation Element or Manipulation
Effect on Company
Beginning inventory overstated by $5,000
Profit will be understated by $5,000
Ending inventory understated by $2,000
Profit will be understated by $2,000
Inventory accounting method effect on
Taxes will be affected by the choice of
cash flows
Early recognition of revenue on a sale
accounting method
Understatement of inventory
Overstatement of receivables
Overstatement of profit
Chapter 12 Inventories (IAS 2)
99
12.6.3 Although LIFO is no longer allowed in IFRS financial statements, some jurisdic-
tions continue to allow the use of LIFO. When comparing entities in the same industry, inven-
tories should be adjusted to FIFO in order to ensure comparability. (In a similar manner, non- | Hennie |
IFRS entities would have their statements adjustments prior to being compared with IFRS
entities).
12.6.4 FIFO inventory balances constitute a closer reflection of economic value because
FIFO inventory is valued at the most recent purchase prices.
Table 12.2 The impact of LIFO vs. FIFO on financial statement variables
Financial Statement Variable
LIFO
Cost of Goods Sold (COGS)
Income
Cash Flow
Working Capital
Higher—more recent prices are used
Lower—COGS higher
Higher—taxes are lower
Lower—current assets are lower
FIFO
Lower
Higher
Lower
Higher
12.6.5 The choice of accounting method therefore has an impact on financial statement vari-
ables, and consequently on the ratios used for financial statement analysis. Some analysts
consider LIFO to be more useful when analyzing profitability and cost because it is supposed
to produce more-realistic values; however, this is not true as, overall, FIFO is significantly
more useful when it comes to analyzing asset (operational efficiency) or equity (profitability
return) ratios.
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Chapter 12 Inventories (IAS 2)
Table 12.3 Equivalent FIFO and LIFO financial statements
and the key financial ratios that they produce
Cash
Accounts Receivable
Inventories
Plant and Equipment
Total Assets
Short-Term Debt
Long-Term Debt
Common Stock
Paid-In Capital
Retained Earnings
Total Liabilities and Capital
Sales
Cost of Good Sold
Interest Expense
Pretax Income
Income Tax Expense
Net Income
Net Profit Margin
Current Ratio
Inventory Turnover
Long-Term Debt or Equity
Return on Assets
Return on Equity
FIFO
($)
LIFO
($)
34
100
200
300
634
40
200
50
100
244
634
600
410
15
175
70
105
FIFO
17.5%
8.4x
2.1x
50.8%
16.6%
26.6%
70
100
110
300
580
40
200
50
100
190
580
600
430
15
155
62
93
LIFO
15.5%
7.0x
3.9x
58.8%
16.0%
27.4%
Chapter 12 Inventories (IAS 2)
101
EXAMPLES: INVENTORIES
EXAMPLE 12.1
Slingshot Corporation purchased inventory on January 1, 20X1, for $600,000. On December
31, 20X1, the inventory had an NRV of $550,000. During 20X2, Slingshot sold the inventory
for $620,000. Based on the above, which of the following statements is true?:
a. The December 31, 20X1, balance sheet reported the inventory at $600,000.
b. The December 31, 20X1, balance sheet reported the inventory at $620,000.
c. When the inventory was sold in 20X2, Slingshot reported a $20,000 gain on its income
statement.
d. For the year ending December 31, 20X1, Slingshot recognized a $50,000 loss on its
income statement.
EXPLANATION
Choice d. is correct. Because IFRS requires the lower of cost or NRV reporting on inventory,
the company must recognize a $50,000 loss ($550,000 – $600,000) on the income statement for
20X1. When the inventory is sold in 20X2, a profit of $70,000 ($620,000 – $550,000) is recog-
nized on the income statement.
Choice a. is incorrect. The inventory must be written down to market value at year-end 20X1.
Choice b. is incorrect. The fact that the inventory was sold for $620,000 in 20X2 has no impact
on the inventory balance at December 31, 20X1.
Choice c. is incorrect. The sale of the inventory at $620,000 must recognize the inventory mar-
ket value of $550,000, resulting in a gain of $70,000.
EXAMPLE 12.2
The financial statements of Parra Imports for 20X0 and 20X1 had the following errors:
Ending Inventory
Rent Expense
$4,000 overstated
$2,400 understated
$8,000 understated
$1,300 overstated
20X0
20X1
By what amount will the 20X0 and 20X1 pretax profits be overstated or understated if these
errors are not corrected?
EXPLANATION
20X0. Because the ending inventory is overstated for 20X0, the COGS will be understated,
resulting in pretax profits being overstated by $4,000. In addition, because rent expense is
understated by $2,400, pretax profits will be overstated by an additional $2,400, for a total
overstatement of $6,400.
20X1. The beginning inventory was overstated by $4,000 for 20X1, so COGS will be
overstated by $4,000, resulting in a profit understatement of $4,000. Because ending invento-
ry is also understated by $8,000, the impact of this error will be an additional COGS over-
102
Chapter 12 Inventories (IAS 2)
| Hennie |
statement of $8,000 and additional profit understatement of $8,000. The overstatement of
$1,300 for the rent will result in an additional understatement of profit, for a total pretax prof-
it understatement of $13,300 (see below).
20X1
Beg. inventory
Purchases
Total
End inventory
COS
Sales
Rent
Profit
Correct ($)
Wrong ($)
Misstatement ($)
6,000
20,000
26,000
–18,000
8,000
30,000
10,000
20,000
30,000
–10,000
20,000
30,000
22,000
10,000
4,000
0
4,000
8,000
12,000
0
1300
13,300
EXAMPLE 12.3
The following information applies to the Grady Company for the current year:
Purchases of merchandise for resale
Merchandise returned to vendor
Interest on notes payable to vendors
Freight-in on merchandise
$300,000
3,000
6,000
7,500
Grady’s inventory costs for the year would be:
a. $297,000 b. $300,000
c. $304,500
d. $316,500
EXPLANATION
Choice c. is correct. The answer was derived based on the following calculation:
Purchase
+ Freight-in
– Returns
$300,000
7,500
(3,000)
$304,500
Choice a. is incorrect. Freight-in must also be included as part of the inventory costs.
Choice b. is incorrect. In addition to purchases of merchandise, the merchandise returned to
the vendor and the freight-in must be included in the inventory calculation.
Choice d. is incorrect. Interest costs on financing are not part of inventory cost (exceptions are
in IAS 23).
Chapter 12 Inventories (IAS 2)
103
EXAMPLE 12.4
An entity has a current ratio greater than 1.0. If the entity’s ending inventory is understated
by $3,000 and beginning inventory is overstated by $5,000, the entity’s net income and the
current ratio would be:
Net income
Current ratio
a. Understated by $2,000
b. Overstated by $2,000
c. Understated by $8,000
d. Overstated by $8,000
Lower
Lower
Lower
Higher
EXPLANATION
Choice c. is correct. The answer was derived based on the following calculations:
D COGS = D Beginning Inventory + D Purchases – D Ending Inventory
= $5,000 + P – (– $3,000)
Assuming D P = 0
D COGS = + $5,000 + $3,000 = + $8,000
If COGS is overstated by $8,000, then net income is understated by $8,000 (assuming taxes
are zero). If the ending inventory is understated, then the current ratio is also lower because
inventory is part of current assets.
EXAMPLE 12.5 (READ TOGETHER WITH IAS 39)
A portfolio manager purchases and sells the following securities over a 4-day period. On day
5, the manager sells five securities at $4 each. Although IFRS does not allow LIFO as a cost
formula, determine
(i)
the cost price of the securities, using the FIFO, LIFO, and weighted average (WAC) cost
formulae, and
(ii) the profit that will be disclosed under each of the three alternatives.
Determining the Buy Cost Related to the Sell
Day
1
2
3
4
Buy Par
10 at $1
15 at $2
20 at $3
Average
45 at 2.22
(a) Cost price
Selling price
(b) Profit
Sell Par
FIFO
LIFO
WAC
(5) at $4
5 at $1
5
(20)
(15)
5 at $3
15
(20)
(5)
5 at $2.22
11
(20)
(9)
104
Chapter 12 Inventories (IAS 2)
EXAMPLE 12.6
Arco Inc. is a manufacturing company in the food industry. The following matters relate to
the company’s inventories:
A. In recent years the company utilized a standard costing system as an aid to management.
The standard cost variances had been insignificant to date and were written off directly in the
published annual financial statements. However, the following two problems were experi-
enced during the year ending March 31, 20X3:
• Variances were of a far greater size as a result of a sharp increase in material and labor
costs as well as a decrease in production.
• A large number of the units produced were unsold at year-end. This is partially attribut-
able to the fact that the products of the company were considered to be overpriced.
The management of the company intends, as in the past, to write off these variances directly
as term costs, and to also write off a portion of the cost of surplus unsold inventories.
B. Chocolate raw material inventories on hand at the end of the year represent 8 months of
usage. Inventory levels normally represent only 2 months’ usage. The current replacement
value of the inventories is less than the initial cost.
EXPLANATION
| Hennie |
A. Both proposed treatments are unacceptable:
• The write-offs of the large variances result in the standard values not approximating cost
according to IAS 2.
• Standard costs should be reviewed regularly and revised in the light of current condi-
tions. The labor and material variances should be allocated to the standard cost of inven-
tories. The production overhead variance resulting from idle capacity should be recog-
nized as an expense in the current period.
• The term overpriced is arbitrary, and any write-down of inventory should be done only
if the NRV of the inventory is lower than its cost.
B. The abnormal portion of raw material on hand (representing 6 months of production)
might need to be written down to NRV. The other raw materials (representing 2 months of
production) should only be written down to NRV if the estimated cost of the finished prod-
ucts will be more than the NRV.
13 Construction Contracts (IAS 11)
13.1
PROBLEMS ADDRESSED
Contracts in this Standard include those construction contracts for which the dates of con-
tracting and of completion typically fall in different accounting periods. They include con-
tracts for:
• Rendering of services.
• Construction or restoration of assets and the restoration of the environment.
This Standard deals with the appropriate criteria for recognition of construction contract rev-
enue and costs, with a focus on the allocation of contract revenue and costs to the account-
ing periods in which construction work is performed.
13.2
SCOPE OF THE STANDARD
This Standard applies to accounting for construction contracts in the financial statements of
contractors. Two types of contracts are distinguished, namely:
• Fixed price contracts—usually a fixed contract price subject to cost escalation clauses.
• Cost plus contracts—the contract costs plus a percentage of such costs or a fixed fee.
IAS 11 specifically outlines:
• Accounting for construction contracts that cannot be measured reliably.
• Where contract costs can be reliably measured, measurement of contract revenue, costs
and associated disclosures should be conducted under the percentage of completion
method.
13.3
KEY CONCEPTS
13.3.1 A construction contract is a contract specifically negotiated for the construction of an
asset or a combination of assets that are closely interrelated or interdependent in terms of
their design, technology, and function or in terms of their ultimate purpose or use.
Construction contracts include those for the construction or restoration of assets and the
restoration of the environment.
105
106
Chapter 13 Construction Contracts (IAS 11)
13.3.2 When the outcome of a construction contract can be estimated reliably, the excess of
revenue over costs (profit) should be recognized based on the stage of completion (percent-
age of completion method).
13.4
ACCOUNTING TREATMENT
13.4.1 Contract revenues comprise
• the initial agreed contract amount, and
• variations, claims, and incentive payments to the extent that they will probably realize
and are capable of being reliably measured.
When the outcome of a contract cannot be reliably estimated, revenue should be recognized
to the extent that it is probable to recover contract costs.
13.4.2 Contract costs comprise
• direct contract costs (for example, materials),
• general contract costs (for example, insurance), and
• costs specifically chargeable to the customer in terms of the contract (for example,
administrative costs).
13.4.3 Any expected excess of total contract costs over total contract revenue (loss) is rec-
ognized as an expense immediately.
13.4.4 The stage of completion is determined by reference to
• portion of costs incurred in relation to estimated total costs,
• surveys of work performed, and
• physical stage of completion.
13.4.5 The principles of IAS 11 are normally applied separately to each contract specifi-
cally negotiated for the construction of:
• An asset (for example, a bridge)
• A combination of assets that are closely interrelated or interdependent in terms of their
| Hennie |
design, technology, function, or use (for example, specialized production plants)
A group of contracts should be treated as a single construction contract if it was negotiated
as a single package.
13.4.6 The following contracts should be treated as separate construction contracts:
• A contract for a number of assets if separate proposals have been submitted for each asset
• An additional asset constructed at the option of the customer that was not part of the
original contract
13.5
PRESENTATION AND DISCLOSURE
13.5.1 Balance sheet and notes include
• amount of advances received,
• amount of retention monies,
• contracts in progress being costs-to-date-plus-profits or costs-to-date-less-losses,
106
Chapter 13 Construction Contracts (IAS 11)
107
• gross amount due from customers (assets),
• gross amount due to customers (liabilities), and
• contingent assets and contingent liabilities (for example, claims).
13.5.2 The income statement includes
• amount of contract revenue recognized.
13.5.3 Accounting policies include
• methods used for revenue recognition, and
• methods used for stage of completion.
13.6
FINANCIAL ANALYSIS AND INTERPRETATION
13.6.1 The use of the percentage-of-completion method requires that the total cost and
total profit of a project be estimated at each balance sheet date. A pro rata proportion of the
total estimated profit is then recognized in each accounting period during the performance
of the contract. The pro rata proportion is based on the stage of completion at the end of the
period and reflects the work performed during the period from an engineering perspective.
(production is the critical event that gives rise to income.)
13.6.2 At each balance sheet date, the percentage of completion method is applied to up to
date estimates of revenue and costs so that any adjustment are reflected in the current peri-
od and future periods. Amounts recognized in prior periods are not adjusted.
13.6.3 The table below summarizes how the choice of accounting method affects the bal-
ance sheet, income statement, statement of cash flows, and the key financial ratios when
accounting for long-term projects. The effects are given for the early years of the project’s life
(Table 13.1).
108
Chapter 13 Construction Contracts (IAS 11)
Table 13.1 Impact of Percentage-of-Completion Method on Financial Statements
Item or Ratio
Percentage-of-Completion Method (as opposed to a situation
where the outcome of a contract cannot be reliably estimated)
Balance Sheet
Billings recorded but not received in cash are recorded as accounts
receivable.
Cumulative project expenses plus cumulative reported income less
cumulative billings is recorded as a current asset if positive or a
current liability if negative.
Upon project completion, work-in-progress and advanced billings net to
zero. Uncollected billings are accounts receivable.
Income
Statement
Project costs are recorded as incurred.
Revenues are recognized in proportion to the costs incurred during the
period relative to the estimated total project cost.
Reported earnings represent estimates of future operating cash flows.
Estimated losses are recorded in their entirety as soon as a loss is estimated.
Cash received from customers is reported as an operating cash inflow
when received.
Cash expended is recorded as an operating cash outflow when paid.
Size of cash flow is the same because accounting choices have no effect
on pretax cash flows.
Higher if the cumulative work-in-progress (cumulative project costs and
cumulative project income) exceeds cumulative billings.
Same if cumulative billings equal or exceed Work-in-Progress.
Lower as only receipts in excess of revenues are deferred as liabilities.
Statement of
Cash Flows
Size of Current
Assets
Size of Current
Liabilities
Net Worth
Higher because earnings are reported before the project is complete.
Profit Margin
Higher because earnings are reported during the project’s life
Asset Turnover
Higher because sales are reported during the project’s life.
Debt or Equity
Lower because liabilities are lower and net worth is higher.
| Hennie |
Return on Equity
Higher because earnings are higher percentage wise than the higher
equity.
Cash Flow
Same because accounting choices have no effect on Cash Flow.
EXAMPLES: CONSTRUCTION CONTRACTS
Chapter 13 Construction Contracts (IAS 11)
109
EXAMPLE 13.1
A company undertakes a 4-year project at a contracted price of $100 million that will be billed
in four equal annual installments of $25 million each year over the project’s life. The project
is expected to cost $90 million producing a $10 million profit. Over the life of the project, the
billings, cash receipts, and cash outlays related to the project are:
Billings
Cash received
Cash outlays
Year 1
($’000)
25,000
20,000
18,000
Year 2
($’000)
25,000
27,000
36,000
Year 3
($’000)
25,000
25,000
27,000
Year 4
($’000)
25,000
28,000
9,000
Schedules must be produced under the percentage-of-completion and completed contract
method, showing
A. the cash flows from the project each year,
B. the income statement for the project each year,
C. the balance sheets each year, and
D. the profit margin, asset turnover, debt-to-equity, return on assets, return on equity, and
the current ratio.
EXPLANATION
A. The cash flow is simply the difference between the cash received and paid every year as
given in the problem:
Cash receipts
Cash outlays
Cash flow
Cumulative cash flow
(on balance sheet)
Year 1
($’000)
20,000
18,000
2,000
Year 2
($’000)
27,000
36,000
(9,000)
Year 3
($’000)
25,000
27,000
(2,000)
Year 4
($’000)
28,000
9,000
19,000
2,000
(7,000)
(9,000)
10,000
B. The revenues recorded on the income statement each year are calculated as:
Revenues
in a Year
=
Costs Incurred in Year
Total Project Cost
¥
Total Estimated
Project Price
Continued on next page
110
Chapter 13 Construction Contracts (IAS 11)
Example 13.1 (continued)
Assuming the cash paid each year is the cost incurred in the year, with a total project cost of
$90 million and the estimated project profit of $10 million, the income statement schedule is:
Revenues = (Year’s Expense
$90,000,000
¥ $100,000,000)
Expense (cash paid)
Income
Cumulative income
(Retained earnings)
Year 1
($’000)
Year 2
($’000)
Year 3
($’000)
Year 4
($’000)
20,000
40,000
30,000
10,000
18,000
2,000
36,000
4,000
27,000
3,000
9,000
1,000
2,000
6,000
9,000
10,000
C. In constructing the balance sheet the following is required:
• The difference between cumulative billings (to customers) and cumulative cash receipts
(from customers) is recorded on the balance sheet as Accounts Receivable.
• The sum of the cumulative expenses and the cumulative reported income is a Work-in-
Progress current asset.
• Cumulative billings (to customers) are an Advanced Billings current liability.
• The net difference between the Work-in-Progress current assets and the Advanced
Billings current liabilities is recorded on the balance sheet as a net current asset if it is
positive or as a net current liability if it is negative.
A schedule of these items is as follows:
Cumulative billings
Cumulative cash receipts
Accounts receivable (on balance sheet)
Cumulative expenses
Cumulative income
Work-in-progress
less: Cumulative billings
Net asset (liability) on balance sheet
Year 1
($’000)
25,000
20,000
5,000
18,000
2,000
20,000
25,000
(5,000)
Year 2
($’000)
50,000
47,000
3,000
54,000
6,000
60,000
50,000
10,000
Year 3
($’000)
75,000
72,000
3,000
81,000
9,000
90,000
75,000
15,000
Year 4
($’000)
100,000
100,000
0
90,000
10,000
100,000
100,000
0
The balance sheet’s cash equals the cumulative cash based on the previous cash flow schedule.
Cumulative income is reported as retained earnings on the balance sheet.
Chapter 13 Construction Contracts (IAS 11)
111
The balance sheet schedule is:
Year 1
($’000)
Year 2
($’000)
Year 3
($’000)
Year 4
($’000)
2,000
(7,000)
(9,000)
10,000
5,000
–
7,000
5,000
3,000
10,000
6,000
–
3,000
15,000
9,000
–
0
0
10,000
0
2,000
6,000
9,000
10,000
Cash (cumulative cash
from the cash flow
schedule)
Accounts receivable
Net asset (0 in last year)
Total assets
Net liability (0 in last year)
Retained earnings
(cumulative income from
income statement
schedule)
Total liabilities and capital
7,000
6,000
9,000
10,000
D. The following illustrates the profit margin, asset turnover, debt-to-equity, return on assets, | Hennie |
return on equity, and the current ratio:
Key Financial Ratios:
Profit margin
Asset turnover
Debt-to-equity
Return on assets
Return on equity
Current ratio
Year 1
10.0%
5.7x
2.5x
57.1%
200.0%
1.4x
Year 2
10.0%
6.2x
0.0x
61.5%
100.0%
–
Year 3
Year 4
10.0%
4.0x
0.0x
40.0%
40.0%
–
10.0%
1.1x
0.0x
10.5%
10.5%
–
112
Chapter 13 Construction Contracts (IAS 11)
EXAMPLE 13.2
When comparing the use of the percentage of completion method with the completed con-
tract method during a long-term project’s life, the percentage-of-completion method will
result in:
a. earlier recognition of cash flows,
b. a higher return on assets,
c. a lower debt-to-equity ratio, and
d. a higher asset turnover.
EXPLANATION
a. No. The choice of accounting method has no effect on cash flow.
b. Yes. Because the periodic earnings will be higher under the percentage-of-completion
method, the return on assets ratio will be higher.
c. Yes. Because the percentage-of-completion method reports lower liabilities and higher net
worth, the debt-to-equity ratio will be lower.
d. Yes. The asset turnover ratio is higher under the percentage-of-completion method
because sales are reported during the life of the project.
EXAMPLE 13.3
Omega Inc. started a 4-year contract to build a dam. Activities commenced on February 1,
20X3. The total contract price amounted to $12 million, and it was estimated that the work
would be completed at a total cost of $9.5 million. In the construction agreement the cus-
tomer agreed to accept increases in wage tariffs additional to the contract price.
The following information refers to contract activities for the financial year ending December
31, 20X3:
1. Costs for the year:
Material
Labor
Operating overheads
Subcontractors
$’000
1,400
800
150
180
2. Current estimate of total contract costs indicates the following:
• Materials are to be $180,000 higher than expected.
• Total labor costs are to be $300,000 higher than expected. Of this amount, only
$240,000 would be brought about by increased wage tariffs. The other amount would
be due to inefficiencies.
• A savings of $30,000 is expected on operating overheads.
3. During the current financial year the customer requested a variation to the original con-
tract and it was agreed that the contract price would be increased by $900,000. The total
estimated cost of this extra work is $750,000.
Chapter 13 Construction Contracts (IAS 11)
113
4. By the end of 20X3, certificates issued by quantity surveyors indicated a 25 percent stage
of completion.
5. Determine the profit to date, based on
• Option 1—contract costs in proportion to estimated contract costs
• Option 2—percentage of the work certified
EXPLANATION
Contract profit recognized for the year ending December 31, 20X3, is as follows:
Contract revenue (Calculation d)
Contract costs to date (Calculation a)
Option 1
$’000
Option 2
$’000
3,107
(2,530)
577
3,285
(2,530)
755
Calculations
a. Contract costs to date
Materials
Labor
Operating overheads
Subcontractors
b. Contract costs (revised estimated total costs)
Original estimate
Materials
Labor
Operating overheads
Variation
c. Contract revenue (revised estimate)
Original amount
Labor (wage increases added to contract price)
Variation
$’000
1,400
800
150
180
2,530
9,500
180
300
(30)
750
10,700
12,000
240
900
13,140
d. Stage of completion
Option 1
Option 2
Based on contract costs in proportion to
estimated total contract costs:
2,530 ÷ 10,700 ¥ 13,140 (rounded off)
Based on work certified: 25% ¥ 13,140
3,107
3,285
14 Income Taxes (IAS 12)
14.1
PROBLEMS ADDRESSED
The key objective of IAS 12, Accounting for Income Tax, is to address the problem of recon-
ciling the tax liability (actual tax payable) with that of tax expense (accounting disclosure).
Other issues are:
• The distinction between permanent and timing differences.
• The future recovery (settlement) of the carrying amount of deferred tax assets (liabili-
ties) in the balance sheet.
• Recognizing and dealing with income tax losses.
14.2
SCOPE OF THE STANDARD
This Standard deals with all income taxes including domestic, foreign, and withholding | Hennie |
taxes, as well as income tax consequences of dividend payments. Specific aspects that it cap-
tures are:
• Outlining the difference between the key concepts of accounting and taxable profit.
• Criteria for recognizing and measuring deferred tax assets/liabilities.
• Accounting for tax losses.
14.3
KEY CONCEPTS
14.3.1 Accounting profit is net profit or loss for a period before deducting tax expense.
14.3.2 Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance
with the rules established by the taxation authorities, based on which income taxes are
payable (recoverable).
14.3.3 Tax expense (tax income) is the aggregate amount included in the determination of
net profit or loss for the period in respect of current tax and deferred tax.
14.3.4 Current tax is the amount of income taxes payable (recoverable) in respect of the tax-
able profit (tax loss) for a period.
14.3.5 Deferred tax liabilities are the amounts of income taxes payable in future periods in
respect of taxable temporary differences.
114
Chapter 14 Income Taxes (IAS 12)
115
14.3.6 Deferred tax assets are the amounts of income taxes recoverable in future periods in
respect of
• deductible temporary differences,
• the carry-forward of unused tax losses, and
• the carry-forward of unused tax credits.
14.3.7 Temporary differences are differences between the carrying amount of an asset or
liability in the balance sheet and its tax base. Temporary differences can be either
• taxable temporary differences, which are temporary differences that will result in tax-
able amounts in determining taxable profit (tax loss) of future periods when the carry-
ing amount of the asset or liability is recovered or settled, or
• deductible temporary differences, which are temporary differences that will result in
amounts that are deductible in determining taxable profit (tax loss) of future periods
when the carrying amount of the asset or liability is recovered or settled.
14.3.8 The tax base of an asset or liability is the amount attributed to that asset or liability
for tax purposes.
14.4
ACCOUNTING TREATMENT
14.4.1 Current tax should be recognized as a liability and expense in the period to which it
relates:
• A liability (asset) for unpaid (overpaid) current taxes should be raised.
• The benefit of a tax loss carried back to recover tax paid with respect to a prior period
should be recognized as an asset.
14.4.2 A deferred tax liability is recognized for all taxable temporary differences, except
when those differences arise from
• goodwill for which amortization is not deductible for tax purposes, or
• the initial recognition of an asset or liability in a transaction that is not a business com-
bination, and
• at the time of the transaction affects neither accounting nor taxable profit.
14.4.3 A deferred tax asset is recognized for all deductible temporary differences to the
extent that it is probable that they are recoverable from future taxable profits. A deferred tax
asset is not recognized when it arises from the initial recognition of an asset or liability in a
transaction that is not a business combination, and at the time of the transaction affects nei-
ther accounting nor taxable profit.
14.4.4 Current and deferred tax balances are measured using the following:
• Tax rates and tax laws that have been substantively enacted by the balance sheet date
• Tax rates that reflect how the asset will be recovered or liability will be settled (liability
method)
• The tax rate applicable to undistributed profits when there are different rates
14.4.5 Current and deferred tax should be recognized as income or expense and included
in the income statement. Exceptions are tax arising from
• a transaction or event that is recognized directly in equity or
• a business combination that is an acquisition.
116
Chapter 14 Income Taxes (IAS 12)
14.4.6 The income tax consequences of dividends are recognized when a liability to pay the
dividend is recognized.
14.4.7 The entity should reassess the recoverability of recognized and unrecognized | Hennie |
deferred tax assets at each balance sheet date. Discounting of tax balances is prohibited.
14.5
PRESENTATION AND DISCLOSURE
14.5.1 Taxation balances should be presented as follows:
• Tax balances are shown separately from other assets and liabilities in the balance sheet.
• Deferred tax balances are distinguished from current tax balances.
• Deferred tax balances are noncurrent.
• Taxation expense (income) should be shown for ordinary activities on the face of the
income statement.
• Current tax balances can be offset when
• there is a legal enforceable right to offset, and
• there is an intention to settle on a net basis.
• Deferred tax balances can be offset when
• there is a legal enforceable right to offset,
• debits and credits relate to the same tax authority
• for the same taxable entity, or
• for different taxable entities that intend to settle on a net basis.
14.5.2 Accounting policy: The method used for deferred tax should be disclosed.
14.5.3 The income statement and notes should contain:
• Major components of tax expense (income)—shown separately—including the:
• Current tax expense (income)
• Deferred tax expense (income)
• Deferred tax arising from the write-down (or reversal of a previous write-down) of a
deferred tax asset
• Tax amount relating to changes in accounting policies and fundamental errors treat-
ed in accordance with IAS 8 allowed alternative.
• Reconciliation between tax amount and accounting profit or loss in monetary terms, or
a numerical reconciliation of the rate.
• Explanation of changes in applicable tax rate (rates) compared to previous period
(periods).
• For each type of temporary difference, and in respect of each type of unused tax losses
and credits, the amounts of the deferred tax recognized in the income statement.
14.5.4 The balance sheet and notes should include:
• Aggregate amount of current and deferred tax charged or credited to equity.
• Amount (and expiration date) of deductible temporary differences, unused tax losses,
and unused tax credits for which no deferred tax asset is recognized.
• Aggregate amount of temporary differences associated with investments in sub-
sidiaries, branches, associates, and joint ventures for which deferred tax liabilities have
not been recognized.
• For each type of temporary difference, and in respect of each type of unused tax losses
and credits, the amount of the deferred tax assets and liabilities is recognized in the
balance sheet.
Chapter 14 Income Taxes (IAS 12)
117
• Amount of a deferred tax asset and nature of the evidence supporting its recognition,
when
• the utilization of the deferred tax asset is dependent on future taxable profits; or
• the enterprise has suffered a loss in either the current or preceding period.
• Amount of income tax consequences of dividends to shareholders that were proposed
or declared before the balance sheet date, but are not recognized as a liability in the
financial statements.
• The nature of the potential income tax consequences that would result from the pay-
ment of dividends to the enterprises’ shareholders, that is, the important features of the
income tax systems and the factors that will affect the amount of the potential tax con-
sequences of dividends.
14.6
FINANCIAL ANALYSIS AND INTERPRETATION
14.6.1 The first step in understanding how income taxes are accounted for in IFRS financial
statements is to realize that taxable profit and accounting profit have very different mean-
ings. Taxable profit is computed using procedures that comply with the tax code and is the
basis upon which income taxes are paid. Accounting profit is computed using accounting
policies that comply with IFRS.
14.6.2 When determining taxable profit, an entity might be allowed or required by the tax
code to use accounting methods that are different from those that comply with IFRS. The
resulting differences might increase or decrease profits. For example, an entity might be
allowed to use accelerated depreciation to compute taxable profit and so reduce its tax lia- | Hennie |
bility, while at the same time it might be required to use straight-line depreciation in the
determination of IFRS accounting profit.
14.6.3 The second step is to understand the difference between current taxes, deferred tax
assets and liabilities, and income tax expense. Current taxes represent the income tax owed
to the government in accordance with the tax code. Deferred taxes represent the other tax
consequences of the recovery of assets and settlement of liabilities. Income tax expense is the
expense reported in the income statement and includes both current tax expense and
deferred tax expense. This means that the income tax paid or payable to the government in
an accounting period usually differs significantly from the income tax expense that is recog-
nized in the income statement.
14.6.4 Are deferred taxes a liability or equity for analysis purposes? An entity’s deferred tax
liability meets the definition of a liability. However, deferred tax liabilities are not current
legal liabilities, because they do not represent taxes that are currently owed or payable to the
government. Taxes that are owed to the government but which have not been paid are called
current tax liabilities. They are classified as current liabilities on a balance sheet, whereas
deferred tax liabilities are classified as noncurrent liabilities.
14.6.5 If an entity is growing, new deferred tax liabilities may be created on an ongoing
basis (depending on the source of potential timing differences). Thus, the deferred tax liabil-
ity balance will probably never decrease. Furthermore, changes in the tax laws or a compa-
ny’s operations could result in deferred taxes never being paid. For these reasons, many ana-
lysts treat deferred tax liabilities as if they are part of a company’s equity capital.
14.6.6 Technically, treating deferred tax liabilities as if they were part of a company’s equi-
ty capital should only be done if the analyst is convinced that the deferred tax liabilities will
increase or remain stable in the foreseeable future. This will be the case when a company is
expected to acquire new assets on a regular basis (or more expensive assets) so that the aggre-
gate timing differences will increase (or remain stable) over time. Under such circumstances,
118
Chapter 14 Income Taxes (IAS 12)
which are normal for most entities, deferred tax liabilities could be viewed as being zero-
interest loans from the government that will, in the aggregate, always increase without ever
being repaid. The rationale for treating perpetually stable or growing deferred tax liabilities
as equity for analytical purposes is that a perpetual loan that requires no interest or principal
payments takes on the characteristics of permanent equity capital.
14.6.7 If an entity’s deferred tax liabilities are expected to decline over time, however, they
should be treated as liabilities for analytical purposes. One consideration is that the liabilities
should be discounted for the time value of money; the taxes are not paid until future periods.
An analyst should also consider the reasons that have caused deferred taxes to arise and how
likely these causes are to reverse.
14.6.8 In some cases, analysts ignore the deferred tax liabilities for analytical purposes
when it is difficult to determine whether they will take on the characteristics of a true liabil-
ity or equity capital over time. Ultimately, the analyst has to decide whether deferred tax lia-
bilities should be characterized as liabilities, equity, or neither based on the situation’s unique
circumstances.
14.6.9 Entities must include income tax information in their footnotes, which analysts
should use to:
• Understand why the entity’s effective income tax rate is different from the statutory tax
rate
• Forecast future effective income tax rates, thereby improving earnings forecasts
• Determine the actual income taxes paid by an entity and compare them with the
| Hennie |
reported income tax expense to better assess operating cash flow
• Estimate the taxable income reported to the government and compare it with the
reported pretax income reported in the financial statements
EXAMPLES: INCOME TAXES
Chapter 14 Income Taxes (IAS 12)
119
EXAMPLE 14.1
Difir Inc. owns the following property, plant, and equipment at December 31, 20X4:
Cost
$’000
900
500
1,500
Accumulated
depreciation
$’000
180
–
300
Carrying
amount
$’000
720
500
1,200
Tax
base
$’000
450
–
–
Machinery
Land
Buildings
In addition:
• Machinery is depreciated on the straight-line basis over 5 years. It was acquired on
January 1, 20X4.
• Land is not depreciated.
• Buildings are depreciated on the straight-line basis over 25 years.
• Depreciation of land and office buildings is not deductible for tax purposes. For machin-
ery, tax depreciation is granted over a period of 3 years in the ratio of 50/30/20 (percent)
of cost, consecutively.
• The accounting profit before tax amounted to $300,000 for the 20X5 financial year and
$400,000 for 20X6. These figures include nontaxable revenue of $80,000 in 20X5 and
$100,000 in 20X6.
• Difir Inc. had a tax loss on December 31, 20X4, of $250,000. The tax rate for 20X4 was 35
percent, and for 20X5 and 20X6 it was 30 percent.
EXPLANATION
The movements on the deferred tax balance for 20X5 and 20X6 will be reflected as follows in
the accounting records of the enterprise:
Deferred tax liability
January 1, 20X5, balance
Machinery (calculation a—270 ¥ 35%)
Tax loss carried forward (250 ¥ 35%)
Rate change (7 ¥ 5/35)
Temporary differences: –Machinery (Calculation a)
–Loss utilized (Calculation b, 190 ¥ 30%)
December 31, 20X5, balance
Temporary difference: –Machinery (Calculation a)
December 31, 20X6, loss utilized (Calculation b, 60 ¥ 30%)
December 31, 20X6, balance
$’000
Dr/(Cr)
(94.5)
87.5
(7.0)
1.0
(27.0)
(57.0)
(90.0)
–
(18.0)
(108.0)
Continued on next page
120
Chapter 14 Income Taxes (IAS 12)
Example 14.1 (continued)
Calculations
a. Machinery
Carrying
amount
$’000
900
(180)
720
(180)
540
(180)
360
Tax
base
$’000
900
(450)
450
(270)
180
(180)
–
January 1, 20X4, purchase
Depreciation
December 31, 20X4
Rate change (5/35 ¥ 94.5)
Depreciation
December 31, 20X5
Depreciation
December 31, 20X6
b. Income tax expense
Accounting profit before tax
Tax effect of items not deductible/taxable for tax purposes:
Nontaxable revenue
Depreciation on buildings (1500/25)
Temporary differences:
Depreciation: accounting
Depreciation: tax
Taxable profit
Assessed loss brought forward
Taxable profit/(tax loss)
Tax loss carried forward
Tax payable/(benefit) @ 30%
Temporary
difference
$’000
Deferred
tax
$’000
270
270
90
360
–
360
20X6
$’000
400
(100)
60
360
–
180
(180)
360
(60)
300
–
90
94.5
94.5
(13.5)
27.0
108.0
–
108.0
20X5
$’000
300
(80)
60
280
(90)
180
(270)
190
(250)
(60)
(60)
(18)
Chapter 14 Income Taxes (IAS 12)
121
EXAMPLE 14.2
Lipreaders Company has net taxable temporary differences of $90 million, resulting in a
deferred tax liability of $30.6 million. An increase in the tax rate would have the following
impact on deferred taxes and net income:
Deferred Taxes
Net Income
a. Increase
b. Increase
c. No effect
d. No effect
No effect
Decrease
No effect
Decrease
EXPLANATION 2
Choice b. is correct. Deferred tax is a liability that results when tax expense on the income
statement exceeds taxes payable. The amount of deferred tax liability will rise if tax rates are
expected to rise. In effect, more taxes will be paid in the future as the timing differences
reverse. This increase in the deferred tax liability will flow through the income statement by
raising income tax expense. Thus, net income will decrease.
Choice a. is incorrect. When deferred taxes increase, net income will be lower.
Choice c. is incorrect. The above scenario affects both deferred taxes and net income.
Choice d is incorrect. Although net income would decrease, deferred taxes would increase
because tax rates in the future will be higher.
122
Chapter 14 Income Taxes (IAS 12)
EXAMPLE 14.3
1. There are varying accounting rules throughout the world that govern how the income tax
expense is reported on the income statement. IFRS requires the use of the liability method. | Hennie |
To illustrate the essential accounting problem posed when different accounting methods are
used to develop financial information for tax and financial reporting purposes, consider the
Engine Works Corporation. In the year just ended, Engine Works generated earnings from
operations before depreciation and income taxes of $6,000. In addition, the Company earned
$100 of tax-free municipal bond interest income. Engine Works’ only assets subject to depre-
ciation are two machines, one that was purchased at the beginning of last year for $5,000, and
one that was purchased at the beginning of this year for $10,000. Both machines are being
depreciated over 5-year periods. The Company uses an accelerated consumption method to
compute depreciation for income tax purposes (worth $5,200 this year) and the straight-line
method to calculate depreciation for financial reporting (book) purposes.
EXPLANATION 3
1. Based on this information, Engine Works’ income tax filing and income statement for the
current year would be as follows:
Income Tax Filing ($)
Income Statement ($)
Income from operations before
depreciation and income taxes
Tax-free interest income
Depreciation—tax allowance
Taxable income
Income taxes payable (35%)
6,000
—a
5,200
800
280
Income from operations before
depreciation and income taxes
Tax-free interest income
Depreciation
Pretax income
Income tax expense
6,000
100
3,000b
3,100
?
a. Tax-free interest income is excluded from taxable income.
b. 1/5 ¥ $5,000 + 1/5 ¥ $10,000 = $3,000.
2. Based on the income tax filing, the income tax that is owed to the government is $280. The
question is what income tax expense should be reported in Engine Works’s income state-
ment? There are two reasons why accounting profit and taxable profit can be different: tem-
porary and permanent differences (not a term specifically used in IFRS 12).
3. Temporary differences are those differences between accounting profit and taxable prof-
it for an accounting period that arise whenever the measurement of assets and liabilities for
income tax purposes differ from the measurement of assets and liabilities for IFRS purposes.
For example, if an entity uses the straight-line depreciation its assets for IFRS purposes and
accelerated depreciation for income tax purposes, the IFRS carrying amount of the assets will
differ from the tax carrying amount of those assets. For income tax purposes, tax deprecia-
tion will be greater than IFRS depreciation in the early years and lower than IFRS deprecia-
tion in the later years.
4. Permanent differences are those differences between IFRS accounting profit and taxable
profit that arise when income is not taxed or expenses are not tax deductible. For example,
tax-free interest income is not included in taxable income, even though it is part of IFRS
accounting profit.
5. Permanent differences affect the current accounting period’s effective income tax rate (the
ratio of the reported income tax expense to pretax income), but do not have any impact on
future income taxes. Temporary differences, on the other hand, affect the income taxes that
Figure 14.1 Income difference before taxes—engine works
Chapter 14 Income Taxes (IAS 12)
123
Pretax
Income
$3,100
–
Taxable
Income
$800
=
Income
Difference
Before Taxes
$2,300
Tax-Free
Interest Income
Reported on the
Financial Statement
$100
–
Tax-Free
Interest Income
Reported to
Government
$0
=
Permanent
Difference
$100
Depreciation for
Tax Purposes
$5,200
–
Depreciation for
Financial
Statement
Purposes
$3,000
=
Timing
Difference
$2,200
will be paid in future years because they represent a deferral of taxable income from the cur-
rent to subsequent accounting periods (or an acceleration of taxable income from the future
into the current accounting period).
6. The $2,200 difference between the $5,200 accelerated tax depreciation and the $3,000
straight-line depreciation is a temporary difference. Over the life of the equipment the total
depreciation expense will be the same for income tax and book purposes. Figure 14.1 sum-
marizes the differences as they apply to Engine Works.
| Hennie |
7. The $2,300 difference consists of the $100 of tax-free interest income that will never be
taxed, but is included in the income statement. This is a permanent difference because this
income is permanently excluded from taxation; the amount of tax that has to be paid now
or in the future is zero; and the $2,200 difference between the $5,200 accelerated consump-
tion depreciation and the $3,000 straight-line depreciation is a timing (temporary) differ-
ence because the taxes that are saved in the current year are only deferred to the future
when the timing differences reverse. Over the life of the equipment the total depreciation
expense will be the same for income tax and book purposes. The $2,200 is a reflection of the
difference in the amount of the total cost of the equipment that is allocated to this period by
the two methods of accounting for depreciation. The income statement has a lower depre-
ciation cost than the tax filing, which results in higher reported income. These differences
will reverse over time when the straight-line depreciation rises above the double-declining
balance depreciation.
15 Property, Plant, and Equipment
(IAS 16)
15.1
PROBLEMS ADDRESSED
This objective of IAS 16 is to prescribe the accounting treatment for property, plant, and
equipment, including:
• Timing of the recognition of assets.
• Determination of asset carrying amounts using both the cost model and the revaluation
model.
• Depreciation charges and impairment losses to be recognized in relation to these val-
ues.
• Disclosure requirements.
15.2
SCOPE OF THE STANDARD
This Standard deals with all property, plant, and equipment, including that which is held as
a lessee under a finance lease (IAS 17) and property that is being constructed or developed
for future use as investment property (IAS 40). The standard prescribes that the initial
amount of the asset be recognized at cost, but after that an election between the cost model
or the revaluation model must be made.
This Standard does not apply to:
• property, plant, and equipment that is classified as held for sale (see IFRS 5),
• biological assets related to agricultural activity (see IAS 41 Agriculture),
• mineral rights and mineral reserves, such as oil or natural gas, or
• similar non-regenerative resources.
15.3
KEY CONCEPTS
15.3.1 Property, plant, and equipment are tangible items that are
• held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes; and
• expected to be used during more than one period.
124
Chapter 15 Property, Plant, and Equipment (IAS 16)
125
15.3.2 Cost is the amount of cash or cash equivalents paid and the fair value of any other
consideration given to acquire an asset at the time of its acquisition or construction.
15.3.3 Fair value is the amount for which an asset could be exchanged between knowl-
edgeable, willing parties in an arm’s length transaction.
15.3.4 Carrying amount is the amount at which an asset is recognized after deducting any
accumulated depreciation and accumulated impairment losses.
15.3.5 Depreciation is the systematic allocation of the depreciable amount of an asset over
its useful life.
15.3.6 An impairment loss is the amount by which the carrying amount of an asset exceeds
its recoverable amount. Recoverable amount is the higher of an asset’s net selling price and
its value in use.
15.3.7 The residual value of an asset is the estimated amount that an entity would cur-
rently obtain from disposal of the asset, after deducting the estimated costs of disposal
(assuming the asset were already of the age and in the condition expected at the end of its
useful life).
15.3.8 Useful life is
• the period over which an asset is expected to be available for use by an entity, or
• the number of production or similar units expected to be obtained from the asset by an
entity.
15.4
ACCOUNTING TREATMENT
MEASUREMENT OF QUALIFYING ASSETS
15.4.1 The cost of an item of property, plant, and equipment should be recognized as an | Hennie |
asset only if
• it is probable that future economic benefits associated with the item will flow to the
entity, and
• the cost of the item can be measured reliably.
15.4.2 The above principle is applied to both costs incurred to acquire an item of property,
plant, and equipment, and to any subsequent expenditure incurred to add to, replace part of,
or service the item. Therefore, an entity should:
• Capitalize replacement or renewal components and major inspection costs
• Write off replaced or renewed components related to a previous inspection (irrespec-
tive of whether identified on acquisition or construction)
• Expense day-to-day servicing costs
15.4.3 Safety and environmental assets qualify as property, plant, and equipment if they
enable the entity to increase future economic benefits from related assets in excess of what it
could derive if they had not been acquired (for example, chemical protection equipment).
Examples are:
• Insignificant items (for example, molds and dies) could be aggregated as single asset items.
• Specialized spares and servicing equipment are accounted for as property, plant, and
equipment.
126
Chapter 15 Property, Plant, and Equipment (IAS 16)
15.4.4 The cost of an item of property, plant and equipment includes:
• Its purchase price and duties paid
• Any costs directly attributable to bringing the asset to the location and condition neces-
sary for it to be capable of operating in its intended manner
• The initial estimate of the costs of dismantling and removing the asset and restoring
the site (see IAS 37)
• Materials, labor, and other inputs for self-constructed assets
15.4.5 The cost of an item of property, plant and equipment excludes:
• General and administrative expenses
• Start-up costs
15.4.6 The cost of an item of property, plant, and equipment might include the effects of:
• Government grants (IAS 20) deducted from cost or set up as deferred income
• Self-constructed assets which include materials, labor, and other inputs
15.4.7 When assets are exchanged and the transaction has commercial substance, items are
recorded at the fair value of the asset (assets) received. In other cases, items are recorded at
the carrying amount of the asset (assets) given up.
15.4.8 The amount expected to be recovered from the future use (or sale) of an asset, includ-
ing its residual value on disposal, is referred to as the recoverable amount. The carrying
amount should be compared with the recoverable amount whenever there is an indication of
impairment. If the latter is lower, the difference is recognized as an expense (IAS 36).
COST MODELS
15.4.9 Choice of cost or fair value. Subsequent to initial recognition, an entity should
choose either the cost model or the revaluation model as its accounting policy for items of
property, plant, and equipment and should apply that policy to an entire class of property,
plant, and equipment.
15.4.10 Cost model. The carrying amount of an item of property, plant, and equipment is
its cost less accumulated depreciation and impairment losses. Assets classified as held for
sale are shown at the lower of fair value less costs to sell and carrying value.
15.4.11 Revaluation model. The carrying amount of an item of property, plant, and equip-
ment is its fair value less subsequent accumulated depreciation and impairment losses.
Assets classified as held for sale are shown at the lower of fair value less costs to sell and car-
rying value.
15.4.12 Property, plant, and equipment is measured at fair value at date of revaluation as
follows:
• If an item of property, plant, and equipment is revalued, the entire class of property,
plant, and equipment to which that asset belongs should be revalued.
• Assets should be regularly revalued so that carrying value does not differ materially
from fair value.
INCOME AND EXPENSES
15.4.13 Revaluation profits and losses. Adjustments to the carrying value are treated as
follows:
• Increases should be credited directly to equity under the heading of revaluation sur- | Hennie |
plus. A reversal of a previous loss for the same asset is taken to the income statement.
Chapter 15 Property, Plant, and Equipment (IAS 16)
127
• Decreases should be recognized (debited) in profit or loss. A reversal of a profit previ-
ously taken to equity can be debited to equity.
15.4.14 Depreciation of an asset is recognized as an expense unless it is included in the car-
rying amount of a self-constructed asset. The following principles apply:
• The depreciable amount is allocated on a systematic basis over the useful life.
• The method reflects the pattern of expected consumption.
• Each part of an item of property, plant, and equipment with a cost that is significant in
relation to the total cost of the item should be depreciated separately at appropriately
different rates.
• Component parts are treated as separate items if the related assets have different useful
lives or provide economic benefits in a different pattern (for example, an aircraft and its
engines or land and buildings).
15.4.15 The depreciation method applied to an asset should be reviewed at least at each
financial year-end and, if there has been a significant change in the expected pattern of con-
sumption of the future economic benefits embodied in the asset, the method should be
changed to reflect the changed pattern. Such a change should be accounted for as a change
in an accounting estimate in accordance with IAS 8.
15.4.16 Depreciation starts when the asset is ready for use and ends when the asset is dere-
cognized or classified as held for sale. When depreciation is based on hourly usage, such
machines are not depreciated when not in use.
15.5
PRESENTATION AND DISCLOSURE
15.5.1 For each class of property, plant, and equipment the following must be presented:
• The measurement bases used for determining the gross carrying amount
• The depreciation methods used
• The useful lives or the depreciation rates used
• The gross carrying amount and the accumulated depreciation (together with accumu-
lated impairment losses) at the beginning and end of the period
• A reconciliation of the carrying amount at the beginning and end of the period showing
• additions, disposals, or depreciation;
• acquisitions through business combinations;
• increases or decreases resulting from revaluations and impairment losses recognized
or reversed directly in equity;
• impairment losses recognized in profit or loss;
• impairment losses reversed in profit or loss;
• net exchange differences arising on the translation of the financial statements; or
• other changes.
15.5.2 The financial statements should also disclose
• restrictions on title and pledges as security for liabilities,
• expenditures recognized in the carrying amount in the course of construction,
• contractual commitments for the acquisition of property, plant, and equipment, and
• compensation for impairments included in profit or loss.
15.5.3 Disclosure of the methods adopted and the estimated useful lives or depreciation
rates should include
128
Chapter 15 Property, Plant, and Equipment (IAS 16)
• methods adopted and the estimated useful lives or depreciation rates,
• depreciation, whether recognized in profit or loss or as a part of the cost of other assets,
during a period, and
• accumulated depreciation at the end of the period.
15.5.4 Disclose the nature and effect of a change in an accounting estimate with respect to
• residual values,
• the estimated costs of dismantling, removing, or restoring items,
• useful lives, and
• depreciation methods.
15.5.5 If items of property, plant, and equipment are stated at revalued amounts, the fol-
lowing must be disclosed:
• Effective date of revaluation
• Independent valuator involvement
• Methods and significant assumptions applied
• Reference to observable prices in an active market or recent arm’s length transactions
• Carrying amount that would have been recognized had the assets been carried under
the cost model
• Revaluation surplus
15.5.6 Users of financial statements can also find the following information relevant to their | Hennie |
needs and disclosure is therefore encouraged:
• Carrying amount of temporarily idle property, plant, and equipment
• Gross carrying amount of fully depreciated items still in use
• The carrying amount of items retired from active use and held for disposal
• Fair value of property, plant, and equipment when this is materially different from the
carrying amount per the cost model in use
15.6
FINANCIAL ANALYSIS AND INTERPRETATION
15.6.1 The original costs of acquired fixed assets are usually recognized over time by sys-
tematically writing down the asset’s book value on the balance sheet and reporting a com-
mensurate expense on the income statement. The systematic expensing of the original cost of
physical assets over time is called depreciation. The systematic expensing of the original cost
of natural resources over time is called depletion. The systematic recognition of the original
cost of intangible assets over time is called amortization expense. Essentially, all three of
these concepts are the same. The cost of acquiring land is never depleted, however, because
land does not get used up over time, but if it does it is depreciated.
15.6.2 Depreciation is a method of expensing the original purchase cost of physical assets
over their useful lives. It is neither a means of adjusting the asset to its fair market value nor
a means to provide funds for the replacement of the asset being depreciated.
15.6.3 There are several methods of determining depreciation expense for fixed assets on
the financial statements. In some countries, these depreciation methods include straight-line,
sum-of-the-years’ digits, double-declining balance, and units-of-production (service hours).
Regardless of the terminology used, the principles that should be applied in IFRS financial
statements are that:
• The depreciable amount is allocated on a systematic basis over the useful life.
• The method used must reflect the pattern of expected consumption.
Chapter 15 Property, Plant, and Equipment (IAS 16)
129
15.6.4 The straight-line depreciation method is generally used worldwide to determine
IFRS depreciation. Both sum-of-the-years’ digits and the double-declining balance methods
are classified as accelerated depreciation (or rather, accelerated consumption-pattern meth-
ods; they are often used for tax purposes and do not comply with IFRS if they do not reflect
the pattern of the expected consumption of the assets).
15.6.5 In some countries, management has more flexibility than is permitted by IFRS when
deciding whether to expense or capitalize certain expenditure which could result in the
recognition of an asset that does not qualify for recognition under IFRS or the expensing of a
transaction that would otherwise qualify as an asset under IFRS. This flexibility will impact
the balance sheet, income statement, a number of key financial ratios, and the classification
of cash flows in the statement of cash flows. Consequently, the analyst must understand the
financial data effects of the capitalization or expensing choices made by management.
15.6.6 Table 15.1 summarizes the effects of expensing versus capitalizing costs on the finan-
cial statements and related key ratios.
Table 15.1 Effects of Capitalizing vs. Expensing Costs
Variable
Expensing
Capitalizing
Shareholders’ Equity
Lower because earnings are lower
Higher because earnings are higher
Earnings
Lower because expenses are higher
Higher because expenses are lower
Pretax Cash Generated
from Operating Activities
Lower because expenses are higher
Higher because expenses are lower
Cash Generated from
Investing Activities
None because no long-term asset is put
on the balance sheet
Lower because a long-term asset is
acquired (invested in) for cash
Pretax Total Cash Flow
Same because amortization is not a
Same because amortization is not a
cash expense
cash expense
Profit Margin
Asset Turnover
Current Ratio
Lower because earnings are lower
Higher because earnings are higher
Higher because assets are lower
Lower because assets are higher
| Hennie |
Same on a pretax basis because
Same on a pretax basis because only
only long-term assets are affected
long-term assets are affected
Debt-to-Equity
Higher because shareholders’
Lower because shareholders’ equity is
equity is lower
higher
Return on Assets
Return on Equity
Lower because the earnings are lower
percentage wise than the reduced
assets
Higher because the earnings are higher
percentage wise than the increased
assets
Lower because the earnings are lower
percentage wise than the reduced
shareholders’ equity
Higher because the earnings are higher
percentage wise than the increased
shareholders’ equity
Stability over Time
Less stable earnings and ratios because More stable earnings and ratios because
large expenses can be sporadic
amortization smoothes earnings over time
15.6.7 Management must make three choices when deciding how to depreciate assets. They
must decide
• the method of depreciation that will be used (straight-line, accelerated consumption, or
depletion in early years),
• the useful life of the asset, which is the time period over which the depreciation will
occur, and
• the residual value of the asset.
130
Chapter 15 Property, Plant, and Equipment (IAS 16)
In IFRS financial statements, these choices are determined by the application of the principles in
IAS 16. In some countries, however, management has greater flexibility. These choices affect the
asset values reported on the balance sheet and the income reported on the income statement. They
also affect several key financial ratios. The analyst should be aware of the effects of these choices.
15.6.8 The easiest way to understand the impact of using straight-line versus accelerated
depreciation is as follows: An accelerated consumption method will increase the deprecia-
tion expense in the early years of an asset’s useful life relative to what it would be if the
straight-line method were used. This lowers reported income and also causes the book value
of the long-term assets reported on the balance sheet to decline more quickly relative to what
would be reported under the straight-line method. As a result, the shareholders’ equity will
be lower in the early years of an asset’s life if accelerated depreciation is used compared with
what it would be if the straight-line method is used. Furthermore, the percentage impact falls
more heavily on the smaller income value than on the larger asset and shareholders’ equity
values. Many of the key financial ratios that are based on income, asset values, or equity val-
ues will also be affected by the choice of depreciation method.
15.6.9 No matter which depreciation method is chosen, however, the total accumulated
depreciation will be the same over the entire useful life of an asset. Thus, the effects shown
in Table 15.2 for the early year (years) of an asset’s life tend to reverse over time. However,
these reversals apply to the depreciation effects associated with an individual asset. If a com-
pany’s asset base is growing, the depreciation applicable to the most-recently acquired assets
tends to dominate the overall depreciation expense of the entity. The effects described in the
table will normally apply over time because the reversal process is overwhelmed by the
depreciation charges applied to newer assets. Only if an entity is in decline and its capital
expenditures are low will the reversal effects be noticeable in the aggregate.
15.6.10 The choice of the useful life of an asset also affects financial statement values and
key financial ratios. All other factors being held constant, the shorter the useful life of an
asset, the larger its depreciation will be over its depreciable life. This will raise the deprecia-
tion expense, lower reported income, reduce asset values, and reduce shareholders’ equity
relative to what they would be if a longer useful life were chosen.
Reported cash flow, however, will not be affected, because depreciation is not a cash expense.
Key financial ratios that contain income, asset values, and shareholders’ equity will, howev- | Hennie |
er, be affected. A shorter useful life tends to lower profit margins and return on equity, while
at the same time raising asset turnover and debt-to-equity ratios.
15.6.11 Choosing a large residual value has the opposite effect of choosing a short useful
life. All other factors being constant, a high salvage (residual) value will lower the deprecia-
tion expense, raise reported income, and raise the book values of assets and shareholders’
equity relative to what they would be if a lower salvage value had been chosen. Cash flow,
however, is unaffected because depreciation is a noncash expense. As a result of a high sal-
vage value, an entity’s profit margin and return on equity increase, whereas its asset turnover
and debt-to-equity ratios decrease.
15.6.12 When depreciation is based on the historical cost of assets, it presents a problem
during periods of inflation. When the prices of capital goods increase over time, the depreci-
ation accumulated over the life of such assets will fall short of the amount needed to replace
them when they wear out.
To understand this concept, consider equipment that costs $10,000, has a 5-year useful life, and
has no salvage value. If straight-line depreciation is used, this asset will be depreciated at a
rate of $2,000 per year for its 5-year life. Over the life of the equipment, this depreciation will
accumulate to $10,000. If there had been no inflation in the intervening period, the original
equipment could then be replaced with a new $10,000 piece of equipment. Historical-cost
Chapter 15 Property, Plant, and Equipment (IAS 16)
131
depreciation makes sense in a zero-inflation environment, because the amount of depreciation
expensed matches the cost to replace the asset.
However, suppose the inflation rate over the equipment’s depreciable life had been 10 per-
cent per year, instead of zero? Then, when it comes time to replace the asset, its replacement
will cost $16,105 ($10,000 ¥ 1.105). The accumulated depreciation is $6,105 less than what is
required to physically restore the entity to its original asset position. In other words, the real
cost of the equipment is higher, and the reported financial statements are distorted.
This analysis illustrates that, during periods of inflation, depreciating physical assets on the basis
of historical cost, in accordance with the financial capital maintenance theory of income, tends to
understate the true depreciation expense. As such, it overstates the true earnings of an entity from
the point of view of the physical capital maintenance (replacement cost) theory of income.
15.6.13 Table 15.2 provides an overview of the impact of changes in consumption pattern,
depreciable asset lives (duration of consumption), and salvage values on financial statements and
ratios. Comparisons of a company’s financial performance with industry competitors would be
similar to the effects of changes in Table 15.2’s variables if competitors use different depreciation
methods, higher (lower) depreciable asset lives, and relatively higher (lower) salvage values.
Table 15.2 Impact of Changes on Financial Statements and Ratios
Change from Straight-Line
to Depreciation Based on
Accelerated Consumption
Pattern in Early Years
Change from
Accelerated Consumption
Pattern in Early Years to
Straight-Line Depreciation
Variable
Earnings
Lower due to higher
depreciation expense
Higher due to lower
depreciation expense
Increase (Decrease) in
Asset Depreciable Life
(Duration of Consumption)
Higher (lower) due to lower
(higher) depreciation
expense
Net Worth
Lower due to higher asset
Higher due to lower asset
write-down
write-down
Higher (lower) due to lower
(higher) asset write-down
Increase (Decrease)
in Salvage Value
Higher (lower) due to
lower (higher)
depreciation
expense
Higher (lower) due to
lower (higher)
asset write-down
Cash Flow
No effect
No effect
No effect
No effect
Profit
Margin
Current
Ratio
Asset
Turnover
Debt-to-
Equity
Return
on Assets
Return
on Equity
Lower due to lower earnings
Higher due to lower earnings Higher (lower) due to higher Higher (lower) due to | Hennie |
(lower) earnings
higher (lower)
earnings
None; only affects long-term None; only affects long-term None; only affects long-term None; only affects
long-term assets
assets
assets
assets
Higher due to lower assets
Lower due to higher assets
Lower (higher) due to higher
(lower) assets
Higher due to lower net
Lower due to higher net
Lower (higher) due to
worth
worth
higher (lower) net worth
Lower due to a larger
Higher due to a larger
Higher (lower) due to a
percentage decline in
earnings versus asset decline
percentage rise in earnings
versus asset rise
larger (smaller) percentage
rise in earnings versus asset
rise
Lower due to a larger
Higher due to a larger
percentage decline in
earnings versus equity
decline
percentage rise in earnings
versus equity rise
Higher (lower) due to a large
(smaller) percentage rise in
earnings versus equity rise
Lower (higher) due
to higher (lower)
assets
Lower (higher) due to
higher (lower) net
worth
Higher (lower) due to
a larger (smaller)
percentage rise in
earnings versus
asset rise
Higher (lower) due to
a large (smaller)
percentage rise in
earnings versus
equity rise
132
Chapter 15 Property, Plant, and Equipment (IAS 16)
EXAMPLES: PROPERTY, PLANT, AND EQUIPMENT
EXAMPLE 15.1
An entity begins the year with assets of $8,500, consisting of $500 in cash and $8,000 in plant,
and equipment. These assets are financed with $200 of current liabilities, $2,000 of 7 percent
long-term debt, and $6,300 of common stock. During the year, the entity has sales of $10,000
and incurs $7,000 of operating expenses, (excluding depreciation), $1,000 of construction costs
for new plant and equipment, and $140 of interest expense. The entity depreciates its plant
and equipment over 10 years (no residual (salvage) value). Ignoring the effect of income taxes,
develop pro forma income statements and balance sheets for the company’s operations for the
year if it expenses the $1,000 of construction costs and if it capitalizes these costs.
The effect of the expense or capitalize cost decision on the company’s shareholders’ equity,
pretax income, pretax operating and investing cash flows, and key financial ratios should be
analyzed.
It is assumed that construction costs will be depreciated over 4 years and that the resulting
asset was ready for use on the first day of Year 1.
The results of the expense or capitalize cost decision should be summarized.
Chapter 15 Property, Plant, and Equipment (IAS 16)
133
EXPLANATION
Expense
Construction costs
Capitalize
Construction costs
Year 0 ($)
Year 1 ($)
Year 0 ($)
Year 1 ($)
500
8,000
—
8,500
200
2,000
6,300
—
8,500
Sales
Operating Expenses
Construction costs
Depreciation Expense
Amortization Expense
Interest Expense
Pretax Income
Cash
Plant and Equipment
Construction costs
Total Assets
Current Liabilities
Long-Term Debt
Common Stock
Retained Earnings
Total Liabilities and Capital
Shareholders’ Equity
Pretax Earnings
Operating Cash Flow (Pretax +
Depreciation and Amortization)
Investing Cash Flow
Net Cash Flow
Pretax Profit Margin
Asset Turnover (Sales/Average Assets)
Current Ratio
Long-Term Debt-to-Equity
Pretax ROE (Income/Average Equity)
10,000
7,000
1,000
800
—
140
1,060
2,360
7,200
—
9,560
200
2,000
6,300
1,060
9,560
7,360
1,060
1,860
—
$ 1,860
10.6%
1.11x
11.8x
27.2%
15.5%
(8000-0/10)
(1000/4)
($8,000 – $800)
($1,000 – $250)
10,000
7,000
—
800
250
140
1,810
2,360
7,200
750
10,310
200
2,000
6,300
1,810
10,310
8,110
1,810
2,860
500
8,000
—
8,500
200
2,000
6,300
—
8,500
(1,000)
$ 1,860
(construction cost)
18.1%
1.06x
11.8x
24.7x
25.1%
134
Chapter 15 Property, Plant, and Equipment (IAS 16)
EXAMPLE 15.2
On January 1, 20X1, Zakharetz Inc. acquired production equipment in the amount of
$250,000. The following further costs were incurred:
Delivery
Installation
General administration costs of an indirect nature
$
18,000
24,500
3,000
The installation and setting-up period took 3 months, and a further amount of $21,000 was
spent on costs directly related to bringing the asset to its working condition. The equipment
was ready for use on 1 April 20X1.
Monthly managerial reports indicated that for the first 5 months, the production quantities | Hennie |
from this equipment resulted in an initial operating loss of $15,000 because of small quanti-
ties produced. The months thereafter show much more positive results.
The equipment has an estimated useful life of 14 years and a residual value of $18,000.
Estimated dismantling costs amount to $12,500.
What is the cost of the asset and what are the annual charges in the income statement relat-
ed to the consumption of the economic benefits embodied in the assets?
EXPLANATION 2
Historical cost of equipment
Invoice price
Delivery
Installation
Other costs directly related to bringing the asset to its working condition
Initial estimate of dismantling costs
Annual charges related to equipment
Historical cost above
Estimated residual value
Depreciable amount
$
250,000
18,000
24,500
21,000
12,500
326,000
$
326,000
(18,000)
308,000
The annual charge to the income statement is $22,000 (308,000 ÷ 14 years). However, note that
in the year ending December 31, 20X1, the charge will be $16,500 (9/12 ¥ $22,000) because the
equipment was ready for use on April 1, 20X1, after the installation and setting-up period.
Chapter 15 Property, Plant, and Equipment (IAS 16)
135
EXAMPLE 15.3
Delta Printers Inc. acquired its buildings and printing machinery on January 1, 20X1, for the
amount of $2 million and recorded it at the historical acquisition cost. During 20X3, the direc-
tors made a decision to account for the machinery at fair value in the future, to provide for
the maintenance of capital of the business in total.
Will measurement at fair value achieve the objective of capital maintenance? How is fair
value determined? What are the deferred tax implications?
EXPLANATION 2
Maintenance of capital
The suggested method of accounting treatment will not be completely successful for the
maintenance of capital due to the following:
• No provision is made for maintaining the current cost of inventory, work-in-process, and
other nonmonetary assets.
• No provision is made for the cost of holding monetary assets.
• No provision is made for back-log depreciation.
Fair value:
The fair value of plant and equipment items is usually their market value determined by
appraisal. When there is no proof of market value, due to the specialized nature of plant and
equipment and because these items are rarely sold (except as part of a going concern), then
the items are to be valued at net replacement cost.
Deferred tax implication of revaluation:
Deferred taxation is provided for on the revaluation amount because:
• The revalued carrying amount is then recovered through use, and taxable economic ben-
efits are obtained against which no depreciation deductions for tax purposes are
allowed. Therefore, the taxation payable on these economic benefits should be provided.
• Deferred taxation, as a result of revaluation, is charged directly against the revaluation
surplus (equity).
16 Leases (IAS 17)
16.1
PROBLEMS ADDRESSED
Lease accounting is mostly concerned with the appropriate criteria for the recognition, as
well as the measurement, of the leased asset and liability. Associated with this primary con-
cern is the somewhat artificial distinction between a finance lease (which is recognized as an
asset and depreciated) and an operating lease (which is expensed as the charges occur).
16.2
SCOPE OF THE STANDARD
This Standard applies to all lease agreements whereby the lessor conveys to the lessee in return
for a payment or series of payments the right to use an asset for an agreed period of time.
The Standard prescribes, for lessees and lessors, the appropriate accounting policies and dis-
closure that should be applied to various types of lease transactions. It specifies the criteria
for distinguishing between finance leases and operating leases, the recognition and mea-
surement of the resulting assets and liabilities as well as disclosures.
This Standard should be applied in accounting for all leases other than
• leases to explore for or use minerals, oil, natural gas, and similar non-regenerative
| Hennie |
resources, and
• licensing agreements for such items as motion picture films, video recordings, plays,
manuscripts, patents, and copyrights.
However, this Standard should not be applied as the basis of measurement for
• property held by lessees that is accounted for as investment property (see IAS 40),
• investment property provided by lessors under operating leases (see IAS 40),
• biological assets held by lessees under finance leases (see IAS 41), or
• biological assets provided by lessors under operating leases (see IAS 41).
16.3
KEY CONCEPTS
16.3.1 A lease is an agreement whereby the lessor conveys to the lessee in return for a pay-
ment or series of payments the right to use an asset for an agreed period of time.
16.3.2 Finance leases transfer substantially all the risks and rewards incident to ownership
of an asset. Title might or might not eventually be transferred.
136
Chapter 16 Leases (IAS 17)
137
16.3.3 The characteristics of finance leases include the following:
• The lease transfers ownership of asset to the lessee at the expiration of the lease
• The lessee has an option to purchase the asset at below fair value; the option will be
exercised with reasonable certainty
• The lease term is for a major part of the economic life of the asset
• The present value of minimum lease payments approximates fair value of the leased
asset
• The leased assets is of a specialized nature and only suitable for the lessee
• The lessee will bear cancellation losses
• The fluctuation gains or losses of residual value are passed on to the lessee
• The lease for a secondary period is possible at substantial lower-than-market rent
16.3.4 Operating leases are leases other than finance leases. Many lease contracts are arti-
ficially structured to qualify as operating leases, causing standard setters to reconsider
whether this category should exist at all.
16.3.5 Minimum lease payments are the payments over the lease term that the lessee is
required to make to a third party. Certain contingent and other items are excluded. However,
if the lessee has an option to purchase the asset at a price that is expected to be sufficiently
lower than fair value at the date the option becomes exercisable, the minimum lease pay-
ments comprise the minimum payments payable over the lease term to the expected date of
exercise of this purchase option and the payment required to exercise it.
16.3.6 Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
16.4
ACCOUNTING TREATMENT
ACCOUNTING BY LESSEES
16.4.1 The classification of leases is done at inception of the lease. The substance rather
than the form of the lease contract is indicative of the classification. The classification is based
on the extent to which risks and rewards incident to ownership of a leased asset lie with the
lessor or the lessee:
• Risks include potential losses from idle capacity, technological obsolescence, and varia-
tions in return due to changing economic conditions.
• Rewards include the expectation of profitable operation over the asset’s economic life
and of gain from appreciation in value or the realization of a residual value.
16.4.2 An asset held under a finance lease and its corresponding obligation are recognized
in terms of the principle of substance over form. The accounting treatment is as follows:
• At inception, the asset (recognized as property, plant and equipment) and a corre-
sponding liability for future lease payments are recognized at the same amounts.
• Initial direct costs in connection with lease activities are capitalized to the asset.
• Lease payments consist of the finance charge and the reduction of the outstanding liability.
The finance charge is to be a constant periodic rate of interest on the remaining balance
of the liability for each period.
• Depreciation and impairment of the leased asset is recognized in terms of IAS 16 and
IAS 36.
138
Chapter 16 Leases (IAS 17)
| Hennie |
16.4.3 Operating lease payments (excluding costs for services such as insurance) are recog-
nized as an expense in the income statement on a straight-line basis, or a systematic basis that is
representative of the time pattern of the user’s benefit, even if the payments are not on that basis.
ACCOUNTING BY LESSORS
16.4.4 An asset held under a finance lease is presented as a receivable. It is accounted for
as follows:
• The receivable is recorded at the net investment amount.
• The recognition of finance income is based on a pattern reflecting a constant periodic
rate of return on the net investment.
• Initial direct costs are deducted from receivables (except for manufacturer or dealer
lessors).
16.4.5 An operating leased asset is classified according to its nature. It is accounted for as
follows:
• Depreciation is recognized in terms of IAS 16 and IAS 38.
• Lease income is recognized on a straight line basis over the lease term, unless another
systematic basis is more representative.
• Initial direct costs are either recognized immediately or allocated against rent income
over the lease term.
SALE AND LEASEBACK TRANSACTIONS
16.4.6 If the leaseback is a finance lease, any excess of sales proceeds over the carrying
amount in the books of the lessee (vendor) should be deferred and amortized over the lease
term. The transaction is a means whereby the lessor provides finance to the lessee and the
lessor retains risks and rewards of ownership. It is therefore inappropriate to recognize the
profit as income immediately.
16.4.7 Profit or loss from an operating lease concluded at fair value is recognized immedi-
ately. Transactions below or above fair value are recorded as follows:
• If the fair value is less than the carrying amount of the asset, a loss equal to the differ-
ence is recognized immediately.
• If the sale price is above fair value, the excess over fair value should be deferred and
amortized over the lease period.
• If the sale price is below fair value, any profit or loss is recognized immediately unless
a loss is compensated by future lease payments at below market price; in this case, the
loss should be deferred and amortized in proportion to the lease payments.
16.5
PRESENTATION AND DISCLOSURE
16.5.1 Lessees—finance leases:
• Asset: Carrying amount of each class of asset
• Liability: Total of minimum lease payments reconciled to the present values of lease lia-
bilities in three periodic bands, namely
• not later than 1 year,
• not later than 5 years, or
• later than 5 years
Chapter 16 Leases (IAS 17)
139
• IAS 16 requirements for leased property, plant, and equipment
• General description of significant leasing arrangements
• Distinction between current and noncurrent lease liabilities
• Future minimum sublease payments expected to be received under noncancellable sub-
leases at balance sheet date
• Contingent rents recognized in income for the period
Lessees—Operating leases:
• General description of significant leasing arrangements (same information as for
finance leases above)
• Lease and sublease payments recognized in income of the current period, separating
minimum lease payments, contingent rents, and sublease payments
• Future minimum noncancellable lease payments in the three periodic bands
• Future minimum sublease payments expected to be received under noncancellable sub-
leases at balance sheet date
16.5.2 Lessors—Finance leases:
• The total gross investment reconciled to the present value of minimum lease payments
receivable in the three periodic bands
• Unearned finance income
• Accumulated allowance for uncollectible receivables
• Contingent rents recognized in income
• General description of significant leasing arrangements
• Unguaranteed residual values
Lessors—Operating leases:
• All related disclosure under IAS 16, IAS 36, IAS 38, and IAS 40
• General description of significant leasing arrangements
• Total future minimum lease payments under noncancellable operating leases in the
three periodic bands
• Total contingent rents recognized in income
16.5.3 Sale and leaseback transactions
| Hennie |
Same disclosures for lessees and lessors apply. Some items might be separately disclosable in
terms of IAS 8.
16.6
FINANCIAL ANALYSIS AND INTERPRETATION
16.6.1 The financial statement effects of accounting for a lease in the financial statements of
the lessee as an operating lease versus a finance lease can be summarized as follows:
• Operating lease accounting reports the lease payments as rental expense on the
income statement.
• The balance sheet is only impacted indirectly when the rental expense flows through to
retained earnings via net income.
• The rental expense is reported as an operating cash outflow (as a part of the entity’s
net income) on the statement of cash flows.
• The total reported expense over the lease term should normally be the same for a
finance lease as the total reported expense over the lease term would be under the
140
Chapter 16 Leases (IAS 17)
operating lease method. However, costs are higher in the early years under the finance
lease method, which causes the earnings trend to rise over the lease term.
• The finance lease method places both an asset and a net amount of debt on the balance
sheet, whereas no such asset or debt items are reported under the operating method.
• Under finance lease accounting, the total lease payment is divided into an interest
component and the repayment of principal; a depreciation component also arises when
the principal (capital portion) is depreciated in terms of IAS 16. Under the operating
method the payment is simply a rental expense.
• Under the operating method, lease payments are reported as operating cash outflows
(interest can be classified as a financing cash flow as well), whereas under the finance
lease method, the cash outflow is normally allocated between operating and financing.
• The interest portion of the finance lease payment is normally reported as an operating
cash outflow, whereas the repayment of the lease obligation portion is treated as a
financing cash outflow. However, the net effect on total cash is the same in both
methods.
• That portion of the lease obligation that is paid or eliminated within 1 year or one oper-
ating cycle, whichever is longer, is classified as a current liability. The remainder is clas-
sified as a long-term liability.
16.6.2 Why do companies lease assets and under what conditions will they favor operating
or finance leases? Several possible answers can be given to this question, but must be con-
sidered within the context of a specific situation—in other words, although the arguments
would often be valid, circumstances could arise which would invalidate the assumptions on
which they are based:
• Companies with low marginal tax rates or low taxable capacity generally find leasing
to be advantageous, because they do not need or cannot obtain the tax advantages
(depreciation) that go with the ownership of assets. In this case either type of lease is
appropriate. Companies with high tax rates prefer finance leases, because expenses are
normally higher in early periods.
• Operating leases are advantageous when management compensation depends on
return on assets or invested capital.
• An operating lease is advantageous when an entity wants to keep debt off of its bal-
ance sheet. This can help them if they have indenture covenants requiring low debt-to-
equity ratios or high interest coverage ratios.
• Finance leases are favored if an entity wants to show a high cash flow from operations.
• Finance leases have advantages when there is a comparative advantage to reselling
property.
Table 16.1 Effect of operating and finance leases on lessee financial statements and key financial ratios
Chapter 16 Leases (IAS 17)
141
Operating Lease
Finance Lease
Item or
Ratio
Balance
Sheet
No effects because no assets or
liabilities are created under the
operating method.
Income
Statement
The lease payment is recorded as
an expense. These payments are
often constant over the life of
the lease.
Statement
of Cash
Flows
The entire cash outflow paid on the
lease is recorded as an operating
cash outflow.
| Hennie |
Higher in the early years because the
rental expense is normally less than
the total expense reported under the
finance lease method.
However, in later years, it will be
lower than under the finance lease
method.
A leased asset (equipment) and a lease obligation are created
when the lease is recorded. Over the life of the lease, both
are written off, but the asset is usually written down faster,
creating a net liability during the life of the lease.
Both interest expense and depreciation expense are created.
In the early years of the lease, they combine to produce a
higher expense than is reported under the operating
method. However, over the life of the lease, the interest
expense declines, causing the total expense trend to
decline. This produces a positive trend in earnings. In the
later years, earnings are higher under the finance lease
method than under the operating method.
Over the entire term of the lease, the total lease expenses are
the same under both methods.
The cash outflow from the lease payments is allocated partly
to an operating or financing cash outflow (interest
expense) and partly to a financing cash outflow
(repayment of the lease obligation principal).
The depreciation of the leased asset is not a cash expense
and, therefore, is not a cash flow item.
Lower in the early years because the total reported expense
under the finance lease method is normally higher than the
lease payment. However, the profit margin will trend upward
over time, so in the later years it will exceed that of the
operating method.
Higher because there are no leased
Lower because of the leased asset (equipment) that is
assets recorded under the operating
method.
created under the finance lease method.
The ratio rises over time as the asset is depreciated.
Higher because no short-term debt
Lower because the current portion of the lease obligation
is added to the balance sheet by the
operating method.
created under the finance lease method is a current liability.
The current ratio falls farther over time as the current
Lower because the operating
method creates no debt.
Return on
Assets
Higher in the early years because
profits are higher and assets are lower.
portion of the lease obligation rises.
Higher because the finance lease method creates a lease
obligation liability (which is higher than the leased asset in
the early years).
However, the debt-to equity ratio decreases over time as
the lease obligation decreases.
Lower in the early years because earnings are lower and assets
are higher.
However, the return on asset ratio rises over time because
the earnings trend is positive and the assets decline as they
are depreciated.
Return on
Equity
Higher in the early years because
earnings are higher.
Lower in the early years because earnings are lower.
However, the return on equity rises over time because of a
positive earnings trend.
Interest
Coverage
Higher because no interest expense
Lower because interest expense is created by the finance
occurs under the operating method.
lease method.
However, the interest coverage ratio rises over time because
the interest expense declines over time.
Profit
Margin
Asset
Turnover
Current
Ratio
Debt-to-
Equity
Ratio
142
Chapter 16 Leases (IAS 17)
Table 16.2 Effects of leasing methods used by lessors on financial statements and ratios
Item or Ratio
Size of Assets
Size of Shareholders’ Equity
Operating Lease
Sales-Type Financial Lease
Lowest, because no
investment write-up
occurs.
Low asset values tend to
raise asset turnover
ratios.
Lowest, because no
asset write-up occurs.
Low shareholders’ equity
tends to raise returns
on equity and debt or
equity ratios.
Highest, largely because of
the sale of the leased asset.
High asset value tends to
lower asset turnover.
Highest, largely because of
the gain on the sale of the
leased asset.
High shareholders’ equity
tends to lower returns on
equity and debt or equity
ratios.
Size of Income in Year Lease
Is Initiated (Year 0)
No effect on income
when lease is initiated.
Highest, because of the gain
on the “sale” of leased asset.
| Hennie |
Size of Income during Life
of Lease (Years 1–3)
High income tends to raise
profit margins and returns
on assets and equity.
Middle, based on terms
of lease and method
of depreciation.
Lowest, because of the
relatively low prevailing
interest rate.
Income tends to be
constant over time if
lease receipts are fixed
and straight-line
depreciation is used.
Interest income tends to
decline over time.
Low income tends to lower
profit margins and returns
on assets and equity.
Operating Cash Flow at Time
Lease Is Initiated
No effect, because no
cash flow occurs when
lease is initiated.
Highest, because of the gain
on the sale of the leased
asset.
Operating Cash Flow over Term Highest, because of the
of the Lease (Years 1–3)
terms of the lease and
the method of
depreciation.
Lowest, because interest
income is low.
Direct-Financing
Lease
Middle, because
there is an investment
write-up, but no
sale of the leased
asset.
Middle, because the
investment write-up
adds to equity, but
there is no sale of
the leased asset.
No effect on income
when lease is
initiated.
Highest, because of
the high effective
return on the lease.
Interest income tends
to decline over
time.
High income tends to
raise profit margins
and returns on
assets and equity.
No effect, because
no cash flow occurs
when lease is
signed.
Middle, because
interest income is
high due to high
effective return on
the lease.
EXAMPLES: LEASES
Chapter 16 Leases (IAS 17)
143
EXAMPLE 16.1
A manufacturing machine with a cash price of $330,000 is acquired by way of a finance lease
agreement under the following terms:
• Effective date: January 1, 20X2
• Lease term: 3 years
• Installments of $72,500 are payable half-yearly in arrears
• Effective rate of interest is 23.5468 percent per annum
• Deposit of $30,000 immediately payable
EXPLANATION
The amortization table for this transaction would be as follows:
Cash Price
Deposit
Installment 1
Installment 2
Subtotal
Installment 3
Installment 4
Installment 5
Installment 6
TOTAL
Installment
$
30,000
72,500
72,500
175,000
72,500
72,500
72,500
72,500
465,000
Interest
$
–
35,320
30,943
66,263
26,050
20,581
14,469
7,637
135,000
Capital
$
30,000
37,180
41,557
108,737
46,450
51,919
58,031
64,863
330,000
Balance
$
330,000
300,000
262,820
221,263
174,813
122,894
64,863
–
The finance lease would be recognized and presented in the financial statements as follows:
Books of the Lessee
An asset of $330,000 will be recorded and a corresponding liability would be raised on
January 1, 20X2.
If it is assumed that the machine is depreciated on a straight-line basis over a period of 6
years, the following expenses would be recognized in the income statement for the first year:
Depreciation (330,000 ÷ 6)
Finance lease charges (35,320 + 30,943)
$55,000
$66,263
The balance sheet at December 31, 20X2, would reflect the following balances:
Machine (330,000 – 55,000)
Long-term finance lease liability
$275,000 Dr
$221,263 Cr
Books of the Lessor
The gross amount of $465,000 due by the lessee would be recorded as a debtor at inception
of the contract, that is, the deposit of $30,000 plus six installments of $72,500 each. The
unearned finance income of $135,000 is recorded as a deferred income (credit balance). The
net amount presented would then be $330,000 ($465,000 – $135,000).
Continued on next page
144
Chapter 16 Leases (IAS 17)
Example 16.1 (continued)
The deposit and the first two installments are credited to the debtor account, which will then
reflect a debit balance of $290,000 at December 31, 20X2.
A total of $66,263 ($35,320 + $30,943) of the unearned finance income has been earned in the
first year, which brings the balance of this account to $68,737 at December 31, 20X2.
The income statement for the year ending December 31, 20X2, would reflect finance income
earned in the first year in the amount of $66,263.
The balance sheet at December 31, 20X2, will reflect the net investment as a long-term receiv-
able at $221,263 ($290,000 – $68,737), which agrees with the liability in the books of the lessor
at that stage.
EXAMPLE 16.2
What is the entry at the time of lease signing to record the assets being leased using the fol- | Hennie |
lowing information?
Asset 1
Lease payment of $15,000 per year for 8 years, $20,000 fair market value purchase option at
the end of Year 8 (guaranteed by the lessee to be the minimum value of the equipment), esti-
mated economic life is 10 years, fair market value of the leased asset is $105,000, and the
interest rate implied in the lease is 10 percent.
Asset 2
Lease payment of $15,000 per year for 8 years, $35,000 fair market value purchase option at
the end of Year 8 (guaranteed by the lessee to be the minimum value of the equipment), esti-
mated economic life is 12 years, fair market value of the leased asset is $105,000, and the
interest rate implied in the lease is 10 percent. The company’s incremental borrowing rate is
11 percent.
Options
a. No entry
b. $89,354 increase in assets and liabilities
c. $192,703 increase in assets and liabilities
d. None of the above
EXPLANATION 2
Issue 1: Determine whether the leases are finance or operating.
Issue 2: Determine the accounting entries needed.
Asset 1
The lease term is for a major part of the asset’s life, at 80 percent (8/10). No further work is
needed with respect to the criteria, because only one criterion (or a combination of criteria)
has to be met to result in the lease being recorded as a finance lease (see IAS 17 paragraph
10). The amount to record is the present value of the 8 years of $15,000 lease payments, plus
the present value of the $20,000 purchase option. The discount rate to use is 10 percent,
which is the lower of the incremental borrowing rate and the lease’s implicit rate. The pre-
sent value is $89,354. This amount will be recorded as an asset and as a liability on the bal-
ance sheet.
Choice b. is correct. The entry required is to record an asset and liability in the amount of
$89,354.
Chapter 16 Leases (IAS 17)
145
Asset 2
The lease term is less than a major part of the asset’s life, with it at 67 percent (8/12). There
is no indication of a bargain purchase option and the property does not go the lessee at the
end of the lease (unless they opt to pay $35,000). The present value of the lease payments,
including the purchase option, is $96,351. The present value of the minimum lease payments
does not approximate the fair market value of $125,000. Asset 2 does not meet any of the
finance lease conditions and is accounted for using the operating method.
Choice d. is correct. No entries are required under the operating method when the lease is
entered into.
EXAMPLE 16.3
Which of the following assets would have a higher cash flow from operations in the first year
of the lease? (Assume straight-line depreciation, if applicable.):
a. Asset 1.
b. Asset 2.
c. Both assets would have the same total cash flow from operations.
d. Insufficient information given.
Asset 1
Lease payment of $15,000 per year for 8 years, $20,000 fair market value purchase option at
the end of Year 8 (guaranteed by the lessee to be the minimum value of the equipment), esti-
mated economic life is 10 years, fair market value of the leased asset is $105,000, and the
interest rate implied in the lease is 10 percent.
Asset 2
Lease payment of $15,000 per year for 8 years, $35,000 fair market value purchase option at
the end of Year 8 (guaranteed by the lessee to be the minimum value of the equipment), esti-
mated economic life is 12 years, fair market value of the leased asset is $105,000, and the
interest rate implied in the lease is 10 percent. The company’s incremental borrowing rate is
11 percent.
Continued on next page
146
Chapter 16 Leases (IAS 17)
Example 16.3 (continued)
EXPLANATION 3
Asset 1
The lease term is for a major part of the asset’s life, with it at 80 percent (8/10). No further
work is needed with respect to the criteria, because only one criterion (or a combination of cri-
teria has to be met to result in the lease being recorded as a finance lease (see IAS 17 paragraph
10). The amount to record is present value of the 8 years of $15,000 lease payments, plus the | Hennie |
present value of the $20,000 purchase option. The discount rate to use is 10 percent, which is
the lower of the incremental borrowing rate and the lease’s implicit rate. The present value is
$89,354. This amount will be recorded as an asset and as a liability on the balance sheet. The
cash flows in the first year will consist of the $15,000 payment, which is allocated between
operating cash flow (an outflow for the interest portion of the payment) and financing cash
flow (an outflow for the principal portion of the payment):
Total payment
Interest portion = 10 percent ¥ $89,354
Principal portion
=
=
=
$15,000
8,935
$6,065
Asset 2
The lease term at 67 percent (8/12) is less than a major part of the asset’s life. There is no indi-
cation of a bargain purchase option and the property does not go to the lessee at the end of
the lease (unless they opt to pay $35,000). The present value of the lease payments is $96,351.
Therefore, the present value of the minimum lease payments does not approximate the fair
market value of $ 125,000. Asset 2 does not meet any of the finance lease conditions and is
accounted for using the operating method. The annual lease payment of $15,000 is an oper-
ating cash outflow.
Choice a. is correct. There is the issue as to whether the leases are finance or operating. Once
this issue is resolved, then the amount and classification of the cash flows can be determined.
As the explanation above shows, the total cash flows are the same—a negative $15,000. Asset
1, being a finance lease, results in a portion of this outflow being considered a financing cash
flow. Thus it shows a lower operating cash outflow, meaning a higher cash flow from opera-
tions.
Choice b. is incorrect. Assuming the leases are of similar size, the finance lease will reflect a
higher operating cash flow than the operating lease. This is true for every year of the lease
term, because a portion of the lease payment is shifted under a finance lease to being a financ-
ing cash outflow.
Choice c. is incorrect. The only way for each to have the same operating cash flows in this
scenario would be if both were treated as operating leases. But, Asset 1 is required to be
accounted for as a capital lease.
Choice d. is incorrect. Sufficient information has been provided.
Chapter 16 Leases (IAS 17)
147
EXAMPLE 16.4
The “capitalization” of a finance lease by a lessee will increase the:
a. Debt-to-equity ratio
b. Rate of return on assets
c. Current ratio
d. Asset turnover
EXPLANATION 4
Choice a. is correct. Because the “capitalization” of a finance lease by a lessee increases the
debt obligation and lowers net income (equity), the entity will be more levered as the debt-
to-equity ratio will increase.
Choice b. is incorrect. Given that net income declines and total assets increase under a finance
lease, the rate of return on assets would decrease.
Choice c. is incorrect. Because the current obligation of the finance lease increases current lia-
bilities, whereas current assets are unaffected, the current ratio declines.
Choice d. is incorrect. Finance leases increase a company’s asset base, which lowers the asset
turnover ratio.
EXAMPLE 16.5
All of the following are true statements regarding the impact of a lease on the statement of
cash flows irrespective of whether the finance lease or operating lease method is used—
except for:
a. The total cash flow impact for the life of the lease is the same under both methods.
b. The interest portion of the payment under a finance lease will affect operating activities,
whereas the principal reduction portion of the finance lease payment will affect financ-
ing activities.
c. Over time, a cash payment under the finance lease method will cause operating cash
flow to decline, whereas financing cash flows will tend to increase.
d. Cash payments made under an operating lease will affect operating activities only.
EXPLANATION 5
Choice c. is correct, because the statement is wrong. When finance leases are used, operating
cash flow will increase over time as the level of interest expense declines and more of the | Hennie |
payment is allocated to principal repayment, which will result in a decline in financing cash
flows over time.
Choice a. is incorrect. This is a true statement as total cash flows over the life of the lease are
the same under the operating and finance lease methods.
Choice b. is incorrect. This is a true statement because a finance lease payment affects oper-
ating cash flows and financing cash flows.
Choice d. is incorrect. The operating lease payment is made up of the rent expense, which
affects operating cash flow only.
148
Chapter 16 Leases (IAS 17)
EXAMPLE 16.6
On January 1, 20X1, ABC Company, lessee, enters into an operating lease for new equipment
valued at $1.5 million. Terms of the lease agreement include five annual lease payments of
$125,000 to be made by ABC Company to the leasing company.
During the first year of the lease, ABC Company will record which of the following?
a. Initially, an increase (debit) of leased equipment of $625,000 and an increase (credit) in
equipment payables of $625,000. At year-end, a decrease (debit) in equipment payable of
$125,000 and a decrease (credit) to cash of $125,000.
b. An increase (debit) in rent expense of $125,000 and a decrease (credit) in cash of
$125,000.
c. No entry is recorded on the financial statements.
d. An increase (debit) in leased equipment of $125,000 and a decrease (credit) in cash of
$125,000; no income statement entry.
EXPLANATION 6
Choice b. is correct. Because the above transaction is an operating lease, only rent expense is
recorded on the income statement, with a corresponding reduction to cash on the balance
sheet to reflect the payment.
Choice a. is incorrect. Operating leases do not include the present value of the asset on-bal-
ance sheet.
Choice c. is incorrect. Rent expense is recorded on the income statement for operating leases.
Choice d. is incorrect. The leased asset is not recorded on the balance sheet for operating
leases.
17 Revenue (IAS 18)
17.1
PROBLEMS ADDRESSED
Revenue is defined as the inflow of economic benefits that derive from activities in the ordi-
nary course of business. Key issues in this Standard are the definition of revenue, criteria for
revenue recognition, and the distinction between revenue and other income (for example,
gains on disposal of noncurrent assets or on translating foreign balances).
17.2
SCOPE OF THE STANDARD
This Standard describes the accounting treatment of revenue. The following aspects are
addressed:
• Revenue is distinguished from other income (income includes both revenue and gains).
• Recognition criteria for revenue is identified.
• Practical guidance is provided on
• moment of recognition,
• amount to be recognized, and
• disclosure requirements.
This Standard deals with the accounting treatment of revenue that arises from
• sale of goods,
• rendering of services,
• use by others of entity assets yielding interest (see also IAS 39),
• royalties, and
• dividends (see also IAS 39).
Revenue excludes
• amounts collected on behalf of third parties, for example, VAT,
• lease income (IAS 17),
• equity method investments (IAS 28),
• insurance contracts (IFRS 4),
• changes in fair value of financial assets and liabilities (IAS 39), and
• initial recognition and changes in fair value on biological assets (IAS ).
149
150
Chapter 17 Revenue (IAS 18)
17.3
KEY CONCEPTS
17.3.1 Revenue is defined as the gross inflow of economic benefits
• during the period,
• arising in ordinary course of activities, or
• resulting in increases in equity, other than contributions by equity participants.
17.3.2 Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
17.3.3 Effective yield on an asset is the rate of interest required to discount the stream of
future cash receipts expected over the life of the asset to equate to the initial carrying amount
of the asset.
17.4
ACCOUNTING TREATMENT
17.4.1 Revenue should be measured at the fair value of the consideration received:
| Hennie |
• Trade discounts and volume rebates are deducted to determine fair value. However,
payment discounts are nondeductible.
• When the inflow of cash is deferred (for example, the provision of interest-free credit),
it effectively constitutes a financing transaction. The imputed rate of interest should be
determined and the present value of the inflows calculated. The difference between the
fair value and nominal amount of the consideration is separately recognized and dis-
closed as interest.
• When goods or services are exchanged for that of a similar nature and value, no rev-
enue recognition occurs (commercial substance of the transaction should govern).
• When goods or services are rendered in exchange for dissimilar goods or services, rev-
enue is measured at the fair value of the goods or services received.
17.4.2 Revenue recognition from the sale of goods takes place when:
• Significant risks and rewards of ownership of the goods is transferred to the buyer
• The entity retains neither continuing managerial involvement of ownership nor effec-
tive control over the goods sold
• The amount of revenue can be measured reliably
• It is probable that the economic benefits of the transaction will flow to the entity
• The costs of the transaction can be measured reliably
17.4.3 Revenue recognition of services takes place as follows (similar to IAS 11—construc-
tion contracts):
• When the outcome of the transaction can be estimated reliably, costs and revenues are
recognized according to the stage of completion at the balance sheet date
• When the outcome of the transaction cannot be estimated reliably, recoverable contract
costs will determine the extent of revenue recognition
17.4.4 Interest income should be recognized on a time proportion basis that takes into
account the effective yield on the asset (the effective interest rate method; see IAS 39):
• Includes amortization of any discount, premium, transaction costs or other differences
between initial carrying amount and amount at maturity
Chapter 17 Revenue (IAS 18)
151
• After impairment write-down, use rate of interest used to discount cash flows, to deter-
mine the impairment loss
17.4.5 Financial service fees are recognized as follows:
• Financial service fees that are an integral part of the effective yield on a financial
instrument (such as an equity investment) carried at fair value are recognized immedi-
ately as revenue.
• Financial service fees that are an integral part of the effective yield on a financial
instrument carried at amortized cost (for example, a loan) are recognized as revenue
over the life of the asset as part of the application of the effective interest rate method.
• Origination fees on creation or acquisition of financial instruments carried at amor-
tized cost, such as a loan, are deferred and recognized as adjustments to the effective
interest rate.
• Most commitment fees to originate loans are deferred and recognized as adjustments
to the effective interest rate or recognized as revenue on earlier expiry of commitment
17.4.6 Royalties are recognized on an accrual basis (substance of the relevant agreements).
17.4.7 Dividends are recognized when the right to receive payment is established.
17.4.8 Repurchase agreements arise when an entity sells goods and immediately conclude
an agreement to repurchase them at a later date; the substantive effect of the transaction is
negated and the two transactions are dealt with as one.
17.4.9 Sales plus service refers to when the selling price of a product includes an amount
for subsequent servicing, and the service revenue portion is deferred over the period that the
service is performed.
17.4.10 Revenue cannot be recognized when the expenses cannot be measured reliably.
Consideration already received for the sale is deferred as a liability until revenue recognition
can take place.
17.4.11 Uncertainty about the collectability of an amount already included in revenue is
treated as an expense rather than as an adjustment to revenue.
17.5
PRESENTATION AND DISCLOSURE
| Hennie |
17.5.1 Disclose accounting policies as follows:
• Revenue measurement bases used
• Revenue recognition methods used
• Stage of completion method for services
17.5.2 The income statement and notes should include
• Amounts of significant revenue categories:
• Sale of goods
• Rendering of services
• Interest
• Royalties
• Dividends
• Amount of revenue recognized from the exchange of goods or services
152
Chapter 17 Revenue (IAS 18)
• Accounting policies adopted for the recognition of revenue
• The methods adopted to determine the stage of completion of transactions involving
the rendering of services
• The amount of each significant category of revenue recognized during the period
including revenue arising from
• The sale of goods
• The rendering of services
17.6
FINANCIAL ANALYSIS AND INTERPRETATION
17.6.1 Accounting income is generated when revenues and their associated expenses are
recognized on an income statement. It is the recognition and matching principles that deter-
mine when this occurs. IAS 18 sets out the criteria that must be met before revenue is earned
(and hence recognized) in IFRS financial statements.
17.6.2 When a company intentionally distorts its financial results or financial condition, or
both, it is engaging in financial manipulation. Generally, companies engage in such activities
to hide operational problems. When they are caught, the company faces outcomes such as
investors losing faith in management and a subsequent fall in the company’s stock price. The
two basic strategies underlying all accounting manipulation are
• to inflate current-period earnings through overstating revenues and gains or understat-
ing expenses, and
• to reduce current-period earnings by understating revenues or overstating expenses. A
company is likely to engage in this strategy in order to shift earnings to a later period
when they might be needed.
17.6.3 Financial manipulation tricks involving revenue can generally be grouped under
four headings:
1. Recording questionable revenue, or recording revenue prematurely:
• Recording revenue for services that have yet to be performed
• Recording revenue prior to shipment or before the customer acquires control of the
products
• Recording revenue for items for which the customer is not required to pay
• Recording revenue for contrived sales to affiliated parties
• Engaging in quid pro quo transactions with customers
2. Recording fictitious revenue:
• Recording revenue for sales that lack economic substance
• Recording revenue that is, in substance, a loan
• Recording investment income as revenue
• Recording supplier rebates that are tied to future required purchases as revenue
• Reporting revenue that was improperly withheld prior to a merger
3. Recording one-time gains to boost income:
• Deliberately undervaluing assets, resulting in the recording of a gain on sale
• Recording investment gains as revenue
• Recording investment income or gains as a reduction in expenses
• Reclassifying balance sheet accounts to create income
Chapter 17 Revenue (IAS 18)
153
4. Shifting revenues to future periods:
• Creating reserves that are reversed (reported as income) in later periods
• Withholding revenues before an acquisition and then releasing these revenues in later
periods
17.6.4 Not all manipulations are equal in their relative scale of importance to investors. For
instance, inflation of revenues is more serious than manipulations that affect expenses.
Companies recognize that revenue growth and the consistency of this growth are important
to many investors in assessing that company’s prospects. Therefore, identifying inflated rev-
enues is of critical importance. The distortions that are used range from the relatively benign
to the very serious.
17.6.5 The early warning signs that will help identify problem companies are:
• Few or no independent members on the board of directors
• An incompetent external auditor or a lack of auditor independence
• Highly competitive pressures on management
• Management that is known or suspected to be of questionable character
| Hennie |
17.6.6 In addition, it is wise to watch companies with fast growth or companies that are
financially weak. All fast-growth companies will eventually see their growth slow, and man-
agers might be tempted to use accounting trickery to create the illusion of continuing rapid
growth. Similarly, weak companies might use accounting manipulations to make investors
believe that the companies’ problems are less severe than they are in reality.
17.6.7 It is also wise to watch companies that are not publicly traded or that have recently
made an initial public offering (IPO). Companies that are not publicly traded might not use
outside auditors, which allows them more leeway to engage in questionable practices
through the use of auditors or advisors who might be less than objective.
154
Chapter 17 Revenue (IAS 18)
EXAMPLES: REVENUE
EXAMPLE 17.1
Sykes and Anson, a high-tech company, is having a very poor year due to weak demand in
the technology markets. The entity’s controller, R. Nadaf, has determined that much of the
inventory on hand is worth far less than the value recorded on the entity’s books. He decides
to write off this excess amount, which totals $10 million. Furthermore, he is worried that the
inventory will fall in value next year and decides to take a further write down of $5 million.
Both of these write-offs occur in the current year.
Which of the following statements is true?
a. The company has engaged in technique known as recording “sham” revenue.
b. The company has overstated its income in the current period.
c. The company has engaged in a technique that shifts future expenses into the current
period.
d. The company should be applauded for being so conservative in its accounting for inven-
tories.
EXPLANATION
Choice c. is correct. The company has overstated the amount of the current charge by $5 mil-
lion. This expected decline in value should not be charged off until it occurs. It is conceivable
that the market for Sykes and Anson’s products will rebound and that the charge-off was not
needed. Effectively, the company has brought forward a potential future expense to the cur-
rent period. The $10 million charge-off is, however, appropriate.
Choice a. is incorrect. The facts do not support any issue concerning sham revenues.
Choice b. is incorrect. The company’s income is understated, not overstated, in the current
period, as a result of the excess $5 million write-off.
Choice d. is incorrect. Whereas conservative accounting is desirable, the entity has gone too
far and is reporting results that are incorrect.
Chapter 17 Revenue (IAS 18)
155
EXAMPLE 17.2
The information below comes from the 20X0 financial statements of Bear Corp. and Bull Co.,
both of which are based in Europe.
Bear Corp.
Bull Co.
Acquisition
accounting
The excess of acquisition cost
over net fair value of assets
acquired is charged to goodwill
and written off over 10 years.
The excess of acquisition cost
over net fair value of assets
acquired is recorded as goodwill
and written off over 20 years.
Soft costs
In anticipation or hope of future
The company expenses all costs
revenues, the company incorrectly
defers certain costs incurred and
matches them against future
expected revenues.
incurred unless paid in advance
and directly associated with future
revenues.
Which company has a higher quality of earnings, as a result of its accounting for its soft
costs?
a. Bull Co.
b. Bear Corp.
c. They are equally conservative.
d. Cannot be determined.
EXPLANATION 2
Choice a. is correct. Bull Co. is more conservative with soft cost reporting because it expens-
es all soft costs unless they are directly tied to future revenue.
Choice b. is incorrect. Bear Corp. is less conservative than Bull Co. with soft cost reporting
because it defers costs and in anticipation of matching them with future revenues.
Choice c. is incorrect. Bull Co.’s method of expensing all soft costs unless directly tied to
future revenue is clearly more conservative.
Choice d. is incorrect.
Comment: Neither company is complying with IFRS in respect of goodwill. Goodwill should | Hennie |
be tested for impairment on an annual basis.
156
Chapter 17 Revenue (IAS 18)
EXAMPLE 17.3
A generous benefactor donates raw materials to an entity for use in its production process.
The materials had cost the benefactor $20,000 and had a market value of $30,000 at the time
of donation. The materials are still on hand at the balance sheet date. No entry has been made
in the books of the entity. The question is whether the donation should be recognized as rev-
enue in the books of the entity.
EXPLANATION 3
The proper accounting treatment of the above matter is as follows:
• The accounting Standard that deals with inventories, IAS 2, provides no guidance on the
treatment of inventory acquired by donation. However, donations received meet the def-
inition of revenue in IAS 18 (that is, the gross inflow of economic benefits during the
period arising in the course of ordinary activities when those inflows result in increases
in equity, other than increases relating to contributions from equity participants). It could
be argued that receiving a donation is not part of the ordinary course of activities. In
such a case the donation would be regarded as a capital gain. For purposes of this case
study, the donation is regarded as revenue.
• The donations should be recorded as revenue measured at its fair value ($30,000) of the
raw materials received (because that is the economic benefit).
• The raw materials received clearly meet the Framework’s definition of an asset, because
the raw materials (resource) are now owned (controlled) by the corporation as a result
of the donation (past event) from which a profit can be made in the future (future eco-
nomic benefits). The recognition criteria of the Framework, namely those of measurabil-
ity and probability, are also satisfied.
• Because the raw materials donated relate to trading items, they should be disclosed as
inventory, with the fair value of $30,000 at the acquisition date being treated as the cost
thereof.
18 Employee Benefits (IAS 19)
18.1
PROBLEMS ADDRESSED
The fundamental issue addressed by this Standard is that entities should identify and recog-
nize all the benefits that they are obliged to pay to employees regardless of form or timing of
the benefit.
18.2
SCOPE OF THE STANDARD
This Standard prescribes the accounting recognition and measurement principles, for all
employee benefits, including those provided under both formal arrangements and informal
practices.
Five types of employee benefits are individually identified, namely:
1. Short-term employee benefits (for example, bonuses, wages, and social security).
2. Postemployment benefits (for example, pensions and other retirement benefits).
3. Other long-term employee benefits (for example, long-service leave and, if not due
within 12 months, profit sharing, bonuses, and deferred compensation).
4. Termination benefits.
5. Equity compensation benefits (for example, employee share options per IFRS 2).
18.3
KEY CONCEPTS
18.3.1 Employee benefits are all forms of consideration given by an entity in exchange for
service rendered by employees.
18.3.2 Postemployment benefits are employee benefits (other than termination benefits
and equity compensation benefits) which are payable after the completion of employment.
18.3.3 Equity compensation plans are formal or informal arrangements under which an
entity provides equity compensation benefits for one or more employees.
18.3.4 Vested employee benefits are employee benefits that are not conditional on future
employment.
157
158
Chapter 18 Employee Benefits (IAS 19)
18.3.5 Return on plan assets comprises interest, dividends, and other revenue derived
from the plan assets, together with realized and unrealized gains or losses on the plan assets,
less any costs of administering the plan and less any tax payable by the plan itself.
18.3.6 Actuarial gains and losses comprise the effects of differences between the previous
actuarial assumptions and what has actually occurred, as well as the effects of changes in | Hennie |
actuarial assumptions.
18.3.7 With regard to a defined contribution plan, the entity’s legal or constructive oblig-
ation is limited to the amount it agrees to contribute to the fund. The actuarial risk (that the
fund is insufficient to meet expected benefits) and the investment risk fall on the employee.
18.3.8 With regard to a defined benefit plan, the entity’s obligation is to provide the agreed
benefits to current and former employees. Actuarial risk (that benefits will cost more than
expected) and investment risk fall on the entity.
18.3.9 Employee benefits can be provided in terms of both the following:
• Legal obligations, which arise from the operation of law (for example, agreements and
plans between the entity and employees or their representatives)
• Constructive obligations, which arise from informal practices that result in an obliga-
tion whereby the entity has no realistic alternative but to pay employee benefits (for
example, the entity has a history of increasing benefits for former employees to keep
pace with inflation even if there is no legal obligation to do so)
18.4
ACCOUNTING TREATMENT
SHORT-TERM EMPLOYMENT BENEFITS
18.4.1 These should be recognized as an expense when the employee has rendered services
in exchange for the benefits or when the entity has a legal or constructive obligation to make
such payments as a result of past events, for example, profit-sharing plans.
POSTEMPLOYMENT BENEFITS
18.4.2 With regard to defined contribution plans, an entity recognizes contributions to a
defined contribution plan as an expense when an employee has rendered services in
exchange for those contributions. When the contributions do not fall due within 12 months
after the accounting period that services were rendered, they should be discounted.
18.4.3 With regard to defined benefit plans, the following rules apply:
• An entity determines the present value of defined benefit obligations and the fair
value of any plan assets with sufficient regularity.
• An entity should use the projected unit credit method to measure the present value of
its defined benefit obligations and related current and past service costs. This method
sees each period of service as giving rise to an additional unit of benefit entitlement
and measures each unit separately to build up the final obligation.
• Unbiased and mutually compatible actuarial assumptions about demographic variables
(for example, employee turnover and mortality) and financial variables (for example,
future increases in salaries and certain changes in benefits) should be used.
• The difference between the fair value of any plan assets and the carrying amount of the
defined benefit obligation is recognized as a liability or an asset.
Chapter 18 Employee Benefits (IAS 19)
159
• When it is virtually certain that another party will reimburse some or all of the expen-
diture required to settle a defined benefit obligation, an entity should recognize its
right to reimbursement as a separate asset.
• Offsetting of assets and liabilities of different plans is not allowed.
• The net total of current service cost, interest cost, expected return on plan assets, and on
any reimbursement rights, actuarial gains and losses, past service cost, and the effect of
any plan curtailments or settlements should be recognized as expense or income.
• Recognize past service cost on a straight-line basis over the average period until the
amended benefits become vested.
• Recognize gains or losses on the curtailment or settlement of a defined benefit plan
when the curtailment or settlement occurs.
• Recognize a specified portion of the net cumulative actuarial gains and losses that
exceed the greater of
• 10 percent of the present value of the defined benefit obligation (before deducting
plan assets), and
• 10 percent of the fair value of any plan assets.
The minimum portion to be recognized for each defined benefit plan is the excess that falls
outside the 10 percent “corridor” at the previous reporting date, divided by the expected | Hennie |
average remaining working lives of the employees participating in that plan. Earlier recog-
nition of these gains and losses is permitted.
OTHER LONG-TERM BENEFITS
18.4.4 Virtually the same rules apply as for defined benefit plans. However, a more simpli-
fied method of accounting is required for actuarial gains and losses as well as past service
costs, which are recognized immediately.
TERMINATION BENEFITS
18.4.5 The event that results in an obligation is termination rather than employee service.
An entity should therefore recognize termination benefits only when it is demonstrably com-
mitted through a detailed formal plan to either
• terminate the employment of an employee or group of employees before the normal
retirement date, or
• provide termination benefits as a result of an offer made in order to encourage volun-
tary redundancy.
Termination benefits falling due more than 12 months after balance sheet date should be
discounted.
EQUITY COMPENSATION BENEFITS
18.4.6 Recognition or measurement requirements are specified in IFRS 2.
18.5
PRESENTATION AND DISCLOSURE
18.5.1 Balance sheet and notes:
• Details about the recognized defined benefit assets and liabilities
• Reconciliation of the movements of the aforementioned
• Amounts included in the fair value of plan assets in respect of
• the entity’s own financial instruments, or
• property occupied or assets used by the entity
160
Chapter 18 Employee Benefits (IAS 19)
• The actual return on plan assets
• Liability raised for equity compensation plans
• Financial instruments issued to and held by equity compensation plans as well as the
fair values thereof
• Share options held by and exercised under equity compensation plans
18.5.2 Income statement and notes:
• Expense recognized for contribution plans
• Expense recognized for benefit plans and the line items in which they are included
• Expense recognized for equity compensation plans
18.5.3 Accounting policies:
• Methods applied for the recognition of the various types of employee benefits
• Description of postemployment benefit plans
• Description of equity compensation plans
• Actuarial valuation methods used
• Principal actuarial assumptions
18.6
FINANCIAL ANALYSIS AND INTERPRETATION
18.6.1
The complexity of the accounting standards applicable to pensions and other
retirement benefits results in a wide range of differences among the companies offering these
plans. As a result of this complexity and the fundamental differences in the 2 types of plans
described below, analysts have a difficult time discerning the underlying economic substance
of a firm’s reported pension and other retirement benefits.
• Defined contribution plans, in which the employer agrees to contribute a specific
amount to a pension plan each year. The employee’s retirement income is largely deter-
mined by the performance of the portfolio into which the contributions were made
• Defined benefit plans require the employer to pay specified pension benefits to retired
employees. The investment risk is borne by the employer
18.6.2
For defined contribution plans, the employer’s annual pension expense is the
amount that the company plan must contribute to the plan each year according to the con-
tribution formula. Pension expense and cash outflow are the same, and there are no assets or
liabilities recorded by the employer. A defined contribution pension plan only obliges the
employer to make annual contributions to the pension plan based on a prescribed formula.
When the contributions are made, the company has no further obligation that year.
18.6.3
For defined benefit plans, the annual pension expense and employer’s liability
are determined by calculating the present value of future benefits to be paid to retirees.
Forecasting future benefits involves actuarial studies and assumptions about future events,
including life expectancies of plan participants, labor turnover rates, future wage levels, dis-
count rates, rates of return on plan assets, etc. Benefits promised to participants are defined | Hennie |
by a specific formula that reflects these estimated future events. The estimated benefits are
allocated to the years of service worked by employees to develop the annual pension
expense. Companies with defined benefit pension plans accrue obligations to pay benefits,
according to the benefit formula, as the employee performs work. However, these obligations
are not discharged until after the employee retires.
Chapter 18 Employee Benefits (IAS 19)
161
18.6.4
Because pension benefit formulas relate the future benefits to the aggregate work
performed by employees for the company until their retirement, there are several alternative
ways of determining the size of the future obligations, and their current values. These are:
• Actuarial estimates and defined benefit formulas. Firms use actuaries to perform
complex calculations in order to estimate the size of future obligations and their pre-
sent value. Included in the computations are projections of employee salary growth,
mortality, employee turnover, and retirement dates. These estimates are combined with
the plan’s benefit formula to generate a forecast of benefits to be paid in the future.
This future benefit stream is discounted to present value, which is the pension obliga-
tion.
• Measures of the defined benefit pension obligation are:
• Accumulated Benefit Obligation (ABO)—the present value of pension benefits earned
based on current salaries
• Projected Benefit Obligation (PBO)—the present value of pension benefits earned,
including projected salary increases
• Vested Benefit Obligation (VBO)—the portion of the benefit obligation that does not
depend on future employee service. Alternatively, it is the vested portion of the ABO
18.6.5 With regard to financial impact of assumptions, for pay-related plans PBO will
be higher than ABO due to the inclusion of future salary increases. PBO and ABO will be the
same for non-pay-related plans because salary increases have no effect on calculations.
However, for non-pay-related plans, if there is enough evidence that past increases in bene-
fits will be extended into the future, PBO will be higher than ABO after adjusting computa-
tions. For all defined benefit plans, calculations of PBO, ABO, and VBO must include auto-
matic increases in benefits such as cost-of-living adjustments.
18.6.6
Accounting standards assume that pensions are forms of deferred compensation
for work currently performed and, as such, pension expenses are recognized on an accrual
basis when earned by employees.
18.6.7
expense, and the funding requirements of the sponsoring firm:
There are many actuarial assumptions that affect pension obligations, the pension
• The discount rate assumption
• The wage growth rate assumption
• The expected return on plan assets assumption
• The age distribution of the work force
• The average service life of employees
18.6.8
In analyzing the actuarial assumptions, analysts need to determine whether the
current assumptions are appropriate, particularly in comparison to the entity’s competitors.
In addition, if the assumptions have been changed, analysts need to determine the effect of a
change in the following parameters on the financial statements:
• Discount rate assumption. If the discount rate is increased, the pension obligations will
decrease, producing an actuarial gain for the year. If the discount rate is decreased,
however, the pension obligation will increase, resulting in an actuarial loss for the year.
• Wage growth rate assumption. The wage growth rate assumption directly affects pen-
sion obligations and the service cost component of the reported pension expense.
Therefore, a higher (lower) wage growth rate assumption will result in a higher (lower)
pension obligation and a higher (lower) service component of its reported pension
expense.
162
Chapter 18 Employee Benefits (IAS 19)
• Expected rate of return on fund assets. Because all funds should earn the same risk-
adjusted return in the long run (if the market is efficient), deviations in this assumption | Hennie |
from the norm that are unrelated to changes in a pension portfolio’s asset mix might
suggest that the pension expense is overstated or understated. In general, if the expect-
ed return on plan assets is too high the pension expense is understated, boosting
reported earnings; if the expected return on plan assets is too low the pension expense
is overstated, reducing reported earnings. Again, manipulating the expected return on
plan assets will manipulate reported earnings and can be used to smooth earnings per
share.
Table 18.1. Summary of Assumptions and Their Impact
Higher (Lower)
Discount Rate
Higher (Lower)
Compensation
Rate Increase
Higher (Lower)
Expected Rate of Return
on Plan Assets
PBO
ABO
VBO
Lower (Higher)
Higher (Lower)
Lower (Higher)
No impact
Lower (Higher)
No impact
Pension Expense
Lower (Higher)
Higher (Lower)
Earnings
Higher (Lower)
Lower (Higher)
No impact
No impact
No impact
Lower (Higher)
Higher (Lower)
Chapter 18 Employee Benefits (IAS 19)
163
EXAMPLE: EMPLOYEE BENEFITS
EXAMPLE 18.1
On December 31, 20X0, an entity’s balance sheet includes a pension liability of $12 million.
Management has made the decision to adopt IAS 19 as of January 1, 20X1, for the purpose of
accounting for employee benefits. At that date, the present value of the obligation under IAS
19 is calculated at $146 million and the fair value of plan assets is determined at $110 million.
On January 1, 19X6, the entity had improved pension benefits (cost for nonvested benefits
amounted to $16 million, and the average remaining period at that date, until vesting, was 8
years).
EXPLANATION
The transitional liability is calculated as follows:
Present value of the obligation
Fair value of plan assets
Past service cost to be recognized in later periods (16 ¥ 3/8)
Transitional liability
Liability already recognized
Increase in liability
$’000
146,000
(110,000)
(6,000)
30,000
12,000
18,000
The entity might (in terms of the transitional provisions of IAS 19) choose to recognize the
transitional liability of $18 million either immediately or recognize it as an expense on a
straight-line basis up to 5 years. The choice is irrevocable. In future such transitional arrange-
ments are dealt with by IFRS 1.
EXAMPLE 18.2
Smith is analyzing three companies in the utilities industry: Northern Lights, Southeast
Power, and Power Grid. After reviewing each company’s pension footnotes, Smith made the
following notes:
Northern
Lights
Southeast
Power
Power Grid
20X0
20X1
20X0
20X1
20X0
20X1
6.0% 5.5% 6.5% 6.5% 6.2% 6.0%
Assumption
Discount Rate
Assumed Rate of
Compensation Growth
3.5% 3.5% 2.5% 3.0% 3.3% 3.0%
Expected Return on Assets
7.0% 7.0% 7.5% 7.2% 8.0% 8.5%
164
Chapter 18 Employee Benefits (IAS 19)
EXAMPLE 18.2.1
If Power Grid had left its expected rate of return on plan assets at 8 percent instead of rais-
ing it to 8.5 percent, the company would have reported in 20X1:
a. A lower accumulated benefit obligation (ABO)
b. A higher projected benefit obligation (PBO)
c. A lower funded status
d. Higher pension expense
EXPLANATION
Choice d. is correct. The expected rate of return on plan assets is a direct (negative) compo-
nent in the computation of pension expense. A lower rate would thus result in a higher pen-
sion expense. however, the ABO, PBO, and funded status are not affected by the expected
return on plan assets.
Choice a. is incorrect. Only pension expense is affected by changes in the expected rate of
return on plan assets. Therefore, there will not be a change in the accumulated benefit oblig-
ation (ABO).
Choice b. is incorrect. Only pension expense is affected by changes in the expected rate of
return on plan assets. Therefore, there will not be a change in the projected benefit obligation
(PBO).
Choice c. is incorrect. Only pension expense is affected by changes in the expected rate of
return on plan assets. Therefore, there will not be a change in the funded status.
EXAMPLE 18.2.2
Based on the statistics and assumptions provided, the most conservative pension accounting
(that is, the one that will produce the highest PBO, ABO, and pension expense) is done by:
| Hennie |
a. Northern Lights
b. Southeast Power
c. Power grid
d. Cannot be determined
EXPLANATION
Choice a. is correct. Northern Lights has the most conservative pension plan assumptions
including the lowest discount rate, highest compensation growth, and the lowest expected
return on plan assets. These assumptions result in a higher ABO and PBO, as well as higher
pension expense than either Southeast Power or Power Grid.
Choice b. is incorrect. All of Southeast Power’s assumptions are more aggressive than the
assumptions made by Northern Lights.
Choice c. is incorrect. All of Power Grid’s assumptions are more aggressive than the assump-
tions made by Northern Lights.
Choice d. is incorrect. Enough information was provided in the table above to determine that
the assumptions made by Northern Light are the most conservative, resulting in a higher
ABO, PBO, and pension expense than either Southeast Power or Power Grid.
Chapter 18 Employee Benefits (IAS 19)
165
EXAMPLE 18.2.3
When Power Grid lowers its discount rate in 20X1 to 6 percent from 6.2 percent in 20X0, the
effect on the PBO and ABO will be:
PBO
a.
Increase
b. Decrease
c. Decrease
d. Increase
ABO
Increase
Increase
Decrease
Decrease
EXPLANATION
Choice a. is correct. The discount rate is used to calculate the present value of future benefits
owed. Therefore, a decrease in the discount rate will increase both the PBO and the ABO.
Choice b. is incorrect. The PBO will not decrease when the discount rate decreases, because
the discount rate is used to calculate the present value of future benefits.
Choice c. is incorrect. The discount rate is used to calculate the present value of future bene-
fits. Therefore, a decrease in the discount rate will not decrease either the PBO or the ABO.
Choice d. is incorrect. The ABO will not decrease when the discount rate decreases, because
the discount rate is used to calculate the present value of future benefits.
19 Accounting for Government
Grants and Disclosure of
Government Assistance (IAS 20)
19.1
PROBLEMS ADDRESSED
This Standard deals with:
• Government grants: government assistance through transfers of resources to an enter-
prise in return for past or future compliance with conditions relating to the operating
activities.
• Government assistance: action by government to provide a specific economic benefit
for an entity (or entities). It excludes benefits provided indirectly through action affect-
ing general trading conditions (for example, provision of infrastructure).
The key issue is whether the entity will continue to comply with the grant/assistance condi-
tions and hence can recognize the grant as income.
19.2
SCOPE OF THE STANDARD
This Standard addresses the following aspects of accounting for government grants and
other forms of government assistance:
• Definition of government grants (assets and income grants) and government assistance.
• The recognition criteria for grants.
• Disclosure of the extent of the benefit (benefits) recognized or received and other forms
of government assistance in each accounting period.
IAS 41 (see chapter 27) deals with government grants related to biological assets.
19.3
KEY CONCEPTS
19.3.1 The term government refers to government, government agencies, and similar bod-
ies whether local, national, or international.
19.3.2 Government grants are assistance by government in the form of transfers of
resources. The following distinction is made between the two types of government grants:
• Grants related to assets: Grants whereby an enterprise qualifying for them should pur-
chase, construct, or otherwise acquire long-term assets
• Grants related to income: Government grants other than those related to assets
166
Chapter 19 Accounting for Government Grants and Disclosure of Government Assistance (IAS 20)
167
19.3.3 Government assistance includes
• free technical and marketing advice,
• provision of guarantees,
• government procurement policy that is responsible for a portion of the enterprise’s
sales, and
• loans at nil or low interest rates (the benefit is not quantified by the imputation of interest).
19.4
| Hennie |
ACCOUNTING TREATMENT
19.4.1 Government grants should be recognized as income on a systematic basis over the
periods necessary to match them with related costs that they should compensate. Examples
include:
• Grants related to depreciable assets recognized as income over the periods and in the
proportions to which depreciation is charged (either reduce cost or defer)
• A grant of land can be conditional upon the erection of a building on the site. Income is
normally then recognized over the life of the building
19.4.2 A government grant as compensation for expenses or losses already incurred or
immediate financial support with no future related costs is recognized as income of the peri-
od in which it becomes receivable.
19.4.3 A repayment of a government grant is accounted for as a revision of an accounting
estimate (refer to IAS 8) as follows:
• Repayment related to income is first applied against an unamortized deferred grant
credit.
• Repayment in excess of a deferred grant credit is recognized as an expense.
• Repayment related to an asset is recorded by increasing the carrying amount of the
asset or reducing a deferred income balance. (Cumulative additional depreciation that
would have been recognized to date is recognized immediately).
19.4.4 Nonmonetary grants (for example, land or other resources) is assessed and recorded
at fair value. Alternatively, the grant and asset (assets) are recorded at a nominal amount.
19.4.5 A forgivable loan (where the lender undertakes to waive repayment of loans under
prescribed conditions) is treated as a grant when there is reasonable assurance that the terms
for forgiveness of the loan will be met. This conflicts with IAS 39 but is not currently
addressed in IFRS.
19.4.6 Government grants, including nonmonetary grants at fair value, should only be rec-
ognized when there is reasonable assurance that
• the enterprise will comply with the conditions attached to them, and
• the grants will be received.
A grant received in cash or as a reduction of a liability to government is accounted for simi-
larly.
168
Chapter 19 Accounting for Government Grants and Disclosure of Government Assistance (IAS 20)
19.5
PRESENTATION AND DISCLOSURE
19.5.1 Presentation
• Asset-related grants. Present in the balance sheet, either by
• setting up the grant as deferred income, or
• deducting it from the carrying amount of the asset.
• Income-related grants. Present in the income statement, either as
• separate credit line item, or
• deduction from the related expense.
19.5.2 Disclosure
Accounting policies:
• Method of presentation
• Method of recognition
Income statement and notes:
• Government grants:
• Nature
• Extent
• Amount
• Government assistance:
• Nature
• Extent
• Duration
• Unfulfilled conditions
• Contingencies attached to assistance
Chapter 19 Accounting for Government Grants and Disclosure of Government Assistance (IAS 20)
169
EXAMPLE: ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE
OF GOVERNMENT ASSISTANCE
EXAMPLE 19.1
Jobworld Inc. obtained a grant of $10 million from a government agency for an investment
project to construct a manufacturing plant of at least $88 million. The principal term is that
the grant payments relate to the level of capital expenditure. The secondary intention of the
grant is to safeguard 500 jobs. The grant will have to be repaid pro rata if there is an under-
spending on capital. Twenty percent of the grant will have to be repaid if the jobs are not safe-
guarded until 18 months after the date of the last asset purchase.
The plant was completed on January 1, 20X4, at a total cost of $90 million. The plant has an
expected useful life of 20 years and is depreciated on a straight-line basis with no residual
value.
EXPLANATION
The grant should be recognized as income on a systematic basis over the periods that will
match it with related costs that it is intended to compensate.
Difficulties can arise where the terms of the grant do not specify precisely the expenditure to
which it is intended to contribute. Grants might be received to cover costs comprising both | Hennie |
capital and revenue expenditure. This would require a detailed analysis of the terms of the
grant.
The employment condition should be seen as an additional condition to prevent replace-
ment of labor by capital, rather than as the reason for the grant. This grant should there-
fore be regarded as an asset-related grant. IAS 20 allows two acceptable methods of pre-
sentation of such grants. The application of each method is demonstrated for the first 3
years of operation:
i. Setting grant up as deferred income
The plant would be reflected as follows in the balance sheets at December 31, of the years as
indicated:
Plant
Historical cost
Accumulated depreciation
Carrying value
Deferred income
20X6
$’000
90,000
(13,500)
76,500
10,000
500
20X5
$’000
90,000
(9,000)
81,000
10,000
1,000
20X4
$’000
90,000
(4,500)
85,500
10,000
1,500
170
Chapter 19 Accounting for Government Grants and Disclosure of Government Assistance (IAS 20)
The following amounts would be recognized in the income statements of the respective
years:
Depreciation (expense)
(90,000,000 ÷ 20)
Government grant (income)
(10,000,000 ÷ 20)
20X6
$’000
4,500
20X5
$’000
4,500
20X4
$’000
4,500
(500)
(500)
(500)
The above amounts are treated as separate income statement items and should not be off-set
under this method of presentation.
ii. Deducting grant in arriving at carrying amount of asset
The adjusted historical cost of the plant would be $80 million, which is the total cost of $90
million less the $10 million grant.
The plant would be reflected as follows in the respective balance sheets:
Plant
Historical cost
Accumulated depreciation
20X6
$’000
80,000
(12,000)
68,000
20X5
$’000
80,000
(8,000)
72,000
20X4
$’000
80,000
(4,000)
76,000
The income statements would reflect an annual depreciation charge of $4 million ($80,000,000
÷ 20). This charge agrees with the net result of the annual amounts recognized in the income
statement under the first alternative.
20 The Effects of Changes in
Foreign Exchange Rates (IAS 21)
20.1
PROBLEMS ADDRESSED
Investments or balances in a foreign currency, or ownership in a foreign operation, expose an
entity to foreign exchange gains or losses. IAS 21 considers the accounting treatment for for-
eign currency transactions and foreign operations. The principal aspects addressed are:
• Exchange rate differences and their effect on transactions in the financial statements.
• Translation of the financial statements of foreign operations (where the presentation
currency differs from the functional currency).
20.2
SCOPE OF THE STANDARD
This Standard prescribes the accounting treatment in relation to:
• Definition and distinction between functional and other currencies which give rise to
exchange differences on transactions.
• Definition and distinction between presentation and functional currency of a foreign
operation results in exchange differences on translation.
• Monetary and non-monetary gains and losses.
The IAS does not apply to derivative transactions and balances that fall within the scope of
IAS 39.
However, the Standard does apply to the measurement of amounts relating to foreign cur-
rency assets, liabilities, and derivatives in its functional currency; and to the translation of
foreign currency assets, liabilities, income and expenses into its presentation currency.
20.3
KEY CONCEPTS
20.3.1 The functional currency is used to measure items in financial statements. It need not
be the local currency of entity. It is the currency of the primary economic environment in
which the entity operates, for example,
• currency that mainly influences sales prices,
• currency of country whose competitive forces and regulations determine sale prices
of goods and services, or
• currency which influences labor, material, and other costs.
171
172
Chapter 20 The Effects of Changes in Foreign Exchange Rates (IAS 21)
20.3.2 The presentation currency of an entity:
• Is used to present the financial statements
• Might be any currency, although many jurisdictions require use of local currency
• Is usually functional currency of parent or major entity | Hennie |
• Exchange differences arise on translation of financial statements measured using a
functional currency that is different from the presentation currency
20.3.3 Exchange differences arise on transactions in a currency other than functional cur-
rency (and are defined as the difference resulting from translating a given number of units of
one currency into another currency at different exchange rates)
20.3.4 Monetary items are units of currency held and assets and liabilities to be received or
paid in a fixed or determinable number of units of currency. The essential feature of a mon-
etary item is a right to receive (or an obligation to deliver) a fixed or determinable number of
units of currency. Monetary items include cash, receivables, loans, payables, long-term debt,
provisions, employee benefit liabilities, and deferred tax assets and liabilities.
20.3.5 Nonmonetary items include equity securities, inventories, prepaid expenses, prop-
erty, plant, and equipment and related accounts, goodwill and intangible assets.
20.3.6 Foreign currency transactions are transactions denominated in a currency other
than the functional currency, including:
• Buying or selling of goods or services
• Borrowing or lending of funds
• Concluding unperformed foreign exchange contracts
• Acquiring or selling assets
• Incurring or settling liabilities
20.3.7 A foreign operation is a subsidiary, associate, joint venture, or branch the activities
of which are based or conducted in a country other than the country of the reporting entity.
(Its functional currency will be determined by the degree of autonomy that it enjoys.)
20.3.8 The functional currency of a foreign operation is
• Same as reporting entity’s functional currency when
• foreign operations are an extension of the reporting entity,
• foreign operation’s transactions with reporting entity are high,
• cash flows of foreign operation directly affect cash flows of reporting entity,
• foreign operation’s cash flows are available for remittance to, reporting entity, and
• foreign operation’s cash flows are insufficient to service existing and normal debt
obligations.
• Different from reporting entity’s functional currency when foreign operation’s
• activities are carried with significant degree of autonomy,
• transactions with reporting entity are low,
• cash flows do not directly affect cash flows of reporting entity,
• cash flows not readily available for remittance to reporting entity, and
• cash flows are sufficient to service existing and normal debt obligations.
Chapter 20 The Effects of Changes in Foreign Exchange Rates (IAS 21)
173
20.4
ACCOUNTING TREATMENT
20.4.1 Determine for each entity whether it is
• a stand-alone entity,
• an entity with foreign operations (parent), or
• a foreign operation (subsidiary, branch).
FUNCTIONAL CURRENCY: USED FOR THE MEASUREMENT OF FOREIGN
CURRENCY TRANSACTIONS
20.4.2 On initial recognition, in the functional currency, a foreign currency transaction
should be reported, by applying the spot exchange rate between the functional currency and
the foreign currency, to the foreign currency amount at the transaction date.
20.4.3 At each balance sheet date, subsequent measurement takes place as follows:
• Monetary items which remain unsettled are translated using the closing rate.
• Nonmonetary items carried at:
• Historical costs are reported using the exchange rate at the date of the transaction.
Approximate or average rates may be more appropriate for inventories.
• Fair values are reported using the exchange rate at the date when the fair value was
determined.
20.4.4 Income statement items may be translated using an average rate.
20.4.5 Resulting exchange differences are included in profit or loss, regardless of whether
they arise on the:
• Settlement of monetary items
• Translation of monetary items at rates different from those at which they were translat-
ed on initial recognition
20.4.6 The following exchange differences are included in equity until disposal of the
related asset or liability, when they are transferred to profit or loss:
| Hennie |
• Those relating to mark-to-market (MTM) gains or losses on available for sale financial
assets (translation gains and losses on the principal portion of the asset are included in
profit or loss).
• Gains or losses on nonmonetary items recognized directly in equity are included in
equity; examples are revaluation gains and losses arising on the revaluation of proper-
ty and plant.
• Intragroup monetary items that form part of an entity’s net investment in a foreign entity
• A foreign liability that is accounted for as a hedge of an entity’s net investment in a for-
eign entity (IAS 39 criteria)
PRESENTATION CURRENCY: TRANSLATION OF FINANCIAL STATEMENTS OF
FOREIGN OPERATIONS FROM FUNCTIONAL CURRENCY
20.4.7 The results and financial position of an entity whose functional currency is not the
presentation currency should be translated into the presentation currency using:
• The closing rate at the balance sheet date for all assets and liabilities
• The exchange rates at the dates of transactions for income and expenses. Approximate
or average rates can be used for practical reasons
20.4.8 All resulting exchange differences are included in a separate component of equity
until disposal of the foreign operation, when they are included in profit or loss.
174
Chapter 20 The Effects of Changes in Foreign Exchange Rates (IAS 21)
20.4.9 Goodwill and fair value adjustments arising on the acquisition of a foreign opera-
tion should be treated as assets and liabilities of the foreign operation and are expressed in
the functional currency of the foreign operation. Translation of goodwill and fair value
adjustments is therefore at the closing rate.
20.4.10 When the functional currency of a foreign operation is the currency of a hyperin-
flationary economy:
• The financial statements are restated for price changes in accordance with IAS 29
• The restated amounts for both the balance sheet and the income statements are trans-
lated into the presentation currency using closing rates.
20.5
PRESENTATION AND DISCLOSURE
20.5.1 An entity should disclose:
• In its income statement—The amount of exchange differences recognized in profit or
loss except for those arising on financial instruments measured at fair value through
profit or loss in accordance with IAS 39
• In its balance sheet—Net exchange differences classified in a separate component of
equity, and a reconciliation of the amount of such exchange differences at the beginning
and end of the period
20.5.2 The difference between the presentation and functional currency should be stated,
together with disclosure of the functional currency and the reason for using a different pre-
sentation currency.
20.5.3 Any change in the functional currency of an entity, and the reason for the change,
should be disclosed.
20.5.4 Presentation in currency other than the functional currency. When an entity pre-
sents its financial statements in a currency that is different from its functional currency, the
entity should describe the financial statements as complying with International Financial
Reporting Standards (IFRS) only if they comply with all the requirements of each applicable
Standard and interpretation.
20.6
FINANCIAL ANALYSIS AND INTERPRETATION
20.6.1 By placing the gain (or loss) from individual currency transactions on the income
statement, the accounting for foreign operations reports the volatility resulting from changes
in exchange rates in profit or loss and, hence, earnings per share, which clearly reflects the
underlying reality. The nature of this gain or loss must be understood by noting the root
cause of its existence.
20.6.2 When entities hold foreign-currency-denominated monetary assets such as cash,
they incur a gain when the value of that currency rises relative to the functional currency, and
they incur a loss when the value of that currency falls.
When entities hold foreign-currency-denominated liabilities, they incur a loss when the
value of the foreign currency rises and a gain when it falls.
| Hennie |
20.6.3 Because entities typically hold both monetary assets and monetary liabilities that are
denominated in foreign currencies, whether a rise (or fall) in the value of the foreign curren-
Chapter 20 The Effects of Changes in Foreign Exchange Rates (IAS 21)
175
cy will result in a gain or loss depends on whether the net monetary position in these cur-
rencies is positive (that is, if assets exceed liabilities) or negative (that is, if liabilities exceed
assets). In general, the gain or loss from currency translation is the product of the average net
monetary position of an entity and the change in the exchange rate between the local and
functional currencies. This requires an analysis of the changes in a company’s net monetary
position. Note that the reported net income from the foreign operations of an entity consists
of three parts:
1. Operational effects, which is the net income that the entity would have reported in the
reporting currency if exchange rates had not changed from their weighted average lev-
els of the previous years
2. Flow effects that have an impact on the amount of revenues and expenses that are
reported on the income statement, but which were received or incurred in foreign cur-
rencies. These can be calculated as a residual
3. Holding gain (loss) effects that have an impact on the values of assets and liabilities
reported on the balance sheet, but which are actually held or owed in foreign currencies
20.6.4 The impact of the translation from functional currency to presentation currency falls
on the equity portion of the balance sheet, and not on the income statement. This means that
presentation-currency-denominated net income and earnings per share figures will not be as
volatile as when the individual transactions are translated (for instance, at spot or closing
rates, with exchange differences flowing through the income statement). However, the net
worth (or equity) shown on the balance sheet becomes more volatile, because the translation
adjustment is put on the balance sheet.
20.6.5 The analyst will find it easier to forecast earnings if there is no need to forecast any
gain or loss from the foreign currency translation component to net income. As was previ-
ously discussed, the nature of the gain or loss from foreign currency translation can be
understood by noting the root cause of its existence. When financial statements are trans-
lated, the net asset or liability position is critical (as compared to the net monetary position
for individual transactions). If an entity has a net asset position in a foreign operation, it
incurs a gain when the foreign currency rises and a loss when the currency falls. When the
net position is a liability, it incurs a gain when the foreign currency falls and a loss when the
currency appreciates.
176
Chapter 20 The Effects of Changes in Foreign Exchange Rates (IAS 21)
EXAMPLE: THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
EXAMPLE 20.1
Bark Incorporated (whose functional currency is the US $) purchased manufacturing equip-
ment from the United Kingdom. The transaction was financed by means of a loan from a
commercial bank in England.
Equipment that costs £400,000 was purchased on January 2, 20X7, and the amount was paid
over by the bank to the supplier on that same day. The loan must be repaid on December 31,
20X8, and interest is payable at 10 percent biannually in arrears. The balance sheet date is
December 31.
The following exchange rates apply:
January 2, 20X7
June 30, 20X7
December 31, 20X7
June 30, 20X8
December 31, 20X8
£1 = $
1.67
1.71
1.75
1.73
1.70
EXPLANATION
The interest payments would be recorded at the spot rates applicable on the dates of pay-
ment in the following manner:
June 30 20X7 (£20,000 ¥ 1.71)
December 31, 20X7 (£20,000 ¥ 1.75)
Total interest for 20X7
June 30, 20X8 (£20,000 ¥ 1.73)
December 31, 20X8 (£20,000 ¥ 1.70)
Total interest for 20X8
$
34,200
35,000
69,200
34,600
34,000
68,600
The loan is initially recorded on January 2, 20X7, and restated at spot rate on December 31, | Hennie |
20X7, as well as December 31, 20X8, after which it is repaid at spot rate. The movements in
the balance of the loan are reflected as follows:
Recorded at January 2, 20X7 (£400,000 ¥ 1.67)
Foreign currency loss on restatement of loan
Restate at December 31, 20X7 (£400,000 ¥ 1.75)
Foreign currency profit on restatement of loan
Restate and pay at December 31, 20X8 (£400,000 ¥ 1.70)
$
668,000
32,000
700,000
(20,000)
680,000
Chapter 20 The Effects of Changes in Foreign Exchange Rates (IAS 21)
177
The loan will be stated at an amount of $700,000 in the balance sheet on December 31, 20X7.
The manufacturing equipment remains at its historical spot rate of $668,000.
The following amounts will be recognized in the income statements:
Interest
Foreign currency loss (profit)
20X8
$
68,600
(20,000)
20X7
$
69,200
32,000
21 Borrowing Costs (IAS 23)
21.1
PROBLEMS ADDRESSED
The acquisition, construction, or production of some assets can take longer than one account-
ing period. If borrowing costs are incurred during that period of time and are directly attrib-
utable to specific assets, it might be legitimate to regard these costs as forming part of the
costs of getting such assets ready for their intended use or sale. The major issue is then the
appropriate criteria that should be applied in order to capitalize these costs.
21.2
SCOPE OF THE STANDARD
This Standard is to be applied in accounting for all borrowing costs, which are defined as
interest and other costs incurred by an entity in connection with the borrowing of funds. IAS
23 prescribes two alternative accounting treatments of borrowing costs effectively available
at the discretion of the preparer:
• Expensed immediately.
• Capitalization (provided they meet the criteria of resulting probable benefit and can be
measured reliably).
21.3
KEY CONCEPTS
21.3.1 Qualifying assets are those assets that require a substantial time to bring them to
their intended use or saleable condition; for example:
• Inventories requiring a substantial period to bring them to a saleable condition
• Other assets such as manufacturing plants, power generation facilities, and investment
properties
21.3.2 Arguments in favor of capitalization of borrowing costs:
• Interest will be included in any contract, whether explicitly stated or not—no contrac-
tor will be willing to produce free of finance costs.
• Borrowing costs form part of acquisition costs.
• Costs included in assets are matched against revenue of future periods.
• Capitalization results in better comparability between assets purchased and constructed.
178
Chapter 21 Borrowing Costs (IAS 23)
179
21.3.3 Arguments against capitalization of borrowing costs:
• The attempt to link borrowing costs to a specific asset is arbitrary.
• Different financing methods can result in different amounts capitalized for the same
asset.
• Expensing borrowing costs causes better comparable results.
21.4
ACCOUNTING TREATMENT
21.4.1 Two methods of accounting for borrowing costs are allowed:
• Borrowing costs should be recognized as an expense in the period in which they are
incurred.
• Borrowing costs directly attributable to the acquisition, construction, or production of a
qualifying asset can be capitalized when
• it is probable that they will result in future economic benefits to the entity, and
• the costs can be measured reliably (by reference to the effective interest rate method
per IAS 39).
21.4.2 When the carrying value of an asset, inclusive of capitalized interest, exceeds the net
realizable value, the asset should be written down to the latter value.
21.4.3 Capitalization commences when
• expenditures on a qualifying asset are being incurred,
• borrowing costs are being incurred, and
• activities necessary to prepare the asset for its intended sale or use are in progress.
21.4.4 Capitalization should cease when
• the asset is materially ready for its intended use or sale,
• active development is suspended for extended periods, and
• construction is completed in part and the completed part can be used independently
| Hennie |
(for example, a business center).
21.4.5 Capitalization should not cease
• when all of the components need to be completed before any part of the asset (for
example, a plant) can be sold or used,
• for brief interruptions in activities,
• during periods when substantial technical and administrative work is being carried
out, and
• for delays that are inherent in the asset acquisition process (for example, wines that
need long periods of maturity).
21.4.6 The amount to be capitalized is the borrowing costs that could have been avoided
if the expenditure on the qualifying asset had not been made:
• If funds are specifically borrowed to obtain a particular asset, the amount of borrow-
ing costs qualifying for capitalization is the actual costs incurred during the period, less
income earned on temporary investment of those borrowings.
• If funds are borrowed generally and used to obtain an asset, the amount of borrowing
costs to be capitalized should be determined by applying the weighted average of the
borrowing costs to the expenditure on that asset. The amount capitalized during a peri-
od should not exceed the amount of borrowing costs incurred during that period.
180
Chapter 21 Borrowing Costs (IAS 23)
21.5
PRESENTATION AND DISCLOSURE
The following should be disclosed:
• Accounting policy adopted for borrowing costs
• Capitalization rate used to calculate capitalized borrowing costs
• Total borrowing costs incurred with a distinction between
• the amount recognized as an expense, and
• the amount capitalized.
21.6
FINANCIAL ANALYSIS AND INTERPRETATION
21.6.1 Capitalized interest becomes a part of the historical cost of the asset. Included in
capitalized interest are explicit interest costs and interest related to a finance lease. This cap-
italized interest requirement does not apply to
• inventories routinely produced or purchased for sale or use,
• assets that are not being made ready for use, or
• assets that could be used immediately, whether or not they are actually being used.
21.6.2 The amount of interest cost to be capitalized is that portion of interest expense
incurred during the asset’s construction period that theoretically could have been avoided if
the asset had been acquired ready to use. This includes any interest on borrowings that are
made specifically to finance the construction of the asset, and any interest on the general debt
of the company, up to the amount invested in the project. The capitalized interest cost cannot
exceed the total interest expense that the entity incurred during the period.
21.6.3 Before the asset is operational, the interest portion should be included and recorded
on the balance sheet as an asset in course of construction. That capitalized interest will sub-
sequently be expensed over the life of the asset by means of depreciation of the asset.
21.6.4 The capitalization of interest expense that is incurred during the construction of an
asset reduces interest expense during the period in which the interest was paid. As a result,
capitalized interest causes accounting profit to be greater than cash flow. For analytical
purposes, especially when comparing two companies that do not have similar borrowing
patterns, analysts often remove the capitalized interest expense from the asset portion of the
balance sheet and treat that capitalized interest as an interest expense. If this adjustment is
not made, important ratios—such as the interest coverage ratio—will be higher than those of
comparable companies.
EXAMPLES: BORROWING COSTS
Chapter 21 Borrowing Costs (IAS 23)
181
EXAMPLE 21.1
Morskoy Inc. is constructing a warehouse that will take about 18 months to complete. It
began construction on January 1, 20X2. The following payments were made during 20X2:
January 31
March 31
June 30
October 31
November 30
$’000
200
450
100
200
250
The first payment on January 31 was funded from the entity’s pool of debt. However, the
entity succeeded in raising a medium-term loan for an amount of $800,000 at March 31, 20X2, | Hennie |
with simple interest of 9 percent per annum, calculated and payable monthly in arrears.
These funds were specifically used for this construction. Excess funds were temporarily
invested at 6 percent per annum monthly in arrears and payable in cash. The pool of debt
was again used to an amount of $200,000 for the payment on November 30, which could not
be funded from the medium-term loan.
The construction project was temporarily halted for 3 weeks in May when substantial tech-
nical and administrative work was carried out.
Morskoy Inc. adopted the accounting policy of capitalizing borrowing costs.
The following amounts of debt were outstanding at the balance sheet date, December 31,
20X2:
Medium-term loan (see description above)
Bank overdraft
(The weighted average amount outstanding during the year was
$750,000 and total interest charged by the bank amounted
to $33,800 for the year)
$’000
800
1,200
A 10 percent, 7-year note dated October 31, 19X7 with simple
9,000
interest payable annually at December 31
Continued on next page
182
Chapter 21 Borrowing Costs (IAS 23)
Example 21.1 (continued)
EXPLANATION
The amount to be capitalized to the cost price of the warehouse in 20X2 can be calculated as
follows:
Specific loan
$800,000 ¥ 9 percent ¥ 9/12
Interest earned on unused portion of loan available during the year:
April 1 to June 30 [(800,000—450,000) ¥ 3/12 ¥ 6%]
July 1 to October 31 [(800,000—550,000) ¥ 4/12 ¥ 6%]
1 November to November 30 [(800,000—750,000) ¥ 1/12 ¥ 6%]
General pool of funds
Capitalization rate is 9.58 percent (Calculation a)
Paid on January 31 (200,000 ¥ 11/12 ¥ 9.58%)
Paid on November 30 (200,000 ¥ 1/12 ¥ 9.58%)
Total Amount To Be Capitalized
$
54,000
(5,250)
(5,000)
(250)
43,500
17,563
1,597
19,160
62,660
Note: Although the activities had been interrupted by technical and administrative work dur-
ing May 20X2, capitalization is not suspended for this period according to IAS 23.
Calculation
a. Capitalization rate for pool of debt
Total interest paid on these borrowings
Bank overdraft
7-year note (9,000,000 ¥ 10%)
Weighted average total borrowings
Bank overdraft
7-year note
Capitalization rate = 933,800 ÷ 9,750,000
= 9.58% (rounded)
$
33,800
900,000
933,800
750,000
9,000,000
9,750,000
Chapter 21 Borrowing Costs (IAS 23)
183
EXAMPLE 21.2
A company has a building under construction that is being financed with $8 million of debt,
$6 million of which is a construction loan directly on the building. The rest is financed out of
the general debt of the company. The company will use the building when it is completed.
The debt structure of the firm is as follows:
Construction loan @ 11%
Long-term debentures @ 9%
Long-term subordinated debentures @ 10%
$’000
6,000
9,000
3,000
The debentures and subordinated debentures were issued at the same time.
EXAMPLE 21.2.1
What is the interest payable during the year?
a. $660,000
b. $1,800,000
c. $1,770,000
d. $1,140,000
EXPLANATION
Choice c. is correct (.11 ($6,000,000) + .09 ($9,000,000) + .10 ($3,000,000) = $1,770,000)
EXAMPLE 21.2.2
The capitalized interest cost to be recorded as an asset on the balance sheet, according to IAS
23, is:
a. $660,000
b. $850,000
c. $845,000
d. $1,770,000
EXPLANATION
Choice c. is correct.
Effective interest rate on the construction loan is 11 percent.
Effective average interest rate on the company’s other debt is:
9,000,000
12,000,000
¥ 9% +
3,000,000
12,000,000
¥ 10% = 9.25%
These two rates are used to calculate the capitalized interest:
Capitalized Interest = $6,000,000 (.11) + 2,000,000 (.0925)
= $660,000 + 185,000 = $845,000
Continued on next page
184
Chapter 21 Borrowing Costs (IAS 23)
Example 21.2 (continued)
EXAMPLE 21.2.3
What amount of interest expense should be reported on the income statement?
a. $920,000
b. $1,140,000
c. $925,000
d. $1,770,000
EXPLANATION 2.3
Choice c. is correct ($1,770,000 – 845,000 = $925,000)
22 Impairment of Assets (IAS 36)
22.1
PROBLEMS ADDRESSED
The objective of this Standard is to prescribe the procedures that an entity applies to ensure
that its assets are carried at no more than recoverable amount. The key concept is the identi- | Hennie |
fication and recognition of movements in asset value subsequent to initial recognition where
such movements result in a reduction of asset value.
22.2
SCOPE OF THE STANDARD
This IAS prescribes:
• The circumstances in which an entity should calculate the recoverable amount of its
assets, including internal and external indicators or impairment;
• The measurement of recoverable amount for individual assets and cash-generating
units; and
• The recognition and reversal of impairment losses.
This Standard covers most noncurrent assets, with the exception of financial assets and non-
current assets classified as held for sale.
22.3
KEY CONCEPTS
22.3.1 An impairment loss is the amount by which the carrying amount of an asset or a
cash-generating unit exceeds its recoverable amount.
22.3.2 The recoverable amount of an asset or a cash-generating unit is the higher of its fair
value less costs to sell and its value in use. Value in use is the present value of the future cash
flows expected to be derived from an asset or a cash-generating unit. If either the net selling
price or the value in use of an asset exceeds its carrying amount, the asset is not impaired.
22.3.3 Fair value less costs to sell is the amount obtainable from the sale of an asset or a
cash-generating unit in an arm’s length transaction between knowledgeable, willing parties
less the costs of disposal.
185
186
Chapter 22 Impairment of Assets (IAS 36)
22.3.4 In determining the value in use of an asset, an entity should use:
• Cash flow projections (before income taxes and finance costs) for the asset or cash-
generating unit in its current condition and based on reasonable and supportable
assumptions that
• reflect management’s best estimate of the range of economic conditions that will
exist over the remaining useful life of the asset,
• are based on the most recent financial budgets and forecasts approved by manage-
ment for a maximum period of 5 years, and
• base any projections beyond the period covered by the most recent budget and fore-
casts on those budget and forecasts using a steady or declining growth rate unless
an increasing rate can be justified.
• A pretax discount rate that reflects current market assessments of the time value of
money and the risks specific to the asset or cash-generating unit. The discount rate
should not reflect risks for which future cash flows have been adjusted
22.4
ACCOUNTING TREATMENT
22.4.1 The recoverable amount of an asset should be estimated if, at the balance sheet date,
there is an indication that the asset could be impaired. The recoverable amount of an asset
should also be estimated annually for
• intangible assets with an indefinite useful life,
• intangible assets not yet ready for use, and
• goodwill.
22.4.2 The entity should consider, as a minimum, the following:
• External sources of information, for example, decline in an asset’s market value, sig-
nificant changes that have an adverse effect on the entity, increases in market interest
rates, and so on.
• Internal sources of information, for example, evidence of obsolescence or physical
damage, significant changes in the extent to which or the manner in which the assets
are used or are expected to be used, and evidence from internal reporting indicating an
asset is performing worse than expected.
22.4.3 An impairment loss should be recognized in the profit or loss unless the asset is car-
ried at revalued amount in accordance with IAS 16 or some other IFRS, in which case it
should be dealt with as a revaluation decrease (see Chapter 15). After recognition of the
impairment loss, the depreciation charge for subsequent periods is based on the revised car-
rying amount.
22.4.4 An entity should reassess at each balance sheet date whether there is any indication
that an impairment loss recognized in a prior period no longer exists or has decreased. If any
such indication exists, the entity should estimate the recoverable amount of that asset. An
impairment loss recognized in prior periods should be reversed if, and only if, there has been | Hennie |
a change in the estimates used to determine recoverable amount since the last impairment
loss was recognized. If that is the case, the carrying amount of the asset should be increased
to its recoverable amount, but only to the extent that it does not increase the carrying amount
of the asset above the carrying amount that would have been determined for the asset (net of
amortization or depreciation) if no impairment loss had been recognized in prior years (for
example, the previous impairment of a security held to maturity or available for sale, in terms
of IAS 39, cannot be reversed to a higher value than what the amortized value would have
been had the impairment not taken place).
Chapter 22 Impairment of Assets (IAS 36)
187
22.4.5 For the purpose of impairment testing, goodwill should be allocated to each of the
acquirer’s cash-generating units or groups of cash-generating units that are expected to ben-
efit from the combination, irrespective of whether other assets or liabilities of the acquiree are
allocated to that unit or those units. 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.
22.4.6 A recoverable amount should be estimated for an individual asset. If it is not possi-
ble to do so, an entity should determine the recoverable amount for the cash-generating unit
to which the asset belongs. The recoverable amount of a cash-generating unit is determined
in the same way as that of an individual asset. The entity should identify all the corporate
assets that relate to the cash-generating unit under review. When corporate assets cannot be
allocated to cash-generating units on a reasonable and consistent basis, the entity should
identify the group of units to which the corporate assets can be allocated on a reasonable and
consistent basis and perform the impairment test for that group of units.
22.4.7 An impairment loss for a cash-generating unit should be allocated to reduce the car-
rying amount of the assets of the unit in the following order:
• Goodwill
• Other assets on a pro rata basis
The carrying amount of any asset should not be reduced below the highest of its fair value
less costs to sell, its value in use, and zero.
22.4.8 A reversal of an impairment loss should be recognized in profit or loss unless the
asset is carried at the revalued amount in accordance with IAS 16 or another IFRS when the
reversal is treated as a revaluation increase in accordance with that Standard.
22.4.9 An impairment loss for goodwill should not be reversed.
22.5
PRESENTATION AND DISCLOSURE
22.5.1 The following should be disclosed for each class of assets and for each reportable seg-
ment, based on the entity’s primary format (where IAS 14 [Segment Reporting] is applicable):
• Amount recognized in the income statement for:
• Impairment losses
• Reversals of impairment losses
• Amount recognized directly in equity for:
• Impairment losses
• Reversals of impairment losses
22.5.2 If an impairment loss for an individual asset or a cash-generating unit is recognized
or reversed and is material to the financial statements, the following should be disclosed:
• Events and circumstances that led to the loss being recognized or reversed
• Amount recognized or reversed
• Details about the nature of the asset or the cash-generating unit and the reportable seg-
ments involved
• Whether the recoverable amount is the net selling price or value in use
• The basis used to determine the net selling price or the discount rate used to determine
value in use, and any previous value in use
188
Chapter 22 Impairment of Assets (IAS 36)
22.6
FINANCIAL ANALYSIS AND INTERPRETATION
22.6.1 An impaired asset is an asset that is going to be retained by the entity and whose
book value is not expected to be recovered from future operations. Lack of recoverability is
indicated by such factors as
• a significant decrease in market value, physical change, or use of the asset, | Hennie |
• adverse changes in the legal or business climate,
• significant cost overruns, and
• current, historical, and probable future operating or cash flow losses from the asset.
22.6.2 Management makes the decisions about whether or not an asset’s value is impaired
by reference to internal and external sources of information, and uses cash flow projections
based on reasonable and supportable assumptions and its own most recent budgets and fore-
casts. In IFRS financial statements, the need for a write-down, the size of the write-down, and
the timing of the write-down are determined by objective and supportable evidence rather
than at management’s discretion. Impairment losses can therefore not be used in IFRS finan-
cial statements to smooth or manipulate earnings in some other way. The discount rate used
to determine the present value of future cash flows of the asset in its recoverability test must
be determined objectively, and is based on market conditions.
22.6.3 From an external analyst’s perspective, it is difficult to forecast impairment losses.
However, the impairment losses themselves and the related disclosures provide the analyst
with useful information about management’s projections of future cash flows.
22.6.4 When impairment losses are recognized the financial statements are affected in sev-
eral ways:
• The carrying amount of the asset is reduced by the impairment loss. This reduces the
carrying amount of the entity’s total assets.
• The deferred tax liability is reduced and deferred tax income is recognized if the
entity cannot take a tax deduction for the impairment loss until the asset is sold or
fully used.
• Retained earnings and, hence, shareholders’ equity is reduced by the difference
between the impairment loss and any associated reduction in the deferred tax
liability.
• Profit before tax is reduced by the amount of the impairment loss.
• Profit is reduced by the difference between the impairment loss and any associated
reduction in deferred tax expense.
22.6.5 In addition, the impairment loss affects the following financial ratios:
• Asset turnover ratios increase because of the lower asset base.
• The debt-to-equity ratios rise because of the lower equity base.
• Profit margins suffer a one-time reduction because of the recognition of the impairment
loss.
• The book value (shareholders’ equity) of the entity is reduced because of the reduction
in equity.
• Future depreciation charges are reduced because the carrying amount of the asset is
reduced.
• Lower future depreciation charges tend to cause the future profitability of the firm to
increase (because the losses are taken in the current year).
Chapter 22 Impairment of Assets (IAS 36)
189
• Higher future profitability and lower asset values tend to increase future returns on
assets.
• Higher future profitability and lower equity values tend to increase future returns on
equity.
22.6.6 Impairment losses do not directly affect cash flows because the cash outflows for the
asset have already occurred and tax deductions, and hence tax payments, might not be affect-
ed. However, the impairment loss is an indicator that future operating cash flows could be
lower than previously forecast.
190
Chapter 22 Impairment of Assets (IAS 36)
EXAMPLE: IMPAIRMENT OF ASSETS
EXAMPLE 22.1
The following information relates to individual equipment items of an entity at a balance
sheet date:
Carrying amount
$
Fair value
less costs to sell
$
Item #1
Item #2 (note 1)
Item #3 (note 1)
Item #4
Item #5 (note 2)
119,000
237,000
115,000
83,000
31,000
121,000
207,000
117,000
75,000
26,000
Value in use
$
114,000
205,000
123,000
79,000
–
Further information
1. Items #2 and #3 are carried at revalued amounts, and the cumulative revaluation sur-
pluses included in equity for the items are $12,000 and $6,000 respectively. Both items
are manufacturing equipment.
2. Item #5 is a bus used for transporting employees in the mornings and evenings. It is not
possible to determine the value in use of the bus separately because the bus does not
generate cash inflows from continuing use that are independent of the cash flows from | Hennie |