Ca Financial Reporting Book.pdf

Financial Accounting & Reporting (FIN)319 Candidate Study Guide

September 2019

Dear Candidate, Welcome to the Financial Accounting & Reporting (FIN) module of the Chartered Accountants Program. On completion of this module you will be one step closer to becoming a Chartered Accountant. Inside this pack you will find your Candidate Study Guide (CSG), which includes the core content for each unit. For those new to the Chartered Accountants Program, the Module Outline directs you to the key resources available to you, both within this printed CSG and online through myLearning. In choosing the Chartered Accountants Program, you are partnering with one of the world’s leading higher education providers in accounting. Candidate feedback is vital to our success, and each term we reflect carefully on candidate feedback. The following pages discuss the changes we have made to the module in response to this feedback. Above all, work hard to achieve the exam results you want and to set yourself up for a successful career as a Chartered Accountant. Yours faithfully,

Joanne Ross CA Senior Module Leader, Financial Accounting & Reporting module

charteredaccountantsanz.com

Copyright © Chartered Accountants Australia and New Zealand 2019. All rights reserved. This publication is copyright. Apart from any use as permitted under the Copyright Act 1968 (Australia) and Copyright Act 1994 (New Zealand), as applicable, it may not be copied, adapted, amended, published, communicated or otherwise made available to third parties, in whole or in part, in any form or by any means, without the prior written consent of Chartered Accountants Australia and New Zealand.

Contents Introduction i Unit 1: Financial reporting

1-1

Unit 2: Presentation of financial statements

2-1

Unit 3: Revenue

3-1

Unit 4: Income taxes Unit 5: Foreign exchange

5-1

Unit 6: Fair value measurement

6-1

Unit 7: Property, plant and equipment

7-1

Unit 8: Intangible assets

8-1

Unit 9: Financial instruments

9-1

Unit 10: Impairment of assets

10-1

Unit 11: Provisions (including employee benefit entitlements), contingent liabilities and contingent assets

11-1

Unit 12: Leases

12-1

Unit 13: Earnings per share (EPS)

13-1

Unit 14: Share-based payments

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Introduction to Units 15–17

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Unit 15: Business combinations

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Unit 16: Accounting for subsidiaries

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Unit 17: Equity Accounting

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Financial tables

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Chartered Accountants Program

Financial Accounting & Reporting

Introduction Welcome to the Financial Accounting & Reporting (FIN) module. This module will develop your understanding of the conceptual framework for financial reporting, and enable you to reference Accounting Standards and pronouncements and apply your knowledge to various practical scenarios.

Learning model The Chartered Accountants Program (the Program) material has been constructed applying the learning principles of ‘tell, show, do’ to learning outcomes devised for each unit. Each unit is made up, primarily, of core content, worked examples, activities and a unit quiz.

TELL Tell me the relevant theory

+

SHOW Show me how to do the task

+

DO Can I do the task unassisted?

The material is delivered in two modes: 1. The Candidate study guide – this print pack, and 2. myLearning – our online environment.

Where do I start? •• The module outline (included in this pack). •• The module plan (included in this pack), to help structure your studies. •• The online orientation video, to introduce you to myLearning. •• Past papers library (available in myLearning), to understand how topics are addressed in exams. It is best to work through the Candidate Study Guide (CSG) units in order. The CSG provides the ‘Tell’ part of your learning, giving core principles and basic examples. The CSG also directs you to required readings, which are an essential part of your studies in FIN. myLearning is an important part of your studies. It contains: •• Important announcements. •• Overview videos in each unit. •• Worked examples and solutions (the ‘show’ part of your learning). •• Activities and solutions (the ‘do’ part of your learning). •• Tables of required readings by unit. •• Adaptive learning lesson in Unit 16 – an interactive online problem that ‘adapts’ and ‘changes’ based on your responses. This lesson was designed to support your learning in consolidations. •• Quiz on each unit.

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•• PDFs of all activities, worked examples and their solutions. •• Past exams and solutions library available in the “Chartered Accountants” area of myLearning. When reviewing the Module outline in the following pages, check that you understand the following: •• Assumed knowledge. •• Accounting Standards. •• Assessment requirements. •• Prescribed textbooks. •• The six-month rule. •• Date formats.

Response to candidate feedback Candidate feedback for FIN119 focused on the volume of content in the module, the predictability of the exam and difficulties with Unit 9 on financial instruments. In response to this feedback, we have rewritten the majority of unit 9 on financial instruments, to simplify the learning and focus on the important aspects of this standard. Candidates also expressed interest in more past papers, and the past paper library has now been created across all modules in the CA program. This replaces the exam preparation series and allows candidates to tailor their revision with a bank of readily available questions and solutions. Virtual classrooms were discontinued in Term 1 across the program, due to a low candidate attendance, however some candidates would like access to this resource. We will continue to work to incorporate this style of learning into the term 3 video offering. Some candidate concerns, particularly around the structure of learning, the number of learning outcomes and the alignment of online assessments cannot be fixed immediately, and will be addressed via our current review project on the CA program.

Good luck! The Chartered Accountants Program is challenging. It is designed to be the best educational product it can be for you, the future practitioners in this profession. As it constantly evolves, Chartered Accountants Australia and New Zealand will continually be actively seeking your feedback to ensure the Program meets the learner’s needs now and for future development. We hope you find your journey through the Program a rewarding and enjoyable experience and encourage you to work steadily through the material. If you require further assistance, post your questions on the discussion forum. Finally, best of luck with your studies. I and the FIN team look forward to conversing with you on the discussion forum online over the course of your studies. Joanne Ross Senior Module Leader, FIN module

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Module outline Overview Financial accounting is a pivotal aspect of an accountant’s work and is the main reporting mechanism for preparing financial statements for organisations across all sectors of the economy. FIN includes practical examples and activities that will develop your understanding of the conceptual framework for financial reporting, and enable you to reference Accounting Standards and pronouncements and apply your knowledge to a variety of practical scenarios. The FIN module is one of the five compulsory modules in the Chartered Accountants Program. It requires a good understanding of financial accounting from a candidate’s previous tertiary studies.

How is the FIN module taught? The FIN module is 12 weeks in duration and offers flexible learning options with the delivery of materials online through myLearning. myLearning is accessible after you enrol in the module by logging into myAccount and selecting myLearning.

Assessment The assessment components are outlined below: Assessment component

Contribution to final marks

Details

Online assessment

20 marks

Three (3) online assessments. Each assessment will consist of 10 single response, multiple-choice questions. It is important you attempt all online assessments

Exam

80 marks

Format: Four (4) compulsory multi-part written questions based on the learning outcomes. Time: Three (3) hours, plus 15 minutes reading time. Resources: The exam is open book – you can bring in any printed or handwritten resources you require. MUST PASS

100 marks

You must achieve 50 marks or more overall, AND 40 marks out of 80 in the exam to pass the module.

To pass the module, you must: 1. pass the exam (achieving 40 out of 80 marks or more) and 2. pass the module overall (achieving 50 out of 100 marks or more). It is therefore critical to practise your exam technique and make the most of the time that you have.

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Time allocation The expected workload for this module is a minimum of 10 hours per week over 12 weeks, or 120 hours in total, excluding module orientation, online assessments, final exam and study time for the final exam. Candidates are advised to plan their enrolment carefully around work and other commitments, to ensure they are able to devote the time required to their studies.

Assumed knowledge It is assumed that candidates have a good understanding of financial accounting and reporting from their tertiary studies. Detailed below is a summary of the assumed knowledge of the module: •• Understanding of the relevant framework, in particular the definitions of and recognition criteria for assets, liabilities, equity, income and expenses. •• Basic understanding of financial accounting and reporting concepts, particularly the general format and content of a set of financial statements. •• Understanding of the principles of disclosure relating to the presentation of financial statements. •• Understanding of the principles relating to the selection and changing of accounting policies. •• Understanding of the accounting treatment and disclosure of changes in accounting policies, accounting estimates and corrections of errors. •• Basic understanding of revenue recognition requirements. •• Understanding of the principles of accrual accounting. •• Basic understanding of the taxation treatments for assets, liabilities, income and expenses. •• Understanding of accounting for inventory. •• Basic understanding of accounting for property, plant and equipment and intangible assets. •• Basic understanding of the principles of consolidated financial statements. •• Basic understanding of accounting for intragroup transactions. •• Basic understanding of acquired goodwill – its nature and accounting treatment under the relevant standard on business combinations. •• Understanding of the concept of the time value of money and discounted cash flows and how to calculate its impact. •• Understanding of accounting for equity. •• Understanding of accounting for the issue of equity and movements in retained earnings and other reserves. •• Basic understanding of the accounting for income tax. •• Basic understanding of the accounting for a business combination. •• Understanding of the translation of an amount from one currency to a foreign currency. Candidates can check their assumed knowledge for each of the technical modules by taking the Quiz in myLearning and if necessary, using the recommended resources to refresh their learning.

Learning resources and supports Each technical module has a range of resources and support available for candidates, including: •• Online learning material. •• Announcements. •• Core content. •• Worked examples and solutions. •• Activities and solutions.

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•• Adaptive learning lesson. •• Integrated activities. •• ‘FIN bites’ technical videos. •• Excel worksheets, supporting selected activities. •• Unit quiz. •• Readings.

Additional support •• Candidate Study Guide – after enrolment you will receive a Candidate Study Guide for all technical modules, containing the module core content and the list of required readings for each unit. •• Discussion forums –– Technical query forums: where candidates can post specific questions to a technical specialist. –– Peer-to-peer forums: where candidates can form study groups or discuss issues with other candidates. •• Past exams library in “Chartered Accountants” area of myLearning – to help candidates prepare for the final exam, past exams will be available to download with suggested solutions. Supplementary exams and solutions from the FIN119 module onwards will not be released.

Prescribed reading material All required readings are examinable. The required reference for this module is: For Australia Chartered Accountants Australia New Zealand 2019, Financial Reporting Handbook Australia 2019, John Wiley & Sons Australia Ltd, Milton, Qld. For New Zealand Chartered Accountants Australia New Zealand 2019, Financial Reporting Handbook New Zealand 2019, John Wiley & Sons Australia Ltd, Milton, Qld.

Accounting Standards All references to Accounting Standards in the learning elements are to International Standards, except where they relate to jurisdiction-specific content. The unit landing page on myLearning provides a summary of the readings from the International Pronouncements together with the equivalent Australian and New Zealand Pronouncements. In the exam, you can refer to the International Standards or the Australian or New Zealand Standards. This is explained in more detail in Unit 1.

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Suggested module plan MODULE COMMENCEMENT 9 September 2019

WEEK 1 commencing 9 September

SEPTEMBER

WEEK 2 commencing 16 September

WEEK 3 commencing 23 September

WEEK 4 commencing 30 September

WEEK 5 commencing 7 October

WEEK 6 OCTOBER

commencing 14 October

WEEK 7 commencing 21 October

WEEK 8 commencing 28 October

WEEK 9

NOVEMBER

commencing 4 November

Adaptive learning lesson

WEEK 10 commencing 11 November

WEEK 11 commencing 18 November

Unit 1 Financial Reporting (8 hrs) Unit 2 Presentation of Financial statements (3 hrs) Unit 2 Presentation of Financial statements - specific standards (10 hrs) Unit 3 Revenue (8 hrs) Unit 4 Income Taxes (9 hrs)

Unit 8 Intangible assets (5 hrs) Unit 9 Financial Instruments Part A (9 hrs)

DECEMBER

Results: released by 4 Oct INTEGRATED ACTIVITY 1 (1 hr)

Unit 9 Financial Instruments Part B (6 hrs)

Catch-up week ONLINE ASSESSMENT 2 17 – 21 October Covering Units 5-9

Unit 10 Impairment of assets (5 hrs) Unit 11 Provisions (4 hrs)

Results: released by 25 Oct

Unit 12 Leases (5 hrs) Unit 13 Earnings per share (4 hrs) Unit 14 Share-based payments (4 hrs) Unit 15 Business combinations (5 hrs)

INTEGRATED ACTIVITY 2 (1 hr)

ONLINE ASSESSMENT 3 7– 11 November Covering Units 10-15 Results: released by 15 Nov

Unit 16 Accounting for subsidiaries (14 hrs)

Unit 17 Equity accounting (3 hrs)

preparation

WEEK 13 Exam commencing 2 December

ONLINE ASSESSMENT 1 26 – 30 September Covering Units 1-4

Unit 5 Foreign exchange (4 hrs) Unit 6 Fair value measurement (4 hrs) Unit 7 Property, Plant & equipment (5 hrs)

WEEK 12 Exam commencing 25 November

CENSUS DATE 27 September 2019

preparation

INTEGRATED ACTIVITY 3 (1 hr) INTEGRATED ACTIVITY 4 (2 hr) (can be attempted throughout the module) EXAM 10 December 2019 Results: 24 January 2020

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Date convention Generally, the date format is as follows: Dates for the current decade are expressed as 20XX, the preceding decade are expressed as 20WX and future years outside of this decade dates are expressed as 20Y3. For example, if a date given in an example is 20X6, 20W6 would be 10 years earlier and 20Y6 would be 10 years in the future. All years are treated as having 365 days. Dates in the exam will use actual years (e.g. 2019).

Learning outcomes Learning outcomes provide an outline of the expected knowledge and skill level achieved on completion of the unit. Learning outcomes are shown on the unit learning page and on the first CSG page for each unit. Each learning outcome commences with a verb, such as ‘explain’, ‘calculate’, ‘demonstrate’ etc. These terms are in the following table of task words. Word

Meaning

Account for

Demonstrate the accounting treatment by using a set of accounts

Advise

Communicate appropriately the recommended course of action based on an analysis of specific circumstances

Analyse

Examine closely; examine something in terms of its parts and show how they are related to each other

Apply

Use established methods/tools/procedures to resolve relatively straightforward scenario or problem

Appraise

Assess the value or quality of something; or assess its performance

Assess

Decide the value of something in a particular context

Calculate

Ascertain or determine by mathematical processes, usually by the ordinary rules of arithmetic

Classify

Place objects/concepts into appropriate categories using an established tool/ methodology or framework

Compare

Critically consider two or more things, emphasising their similarities

Consider

Think carefully about something before making a decision, to look closely or attentively at something

Construct

Build or make something, to form an idea, a process or procedure by bringing together various theoretical and conceptual elements

Contrast

Critically consider two or more things, emphasising their differences

Critique

Give a judgement about the value of something and support that judgement with evidence

Define

Make clear what is meant by something; or use a definition or definitions to explore a concept

Demonstrate

A practical explanation of how something works or is performed

Describe

Present a detailed account of something focusing on depth of knowledge

Design

Develop a procedure/process or course of action based on a selection of the optimum combination from a range of available options

Determine

Establish the most appropriate or most correct answer or course of action from a range of available options

Develop

Bring something into existence that has not previously existed, or to reshape something from its initial position into something more refined

Discuss

Present a detailed account offering an interpretation of something or focusing on breadth of knowledge

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Word

Meaning

Distinguish

Separate one from the other by distinct difference

Evaluate

Determine the value of something, normally with reference to specific criteria

Examine

Inspect something in detail and investigate the implications

Explain

Make clear the details of something; or show the reason for or underlying cause of something; or the means by which something occurs

Identify

Point to the essential part or parts. You might also have to explain clearly what is involved

Illustrate

Offer an example or examples, to show how something happens, or that something happens, or to make concrete a concept by giving examples

Integrate

Combine one aspect of their learning with another to form a holistic understanding of a process, procedure or course of action

Interpret

Make clear the meaning of something and its implications

Justify

Provide reasons why certain decisions should be made, conclusions reached and/or courses of action taken

List

Note or itemise in point form

Outline

Go through and identify briefly the main features of something

Plan

Prepare a detailed proposal for doing or achieving something

Prepare

Follow established procedures/methods to create a report of financial information or commentary (e.g. Using a pro forma spreadsheet)

Prioritise

Designate or treat something as being very or more important; or determine the order for dealing with (a series of items or tasks) according to their relative importance

Produce

Without using a pro forma spreadsheet, or without any guidance, create a report of financial information with commentary

Recommend

Advocate a particular outcome or course of action based on an analysis of a range of available options

Review

Report the main facts about something

Select

Carefully choose as being the best or most suitable

Solve

Resolve; or work out to a result or conclusion

State

Accurately articulate established principles, concepts, terms, etc.

Summarise

Describe something concisely

Unit 1 At the end of this unit you will be able to: 1. Describe the purpose of financial reporting. 2. Analyse the reporting requirements of an entity based on the national regulatory framework including whether an entity is a reporting entity. 3. Explain the interaction between the national and international financial reporting regulatory frameworks including the relationship with their respective Accounting Standards. 4. Explain a Chartered Accountant’s ethical requirements relating to financial reporting. 5. Explain contemporary issues affecting financial reporting.

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Unit 2 At the end of this unit you will be able to: 1. Advise on the requirements for financial statements 2. Prepare, analyse and explain a complete set of financial statements. 3. Explain and account for changes in accounting policies, revisions of accounting estimates and errors. 4. Identify and analyse related parties. 5. Explain and account for discontinued operations. 6. Explain and account for events after the reporting period.

Unit 3 At the end of this unit you will be able to: 1. Identify, measure and recognise revenue from contracts with customers.

Unit 4 At the end of this unit you will be able to: 1. Explain the purpose of tax effect accounting. 2. Calculate and account for current tax. 3. Calculate and account for deferred tax. 4. Explain and account for changes in prior year taxes. 5. Explain and account for income tax expense.

Unit 5 At the end of this unit you will be able to: 1 Explain and account for foreign currency transactions and balances. 2. Determine the functional currency. 3. Explain and account for the translation of financial statements of an entity from its functional currency to its presentation currency.

Unit 6 At the end of this unit you will be able to: 1. Explain and identify the key principles of fair value measurement, along with the related disclosure requirements.

Unit 7 At the end of this unit you will be able to: 1. Describe the nature of property, plant and equipment. 2. Explain and account for property, plant and equipment during its useful life. 3. Explain and account for borrowing costs in relation to a qualifying asset.

Unit 8 At the end of this unit you will be able to: 1. Identify and explain the key characteristics of an intangible asset, including whether it can be recognised for financial reporting purposes. 2. Explain and account for an intangible asset.

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Unit 9 At the end of this unit you will be able to: 1. Explain and identify financial instruments and the principles for classifying them as financial assets, financial liabilities or equity instruments of the issuer. 2. Account for financial assets, financial liabilities and equity instruments of the issuer (including derivatives). 3. Explain and account for basic cash flow and fair value hedges. 4. Explain and account for impairment of financial assets. 5. Explain and account for the derecognition of financial assets and financial liabilities.

Unit 10 At the end of this unit you will be able to: 1. Explain and account for an impairment loss for an individual asset. 2. Identify, explain and account for an impairment loss for a cash-generating unit (CGU) including impairment of goodwill. 3. Explain and account for reversals of impairment losses.

Unit 11 At the end of this unit you will be able to: 1. Explain and account for a provision. 2. Identify and explain a contingent liability. 3. Identify and explain a contingent asset.

Unit 12 At the end of this unit you will be able to: 1. Discuss the characteristics of a lease. 2. Explain and account for lease transactions (for lessees). 3. Explain and account for lease transactions (for lessors). 4. Explain and account for sale and leaseback transactions.

Unit 13 At the end of this unit you will be able to: 1. Explain the requirements for disclosing earnings per share (EPS) information, including which entities need to include EPS information. 2. Calculate basic and diluted EPS for continuing and discontinued operations.

Unit 14 At the end of this unit you will be able to: 1. Identify and account for share-based payments.

Units 15-17 At the end of this introduction you will be able to: 1. Identify the appropriate classification for investments as subsidiaries, associates or joint arrangements.

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Unit 15 At the end of this unit you will be able to: 1. Identify a business combination. 2. Explain the concept of control. 3. Explain and account for a business combination in the books of the acquirer. 4. Account for subsequent adjustments to the initial accounting for a business combination.

Unit 16 At the end of this unit you will be able to: 1. Explain how a business combination is accounted for in the books of the acquiree. 2. Explain and account for a consolidation for a wholly-owned subsidiary. 3. Explain and account for a consolidation for a partly-owned subsidiary. 4. Account for movements in the parent’s interest in a subsidiary

Unit 17 At the end of this unit you will be able to: 1. Explain and account for an investment using the equity method. 2. Explain the concepts of significant influence and joint control.

Six-month rule Legislation changes constantly. In the Program modules, you are expected to be up to date with relevant legislation, Standards, cases, rulings, determinations and other guidance as they stand six months before the exam date unless otherwise stated. In some instances the International Accounting Standard may have been updated while the Australian Standard or New Zealand Standard may not. International Standards can be accessed from the IFRS website (www.ifrs.org), you will need to register to access the content on this website but it is free to do so You are always encouraged to be aware of developments in financial reporting. The relevant date for legislation is the date the legislation receives royal assent. The relevant date for Accounting Standards and other material is the issue date. Early adoption of Standards is generally encouraged.

Goods and service tax You should ignore the impact of goods and service tax (GST) throughout the module unless the learning element specifically refers to it.

CA Program policies and Candidate code of conduct As a CA program candidate, you are bound by the CA program candidate code of conduct. This is available in the orientation section of myLearning. The policies governing the CA program are available on our website. Cheating, plagiarism, falsifying data, breaching copyright, collusion and other forms of academic dishonesty are breaches of the CA Program’s Code of Conduct and will be addressed in accordance with the CA Program’s Misconduct Policy. The policy also applies to social media use. Candidates need to behave professionally and ethically when posting anything about the CA Program on social media.

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Candidate support and Special consideration Policies on special consideration are available on our website. You will find links to special consideration forms on our Contacts page in myLearning. Should you find you require additional support during your studies, please get in touch with us via email to [email protected], or contact our Candidate Support team on [email protected].

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Unit 1: Financial reporting Contents Introduction 1-3 Overview of international standard-setting

1-4

Convergence of national and international standards International financial reporting regulatory framework

1-5 1-6

The Conceptual Framework and the purpose of financial reporting 1-7 Qualitative characteristics 1-7 Elements of financial statements, recognition and measurement criteria 1-8 Definition and recognition criteria 1-9 Future developments 1-10 Practical issues in using Accounting Standards 1-11 Comparing the IASB, AASB and XRB standards 1-11 Australia-specific 1-12 New Zealand-specific 1-12 National reporting requirements and the regulatory framework 1-12 Australia-specific 1-13 New Zealand-specific 1-23 Interrelationship between international and national requirements 1-28 International and national frameworks – interaction and key differences 1-28 Australia-specific 1-28 New Zealand-specific 1-31 Ethical requirements in preparing financial reports 1-38 Ethical requirements 1-38 IESBA Code 1-39 Fundamental principles 1-39 Threats and safeguards 1-39 Australia-specific 1-41 New Zealand-specific 1-41 Non-compliance with laws and regulations (NOCLAR) 1-43

fin31901_csg_06

Contemporary financial reporting issues 1-44 International level 1-44 Australia-specific 1-47

Unit 1 – Core content

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Learning outcomes At the end of this unit you will be able to: 1. Describe the purpose of financial reporting. 2. Analyse the reporting requirements of an entity based on the national regulatory framework including whether an entity is a reporting entity. 3. Explain the interaction between the national and international financial reporting regulatory frameworks including the relationship with their respective Accounting Standards. 4. Explain a Chartered Accountant’s ethical requirements relating to financial reporting. 5. Explain contemporary issues affecting financial reporting.

Introduction Financial reporting is a key tool that entities use to communicate with users of financial reports. Information about the resources of the entity and claims against those resources is central to users’ decision-making. The new Conceptual Framework for Financial Reporting (the Conceptual Framework), issued in March 2018, describes the objective of general purpose financial reporting and defines the concepts supporting this objective. The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. IASB 2018, The Conceptual Framework for Financial Reporting

Users of financial reports also use such information when trying to form a view about an entity and its management. For example, what can the user expect in terms of future cash flows? How does this entity compare to other entities? How has management discharged its responsibilities? Has management used the entity’s resource efficiently and effectively? Financial reporting relies on the information from financial accounting processes within the entity, and entities use this information to prepare reports for external users. However, users have different information needs, and they generally do not have the power to request tailored financial information. This is where general purpose financial reports (GPFR), prepared under International Financial Reporting Standards (IFRS), play a vital role. The Financial Accounting & Reporting (FIN) module considers both the financial accounting methods and the formal financial reports. Entities want to minimise the work during report preparation, so financial accounting processes are designed with the Accounting Standards and disclosure requirements in mind. This unit provides an overview of the financial reporting framework and the regulatory requirements applicable to financial reporting, both nationally and internationally. It also explains the ethical requirements that apply to the work of a Chartered Accountant when preparing financial reports.

Core content – Unit 1

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This unit addresses the learning outcomes via the following sections: •• Overview of international standard-setting. •• The Conceptual Framework and the purpose of financial reporting. •• Practical issues in using Accounting Standards. •• National reporting requirements and the regulatory frameworks. •• Interrelationship between international and national requirements. •• Ethical requirements in preparing financial reports. •• Contemporary issues in financial reporting. Later units discuss financial reporting from an International perspective, applying the IFRS standards topic by topic in more detail. Please note that for exam purposes only, the international standards, the Australian Accounting Standards Board (AASB) standards, or the New Zealand IFRS (NZ IFRS) can be used interchangeably. This unit will explain how to navigate the different standards for the purposes of both your study and your professional practice. Unit 1 overview video [Available online in myLearning]

Overview of international standard-setting Prior to the formation of the International Accounting Standards Board (IASB), Accounting Standards were set by the International Accounting Standards Committee (IASC). These International Accounting Standards (IAS) went through a variety of processes to be adopted in member nations; however, reporting standards differed widely between countries. The IASB was formed in 2001 to work towards convergence between national and international standards. Currently, the IASB is the standard-setting body, overseen by the IFRS Foundation. ‘Our mission is to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth and long-term financial stability in the global economy.’ www.IFRS.org, accessed 13 April 2018

‘If we really believe in open international markets and the benefits of global finance, then it can’t make sense to have different accounting rules and practices for companies and investors operating across national borders. That is why we need global standards. Ultimately this will get done.’ Paul A Volcker Chairman of the US Federal Reserve (1979–1987) and Chairman of the IFRS Foundation Trustees (2000–2005).

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Convergence of national and international standards ‘The IASB is committed to developing, in the public interest, a single set of high quality global accounting standards that provide high quality, transparent and comparable information in general-purpose financial Statements.’ Pacter, Paul 2015, IFRS as Global Standards: a Pocket Guide, IFRS Foundation.

A converged set of financial reporting standards make sense. As entities expand and operate across many jurisdictions, converged reporting is less costly, improves an entity’s access to capital and ensures reports to the users are comparable. The extent of cross-border investment is growing constantly, and financial reporting must respond to, and enhance, this growth. In line with the IASB and IFRS Foundation’s aims, convergence should aid in bringing transparency, accountability and efficiency to financial markets around the world. It is important to remember that measurements in financial reporting are often not exact. In practice, decisions around applying Accounting Standards are not always black and white. The IASB’s Conceptual Framework for Financial Reporting (the Conceptual Framework) states that ’to a large extent, financial reports are based on estimates, judgements and models’. This use of estimates and judgements in reporting creates even more need for converged standards and agreed-upon principles for financial reporting. Of course, in reality, full convergence is not always possible. The IASB does not have the power to require adoption of IFRS in any jurisdiction, nor is it able to supervise a country’s adoption. There are differing local requirements and local regulatory frameworks, and there are cultural differences in implementing the same set of standards. Partial convergence is common in many countries. This unit considers the requirements in your local jurisdiction, and how these requirements interact with those of the IASB. The IASB issues regular updates on the adoption of IFRS. Currently, these standards are required or permitted to be used in 150 countries. Some countries have taken the approach of adopting IFRS, replacing their previous generally accepted accounting principles (GAAP) with equivalent IFRS. For example, the European Union has adopted this approach for the preparation of consolidated financial statements of listed companies. Australia has largely adopted this approach with some exceptions, including tailoring the Australian Standards for use by not-for-profit (NFP) entities and by entities that meet the criteria for reduced disclosure requirements reporting. Other countries have chosen to eliminate differences between their existing national GAAP and the IFRS, where possible and practicable. Countries following this strategy include Japan, China and India. Companies in both Australia and the European Union have been reporting under the IFRS regime since 2005, and companies in New Zealand since 2007. In general, the move to the standard platform of reporting under IFRS has been successful; however, not all members of the business community agree that the adoption of IFRS has been useful. For an overview of the aims of the IASB, the IFRS Foundation and the standard-setting process, consider the further reading below. Further reading

Pacter, Paul 2017, Pocket Guide to IFRS® Standards: the global financial reporting language, www.ifrs.org → Use around the world – Pocket Guide to IFRS Standards, accessed 13 April 2018.

Core content – Unit 1

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Financial Accounting & Reporting

Chartered Accountants Program

International financial reporting regulatory framework The diagram below depicts how international financial reports are regulated. For the purposes of the FIN module, we are concentrating on the private sector; that is, the roles of the IASB, the IFRS Interpretations Committee and the IFRS Foundation, including the IASB’s Conceptual Framework. The role of the International Public Sector Accounting Standards Board (IPASB) is beyond the scope of the module.

International Financial Reporting Regulatory Framework International Financial Reporting PRIVATE SECTOR (including not-for-profit) IFRS Foundation IASB (International Accounting Standards Board) Issues: IFRSs International Financial Reporting Standards

PUBLIC SECTOR (including not-for-profit) International Federation of Accountants

IFRS Interpretations Committee

IPSASB (International Public Sector Accounting Standards Board)

Issues: IFRICs (Interpretations of IFRS)

Issues: IPSASs (International Public Sector Accounting Standards)

IASB Conceptual Framework for Financial Reporting (Underpins IFRS and IFRICs)

IPSASB Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities (Underpins IFRS and IFRICs)

To understand each of the relevant roles above, refer to the IFRS website (www.ifrs.org), or download the ‘Who we are and what we do’ brochure (www.ifrs.org → About us → Who we are → Our structure). This international approach (i.e. having separate standard setters for different sectors) differs to the approach adopted by national jurisdictions. In Australia, the Australian Accounting Standards Board (AASB) sets Accounting Standards for both the private and public sectors, including NFP entities. Similarly, in New Zealand, Accounting Standards are set by the External Reporting Board (XRB). Drawing on the concepts set out in the Conceptual Framework, the IASB then sets and modifies the IFRSs. This unit will now go on to examine the foundation layer of international financial reporting as shown in the diagram above. Specific IFRSs, as set by the IASB, are discussed in later units.

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The Conceptual Framework and the purpose of financial reporting Learning outcome 1. Describe the purpose of financial reporting. A new version of the Conceptual Framework was issued by the IASB in March 2018. The elements and concepts defined and explained within the Conceptual Framework are the building blocks for a set of meaningful and robust financial statements. The Conceptual Framework acts as the foundation, defining the concepts that underpin the IFRS standards. Before we can delve into the focus areas of this unit, we need to consider the purpose of financial reporting, so as to better understand an entity’s reporting requirements. Paragraph 1.2 of the Conceptual Framework states: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity.

Financial reports tell a story about an entity. The users need these reports to assist them in making decisions and, as per the Conceptual Framework, these decisions rely on information such as: (a) the economic resources of the entity, claims against the entity and changes in those resources and claims, and (b) how efficiently and effectively the entity’s management and governing Board have discharged its responsibilities to use the entity’s economic resources. As you may recall from your university studies, general purpose financial reports are designed to meet the needs of users who do not have the power to request reports specifically designed to meet their own needs. These reports do not ’value’ the entity, but instead provide information to help in users own estimations of value. As noted above, the Conceptual Framework sets out the objective of financial reporting. It also discusses the qualitative characteristics of useful information, and the definitions and recognition criteria for the elements within the financial statements, and concepts of capital and capital maintenance.

Qualitative characteristics The Conceptual Framework para. 2.4 states: For financial information to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.

These qualitative characteristics, along with the Conceptual Framework definitions and recognition criteria, underpin most of the more specific principles within individual Accounting Standards. The Conceptual Framework is not mandatory in most circumstances; however, the concepts within form the foundation of the mandatory Accounting Standards. The exception to this statement lies in the requirements of IAS 8 Accounting Policies, Changes in Accounting estimates and Errors (IAS 8). Paragraphs 10 and 11 state that where the standards do not specifically cover an issue or transaction the entity is facing, the entity should first look at guidance from Accounting Standards covering similar or related issues, and then look at the definitions, recognition criteria and measurement concepts in the Conceptual Framework. It is worth reading the key aspects of the Conceptual Framework, as this should further develop your understanding of all standards.

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Financial Accounting & Reporting

Chartered Accountants Program

Required reading The Conceptual Framework for Financial Reporting 2018.

Elements of financial statements, recognition and measurement criteria We are currently in a unique situation where the new Conceptual Framework for Financial Reporting (2018) has been immediately adopted by the Standard-setters and the interpretations committee. For other users, the effective date is 1 January 2020, although earlier application is permitted. The Conceptual Framework defines the elements of the financial statements as assets, liabilities, equity, income and expenses. It also specifies the recognition criteria for each of these elements. Before an item can be recognised, it is first checked against the definition set out in the Conceptual Framework. An item that both meets this definition and satisfies the related recognition criteria should be recognised in the financial statements. An asset or liability is recognised only if recognition of that asset or liability and of any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, including: (a) relevant information about the asset or liability and about any resulting income, expenses or changes in equity (see paras 5.12–5.17); and (b) a faithful representation of the asset or liability and of any resulting income, expenses or changes in equity (see paras 5.18–5.25). The definition and recognition criteria are summarised in the table below. Further discussion on each element is contained within the Conceptual Framework.

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A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (para. 4.4(a)

A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (para. 4.4(b))

The residual interest in the assets of the entity after deducting all its liabilities (para. 4.4(c))

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (para. 4.25(a))

Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (para. 4.25(b))

Asset

Liability

Equity

Income

Expenses

Economic resource

Definition

Item

When a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably (para. 4.49)

Because equity is the arithmetic difference between assets and liabilities, a separate recognition criteria for equity is not needed

It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation, and the amount at which the settlement will take place can be measured reliably (para. 4.46)

It is probable that the future economic benefits will flow to the entity, and that the asset has a cost or value that can be measured reliably (para. 4.44)

Recognition

Conceptual framework (2010)

Definition and recognition criteria

An economic resource is a right that has the potential to produce economic benefits (para. 4.4)

Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims (para. 4.69)

Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims (para. 4.68)

The residual interest in the assets of the entity after deducting all its liabilities (para. 4.63)

events (para. 4.26)

comprehensive income

Statement of financial position

Statement of financial position

Recognised in

Information may lack representational faithfulness if there is a high degree of measurement uncertainty (paras 5.19, 5.21 and 5.22)

(b) The asset or liability exists but the probability of an inflow or outflow of economic benefits is low (para. 5.12)

(a) it is uncertain whether the asset or liability exists (para. 5.14), or

Information may not be relevant if:

Statement of profit or loss and other comprehensive income

(b) A faithful representation of the asset Statement of financial position or liability (and related income, expense or changes in equity) Statement of changes in equity The new 2018 Conceptual Framework discusses cases where these criteria Statement of profit may not apply, that is: or loss and other

(a) Relevant information about the asset or liability (and related income, expense or change in equity)

What is useful information?

Recognition

An asset is a present It is recognised if: economic resource controlled 1. it meets the definition by the entity as a result of past AND events. (para. 4.3) 2. the asset or liability and any resultant income, expense or changes in equity A present obligation of the entity to transfer an economic provide users with useful information (para. 5.7) resource as the result of past

Definition

Conceptual Framework (2018)

Chartered Accountants Program Financial Accounting & Reporting

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Future developments Definition of reporting entity According to the Conceptual Framework (2018) para. 3.10, a reporting entity is an entity that chooses, or is required, to prepare general purpose financial statements.

A reporting entity is not necessarily a legal entity. It can comprise a portion of an entity, or two or more entities. At the time of writing, the IASB has not yet made the 2018 Conceptual Framework publicly available. Check myLearning for more information. Australian candidates should note that the IASB definition of ‘reporting entity’ differ significantly from the AASB definition. The AASB is currently working to resolve these differences and their impact on financial reporting in Australia.

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Practical issues in using Accounting Standards In the FIN module, candidates may refer to either the International, Australian, or New Zealand standards. The majority of the learning material for the module contains references to IFRS and IAS; however, paragraph references to equivalent local standards are provided in the Required readings list which can be found in myLearning.

Comparing the IASB, AASB and XRB standards The IASB, AASB and XRB standards are mostly the same. The international standards come in two ’generations’: •• IFRS (the new generation standards). These are current and latest standards, issued by the IASB. •• IAS (the older generation standards). These are the older standards, issued by the previous standard-setting body and were adopted by the IASB when it took over in 2001. For the purposes of this module, when referring to the international standards as a whole, the term IFRS is used. This is consistent with the definition of IFRS in IAS 1 para. 7. A comparison between the IASB, AASB and XRB standards is best demonstrated through examples. Below is an example of a comparison, using a ‘new generation’ IFRS standard: IASB

AASB

XRB

IFRS 13 Fair Value Measurement, para. 9 states, ’This IFRS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

AASB 13 Fair Value Measurement, para. 9 states, ’This standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’

NZ IFRS 13 Fair Value Measurement, para. 9 states, ’This NZ IFRS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’

It is clear from the above example that the paragraphs are directly comparable. Below is an example of a comparison from an ‘older generation’ of IAS standards. Please note that in Australia, these standards are numbered as 100 series – therefore, IAS 12 is referred to as AASB 112. However, in New Zealand, the numbering agrees to the IASB standard and therefore IAS 12 is referred to as NZ IAS 12. IASB

AASB

XRB

IAS 12 Income Taxes, para. 56 states, ’The carrying amount of a deferred tax asset shall be reviewed at the end of each reporting period…’

AASB 112 Income Taxes, para. 56 states, ’The carrying amount of a deferred tax asset shall be reviewed at the end of each reporting period…’

NZ IAS 12 Income Taxes, para. 56 states, ’The carrying amount of a deferred tax asset shall be reviewed at the end of each reporting period…’

Similarly, Interpretations, which help clarify the intended application of an Accounting Standard, are either IFRIC (for the new generation) or SIC (for the older generation). For local standards, there are usually some jurisdiction-specific paragraphs within the standards: •• In Australia, jurisdiction-specific paragraphs, which often relate to how the standard applies to NFP entities and application of the Reduced Disclosure Regime (RDR), are prefaced by ‘Au’. •• In New Zealand, jurisdiction-specific paragraphs are prefaced by ’NZ’. As candidates work through a given unit, we recommend referring to the related paragraphs of the standard. While the Candidate Study Guide provides extensive guidance, a Chartered Accountant needs to be able to access the most authoritative source of information for financial reporting, and navigating the standards is part of your professional skill set. It is always best to go to the source.

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AU

Chartered Accountants Program

Australia-specific The numbering system of Australian accounting pronouncements differs to the numbering system used by the IASB, as shown below: Correlation between Australian standard numbering and international standard numbering systems Australian pronouncements

Corresponding IASB pronouncements

AASB Standards AASB 1 to AASB 17

IFRS 1 to IFRS 17

AASB 101 to 141

IAS 1 to IAS 41

AASB 1004 to AASB 1059

Australia-specific standards with no international equivalent

AASB Interpretations

NZ

Interpretation 1 to 23

IFRIC 1 to 23

Interpretation 107 to 132

SIC 7 to SIC 32

Interpretation 1003 to 1055

Australia-specific interpretations with no international equivalent

New Zealand-specific The numbering system of the New Zealand pronouncements is broadly the same as that developed by the IASB, with the exception of those relating to New Zealand-specific standards. This is further explored below: New Zealand pronouncements

Corresponding IASB pronouncements

NZ IFRS 1 to NZ IFRS 17

IFRS 1 to IFRS 17

NZ IAS 1 to NZ IAS 41

IAS 1 to IAS 41

FRS 42 to FRS 44

New Zealand-specific

NZ Interpretations NZ IFRIC 1 to NZ IFRIC 23

IFRIC 1 to IFRIC 23

NZ SIC 7 to NZ SIC 32

SIC 7 to SIC 32

National reporting requirements and the regulatory framework Learning outcome 2. Analyse the reporting requirements of an entity based on the national regulatory framework including whether an entity is a reporting entity. Each country has its own requirements for the preparation of financial reports. Some countries largely draw on the international financial reporting regulatory framework, while others have their own long-established frameworks. In the following pages, there is a substantial amount of jurisdiction material. Candidates should note that they are only required to study the material related to their region. Australian and MICPA candidates should read the Australia-specific boxes. New Zealand candidates should read the New Zealand-specific boxes.

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AU

Australia-specific Australian regulatory framework The Australian regulatory framework determines an entity’s financial reporting obligations. This framework is overseen by statutory bodies or enshrined in legislation which establishes the rules and regulations for financial report preparation. The Australian financial reporting regulatory framework is depicted in the following diagram:

Financial Reporting Regulatory Framework (Australia) Financial Reporting Regulatory Framework (Australia) ASIC

(Australian Securities and Investments Commission) Conducts: Surveillance program to improve quality of financial reporting

Corporations Act (2001)

FRC

Establishes: Legislative and regulatory requirements which include class orders and regulatory guides

(Financial Reporting Council)

ASX

APESB

(Australian Securities Exchange)

(Accounting Professional and Ethical Standards Board)

Issues: Listing Rules

Issues: • Code of ethics • Professional standards

Oversees: AASB and AUASB

Lobby groups: CA ANZ/CPAA/IPA ASX ASIC

AUASB

AASB

(Auditing and Assurance Standards Board)

(Australian Accounting Standards Board)

Issues: • Auditing Standards • Guidance statements

Issues: • AASBs (Accounting Standards) • Interpretations

Australian Conceptual Framework

Proposed short term approach (two frameworks)

Proposed longer term approach

AASB Framework for the Preparation and Presentation of Financial Statements

Revised Conceptual Framework (2018) applies to publicly accountable for-profit entities

SAC 1 amended Change to legislation to define who publicly lodges and what they should report

SAC 1

Existing Conceptual Framework (2010) & SAC 1 applies to other entities

Definition of the Reporting Entity

Single Conceptual Framework

OUTPUT

Australian general purpose financial report1

Notes 1. A non-reporting entity may be required to prepare a financial report. Where a financial report is prepared, the output may be a special purpose financial report.

Details on the roles and responsibilities of each regulatory body can be obtained from their respective websites. A brief summary is also provided in the ‘Regulatory Bodies’ document, available in the Unit 1 folder in myLearning.

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Standards and legislation affecting Financial Reporting in Australia (based on current situation at 29 November 2018 and Conceptual Framework 2010) The following section outlines some of the key components of regulation in Australia surrounding financial reporting.

The Corporations Act 2001 The Corporations Act 2001 (Corporations Act or the Act) plays an integral role within the accounting framework of Australia. Key sections of the Corporations Act that you should be familiar with from your university studies include: •• Section 334 – grants the AASB power to make Accounting Standards. •• Section 336 – grants the AUASB power to make Auditing Standards. •• Chapter 2M, especially s. 286, Part 2M.3 (financial reporting), and Corporations Regulation 2M.3.01 – for annual financial reports. •• Part 1.2A (disclosing entities), ss 302–306 and s. 320 – for half-year reports. Other relevant provisions of the Corporations Act include: •• Section 601CK – financial reporting by registered foreign companies. •• Section 989B – Financial reporting by financial services licensees.

Reporting requirements for an Australian entity Determining the reporting requirements for Australian entities requires considering the following three questions: Which entities are required to prepare a financial report in Australia?

What are the main components of a financial report in Australia?

What are the rules governing how a financial report is prepared?

Entities that are required to prepare a financial report

Entities operating under Corporations Act 2001

Entities with reporting obligations under other legislation or regulatory requirements

In Australia, a large number of business entities are registered under, and governed by, the Corporations Act.

Australian entities under the Corporations Act The following table identifies the types of entities in Australia that you need to have an understanding of in the FIN module. It shows how they are defined under the Corporations Act and also includes a brief summary of the additional reporting requirements for each. Types of Australian entities Entity

Corporations Act definition

Reporting requirements

Disclosing entities

An entity is a disclosing entity if it has issued any enhanced disclosures securities (ED securities) (s. 111AC). The most common types of disclosing entities are those listed on a stock exchange (e.g. the ASX) and those entities that have raised funds by way of a product disclosure statement (e.g. managed investment schemes with more than 100 security holders)

There are extended reporting obligations for an entity that is a disclosing entity. For example, a disclosing entity must also prepare a half-year financial report under the Corporations Act s. 302 that is also prepared in accordance with AASB 134 Interim Financial Reporting

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Types of Australian entities Public companies

As defined in s. 9, includes: •• Companies other than proprietary companies •• Listed companies (which are also disclosing entities)

Public companies have some specific reporting implications, in particular content that must be included in directors’ reports

•• Companies limited by guarantee Proprietary companies

A proprietary company is either a company limited by shares or an unlimited company with share capital, which has less than 50 non-employee shareholders. In addition, proprietary companies cannot offer securities for sale, except in limited circumstances (s. 45A(1))

Large proprietary companies must prepare and lodge an audited financial report Small proprietary companies generally are not required to prepare and lodge a financial report

Other types of entities that are defined under the Corporations Act are: •• Registered schemes. •• Companies limited by guarantee. •• Australian financial services licence (AFSL). Section 292 of the Act requires the following types of entities to prepare an annual financial report, which must be lodged with the Australian Securities and Investments Commission (ASIC): •• Disclosing entities. •• Public companies. •• Large proprietary companies. •• Registered schemes. •• Small proprietary companies (in limited circumstances only).

Large or small proprietary companies A large proprietary company is required to prepare and lodge a financial report with ASIC, while a small proprietary company generally is not. It is therefore important to understand the distinction between a large and a small proprietary company. Section 45(A) of the Corporations Act prescribes the criteria for small and large proprietary companies, the tests of which are outlined in the table below. If a proprietary company falls below the threshold in two or more of the tests, it is classified as a small proprietary company; otherwise, it is classified as a large proprietary company. Classification of proprietary limited companies – criteria Test

Threshold

1. Consolidated revenue for the year

$50 million

2. Consolidated gross assets at the end of the financial year

$25 million

3. Employees at the end of the financial year

100 employees (full-time equivalent)

The above threshold apply for the financial beginning on or after 1 July 2019 and should be used in the FIN module. Further reading (Australia) Reducing the financial reporting burden by increasing the thresholds for large proprietary companies The Department of the Treasury 2018, https://static.treasury.gov.au/uploads/sites/1/2018/11/ c2018-t342318-Explanatory-Statement.pdf, accessed 29 November 2018.

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Reporting by small proprietary companies As per the Corporations Act s. 292(2), small proprietary companies are required to prepare a financial report when: •• Shareholders with at least 5% of votes direct the company to do so in writing. The shareholders can also specify the extent to which Accounting Standards are applied, and whether the financial report is to be audited (s. 293). •• ASIC directs the company to prepare a financial report (s. 294). •• It is controlled by a foreign company and was not consolidated into financial statements lodged with ASIC (s. 292(2)(b)).

Other entities required to prepare financial statements In Australia, there are entities other than those identified above that are required to prepare financial statements under other legislative or regulatory requirements. For example: •• Entities that are registered under certain state and territory legislation (e.g. incorporated associations). •• Superannuation entities. •• Registered charities. •• Public sector entities. The reporting requirements for these other entities are not discussed in the FIN module.

Main components of financial reports in Australia Which entities are required to prepare a financial report in Australia?

What are the main components of a financial report in Australia?

What are the rules governing how a financial report is prepared?

Financial statements versus financial report As discussed above, specific entities are required to prepare a financial report. So what is the difference between financial statements and a financial report?

Financial statements A complete set of financial statements is defined in Australian Accounting Standard AASB 101 Presentation of Financial Statements (AASB 101) and the equivalent International Accounting Standard IAS 1 Presentation of Financial Statements (IAS 1). As laid out in AASB 101/IAS 1 para. 10, this generally comprises: •• Statement of financial position. •• Statement of profit or loss and other comprehensive income. •• Statement of changes in equity. •• Statement of cash flows. •• Comparative information (as specified in AASB 101 paras 38 and 38A). •• Notes, which comprise a summary of significant accounting policies and other explanatory information.

Financial report Australian entities that are registered under the Corporations Act prepare, where required, a financial report. In accordance with s. 295, the financial report comprises: •• Financial statements. •• Notes to the financial statements including disclosures required by regulations under the Corporations Act. •• Directors’ declaration. A financial report is effectively the complete set of financial statements and the directors’ declaration, and is often referred to as the ‘statutory financial report’.

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Directors’ declaration : A requirement of Corporations Act ss 295(4) and (5), a directors’ declaration is a signed statement on behalf of the board of directors that covers a number of assertions, including whether: •• There are reasonable grounds to believe that the entity will be able to pay its debts as and when they become due and payable. •• The financial statements and notes give a true and fair view of an entity’s financial position and performance, and comply with Accounting Standards. The following diagram summarises the required elements for a financial report in Australia

Financial reports in Australia Directors’ declaration

Financial statements

AASB 101/IAS 1

Corporations Act ss 295(4) and (5)

• Statement of financial position • Statement of profit or loss and other comprehensive income • Statement of changes in equity • Statement of cash flows • Notes

• Statement of solvency from the directors • Statement of compliance with Accounting Standards, and true and fair view

Required reading (Australia) Corporations Act 2001, ss 292–295. AASB 101 paras Aus1.1 and 10.

Rules governing how financial reports are prepared Which entities are required to prepare a financial report in Australia?

What are the main components of a financial report in Australia?

What are the rules governing how a financial report is prepared?

‘True and fair’ view The fundamental requirement for a financial report to give a ‘true and fair’ view of an entity’s financial position and performance is contained in the Corporations Act s. 297. In practice, this means that if, in rare circumstances, the financial report does not give a true and fair view when prepared in accordance with the applicable Accounting Standards, additional disclosures must be made to provide this (s. 295(3)(c)).

Obligation to comply with Accounting Standards Where the Corporations Act requires a financial report to be prepared, this must be done in accordance with Accounting Standards (s. 296(1)). Required reading (Australia) Corporations Act 2001, ss 296(1) and 297.

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Relief from requirements to prepare financial reports : ASIC legislative instruments – exemptions from specified financial reporting requirements ASIC has the power, in certain circumstances, to provide entities with relief from certain financial reporting requirements of the Corporations Act through legislative instruments. ASIC’s legislative instruments commonly entail extensive prerequisites for any entity that wishes to apply for relief. The following table lists some of ASIC’s commonly used legislative instruments, with a brief description of the relief they provide: Commonly used ASIC Legislative Instruments Relief 2016/784 ASIC Corporations (Audit Relief ) Instrument

2016/785 ASIC Corporations (Wholly Owned Companies) Instrument 2017/204 ASIC Corporations (Foreigncontrolled companies reports) Instrument CO 10/654 Inclusion of parent entity financial statements in financial reports

Provides relief from preparing and lodging an audited financial report for large proprietary companies, and also for small proprietary companies that are controlled by a foreign company Applies when an entity’s financial report has not been audited since 1993, is not a disclosing entity, and all its directors and shareholders have resolved to dispense with an audit, in addition to a range of strict financial conditions Wholly owned entities may be relieved from the requirement to prepare and lodge audited financial statements under Chapter 2M of the Corporations Act when they enter into deeds of cross-guarantee with their parent entity and meet certain other conditions Provides relief to small proprietary companies that are controlled by a foreign company but not part of a large group from the requirement to prepare and lodge an audited financial report Allows companies, registered schemes and disclosing entities that present consolidated financial statements to include their own parent entity financial statements as part of their full-year financial report or concise report under Chapter 2M of the Corporations Act Entities taking advantage of the relief are not required to present the summary parent entity information that is otherwise required by Corporations Regulations 2001, reg. 2M.3.01. The directors’ declaration and auditor’s report must include the relevant opinions in relation to the parent entity financial statements and related notes

ASIC regulatory guides ASIC also issues regulatory guides providing practical guidance and advice to regulated entities by explaining when and how ASIC will exercise specific powers under legislation (primarily the Corporations Act); and explaining how it interprets the law, and the principles underlying its approach. Some of the key regulatory guides applicable to financial reporting include: Key ASIC regulatory guides Regulatory guide

Title

Brief description

RG 43

Financial reports and audit relief

Explains how ASIC may exercise its powers to grant relief from the financial reporting and audit requirements of Parts 2M.2, 2M.3 and 2M.4 (other than Division 4) of the Corporations Act

RG 85

Reporting Provides guidance on the application of the reporting requirements for non- entity test, and the reporting obligations for nonreporting entities reporting entities

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Key ASIC regulatory guides Regulatory guide

Title

Brief description

RG 115

Audit relief for proprietary companies

Refers to the class order relief given under2016/784. It also indicates when ASIC will give additional relief from audit requirements to individual proprietary companies on a case-by-case basis under s. 340

RG 230

Disclosing non-IFRS financial information

Provides guidance on the use of financial information that is not presented in accordance with Accounting Standards in financial reports and other corporate documents.

RG 247

Effective disclosure in an operating and financial review

Provides guidance to listed entities and their directors on providing useful and meaningful information to share/unit holders when preparing an operating and financial review in a directors’ report

The Australian Conceptual Framework (Australian Framework) The Australian Framework largely incorporates the IASB’s Conceptual Framework, as well as some Australia-specific guidance. Unlike the IASB’s Conceptual Framework, the Australian Framework also contains guidance for not-for-profit entities. As with the IASB’s Conceptual Framework, the Australian Framework is not mandatory, but the principles underpin the AASB Standards. The Australian Conceptual Framework forms the foundation underpinning the AASB standards. Drawing on the concepts outlined in the Australian Conceptual Framework, the AASB then goes on to set new accounting standards, or amend existing ones. Where there are difficulties applying accounting standards in practice, an interpretation may be issued.

Statement of Accounting Concepts 1: Definition of the Reporting entity The reporting entity concept established in SAC 1 is currently central to financial reporting in Australia. Given that the SAC 1 definition of ‘reporting entity’ is in conflict with the definition in the IASB Conceptual Framework (2018), the AASB is currently undertaking a project to investigate potential changes both to SAC 1 and the Corporations Act 2001. The AASB is proposing to remove the current definition of ‘reporting entity’ from Australian Accounting requirements to resolve this conflict, among other things. Removing this definition would also remove the option to prepare special purpose financial statements, if entities are required to comply with Australian Accounting Standards. SAC 1 defines and explains the concept of a reporting entity. SAC 1 para. 40 states: Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect the existence of users dependent on general purpose financial reports for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources.

SAC 1 requires the use of professional judgement to determine whether an entity is a reporting or non-reporting entity. This means that the preparer of a financial report must consider the likely users and their information needs. In deciding these issues, the following factors are considered: •• The degree to which management and ownership interest is separated – for example, listed companies have many investors who are not involved in the management of the business. •• Political or economic interest – for example, financial reports of public sector bodies are of interest to the public. •• Financial characteristics – for example, very large organisations and those that employ many people are often considered to be reporting entities. Examples of reporting entities In applying SAC 1: •• some types of entities will always be reporting entities •• other types of entities will require professional judgement to determine their reporting status. At present, reporting entities in Australia must prepare a GPFR to comply with all relevant Accounting Standards.

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Reporting and non-reporting entities Reporting

Non-reporting

•• Disclosing entities

•• Some proprietary companies (e.g. wholly owned subsidiaries of Australian reporting entities)

•• Registered schemes •• Listed public companies

•• Some unlisted public companies

•• Some proprietary companies •• Some unlisted public companies •• Public sector entities

GPFR versus SPFR A GPFR is designed to meet the information needs of a wide group of users, whereas a special purpose financial report (SPFR) is tailored to meet the needs of a specific group of users. The reporting framework used in an SPFR is therefore particular to the report, and based on the information needs of its users. When preparers in Australia are choosing the type of financial report to present, the entity’s reporting entity status is an important factor to consider. If an entity is classified as a reporting entity, it must prepare a GPFR, whereas non-reporting entities can prepare a SPFR. The Corporations Act requires a financial report to provide a true and fair view of the financial position and performance of an entity and comply with Accounting Standards, but at present it does not specify what form of financial report must be prepared. There may be amendments proposed to the Corporations Act in response to the issues around the reporting entity concept in Australia.

Reporting requirements resulting from the SAC 1 classification The reporting frameworks for reporting and non-reporting entities based on a user’s information needs, both for GPFRs and SPFRs, are summarised below: Reporting entities (SAC 1)

General purpose financial report

Comply with all Accounting Standards

Non-reporting entities (SAC 1)

Special purpose financial report

Specific financial reporting is based on information needs of specified users – may or may not comply with some or all Accounting Standards

Special purpose reporting As discussed above, the ability to produce special purpose financial reports may soon be removed from the Australian financial reporting landscape. Special purpose reporting involves the reporting of information that meets the needs of specific users (e.g. a financial report prepared on a tax basis for lodgement with the taxation authority, or a financial report prepared on a cash basis for specific users). These types of reports, however, are outside the scope of this unit. The discussion in this section is focused on an SPFR that is prepared by entities under the Corporations Act. As mentioned, an SPFR is prepared based on the needs of its specified users; however, the Corporations Act requires the financial report to still present a true and fair view of an entity’s financial position and performance, and comply with Accounting Standards. The application paragraphs in certain Accounting Standards (e.g. AASB 107 Statement of Cash Flows), state that the Standards apply to all entities that prepare financial reports under Part 2M.3 of the Corporations Act (i.e. regardless of whether they are reporting entities or not).

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Despite these application paragraphs, there is some debate as to whether preparing an SPFR in compliance only with these Accounting Standards is sufficient to allow the presentation of a financial report that gives a true and fair view under the Corporations Act. To provide guidance on classifying a non-reporting entity and the financial reporting requirements, ASIC issued Regulatory Guide 85 Reporting requirements for non-reporting entities (RG 85). In this guide, ASIC states that, in its view, the recognition and measurement requirements of all accounting standards must be applied in order to determine the financial position and profit or loss of an entity reporting under the Corporations Act (RG 85 paras 2.1‑2.10). In practice, most preparers of SPFRs, if required to prepare and lodge a financial report under the Corporations Act, follow the requirements of RG 85. Further information This podcast covers the issues around applying the IASB’s Revised Conceptual Framework and solving the reporting entity and special purpose financial statement problems (commencing at 6 minutes, 30 seconds on the podcast) Stevens, T 2018, The biggest changes in years are happening now are you ready?, podcasts, 1 June, www.accountantsdaily.com.au, accessed 29 November 2018

Further reading (Australia) •• SAC 1 paras 6, 12, 19–22 and 40. •• RG 85 paras 2.1–2.10.

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Summary of annual reporting requirements (current situation at July 2019 prior to proposed amendments) The requirements for annual financial reporting in Australia are summarised in the following flowchart: Refer to any other applicable legislation or regulation for reporting requirements

NO

Is the entity within the scope of the Corporations Act 2001?

YES

Is the entity a small YES proprietary company or small company limited by guarantee?

Has the entity been directed to prepare a financial report by members or by ASIC?

NO

Not required to prepare a financial report

NO YES Checkpoint Entity should be one of the following: • Disclosing entity • Public company • Large proprietary company • Registered scheme

YES

Prepare a financial report based on the standards and interpretations to the extent directed by members or ASIC

Is the entity a reporting entity?

NO

Is the entity electing to prepare a GPFR?

In preparing SPFR, comply with the accounting standards necessary to give a true and fair view (must include AASB 101, 107, 108, 1031, 1048 and 1054). Compliance with the recognition and measurement rules of all accounting standards may also be required

NO

YES

Is the entity publicly accountable?

YES

NO

Is the entity electing to apply Tier 1 reporting requirements under the reduced disclosure regime?

YES

Prepare GPFR complying with all accounting standards

NO

Apply Tier 2 reporting requirements in preparing general purpose financial report

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NZ

New Zealand-specific Financial reporting regulatory framework in New Zealand Financial reporting in New Zealand is regulated by a combination of legal and professional pronouncements. The combination of these Acts of Parliament, professional codes and accounting standards is referred to as the New Zealand Financial Reporting Framework (the Framework). The Framework sets out the requirements for the preparation, audit, filing requirements and presentation of financial statements.

Financial Reporting Regulatory Framework (New Zealand) FMA

(Financial Markets Authority) Financial markets regulator Promotes and facilitates: Development of fair, efficient and transparent financial markets

Acts and Regulations • Companies Act 1993 • Financial Markets Conduct Act 2013 • Financial Reporting Act 2013/1993

NZX

XRB

(External Reporting Board) Establishes: Standard-setting strategies

(New Zealand Stock Exchange) Issues: • Listing Rules

Oversees: • NZASB • NZAuASB

Establish: Legislative and regulatory requirements for financial reporting by companies and specific requirements for issuers

NZASB

(New Zealand Accounting Standards Board) Issues: • NZ IFRSs (Accounting Standards) • Interpretations in accordance with XRB’s strategy

NZICA

(New Zealand Institute of Chartered Accountants) Issues: • Code of ethics • Professional Standards • Engagement Standards

NZAuASB

(New Zealand Auditing and Assurance Standards Board) Key responsibilities: • Professional and ethical standards for auditors • Auditing Standards

New Zealand Conceptual Framework Conceptual Framework for Financial Reporting

OUTPUT

NZ GAAP compliant general purpose financial reports

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Legal framework of financial reporting in New Zealand This section gives a brief overview of the legislation relating to financial reporting in New Zealand. There is a great deal of change occurring to the financial reporting framework due to the enactment of the Financial Markets Conduct Act 2013 (FMCA 2013), the Financial Reporting Act 2013 (FRA 2013) and amendments to other pieces of legislation (for example the Companies Act 1993 which were enacted through the Financial Reporting (Amendments to other Enactments) Act 2013. These Acts commenced on 1 April 2014, with a two-year period of transition. The implementation of these Acts changed the financial reporting requirements for a number of entities. The changes are based on three important underlying policy development principles, which are public accountability, economic significance and separation of ownership and management. The changes in the legislation resulted in the following: •• Removal of GPFR requirements for a number of small- to medium-sized entities. •• Captured a broader range of entities that are economically significant based on the size criteria. •• Where an entity has subsidiaries, only group financial statements are required. •• Audit requirements with opt-out/opt-in options. •• Amended the time frame for the filing or distribution of the financial statements. •• Amended the preparation, audit and filing requirements for overseas companies based on a size criteria that is smaller than those applying to domestic companies. The following table gives a brief overview of the key Acts of Parliament that underpin financial reporting. (There are many other Acts that have an impact on financial reporting, this unit will only focus on the key legislation.) FMCA 2013

This Act governs how financial products are created, promoted and sold. It also sets out the obligations for entities that offer, deal and trade in financial products The concept of ‘issuer’ from Financial Reporting Act 1993 (FRA 1993) (i.e. entity with public accountability) was replaced with the concept of ‘FMC reporting entity’, which has a wider scope. FMC reporting entities are required to prepare general purpose financial statements (GPFS), have them audited and file them with the Registrar of Companies. The applicable financial reporting obligations reside within the FMCA 2013, rather than the FRA 2013 Under the FMCA 2013, financial statements have to be filed within four months of balance date, compared to five months and 20 days under the FRA 1993

FRA 2013 and FRA 1993

FRA 1993 sets out the requirements for the preparation and content of financial statements. The new FRA 2013 replaced FRA 1993, although the two ran in conjunction for the period of transition, which ceased on 1 December 2016 The FRA 2013 is applicable for reporting periods beginning on or after 1 April 2014

Financial Reporting The purpose of this Act is to make amendments to other enactments in (Amendments to other connection with the FRA 2013 Enactments) 2013 The Act effectively details all the changes to the enabling legislation of other types of entities such as limited partnerships, companies, partnerships, building societies, charities and retirement villages Companies Act 1993 (CA 1993)

CA 1993 provides the administrative requirements (e.g. registration, formation, operation and cessation of a company) for companies and their members It sets out the responsibilities of directors, and the requirements for keeping accounting records, preparing an annual report, and appointing auditors CA 1993 has been amended as a result of FMCA 2013 and FRA 2013

Required reading (New Zealand) The Financial Markets Authority (FMA) website has a dedicated section on financial reporting for FMC reporting entities as well as FAQs for questions about transition to the FMC Act. www.fma.govt.nz → Compliance → Financial reporting – accessed April 2018.

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Regulatory framework In addition to the legal framework, the government and other agencies are also responsible for monitoring and (should breaches under the legal framework occur) disciplining entities and their members. The following parties are involved in the regulatory process: •• Financial Markets Authority (FMA). •• Registrar of Companies. •• New Zealand Stock Exchange (NZX).

Financial Markets Authority The Financial Markets Authority Act 2011 (FMAA 2011) established the FMA as an independent Crown entity, and sets out FMA’s main objective, which is to ‘promote and facilitate the development of fair, efficient, and transparent financial markets’. The FMAA 2011 also sets out FMA’s functions, which are to: •• Promote participation of businesses, investors, and consumers in the financial markets. •• Exercise its powers and duties under various financial markets and other legislation. •• Monitor compliance with, investigate, and enforce financial markets legislation. •• Monitor, inquire into and investigate matters relating to financial markets, or the activities of financial market participants or any person involved with those markets. •• Review the regulations and practices relating to financial markets and its participants. •• Cooperate with other law enforcement or regulatory agencies, including overseas regulators. In addition, the FMA also: •• Produces policies and guidance to help professionals comply with the legislation. •• Provides useful information and resources to help investors make better financial decisions. •• Issues warnings and alerts to the public.

Registrar of Companies Part 21 of CA 1993 includes a list of penalties for financial reporting offences, which could lead to fines ranging from $5,000 to $200,000 plus prison terms for more serious offences. Financial reporting offences in relation to the preparation, audit and registration of the financial statements are specified in s. 207G. If convicted of a reporting offence (e.g. failing to prepare, audit or file financial statements) a company is liable to a fine not exceeding $50,000 and each director is liable to a penalty not exceeding the same amount (s. 374(3) CA 1993).

New Zealand Stock Exchange The New Zealand Stock Exchange (NZX) also has a role in the regulation of entities listed on its exchange. This involves supervising listed entities’ compliance with the NZX Listing Rules and assisting the FMA as a co-regulator under the FMCA 2013. The New Zealand Markets Disciplinary Tribunal (NZMDT) is an independent body charged with hearing matters referred to it in relation to the conduct of parties who are regulated by NZX’s market rules. NZMDT is empowered to impose penalties on parties it determined to have engaged in conduct that breached any of the NZX rules. Disciplinary tribunal announcements are publicly available on the NZX website.

Reporting requirements for New Zealand entities To appropriately determine the financial reporting requirements and applicable standards for New Zealand entities, it is important to consider the following questions: •• Is the entity required to prepare GPFS under legislation? If not, is it opting in to prepare general purpose financial statements? •• Is it a public benefit entity (PBE) or a for-profit entity? •• Which tier of reporting will it fall under?

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We will explore each of the above questions in further detail below.

Is the entity required to prepare GPFS under legislation? Under the new legislation, the following entities will need to prepare general purposes financial statements (GPFS): FMC reporting entities An FMC reporting entity is a new term arising in the FMCA 2013. Section 451 states which entities are FMC reporting entities: (a) every person who is an issuer of a regulated product (except for those that have less than 50 shareholders or 50 parcels of shares for their voting shares (s. 452)) (b) every person who holds a licence (e.g. a fund manager) under Part 6 (c) every licensed supervisor (d) every listed issuer (e.g. companies listed on the NZX) (e) every operator of a licensed market (e.g. the NZX) (f ) every recipient of money from a conduit issuer (entities that raise funds and pass onto another entity) (g) every registered bank (these are banks registered by the Reserve Bank of New Zealand (RBNZ)) (h) every licensed insurer (these are licensed by the RBNZ) (i) every credit union (these are licensed by the RBNZ) (j) every building society (these are licensed by the RBNZ) (k) every person that is an FMC reporting entity under clause 27A of Schedule 1 (entities that have gained more than 50 shareholders through small offers under the FMCA).

As you can see the list of entities that will be required to report under the FMCA is extensive. For the purpose of your studies, the most common will be (a) and (d) – entities that have issued shares to more than 50 shareholders and listed companies on the NZX. The financial reporting requirements for FMC reporting entities are detailed in Part 7 of the FMCA 2013, which covers ss 450–461M. The key points to note are; ss 460–461, which requires financial statements (or group financial statements if relevant) to be prepared within four months of balance date; s. 461D, which requires those financial statements be audited; and s. 461H, which requires the financial statements be lodged with the Registrar of Companies. Large companies When determining the reporting requirements for a large company, the first check is to make sure it is not an FMC reporting entity as detailed above. FRA 2013 directs any entity that is an FMC reporting entity to FMCA 2013 where its financial reporting requirements are detailed (s. 56 (3) FRA 2013). An entity that is not an FMC reporting entity will prepare financial statements under FRA 2013 only if it meets the size criterion in s. 45(1) FRA 2013, which states: …an entity (other than an overseas company or a subsidiary of an overseas company) is large in respect of an accounting period if at least 1 of the following paragraphs applies: (a) as at the balance date of each of the 2 preceding accounting periods, the total assets of the entity and its subsidiaries (if any) exceed $60 million; (b) in each of the 2 preceding accounting periods, the total revenue of the entity and its subsidiaries (if any) exceeds $30 million.

Note that the size criterion is only that either revenue or total assets meets the criterion, not both. Additionally, the group financial statements of a large company are not required to be prepared if it is a subsidiary of a New Zealand incorporated entity and the group prepares GAAP group financial statements. A large company should have its financial statements audited although there are opt-out arrangements. At a meeting of shareholders, 95% of those entitled to vote must pass a resolution to opt out of the audit requirement (s. 207J CA 1993). There is no requirement for a large company to lodge its financial statements with the Registrar unless it has significant overseas ownership (25% or more). Note that the size criterion also applies to partnerships and limited partnerships, industrial and provident societies, although we do not focus on these types of entities in this unit. Page 1-26

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Overseas companies The size criterion for an overseas-owned company to determine whether it is required to prepare financial statements is smaller than for New Zealand resident companies. Section 45(2) of the FRA 2013 states:

NZ

…an overseas company or a subsidiary of an overseas company is large in respect of an accounting period if at least 1 of the following paragraphs applies: (a) as at the balance date of each of the 2 preceding accounting periods, the total assets of the entity and its subsidiaries (if any) exceed $20 million; (b) in each of the 2 preceding accounting periods, the total revenue of the entity and its subsidiaries (if any) exceeds $10 million.

If this criterion is met, s. 201 CA 1993 requires the company to prepare financial statements. These financial statements must be filed with the Registrar of Companies within five months of balance date (ss 201 and 207E CA 1993). A large overseas company is not required to have an audit of its financial statements or group financial statements if its New Zealand business is not large, and under the law in force in the country where the overseas company is incorporated or constituted, the qualifying financial statements are required to be prepared, but are not required to be audited (s. 206(3) CA 1993). Other reporting entities The following entities must also prepare financial statements: •• Retirement villages (but only if publicly listed). •• Registered charities. •• Large friendly societies with $30 million or more in total expenditure. •• Maori incorporations. •• Public sector PBEs.

Opt-in and opt-out provisions CA 1993 provides opt-in and opt-out provisions. These permit shareholders to determine whether a company should opt in or out of compliance with CA 1993. The key points are: •• Companies with 10 or more shareholders can opt out of preparing financial statements, audit requirements and annual report by a 95% majority vote. Large companies cannot take advantage of this provision (s. 207I CA 1993). •• Large companies can opt out of the audit requirements only by a 95% majority vote (s. 207J CA 1993). •• Companies with fewer than 10 shareholders can opt in to preparing financial statements, audit requirements and annual report by written notice from shareholders of at least 5% of voting shares (s. 207K CA 1993). Below is a summary of the financial reporting, audit and filing requirements for companies in New Zealand. Category

Prepare GPFS

Audit requirement

Filing requirement

FMC reporting entities





Within four months of balance date

Large overseas companies/overseas owned companies





Within five months of balance date

Large companies





Only if it is more than 25% overseas owned

Companies with 10 or more shareholders

 

 

2

No1

3

No

Companies with fewer than 10 shareholders and chose to opt in to GPFS

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1

2

2

3

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Notes 1 Can be excused from the audit requirement if s. 206(3) CA 1993 applies. 2 Can opt out by resolution approved by not less than 95% of the votes of shareholders entitled to vote and voting on the question. 3 Can opt in by written notice from shareholders who together hold not less than 5% of the voting shares.

The financial reporting requirements of entities other than companies are outside the scope of the FIN module.

Interrelationship between international and national requirements Learning outcome 3. Explain the interaction between the national and international financial reporting regulatory frameworks including the relationship with their respective Accounting Standards.

International and national frameworks – interaction and key differences As discussed earlier, some countries largely draw on the International Financial Reporting Standard regulatory framework, while other nations have their own, long-established frameworks for financial reporting. The similarities between the international and national frameworks are evidenced by the relationship between the IFRS and national standards. Differences in the frameworks, or their application, may arise due to a national framework involving additional statutory bodies and/ or legislation establishing the rules and regulations for financial report preparation. Conversely, aspects of a country’s regulatory framework may appear to follow the international framework, yet differences may still arise for various reasons.

AU

Australia-specific Some of the main sources of differences between the International and Australian regulatory frameworks for financial reporting are as follows: 1. The Reporting entity concept in Australia’s SAC 1 was needed, owing to the prior lack of a definition at international level. 2. ’Au’ requirements inserted into IFRS-equivalent standards (also known as jurisdiction-specific requirements, usually related to Australia’s commitment to sector-neutral standards). 3. Australian standards with no international equivalent. 4. Differential reporting requirements from SAC 1 and the Corporations Act. 5. The non-adoption of IFRS for SMEs in Australia and the use of the RDR.

The Conceptual Framework and the reporting entity concept The Australian Conceptual Framework is a slightly modified version of the IASB’s Conceptual Framework. One of the major differences between the IASB’s Conceptual Framework and the Australian Framework is the view on the reporting entity. Given this concept decides who prepares GPFRs in Australia, this is a significant difference. As we can see from the table below, the two definitions have quite a different emphasis, that is, the Australian definition is focused on the users, while the IASB definition is focused on the actual choices of the entity in relation to financial reporting.

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Australian definition, per SAC 1

The new IASB definition, as per the IASB Conceptual Framework 2018

Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect the existence of users dependent on general purpose financial reports for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources

A reporting entity is an entity that chooses, or is required, to prepare general purpose financial statements

AU

A reporting entity is not necessarily a legal entity. It can comprise a portion of an entity, or two or more entities

As the IASB has now issued its Conceptual Framework, the Australian reporting requirements will need to change to ensure compliance with IFRS.

Australia-specific paragraphs For a variety of reasons there may be Australian clauses included within an AASB Standard (indicated by the paragraph prefix ‘Aus’ within the Standard) that are not included in the IFRS. Most of these Australian clauses are due to either specific requirements applying to NFP entities, or Australia-specific issues. Where such clauses have been inserted, the AASB includes an explanation of any divergences from the IFRS version of the Accounting Standard at the beginning of each standard. Australia aims to issue sector-neutral standards, that is, the same transaction will be treated in the same way by different sectors. The IASB does not take this approach as IFRSs are designed to apply to the reporting of for-profit entities. Internationally, NFP or public sector standards are issued by different international standard-setting bodies. This is a key source of difference between AASB standards and IFRS. Other differences may relate to Australia-specific issues. For example, AASB 124 Related Party Disclosures requires disclosure of the name of the ultimate controlling entity incorporated within Australia (AASB 124 para. Aus13.1). The AASB adopts the practice of inserting NFP-specific paragraphs within each Standard. It also inserts Australia-specific clauses in the application paragraphs when adopting an IFRS, making that Standard applicable to NFP entities that: •• prepare financial reports in accordance with Part 2M.3 of the Corporations Act •• as reporting entities, prepare a GPFR •• prepare financial statements that are held out to be GPFRs. Note that an NFP entity is consistently defined in several Accounting Standards, including in AASB 102 Inventories, as one ‘whose principal objective is not the generation of profit’ (AASB 102 para. Aus6.1).

Australian standards with no international equivalent There are also AASB standards for which there is no international equivalent. These include: •• AASB 1004 Contributions (a NFP-specific standard). •• AASB 1039 Concise Financial Reports. •• AASB 1048 Interpretation of Standards. •• AASB 1052 Disaggregated Disclosures. •• AASB 1053 Application of Tiers of Australian Accounting Standards. •• AASB 1054 Australian Additional Disclosures. •• AASB 1057 Application of Australian Accounting Standards. •• AASB 1058 Income of Not-For-Profit Entities •• AASB 1059 Service Concession Arrangements: Grantors

Differential financial reporting Differential reporting is the different reporting and disclosure requirements for different tiers of entities. In Australia, these differences may arise as a result of the reporting entity concept (as per SAC 1) and some provisions of the Corporations Act, as follows:

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•• The reporting entity concept (application of SAC 1). As discussed earlier in this unit, SAC 1 prescribes the classification of entities as reporting entities where it is reasonable to expect the existence of users dependent on GPFRs for information. Such entities are required to prepare their GPFRs in accordance with full IFRS as adopted in Australia. •• The Corporations Act prescribes differential reporting requirements on entities based on: –– classification (as public or proprietary, disclosing or non-disclosing entities) –– size (as a large or small proprietary company). As a result of the current differential reporting requirements, there are a large number of entities in Australia that are required to apply full IFRSs as adopted in Australia, but find the associated disclosures as adopted in Australia burdensome. Because of this differential reporting framework, the AASB decided not to adopt IFRS for SMEs. Instead, Australia uses AASB 1053 Application of Tiers of Australian Accounting Standards to apply two tiers of reporting, whereby Tier 2 entities may reduce their disclosures via the RDR. These tiers of reporting are likely to change with the proposed AASB amendments. AASB 1053 identifies two tiers of GPFR reporting requirements, as follows: AASB 1053 tiers of reporting Tier

Includes

Reporting requirements

1

•• For-profit private sector entities that have public accountability

These entities are required to prepare GPFRs using the full set of IFRSs as adopted in Australia

•• Australian government and state, territory and local governments 2

•• For-profit private sector entities that do not have public accountability •• Not-for-profit private sector entities •• Public sector entities, whether for-profit or not-for-profit, other than the Australian government and state, territory and local governments

Entities in Tier 2 have the option of: •• Preparing their GPFRs in accordance with the full set of IFRSs as adopted in Australia OR •• Complying with AASB 1053, which requires compliance with the recognition and measurement elements of AASBs but allows substantially reduced disclosures

Public accountability as defined in AASB 1053 It is important to understand the term ’public accountability’ when applying the tiers of financial reporting under AASB 1053. Public accountability means accountability to those existing and potential resource providers and others external to the entity that make economic decisions but are not in a position to demand reports tailored to meet their particular information needs. A for-profit private sector entity has public accountability if: (a) its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market, or (b) it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks (AASB 1053 Appendix A). Commonwealth, state and territory governments and local governments are deemed to have public accountability, and the appropriate regulator would be able to declare any other public sector entity to be publicly accountable. As part of the introduction of the RDR, the AASB issued a number of Standards to make amendments to many of the AASB Standards and Interpretations.

Consequences of adopting the RDR •• When an entity applies Tier 2 RDR, the entity has prepared a GPFR. •• To transition from full IFRS as adopted in Australia to adopting the RDR, an entity merely omits the disclosures that are now optional for non-publicly accountable reporting entities.

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•• Because this is an Australian-specific Standard, the entity applying the RDR to its financial report cannot claim compliance with IFRS. This can be an issue where the report is presented to an overseas audience.

AU

•• The entity applying the RDR will be complying with all IFRS recognition and measurement requirements, but not with all of the disclosure requirements. •• Where an entity using the RDR wishes to move to full IFRSs as adopted in Australia in the future, it will need to apply AASB 1 First-time Adoption of Australian Accounting Standards on transition because it is unable to make an ‘explicit and unreserved statement of such compliance [with IFRS] in the notes’ (AASB 101 Presentation of Financial Statements, para. 16) as only some disclosures were presented in financial statements in previous reporting periods. Accessing RDR versions of AASB Standards and Interpretations The RDR versions apply only when AASB 1053 is being applied. The disclosure requirements that eligible entities are not required to comply with are clearly identified within each Standard as shaded text. Model illustrative RDR financial statements are prepared by some of the large accounting firms and these can be found on their websites. Further reading (Australia) AASB 1053 Application of Tiers of Australian Accounting Standards. Deloitte, Reduced Disclosure Regime (RDR) Model Financial Statements, accessed 27 April 2018, www.deloitte.com.au → Services → Audit & Assurance → Accounting Technical → Illustrative financial reports.

NZ

New Zealand-specific The External Reporting Board The External Reporting Board (XRB) is the standard-setter in New Zealand. It is an independent Crown entity established on 1 July 2011 under s. 22 FRA 1993 (now seen in s. 11 FRA 2013). The XRB’s functions are as follows: •• Developing and implementing an overall strategy for Financial Reporting Standards and Auditing and Assurance Standards (including developing and implementing tiers of financial reporting and assurance). •• Preparing and issuing Accounting Standards. •• Preparing and issuing Auditing and Assurance Standards, including the professional and ethical standards that will govern the professional conduct of auditors. •• Liaising with national and international organisations that exercise functions that correspond with, or are similar to, those conferred on the XRB.

New Zealand generally accepted accounting practice (NZ GAAP) There have been significant changes in the Accounting Standards framework subsequent to its initial release in April 2012. The changes have been implemented progressively from 2012 to 2016. The new framework is based on a multi-sector, multi-tier reporting approach. Under the new framework: •• For-profit entities will report under Financial Reporting Standards that are different to those for public sector and not-for-profit entities. •• For-profit entities that are required to prepare GPFS will report using for-profit Accounting Standards based on NZ IFRS. If there is no such statutory obligation, then it can prepare special purpose financial statements (SPFS) for their users (e.g. Inland Revenue or its bank). •• Public benefit entities (PBEs) will use PBE Accounting Standards based on International Public Sector Accounting Standards (IPSAS) and are separated between public sector PBEs and not-for-profit public benefit entities (NFP PBEs) entities.

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XRB A1 Accounting Standards Framework In previous sections, we have identified who should prepare GPFS. This section deals with the accounting standards framework under which GPFS should be prepared. XRB A1 Accounting Standards Framework provides the criteria for determining under which tier of reporting an entity falls. In December 2015 the XRB issued a final version of XRB A1 which is effective from 1 January 2016 , which has had minor amendments made during 2017 which apply to reporting periods beginning on or after 1 January 2018. At time of writing, the most recent version on the website is signalled by the notation ‘Date compiled to: 20 December 2017’. All previous versions of XRB A1 are also available on the XRB website.

Difference between public benefit and for-profit entities It is important to understand the distinction between PBEs and for-profit entities, as the accounting standards framework is different for these two types of entities. For-profit entities report under for-profit accounting standards, whereas public benefit entities report in accordance with PBE accounting standards. Paragraph 6 of XRB A1 defines PBEs as ‘reporting entities whose primary objective is to provide goods or services for community or social benefit and where any equity has been provided with a view to supporting that primary objective rather than for a financial return to equity holders’. It also defines for-profit entities as ‘reporting entities that are not public benefit entities’. Therefore, the test is to determine first whether or not the reporting entity meets the criteria to be a public benefit entity. If it doesn’t, then it is a for-profit entity.

Determining the appropriate tier for for-profit entities The flowchart below can assist preparers to determine which tier of reporting a for-profit entity that is preparing general purpose financial reports must report under: For-Profit Entity

Public Accountability? (as defined)

Yes

Tier 1

Use

NZ IFRS

No

Large Public Sector Entity?

Yes

No

Elect to be in Tier 1 anyway?

Yes

No

Tier 2

Use

NZ IFRS RDR

Source: Modified from XRB website, 1 February 2017 (no longer available).

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Below is a summary of the criteria for each tier of reporting for for-profit entities: Tier of reporting

Criteria

Accounting standards framework

Tier 1

•• Public accountability, or

NZ IFRS

NZ

•• Large for-profit public sector entity (large is defined as total expenses > $30 million) •• No public accountability, and

Tier 2

NZ IFRS RDR

•• Not a large for-profit public sector entity

It is worth noting that an entity sits in Tier 1 unless it elects to report in accordance with Tier 2, provided that it meets the criteria to be able to report under the lower tier. Required reading (New Zealand) Companies Act 1993, Sections 200-205, 207E-207L, 208, 211. Financial Markets Conduct Act 2013, Part 7. Financial Reporting Act 2013, Sections 45, 47, 56.

Determining the appropriate tier for not-for-profit public benefit entities Below is the flowcharts for NFP PBEs, applicable for accounting periods beginning on or after 1 April 2015: NFP PBE

Public Accountability? (as defined)

Yes

Tier 1

Use

PBE Standard

Use

PBE SFR C (NFP)

Use

PBE SFR A (NFP)

No

Large Entity?

Yes

No

Decide to be in Tier 1 anyway?

Yes

No

Meet criteria for Tier 4?

No

Meet criteria for Tier 3?

No

Yes

Elect to be in Tier 4?

Yes

Elect to be in Tier 3?

Yes

Tier 4

No

Yes

Tier 3

No

Tier 2

Use

PBE Standards RDR

Source: Modified from XRB website, 1 February 2017 (no longer available). Core content – Unit 1

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Below is a summary of the criteria for each tier of reporting for NFP entities: Tier of reporting

Criteria

Accounting Standards framework

Tier 1

•• Public accountability, or

PBE Standards

•• Large entity (large is defined as total expenses > $30 million) Tier 2

•• No public accountability, and

PBE Standards – RDR

•• The entity is not large as defined above Tier 3

•• No public accountability, and

PBE SFR-A*

•• Has total expenses of less than, or equal to, $2 million Tier 4

•• Entity is permitted by an Act to report in accordance with non-GAAP Standards (i.e. cash basis of accounting) because it has no public accountability and does not meet the size threshold to be a ‘specified not-for-profit entity’**

PBE SFR -C****

Notes * Public Benefit Entity Simple Format Reporting Standard – Accrual. ** If in each of the two preceding accounting periods, total operating payments are less than $125,000 (s. 46 FRA 2013). *** Public Benefit Entity Simple Format Reporting Standard – Cash.

The flowcharts for NFP PBEs and public sector PBEs are identical and both apply PBE accounting standards. However, there are differences between the public sector PBE accounting standards and NFP PBE accounting standards, denoted by ‘PS’ for public sector and ‘NFP’ for the not-forprofit sector. In addition, the public sector PBE accounting standards are applicable for reporting periods beginning on or after 1 July 2014, whereas the NFP PBE accounting standards are applicable for reporting periods beginning on or after 1 April 2015.

Defining public accountability To establish whether an entity sits in Tier 1, one key definition to satisfy is that of public accountability. An entity has public accountability if: (a) its debt or equity instruments are traded in a public market, or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets), or (b) it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This is typically the case for banks, credit unions, insurance providers, securities brokers/dealers, mutual funds and investment banks. An entity is deemed to be publicly accountable in the New Zealand context if: (a) it is an FMC reporting entity or a class of FMC reporting entities that is considered to have a ‘higher level of public accountability’ than other FMC reporting entities under section 461K of the Financial Markets Conduct Act 2013, or (b) it is an FMC reporting entity or a class of FMC reporting entities that is considered to have a ‘higher level of public accountability’ by a notice issued by the FMA under section 461L(1)(a) of the FMC 2013. Further reading (New Zealand) •• XRB A1 Accounting Standards Framework. •• XRB website – for information on the tiers of reporting and the financial reporting framework. There is a specifically useful section ‘Know your standard’ (www.xrb.govt.nz → Know your Standard), which is helpful in ascertaining which standards to apply. •• EY Financial Reporting Guide – An overview of the New Zealand Financial Reporting Framework (January 2017) – www.ey.com/NZ/en/issues/ifrs → Financial Reporting tools for For-Profit entities → EY Publications → Financial Reporting Guide an overview of the New Zealand financial reporting framework (December 2017), accessed 27 November 2018.

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Main components of financial reports in New Zealand Financial statements Under NZ IAS 1 Presentation of Financial Statements (NZ IAS 1) para. 10, a complete set of financial statements comprises of: •• Statement of financial position. •• Statement of profit or loss and other comprehensive income (also known simply as statement of comprehensive income). •• Statement of changes in equity. •• Statement of cash flows. •• Notes, comprising a summary of significant accounting policies and other explanatory information. •• Comparative information in respect of the preceding period.

Annual reports The contents of the annual report are detailed in s. 211 CA 1993. According to s. 211, the annual report should: •• Describe the company’s state of affairs and any change in the nature or class of its business. •• Disclose any entries in the interest register for the accounting period. •• Disclose the total remuneration and other benefits of the directors for the accounting period. •• Disclose the number of employees who, during the period, received remuneration and other benefits exceeding $100,000, and state the number of such employees or former employees in brackets of $10,000. •• Disclose the total amount of donations made by the company for the period. •• Disclose the names of the directors of the company at the end of the period, as well as the names of any directors who ceased to hold office during the period. •• Disclose separately the amount payable to the auditor of the company for audit fees and other services. •• Be signed on behalf of the board by two directors of the company or, if the company has only one director, by that director. •• Include financial statements, or group financial statements, for the accounting period that are prepared in accordance with Part 11 of the CA 1993 or Part 7 of the FMCA 2013 or any other enactment (if any). •• Include the auditor’s report if required. While the requirements of CA 1993 in relation to the annual report seem large, note that s. 211(3) states that if 95% of the shareholders agree, the first seven items on the above list are not required to be disclosed. If this was the case, then only the financial statements, audit report and signing of the financial statements are required. In practice, many smaller companies take advantage of this exemption from all the disclosure requirements. However, many large listed companies prepare annual reports that include a detailed analysis and commentary on the performance of the business over the accounting period, as well as the annual financial statements.

Other standards and guidance relating to financial reporting There are other New Zealand Financial Reporting Standards (FRS) and guidance that may be relevant to the preparation of financial information, depending on the entity or circumstances of the report. These are: •• FRS-42 Prospective Financial Statements (FRS-42). •• FRS-43 Summary Financial Statements (FRS-43). •• FRS-44 New Zealand Additional Disclosures (FRS-44).

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FRS-44 sets out the additional New Zealand specific disclosure requirements for for-profit entities applying NZ IFRS. The disclosure requirements relate to compliance with NZ IFRS, the applicable financial reporting standards, the reporting framework, disclosure around audit fees, imputation credits, and reconciliation of net operating cash flows to profit (loss), prospective financial statements and the statement of service performance.

Compliance with NZ GAAP FRA 2013 s. 9 states that the financial statements of a reporting entity must comply with NZ GAAP if any Act that applies to an entity provides that the financial statements must comply, or be prepared, in accordance with GAAP. As per s. 8 FRA 2013, NZ GAAP means that financial statements must comply with: (a) applicable financial reporting standards, and (b) in relation to matters for which no provision is made in applicable financial reporting standards, an authoritative notice.

True and fair view It is implicit that if financial statements are prepared under NZ GAAP, they will show a true and fair view of the financial performance and position of an entity. The legislative requirements for financial statements to give a true and fair view have been removed. Instead, the requirements in applicable financial reporting standards (e.g. NZ IAS 1) apply. In the previous FRA 1993, if compliance with NZ GAAP resulted in financial statements that did not present a true and fair view, the directors of the reporting entity added such information and explanations as to give a true and fair view of the matters. Under FRA 1993, entities were not permitted to depart from accounting standards; however, under FRA 2013, entities can now do so only if complying with the Standards would be so misleading as to conflict with the objective of financial statements (para. 19 NZ IAS 1). Such situations are expected to be extremely rare in practice.

Special purpose financial statements As discussed earlier, certain entities (e.g. FMC reporting entities) are required to prepare GPFS in accordance with legislation, and that such financial statements must comply with NZ GAAP. Special purpose financial statements (SPFS) are those other than GPFS, and are tailored to the needs of specific users. The reporting framework used in SPFS is therefore determined separately for each set of SPFS based on the information needs of users. SPFS do not have to comply with NZ GAAP; rather, they specify the accounting policies according to which they have been prepared. Examples of SPFS would include those that have been prepared for an entity that is not a reporting entity, but wishes to provide some financial information to its shareholders, and those for which shareholders are able to specify what information they would like to receive. Another example would be larger entities that prepare specified financial information for banks and other finance providers (which is sometimes done for certain companies within a group). For such cases, reports may be prepared on a special purpose basis for specific users in addition to the annual financial statements that are prepared for shareholders. As discussed earlier, many small- to medium-sized companies in New Zealand no longer have to prepare GPFS, provided that they meet certain criteria. However, they still need to prepare SPFS that meet the need of other users (e.g. Inland Revenue minimum requirements), as part of the amendments to the Tax Administration Act 1994. Chartered Accountants Australia and New Zealand (through one of its predecessors, New Zealand Institute of Chartered Accountants) recognised that the Inland Revenue minimum requirements may not provide all the necessary information that other potential users may need, especially the larger medium-sized entities. Therefore, it has developed an optional special purpose financial reporting framework, called Special Purpose Financial Reporting Framework for For-Profit Entities, to provide guidance on the preparation of SPFS.

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Small- and medium-sized entity reporting International Since IFRS were adopted in New Zealand and many other countries, it has been debated whether the requirements are too onerous for small- and medium-sized entities (SMEs) that are required to prepare GPFS. In response to these concerns, the IASB issued a new Standard, IFRS for SMEs, in July 2009. IFRS for SMEs is an Accounting Standard that a country can apply to entities that do not need to apply the full set of IFRS. It is a large Standard, covering all financial reporting topics. It contains significantly reduced disclosure requirements (in comparison to the full IFRS), as well as some modifications to the recognition and measurement requirements.

New Zealand In New Zealand, IFRS for SMEs was not adopted, as there was already a differential reporting regime for smaller entities in place. Differential reporting and Old GAAP were withdrawn from use from the period that begins on or after 1 April 2015 (i.e. 31 March 2016 balance dates). Under the new tier structure, entities with public accountability are required to prepare financial statements using NZ IFRS or PBE Standards (if they are PBEs). Companies that do not have public accountability can apply the RDR, unless they meet the ‘small’ criterion. This means that small forprofit entities do not need to prepare GPFSs, and PBEs can use a simpler method of preparation.

Reduced disclosure regime The RDR was implemented in New Zealand as part of the new tier structure and offers reduced disclosure requirements that are harmonised with those in Australia. RDR applies the same recognition and measurement requirements as previously in NZ IFRS, but allows disclosure concessions. Rather than issuing a new set of RDR financial reporting standards, the XRB has amended the existing standards by including an asterisk (*) to paragraphs that RDR entities do not have to comply with. In place of these exempted disclosures, additional New Zealand-specific paragraphs with the prefix ‘RDR’ have been entered into the standard where necessary.

Interim financial reporting Entities listed on the NZX are required to produce interim financial reports in accordance with the NZSX/NZDX Listing Rules (Listing Rules). Appendix 1 of the Listing Rules specifies the information that must be contained in the interim reports, including: •• Details of the reporting period and the previous corresponding period. •• Statement of financial performance. •• Statement of financial position (may be condensed). •• Statement of cash flows (may be condensed). •• Other relevant information, such as dividends, purchase or sale of subsidiaries, net tangible assets per security, details of associates, and joint ventures. Half-year reports must be prepared in accordance with applicable financial reporting Standards, and disclosure of critical accounting policies/changes in accounting policies. Interim reports are prepared in accordance with NZ IAS 34 Interim Financial Reporting.

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Ethical requirements in preparing financial reports Learning outcome 4. Explain a Chartered Accountant’s ethical requirements relating to financial reporting. The preparation of financial information often involves the exercise of professional judgement; for example, in assessing the useful life of an asset or determining a provision. An accountant will face choices when preparing financial statements and will need to use their professional judgement to determine the outcome. When using their professional judgement it is important that the accountant understands their ethical obligations and the need to comply with those ethical obligations.

Ethical requirements The accounting profession is self-regulated by a code of ethics that governs professional behaviour. The ethical principles and guidelines are set out in the International Code of Ethics for Professional Accountants including International Independence Standards (the IESBA Code), issued by the International Ethics Standards Board of Accountants (IESBA). A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest. Therefore, a professional accountant’s responsibility is not exclusively to satisfy the needs of an individual client or employer. In acting in the public interest, a professional accountant shall observe and comply with this code. IESBA Code, s. 100.1 A1

A new version of the Code was issued by the IESBA in April 2018, which applies from 1 July 2019. IESBA Code of ethics R110.2 Professional accountants shall comply with each of the fundamental principles

Integrity

Objectivity

Confidentiality

R120.3 Apply the conceptual framework (ie s.120 IESBA code)

Identify threats R120.6 Self-interest Self-review Advocacy Familiarity Intimidation

Evaluate threats R120.7

Professional competence and due care

R120.5 When applying the conceptual framework, the professional accountant shall: (a) Exercise professional judgement (b) Remain alert for new information and to changes in facts and circumstances (c) Use the reasonable and informed third party test described in paragraph 120.5A4.

Address threats R120.10 Eliminate circumstances Apply safeguards Decline/end activity NOCLAR s.260/s.360 creates a self interest or intimidation threat to compliance with principles of integrity and professional behaviour Duty to comply

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Professional behaviour

Alert mgt/ those in governance

Take further action in public interest

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IESBA Code The IESBA Code sets out the ethics requirements for professional accountants. The IESBA Code is structured into three parts: •• Part 1 – Complying with the Code, Fundamental Principles and Conceptual Framework. •• Part 2 – Professional Accountants in Business. •• Part 3 – Professional Accountants in Public Practice. Part 1 establishes the fundamental principles and provides a conceptual framework that can be applied to: •• identify threats to independence •• evaluate the significance of the threats identified •• apply safeguards (when necessary) to eliminate or reduce the threats to an acceptable level. Parts 2 and 3 describe how the conceptual framework applies in specific circumstances. They provide examples of safeguards that may appropriately address threats to compliance with the fundamental principles. Where no safeguard is available in a particular circumstance, the threat must be avoided altogether. It is important to note that accountants are expected to be guided by both the words and the spirit of the IESBA Code, using the conceptual framework. While all sections of the IESBA Code are equally important, this unit focuses on Part 1, sections 110 and 120; Part 2 sections 200 and 260; Part 3 sections 300 and 360.

Fundamental principles The IESBA Code lists its five fundamental principles in para. 110.1 A1, as outlined below: IESBA Code – fundamental principles Paragraph

Principle

Definition

110.1 A1(a) R111.1

Integrity

To be straightforward and honest in all professional and business relationships

110.1 A1(b) R112.1

Objectivity

Not to compromise professional or business judgments because of bias, conflict of interest or undue influence of others

110.1 A1(c) R113.1

Professional competence and due care

(i) Attain and maintain professional knowledge and skill at the level required to ensure that a client or employing organization receives competent professional service, based on current technical and professional standards and relevant legislation; and (ii) Act diligently and in accordance with applicable technical and professional standards

110.1 A1(d) R114.1

Confidentiality

To respect the confidentiality of information acquired as a result of professional and business relationships

110.1 A1(e) R115.1

Professional behaviour

To comply with relevant laws and regulations and avoid any conduct that the professional accountant knows or should know might discredit the profession

Each of these principles is discussed in more detail in Section 110 subsections 111-115 of the IESBA Code.

Threats and safeguards An accountant experience a wide range of relationships and circumstances, some of which may create a threat to their compliance, or perceived compliance, with the fundamental principles. Paragraph R120.6 of the IESBA Code requires the accountant to identify threats to compliance with the fundamental principles:

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IESBA Code – threats to fundamental principles Paragraph

Threat

Definition

Example

120.6 A3(a)

Self-interest

The threat that a financial or other •• A financial accountant within an interest will inappropriately influence organisation with a bonus based on the professional accountant’s judgment accounting profit or behaviour •• Other ‘at risk’ compensation affected by financial reporting choices

120.6 A3(b)

Self-review

The threat that a professional accountant •• Reporting on systems where will not appropriately evaluate the the professional accountant has results of a previous judgment made; or been involved in their design or an activity performed by the accountant, implementation or by another individual within the accountant’s firm or employing organization, on which the accountant will rely when forming a judgment as part of performing a current activity

120.6 A3(c)

Advocacy

The threat that a professional accountant will promote a client’s or employing organization’s position to the point that the accountant’s objectivity is compromised

•• Pressure from within an entity to make reporting choices to manage earnings or EPS •• Acting as an advocate on behalf of your employer in resolving disputes with third parties

120.6 A3(d)

Familiarity

The threat that due to a long or close relationship with a client, or employing organization, a professional accountant will be too sympathetic to their interests or too accepting of their work

•• Accepting preferential treatment with suppliers or customers unless the value is clearly insignificant

120.6 A3(e)

Intimidation

The threat that a professional accountant will be deterred from acting objectively because of actual or perceived pressures, including attempts to exercise undue influence over the accountant

•• Being threatened with dismissal unless particular financial reporting outcomes are achieved •• Being threatened with litigation •• Being pressured to reduce the extent of work required in order to reduce fees

‘Safeguards’ are actions or other measures that may eliminate threats or reduce them to an acceptable level. There are two broad categories of safeguards: •• Those created by the profession, legislation or regulation – for example, professional Standards, professional or regulatory monitoring, and disciplinary procedures. •• Those created in the workplace – for example, documented internal policies or a firm’s quality control policies and procedures. Required reading IESBA Code Section 110, ss 111-115, sections 120, 200, 260, 300 and 360. Further reading IESBA Code remaining sections.

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AU

Australia-specific Australian ethical requirements The Accounting Professional and Ethical Standards Board (APESB) issues standards that outline the professional conduct required by members of the professional accounting bodies. Compliance with these standards is mandatory for all Australian Chartered Accountants. Three key requirements of the standards are relevant to financial reporting: 1. APES 110 Code of Ethics for Professional Accountants (including Independence Standards). This replicates the fundamental ethical principles contained within the IESBA Code. 2. APES 205 Conformity with Accounting Standards. This Australian-specific professional standard imposes obligations on members to follow accounting standards when they prepare, present, audit, review or compile financial statements which are either GPFR or an SPFR. 3. APES 315 Compilation of Financial Information. This Australian-specific professional standard is applicable to members in public practice who compile financial information. Financial information includes financial statements. The standard sets out the format of reports that a member must issue to accompany a GPFR or SPFR that the member has compiled at the request of the client. Should an Australian Chartered Accountant be disciplined for failure to comply with an ethical principle/principles, such a breach is taken by Chartered Accountants Australia and New Zealand (Chartered Accountants ANZ) as a breach of APES 110 rather than the IESBA Code. Required reading (Australia) Code of Ethics for Professional Accountants (2018): Guide, scope and Part 1. APES 205 paras 5.1–5.6. Further reading (Australia) APES 110, Remaining sections. APES 205, remaining paragraphs. APES 315.

New Zealand-specific The IESBA has been ’trickled down’ into New Zealand via the Professional Engagement Standards and Code of Ethics that was issued by NZICA.

NZ

New Zealand ethical requirements New Zealand Institute of Chartered Accountants The New Zealand Institute of Chartered Accountants (NZICA) entity retains a duty to control and regulate the practice of the profession of accountancy by its members in New Zealand and it cannot delegate that duty (in whole or in part) to any person under the NZICA Act 1996. This governing body takes the form of the New Zealand Regulatory Board under the Chartered Accountants Australia and New Zealand governance model. The New Zealand Regulatory Board: •• prescribes the Code of Ethics •• appoints, authorises delegations for oversees and directs the permanent bodies specified in the NZICA Rules, and •• carries out any other functions or responsibilities that are conferred by the Act, any other enactment, the NZICA Rules or the Chartered Accountants Australia and New Zealand By-Laws. The New Zealand Regulatory Board reports to the Chartered Accountants Australia and New Zealand Board. Core content – Unit 1

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The NZICA Code of Ethics is binding on all New Zealand members, and mandates the professional and ethical expectations of members. Under the NZICA Code of Ethics, all New Zealand members shall comply with the following fundamental principles: •• Integrity: be straightforward and honest in all professional and business relationships. •• Objectivity: to not allow bias, conflict of interest or undue influence of others to override professional or business judgements. •• Professional competence and due care: maintain professional knowledge at the level required to ensure that a client receives competent professional services. •• Confidentiality: to respect the confidentiality of information acquired as a result of professional and business relationships. •• Professional behaviour: to comply with relevant laws and regulations, and avoid any action that discredits the member’s profession. NZICA can investigate complaints against New Zealand members. If the complaint is found to be valid, the member may be cautioned, suspended from membership for a period of time, or removed from the register of members. They may also be fined.

The External Reporting Board (XRB) The New Zealand Audit and Assurance Standards Board (NZ AuASB), a sub-board of the XRB, also sets professional and ethical standards that apply to all assurance providers adopting the XRB Auditing and Assurance Standards. Required reading (New Zealand) NZICA Code of Ethics (2018) effective 15 June 2019: Preface, Scope and Part 1. Further reading (New Zealand) NZICA Code of Ethics (2018) effective 15 June 2019: Remaining sections.

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Non-compliance with laws and regulations (NOCLAR) The IESBA Code has been revised recently to address accountants’ responsibility in relation to non-compliance with laws and regulations (NOCLAR). The revised IESBA Code sets out a framework for professional accountants to respond to identified or suspected non-compliance with laws and regulations. The IESBA Code has always required professional accountants to act in public interest; however, when breaches of laws and regulations have been identified there has been a conflict with the accountant’s duty of confidentiality. The revisions to the IESBA Code set out how accountants may, in certain cases, disclose non-compliance to appropriate authorities without breaching client confidentiality. These revisions will allow professional accountants to play a greater role in combating fraud, money laundering and corruption. NOCLAR is a new ethical Standard effective from July 2017 that sets the framework for auditors and other accountants on how to act in the public interest when they become aware of noncompliance or suspected non-compliance with laws and regulations. The NOCLAR Standard is incorporated in s. 360 (Professional Accountants in Public Practice) and 260 (Professional Accountants in Business) of the new IESBA Code. NOCLAR also impacts on other sections of the IESBA Code. NOCLAR is defined as any act of omission or commission (intentional or unintentional) committed by a client that is contrary to the prevailing laws or regulations. It is an act that causes substantial harm and involves serious adverse consequences to investors, creditors, employees or the general public in either financial or non-financial terms; for example, committing financial fraud resulting in significant losses to investors.

Financial products & services

Public health & safety Proceeds of crime Banking securities markets trading

corruption

Tax & pension liabilities data

fraud

protection bribery Environmental protection Money laundering Terrorist financing Data protection

NOCLAR Required reading ‘Responding to Non-compliance with Laws and Regulations’, www.ifac.org → Publications → responding to NOCLAR, accessed 30 April 2018.

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Contemporary financial reporting issues Learning outcome 5. Explain contemporary issues affecting financial reporting. There are a number of important developments relevant to broad financial reporting issues.

International level Important contemporary financial reporting issues at the international level are outlined below.

Better communication in financial reporting – making disclosures more meaningful In the face of increasing complexity in financial reports, there has been a significant movement to improve the relevance of financial information and how it is communicated. The IASB’s participation has been to undertake a series of implementation projects and research projects focused on disclosures. The current research projects and exposures are focused on the following: •• Primary financial statements. The IASB is exploring targeted improvements to the structure and content of financial statements with a focus on the statements of financial performance. The focus is on reducing presentation choices for items in the statement of profit or loss and other comprehensive income and the statement of cash flows to make it easier for investors to compare the performance and future prospects of companies. A number of sub-totals are required by para. 81A of IAS 1, and new totals such as profit before financing and tax (or EBIT), are being developed by the IASB. However, an entity may decide that a different, non-IFRS total is a more relevant measure of its financial performance. This is referred to as a management performance measure (MPM). The IASB is proposing to bring MPMs within the financial statements, to make these measures more transparent and subject to audit. The MPMs will not be subject to constraints, but they must be identified as MPMs and be reconciled to the most appropriate IFRS sub-total. •• Principles of disclosure. The IASB’s objective is to develop new or clarify existing disclosure principles in order to address concerns arising from the level of judgement exercised by companies in deciding what information to disclose in financial statements and the most effective way to organise and communicate it. In March 2017 the IASB released a discussion paper called Disclosure Initiative – Principles of Disclosure. •• Standards-level review of disclosures. This project will develop guidance for the standard setter on disclosure principles, then test the guidance out via a targeted application to one or two standards. This is expected to result in an exposure draft by the end of 2018. •• Materiality. This aspect of disclosures has progressed to amendments to two accounting standards and is detailed below. Further reading ‘Better Communication: making disclosures more meaningful’ shows examples of improved disclosures in real financial reports, accessed 4 Dec 2018, www.ifrs.org/-/media/project/disclosureinitative/better-communication-making-disclosures-more-meaningful.pdf?la=en

Materiality The principle of materiality is applied when determining whether an Accounting Standard applies and in assessing how to apply Accounting Standards. In October 2018 the IASB made amendments to IAS 1 and IAS 8 to clarify and align the definition of materiality in IAS 1, IAS 8, and the Conceptual Framework, and provide guidance to improve consistency in their application.

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These amendments are effective for annual reporting periods beginning on or after 1 January 2020, however earlier application is permitted. The definition of ‘materiality’ is as follows: Information is material if omitting, misstating, or obscuring it could reasonably be expected to influence the decisions that the primary users of general-purpose financial statements make on the basis of those financial statements, which provide financial information about a specific entity.

The IASB does not expect the amended definition to significantly affect how materiality judgements are made in practice, or to significantly affect an entity’s’ financial statements. In addition, in September 2017 the IASB also issued a practice statement on materiality entitled: Practice Statement 2: Making materiality judgements. The statement provides guidance on how to make materiality judgements when preparing their general purpose financial statements in accordance with IFRS. The Practice Statement is not mandatory and it neither changes the requirements nor introduces new ones. The aim is to drive behavioural change by supporting preparers of financial statements with the tools to make their financial statements more useful and concise, rather than view disclosure preparation as completing a checklist from each relevant standard. It recommends a four-step process in making materiality judgements: Step 1 Identify

Requirements of IFRS Standards

Knowledge about primary users’ common information needs

Step 2 Access

Quantitative factors

Step 3 Organise

Organise the information within the draft financial statements

Step 4 Review

Qualitative factors

(entity-specific and external)

Renew the draft financial statements

The practice statement also provides illustrations and explanations to help preparers of financial statements to better apply the concept when identifying appropriate disclosures.

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Further reading Better communication in financial reporting, www.ifrs.org → Project → Better communication in financial reporting, accessed 23 November 2018.

Reducing disclosures The issue of financial statement disclosures is topical, as many are finding the current level of disclosures overwhelming. The key issue is that there is so much noise and distraction in financial reports that it is difficult for users to ‘cut through’ and find the key messages. Current discussions on the topic suggest that there is scope for entities to improve the clarity in financial reports under existing disclosure requirements by highlighting key information, reordering content into logical sections and removing unnecessary disclosures. As identified in a paper published by the CA ANZ, Noise, Numbers and Cut-Through, some listed companies in Australia and New Zealand are into their second year of ‘streamlining’ their financial reports, and many more are expected to follow suit this reporting season. Standard-setters and regulators have added their voice, publicly supporting the removal of immaterial disclosures. The IASB is also considering this topic with their Disclosure Initiative project (discussed above), which aims to improve how information is presented and disclosed in financial reports. Further reading CA ANZ 2015, ‘Noise, Numbers and Cut-Through’, www.charteredaccountantsanz.com → News and analysis → Insights → Future[inc] → Archive → Noise, Numbers and Cut-Through, accessed 25 April 2018.

Sustainability reporting The Global Reporting Initiative (GRI) is an international independent organisation that promotes the use of sustainability reporting as a way for entities to become more sustainable and contribute to sustainable development. Sustainability issues include issues such as climate change, human rights and corruption. The GRI Framework includes reporting guidelines, sector guidance and other resources. It is supportive of integrated reporting as it develops as an important and necessary innovation of corporate reporting. During 2015 thought leaders in various fields were interviewed on a number of subjects related to sustainability reporting. Articles, videos and papers based on these interviews were disseminated to the GRI network. The final publication, ‘The Next Era of Corporate Disclosure: Digital, Responsible, Interactive’ was issued in March 2016. Further reading GRI, ‘The Next Era of Corporate Disclosure: Digital, Responsible, Interactive’, www.globalreporting.org → Information → In the Spotlight → Sustainability and Reporting 2025, accessed 19 April 2018.

Integrated reporting The International Integrated Reporting Council (IIRC) is a global coalition of regulators, investors, companies, standard-setters, the accounting profession and non-government organisations. It was formed in 2010 as part of global efforts to increase integrated business reporting. While many companies prepare traditional financial reports and separate sustainability reports, integrated reports attempt to serve as the reporting centrepiece to integrated thinking within an organisation. These reports widen the traditional views of capital beyond financial capital, to incorporate manufactured capital, human capital, social and relationship capital, intellectual capital and natural capital.

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Financial Accounting & Reporting

An integrated approach argues that the interrelationships between these forms of capital act to create short-, medium- and long-term value, and that examining the integrated whole and embedding this in decision-making processes within an entity is key to understanding an entity’s value creation over time. The International Integrated Reporting Framework, (the IIR Framework) was released in December 2013 following extensive consultation and testing by businesses and investors in all regions of the world who participated in the IIRC Pilot Programme. The purpose of the IIR Framework is to establish guiding principles and content elements that govern the overall content of an integrated report, and to explain the fundamental concepts that underpin them. The IIR Framework defines reporting boundaries, users and materiality quite differently to traditional financial reporting, and these reports are deliberately more forward-looking. In 2014 a new group called the Corporate Reporting Dialogue (CRD) was created. The CRD operates under the umbrella of the IIRC and its participants include the IASB, FASB, GRI and IIRC. The CRD is an initiative designed to respond to market calls for greater coherence, consistency and comparability between frameworks, standards and related requirements. To assist with this, the CRD published a corporate reporting landscape map that is intended to help stakeholders understand the similarities and differences in the corporate reporting frameworks and standards. Further reading •• Integrated Reporting , ‘What? The tool for better reporting’, www.integratedreporting.org → What? The tool for better reporting, accessed 19 April 2018. •• Corporate Reporting Dialogue, www.corporatereportingdialogue.com, accessed 19 April 2018.

AU

Australia-specific As discussed earlier, the IASB develops, amends and publishes IFRSs and IFRICs, which are used in preparing financial reports in numerous countries. Therefore, many changes to financial reporting are directed from the international level. However, significant changes may still occur at the national level, driven by country-specific issues. Important contemporary financial reporting issues at the national level are outlined below.

Australian Securities and Investments Commission (ASIC) – Areas of focus Each year, ASIC announces the areas on which it will focus its reviews of financial reports of listed entities and other entities of public interest. The current areas of focus are: •• Estimates – impairment and asset values. •• Accounting policy choice –– Revenue recognition – ensuring that revenue is recognised based on the substance of the underlying transactions. –– Expense deferral – ensuring that expenses are only deferred when permitted to by Accounting Standards. –– Tax accounting. –– Estimates and accounting policy judgements. –– Impact of new revenue, financial instrument, lease and insurance standards. These areas have been ASIC’s focus for a number of periods.

AASB The AASB is currently conducting outreach sessions to clarify the future of special purpose financial reports in light of the changes to the IASB conceptual framework Exposure draft ED/2017/5 Accounting Policies and Accounting Estimates which proposes amendments to IAS 8. The objective of the amendments is to better distinguish accounting policies from accounting estimates. This is discussed further in Unit 2.

Core content – Unit 1

Page 1-47

Financial Accounting & Reporting

Chartered Accountants Program

Activity 1.1: Applying the regulatory framework [Available online in myLearning] Quiz [Available online in myLearning]

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Core content – Unit 1

Unit 2: Presentation of financial statements Contents Introduction

2-3

Content of general purpose financial statements 2-4 Statement of financial position 2-4 Statement of profit or loss and other comprehensive income 2-8 Statement of changes in equity 2-12 Statement of cash flows 2-15 Disclosures 2-16 Steps in preparing financial statements under International Accounting Standards Step 1 – Prepare the year-end adjusting entries Step 2 – Prepare the year-end tax entries Step 3 – Prepare the final trial balance Step 4 – Prepare the statement of financial position, statement of profit or loss and other comprehensive income, and statement of changes in equity Step 5 – Prepare the statement of cash flows Step 6 – Prepare the notes to the financial statements Interim Financial Reporting

Standards that impact disclosures and adjustments

2-21 2-22 2-22 2-22 2-22 2-22 2-23 2-23

2-25

Accounting policies, changes in accounting estimates and errors (IAS 8) 2-25 Selecting accounting policies 2-25 Importance of accounting policies 2-26 Changes in accounting policies 2-27 Accounting policies versus accounting estimates 2-28 Accounting estimates 2-28 Applying a change in an accounting estimate 2-29 Summary – changes in accounting policies, changes in accounting estimates and prior period errors 2-32 Future developments 2-33 Related party disclosures 2-34 Related party relationships 2-34 Related party transactions 2-35 Disclosures 2-36 Discontinued operations 2-37 Definition of a discontinued operation 2-37 Measuring the assets and liabilities of a discontinued operation 2-37 Presentation of discontinued operations 2-37 Disclosures 2-39

fin31902_csg_04

Events after the reporting period Timing of events Accounting for events after the reporting period Adjusting events Non-adjusting events Disclosures

Unit 2 – Core content

2-39 2-39 2-40 2-40 2-41 2-42

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[This page has deliberately been left blank]

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Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Learning outcomes At the end of this unit you will be able to: 1. Advise on the requirements for financial statements 2. Prepare, analyse and explain a complete set of financial statements. 3. Explain and account for changes in accounting policies, revisions of accounting estimates and errors. 4. Identify and analyse related parties. 5. Explain and account for discontinued operations. 6. Explain and account for events after the reporting period.

Introduction This unit provides an overview of the requirements for preparing financial statements, and the content of those financial statements. It is important to work through the concepts and the issues discussed in this unit as they are consistently referred to throughout this module. This unit assumes that the preceding unit on financial reporting has been worked through and understood. While financial statements are often seen as just a set of statements and supporting notes, being able to understand and explain how and what information is disclosed in financial statements and notes is a very important skill for a Chartered Accountant. The career of a Chartered Accountant is likely to involve the preparation of sets of financial statements, whether for clients or employers. The unit is structured in the following sections: •• Content of general purpose financial statements. •• Steps in preparing financial statements under International Accounting Standards. •• Standards that impact disclosures and adjustments: (a) Accounting policies, changes in estimates and errors (IAS 8). (b) Related parties (IAS 24). (c) Discontinued operations (IFRS 5). (d) Events after reporting period (IAS 10). Unit 2 overview video [Available online in myLearning]

Unit 2 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Content of general purpose financial statements Learning outcomes 1. Advise on the requirements for financial statements. 2. Prepare, analyse and explain a complete set of financial statements. IAS 1 Presentation of Financial Statements sets out the basic structure and contents for all financial statements, including: •• the overall requirements for the presentation of GPFSs •• guidelines for their structure, and •• the minimum requirements for their content. As per IAS 1 para. 10, a ‘complete set of financial statements’ contains: •• a statement of financial position •• a statement of profit or loss and other comprehensive income •• a statement of changes in equity •• a statement of cash flows •• notes, made up of a summary of significant accounting policies and other explanatory information •• comparative information for the preceding period •• a statement of financial position ‘as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively’, or makes a retrospective restatement, or reclassification, of items in its financial statements. In preparing a complete set of financial statements, IAS 1 also states that an entity: •• may use other titles for any one of these statements (para. 10); for example, the entity may call the statement of financial position a balance sheet, and •• needs to present each of the financial statements with ‘equal prominence’ (para. 11). Each of the financial statements is discussed in turn below, as well as the basic requirements for the face of the financial statement. Some published financial statements are also used as examples, to illustrate the learning. Required reading IAS 1 (or local equivalent).

Statement of financial position The statement of financial position is a statement, at a specified date, of an entity’s: •• assets •• liabilities •• equity. The definitions of assets, liabilities and equity were discussed in relation to the Conceptual Framework in Unit 1.

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Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

IAS 1 and the statement of financial position paragraphs (paras 54-80A) The following diagram illustrates some key requirements of IAS 1 for the statement of financial position:

IAS 1

Line items on face of the statement of financial position

Para. 54

Information on face of statement of financial position, statement of changes in equity OR in notes to financial statements

Paras 77 and 79

Current/non-current asset and liability distinction

Paras 60, 61, 66 and 69

The table below shows a simple balance sheet or statement of financial position, crossreferenced to relevant paragraphs of IAS 1, and units in the CSG or other FIN learning elements. (Other accounts are covered in different units throughout the module.) Further disaggregation may be required by IAS 1 paras 77–80A; however, this would normally be shown in the notes to the accounts. Statement of financial position as at 30.06.X8 CSG unit

IAS 1 paragraph

Current assets

60 and 66

Cash and cash equivalents

54(i)

Trade and other receivables

Unit 9

54(h)

Inventories

Assumed knowledge – See video on myLearning

54(g)

Other financial assets including derivatives

Unit 9

54(d)

Current tax assets

Unit 4

54(n)

Assets held for sale

Unit 2

54(p)

Total current assets Non-current assets

60 and 66

Property plant and equipment

Unit 7

54(a)

Intangible assets

Unit 8

54(c)

Goodwill

Unit 8

54(c)

Financial assets

Unit 9

54(d)

Deferred tax assets

Unit 4

54(o)

Total non-current assets Total assets Current liabilities

60 and 69

Bank overdraft

Unit 9

54(i) and 54(m)

Trade and other payables

Unit 9

54(k)

Provisions

Unit 11

54(l)

Unit 2 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Statement of financial position as at 30.06.X8

Current tax liability

CSG unit

IAS 1 paragraph

Unit 4

54(n)

Total current liabilities

Non-current liabilities

60 and 69

Financial liabilities

Unit 9

54(m)

Deferred tax liabilities

Unit 4

54(o)

Bank loan

Unit 9

54(m)

Share capital

Unit 9

54(r)

Reserves

Units 5, 9

54(r)

Total non-current liabilities Total liabilities Net assets Shareholders equity

Retained earnings

54(r)

Equity attributable to the owners of the entity

Unit 16

54(r)

Equity attributable to non-controlling interest

Unit 16

54(q)

Total equity

Distinction between current and non-current assets or liabilities IAS 1 sets out the rules for distinguishing between current and non current assets, and current and non current liabilities. Having clear requirements around this classification ensures comparability between sets of financial statements. The format of these rules within IAS 1 allows for the differences that arise due to industry factors and operating cycles. An entity is generally required to present its current and non-current assets and liabilities separately on the face of the statement of financial position (IAS 1 para. 60).

Assets are current if:

cash or cash equivalent OR

Liabilities are current if:

no unconditional right to defer settlement beyond 12 months OR

held for trading OR expects to realise within 12 months OR normal operating cycle

…all other assets are non-current (IAS 1 para. 66)

Page 2-6

held for trading OR

due within 12 months OR expects to settle within 12 months OR within normal operating cycle

…all other liabilities are non-current (IAS 1 para. 69)

Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

The only exception to this is when a presentation based on liquidity would provide users of the financial statements with information that is reliable and more relevant. For example, financial institutions present their statements of financial position on a liquidity basis (rather than on a current/non-current format) as this is more reflective of how their assets are used and their liabilities expected to be settled.

STATEMENT OFbelow FINANCIAL POSITION 30 JUNE 2018Holdings Limited’s 2018 The balance sheet is an extract fromAS theAT Harvey Norman Annual Report: Statement of Financial Position as at 30 June 2018

Note

CONSOLIDATED June 2018 $000

June 2017 $000

Current Assets Cash and cash equivalents

28(a)

170,544

80,224

Trade and other receivables

7

724,690

640,686

Other financial assets

8

31,463

29,191

Inventories

9

345,287

315,968

Other assets

10

45,144

45,878

Intangible assets

11

490

486

1,317,618

1,112,433

Total current assets Non-Current Assets Trade and other receivables

12

78,443

78,777

Investments accounted for using equity method

37

4,497

26,355

Other financial assets

13

18,283

30,076

Property, plant and equipment

14

660,337

625,112

Investment properties

15

2,429,397

2,241,754

Intangible assets

16

69,067

75,237

Total non-current assets

3,260,024

3,077,311

Total Assets

4,577,642

4,189,744

Current Liabilities Trade and other payables

17

289,986

238,628

Interest-bearing loans and borrowings

18

422,191

386,651

15,608

42,541

Income tax payable Other liabilities

19

66,825

41,571

Provisions

20

35,354

34,034

829,964

743,425

333,858

Total current liabilities Non-Current Liabilities Interest-bearing loans and borrowings

21

503,203

Provisions

20

11,645

13,052

Deferred income tax liabilities

5(d)

280,735

267,219

Other liabilities

23

14,163

19,283

809,746

633,412

Total Liabilities

1,639,710

1,376,837

NET ASSETS

2,937,932

2,812,907

386,309

Total non-current liabilities

Equity Contributed equity

24

388,381

Reserves

25

185,384

174,950

Retained profits

26

2,337,241

2,229,200

2,911,006

2,790,459

Parent entity interests Non-controlling interests TOTAL EQUITY

27

26,926

22,448

2,937,932

2,812,907

The above Statement of Financial Position should be read in conjunction with the accompanying notes.

Source: Harvey Norman, 2018 Annual Report. HARVEY NORMAN HOLDINGS LIMITED | ANNUAL REPORT 2018

Unit 2 – Core content

67

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Financial Accounting & Reporting

Chartered Accountants Program

IAS 1 para. 54 requires a number of line items to be included in a financial statement, but additional line items are allowed. Similarly, paras 77–79 outline a number of disclosures and disaggregations that are required, but these can be shown on the face of the balance sheet or in the notes. As previously discussed, the Standard sets out the rules for classifying current and non-current assets and liabilities. It also states that deferred tax liabilities cannot be shown as current. The split of equity attributable to the parent entity interests and non-controlling interests shown in the balance sheet above is required by IAS 1 para. 54. This split will be discussed further in the units on business combinations (Unit 15) and accounting for subsidiaries (Unit 16). Much of the presentation of the balance sheet, such as some line items, sub totals, order and format are not prescribed by the Standard, and it is up to the entity to decide the most appropriate presentation method. In practice, most entities follow model financial statements and present the statement of financial position in one of a few ’accepted’ formats.

Statement of profit or loss and other comprehensive income A simple example of a statement of profit or loss and other comprehensive income (SPLOCI) is shown below. The statement can be presented as two statements, or, in this case, as a single statement. This entity shows expenses by function, but an entity can also classify expenses by nature. Please note that this is an example only and does not reflect all possible inclusions. Some additional disclosures may also be required in the notes. This statement is cross-referenced to relevant paragraphs of IAS 1 and also maps where you will touch on key items within the FIN CSG. Statement of profit or loss and other comprehensive income for the year ended 30.06.X8

Revenue

CSG unit

IAS 1 paragraph

Unit 3

82 – essential line item

Cost of sales

103 – classify expenses by function (or nature: para. 102) – on face of SPLOCI or in notes

Gross profit Other income Selling and distribution expenses Administrative expenses Research and development expenses

Unit 8

97, if material, show separately (on face or notes)

Unit 17

82, essential line items

Other expenses Share of profit from associates accounted for using the equity method of accounting Finance costs

82, essential line items

Finance income Profit before tax Income tax expense

Unit 4

82, essential line items

Unit 2

82, 97, 98

Profit for the year from continuing operations Profit/(loss) for the year from discontinued operations

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Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Statement of profit or loss and other comprehensive income for the year ended 30.06.X8 CSG unit

IAS 1 paragraph

Units 15–16

81B, must split totals between owners/NCI

Profit for the year Profit for the period attributable to:

Owners of the parent entity



Non-controlling interest

Other comprehensive income (OCI) Items that will not be reclassified to profit and loss Revaluation of land and buildings

82A, classifications within OCI Unit 7

Income tax on items that will not be reclassified Items that are or may be reclassified to profit and loss

82A

Foreign currency translations of overseas subsidiaries

Unit 5

FVTOCI investments

Unit 9



Net change in fair value



Reclassification to profit and loss

Cash flow hedging

Net change in fair value



Reclassification to profit and loss

Share of other comprehensive income from associates accounted for using the equity method

92, disclose reclassification adjustments in OCI Unit 9 92 Unit 17

Income tax on items that are or may be reclassified

91, show OCI items either net of tax or aggregate, split by may be reclassified/ never reclassified

Other comprehensive income for the period, net of tax

81A, must have totals

Total comprehensive income for the period

81A

Total comprehensive income attributable to:

Owners of the parent entity



Non-controlling interest

Units 15–16

81B, must split totals between owners/NCI

IAS 1 requirements for the statement of profit or loss IAS 1 allows some flexibility for the presentation of items in the profit or loss (section or statement). This flexibility recognises that different entities in different industries will have different classes of expenses that provide information to the users of the financial statements.

Other comprehensive income Accounting Standards do not permit certain items to be included in measuring an entity’s profit or loss. Typically, the items disclosed in other comprehensive income (OCI) are current year movements in reserves other than retained earnings (the movement in a revaluation surplus account).

Unit 2 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Recycling OCI When an item is classed as ’may be reclassified’, it is often referred to as ‘recycling OCI’. This is because the item first appears in other comprehensive income, but may later be moved to the profit and loss and ‘recycled’. Examples of items which are recycled include the cumulative movements in the fair value of fair value through OCI (FVTOCI) financial assets. These gains and losses are originally recognised in a reserve account within OCI, with the reserves reclassified to the profit or loss when they are derecognised under IFRS 9 Financial Instruments. FVTOCI financial assets are discussed in the unit on financial instruments (Unit 9). Other comprehensive income video [Available online in myLearning]

Further reading IFRS 9 Appendix B para. B5.7.1A. Below is a SPLOCI for Harvey Norman Limited for the year ended 30 June 2018. Note that: •• Harvey Norman has chosen to present the SPLOCI as two separate statements. •• Harvey Norman has chosen to classify expenses by function. •• The functional presentation shows a cost of goods sold and a gross profit amount, and groups expenses in categories such as distribution, marketing and occupancy. •• The statement of comprehensive income shows two categories of OCI: may be reclassified and will not be reclassified to profit or loss. You are hopefully familiar with revaluations of property, plant and equipment from your university studies. A revaluation on property, plant and equipment is shown here under the heading of never to be reclassified to profit and loss. Also note that any tax relating to this revaluation is disclosed with the OCI item. Under IAS 1 para. 90, the tax related to OCI can either be shown on the face of the SPLOCI or in the notes. Accounts that you may be less familiar with are the foreign currency translation reserve and cash flow hedge reserve. We will later examine these accounts in the units on foreign exchange (Unit 5) and financial instruments (Unit 9), respectively. For now, just note that these items are shown as other comprehensive income under the sub-heading ’Items that may be reclassified subsequently to profit or loss’.

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Core content – Unit 2

Chartered Accountants Program INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 2018

Financial Accounting & Reporting

Income statement for the year ended 30 June 2018

Note 3

Sales revenue Cost of sales Gross profit

3

Revenues and other income items Distribution expenses Marketing expenses

CONSOLIDATED June 2018 $000

June 2017 $000

1,993,760

1,833,123

(1,326,339)

(1,235,602)

667,421

597,521

1,240,703

1,305,344

(41,602)

(36,189)

(374,322)

(384,885)

Occupancy expenses

4

(241,220)

(226,994)

Administrative expenses

4

(585,683)

(492,453)

Other expenses

4

(114,573)

(107,666)

Finance costs

4

(26,344)

(20,072)

Share of net profit of joint ventures entities

37

5,792

5,200

530,172

639,806

(150,122)

(186,840)

380,050

452,966

375,378

448,976

Profit before income tax Income tax expense

5(a) & 5(c)

Profit after tax Attributable to: Owners of the parent Non-controlling interests

4,672

3,990

380,050

452,966

Earnings Per Share: Basic earnings per share (cents per share)

6

40.35 cents

33.71 cents

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 JUNE 2016 Diluted earnings per share (cents per share)

6

40.30 cents

33.67 cents

26.0 cents 30.0 cents Dividends per share (cents per share) STATEMENT OF COMPREHENSIVE INCOME26FOR THE YEAR ENDED 30 JUNE 2018

CONSOLIDATED

notes. the accompanying withyear read in conjunction Statement should be Income Income The aboveof Statement Comprehensive for the ended 30 June 2018

June 2016 CONSOLIDATED $000

Profit for the year Profit for the year

Items that may be reclassified subsequently to profit or loss: Foreign currency translation Items that may be reclassified subsequently to profit or loss: Net fair value gains on available-for-sale investments Foreign currency translation Net movement on cash flow hedges Net fair value (losses) / gains on available-for-sale investments Income tax effect on net movement on cash flow hedges

June 2018 $000 380,050

Income tax effect on net movement on cash flow hedges

(4)

Fair value revaluation of land and buildings Items that will not be reclassified subsequently to profit or loss: Income tax effect on fair value revaluation of land and buildings Fair value revaluation of land and buildings

15,553

Income tax effect on fair value revaluation of land and buildings

(2,693)

Other comprehensive for the year of tax) Other comprehensive income income for the year (net(net of tax) Total comprehensive income for the year (net of tax) Total comprehensive income for the year (net of tax)

68comprehensive income attributable to: Total Total comprehensive income attributable to: - Owners of the Parent Owners of the parent - Non-controlling interests Non-controlling interests

29,742 1,101 3,978 (1,193)

(221) 16

385,067

12,777 (3,499)

4,050 18

25,467

13,115 (2,055)

(5,362)

42,906 394,246

17,225 470,191

12,095 281,009

390,938 278,433 3,308 467,496 2,576

5,804 390,871

(6,942)

(3,560) 1,302 4,699 (1,406)

(6)

10,821 390,871

June 2017 $000 268,914 452,966

(1,830)

Net movement on cash flow hedges

Items that will not be reclassified subsequently to profit or loss:

351,340

June 2015 $000

2,695

394,246

470,191 281,009

The above Statement of Comprehensive Income should be read in conjunction with the accompanying notes. The above Statement of Comprehensive Income should be read in conjunction with the accompanying notes.

Source: Harvey Norman, 2018 Annual Report. * Note that available-for-sale investments relate to IAS 39. This would now be FVTOCI financial instruments under IFRS 9.

Unit 2 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Statement of changes in equity The statement of changes in equity presents a reconciliation between the carrying amount at the beginning and end of the period for each component of equity. These components vary between entities, but may include: Equity account

Some examples of movements to show in the statement of changes in equity

Share capital

Share issues, buybacks Business combinations

Retained earnings or accumulated losses

Profit or loss for period, dividends, transfers to/from reserves

Accumulated balances of OCI items/reserves Foreign currency translation reserve

+/– amounts on translation of a foreign subsidiary

Cash flow hedge reserve

Effective portions of cash flow hedges Reclassifications to profit and loss

FVOCI reserve

+/– changes in fair value +/– reclassifications to profit and loss

Revaluation surplus

+ revaluation increments – Revaluation decrements for assets previously revalued upwards

Share-based payments reserve

Equity settled share-based payments (see the unit on share‑based payments (Unit 14) for detailed discussion on possible equity accounts)

The total amount of movement in equity is equal to the change in the entity’s net assets or liabilities. The statement of changes in equity separately discloses changes arising from (IAS 1 para. 106(d)): (i) profit or loss (ii) other comprehensive income (iii) transactions with the owners. Like equity on the balance sheet, the total comprehensive income must be split between owners of the parent and the non-controlling interest (IAS 1 para. 106 (a)). The components of equity and the movements that bring about changes to these movements are illustrated in the following diagram:

Profit or loss IAS 1 para. 106d

Share capital Components of equity

OCI balances/reserves

Retained earnings/ accumulated losses

Movements for each component of equity

Other comprehensive income IAS 1 para. 106a Transactions with owners (e.g. dividends) IAS 1 para. 106b

Retrospective adjustments on changes in accounting policies and material errors

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Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Below is an example of the format for a statement of changes in equity for a group where all subsidiaries are wholly owned. This is the format that should be used in FIN module exams. (Extract from FIN216 main exam, examiner’s feedback.) Epic Limited Group Consolidated statement of changes in equity for the year ended 30 June 20X6 Attributable to owners of the parent Issued Cash flow Foreign capital hedge currency reserve translation reserve

Revaluation surplus

Retained earnings

Total equity

$

$

$

$

$

$

3,290,000

401,000

200,000

–

2,375,000

6,266,000

–

–

–

–

3,700,000

3,700,000

Revaluation of property, plant and equipment

–

–

–

7,000,000

–

7,000,000

Foreign currency translation differences on foreign subsidiary

–

–

(11,436)

–

–

(11,436)

Effective portion of changes in fair value of cash flow hedge

–

849,632

–

–

–

849,632

Total OCI

–

849,632

(11,436)

7,000,000

–

7,838,196

Total comprehensive income

–

849,632

(11,436)

7,000,000

3,700,000

11,538,196

Opening balance at 1 July 20X5

Total comprehensive income: Profit for the year Other comprehensive income

Transactions with owners recorded directly in equity Contributions by and distributions to owners Dividends

–

–

–

– (2,300,000)

(2,300,000)

Total transactions with owners

–

–

–

– (2,300,000)

(2,300,000)

3,290,000

1,250,632

188,564

Balance at 30 June 20X6

7,000,000

3,775,000

15,504,196

Below is an extract from the published financial statements of Harvey Norman, showing one year’s statement of changes in equity. Comparatives were also presented on a separate page.

Unit 2 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Statement of changes in equity for the year ended 30 June 2018 Owners v NCI split Required by IAS 1 para. 10a

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 JUNE 2018

Attributable to Equity Holders of the Parent Contributed Equity

Retained Profits

$000 At 1 July 2017 Other comprehensive income: Revaluation of land and buildings Reverse expired or realised cash flow hedge reserves Currency translation differences Fair value of forward foreign exchange contracts Fair value of available for sale financial assets Other comprehensive income Profit for the year Total comprehensive income for the year Cost of share based payments Shares issued Dividends paid Distribution to members At 30 June 2018

Asset Revaluation Reserve

Foreign Currency Translation Reserve

$000

Available for Cash Flow Sale Reserve Hedge Reserve

$000

$000

$000

386,309

2,229,200

131,304

42,374

13,732

-

-

13,222

-

-

-

-

-

-

-

-

(1,715)

-

-

-

-

-

-

-

375,378

2,072 388,381

Employee Equity Benefits Reserve

$000

Acquisition Reserve

$000

Noncontrolling Interests

$000

TOTAL EQUITY

$000

$000

(20)

9,611

(22,051)

22,448

2,812,907

-

-

-

-

(362)

12,860

-

20

-

-

-

20

-

-

-

-

1,494

(221)

-

-

(8)

-

-

-

(8)

-

(1,830)

-

(1,830)

13,222 -

(1,715) -

(1,830) -

375,378

13,222

(1,715)

(1,830)

(267,337) -

-

-

-

2,337,241

144,526

40,659

11,902

Agrees to- total 12 amounts -in SPLOCI-

-

1,132 4,672

10,821 380,050

12

-

-

5,804

390,871

-

745 -

-

(976) (350)

745 2,072 (268,313) (350)

(8)

10,356

(22,051)

26,926

2,937,932

-

The above Statement of Changes in Equity should be read in conjunction with the accompanying notes.

Totals agree to line items in equity section of the balance sheet

Statement of changes in equity for the year ended 30 June 2018 (cont.) HARVEY NORMAN HOLDINGS LIMITED | ANNUAL REPORT 2018

70

Under IFRS 9 this will be the In the FIN module we use FVTOCI reserve the wording in the standard, STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 JUNE 2018 (CONTINUED ) (Harvey Norman has not yet Revaluation surplus adopted IFRS 9) Attributable to Equity Holders of the Parent Contributed Equity

At 1 July 2016 Other comprehensive income: Revaluation of land and buildings Reverse expired or realised cash flow hedge reserves Currency translation differences Fair value of forward foreign exchange contracts Fair Fairvalue valueofofavailable availablefor forsale sale financial financial assets assets Other comprehensive income Profit for the year Total comprehensive income for the year Cost of share based payments Shares issued Dividends paid Distribution to members At 30 June 2017

Under IFRS 9 this will be net movement in FVTOCI financial assets

Retained Profits

Asset Asset Revaluation Revaluation Reserve Reserve

Foreign Currency Translation Reserve

Available Availablefor Sale forReserve Sale Reserve

Cash Flow Employee Hedge Reserve Equity Benefits Reserve

$000

$000

$000

$000

385,296

2,125,186

111,199

48,021

$000 9,682

$000

-

-

20,105

-

-

-

-

-

-

-

-

(5,647)

-

-

-

-

-

-

-

448,976

1,013 386,309

$000

Acquisition Reserve

Non-controlling Interests

$000

TOTAL EQUITY

$000

$000

(32)

8,995

(22,051)

22,378

2,688,674

-

-

-

-

-

20,105

-

32

-

-

-

32

-

-

-

-

(1,295)

(6,942)

-

-

(20)

-

-

-

(20)

-

4,050

-

-

-

-

4,050

20,105 -

(5,647) -

4,050 -

12 -

-

-

(1,295) 3,990

17,225 452,966

448,976

20,105

(5,647)

4,050

12

-

-

2,695

470,191

(344,962) -

-

-

-

-

616 -

-

(645) (1,980)

616 1,013 (345,607) (1,980)

2,229,200

131,304

42,374

13,732

(20)

9,611

(22,051)

22,448

2,812,907

The above Statement of Changes in Equity should be read in conjunction with the accompanying notes.

In the FIN module this section should have a heading “transactions with owners recorded directly in equity, with a sub-total

The above Statement of changes in equity should be read in conjunction withHARVEY the NORMAN accompanying HOLDINGS LIMITEDnotes. | ANNUAL REPORT 2018

71

Source: Harvey Norman, 2018 Annual Report.

Page 2-14

Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Statement of cash flows The statement of cash flows provides information on how an entity generated and used cash and cash equivalents during a financial period. This information assists users of financial statements in understanding movements in net assets and changes in the entity’s financial structure. It may also provide useful information in determining whether the entity can: •• •• •• ••

generate positive cash flows in the future meet its financial commitments as and when they fall due continue to provide goods and services in the future obtain external finance where necessary.

The requirements relating to the presentation and disclosures included in the statement of cash flows are contained in IAS 7. The statement of cash flows must disclose some specific categories of cash flows, such as interest, dividends and income tax (IAS 7 paras 31 and 35). However, most line items in the statement of cash flows are not prescribed. Required reading IAS 7.

Preparing the statement of cash flows and related disclosures IAS 7 para. 6 defines cash flows as ‘inflows and outflows of cash and cash equivalents’. The key issues to remember when preparing the statement of cash flows include: •• Cash flows are classified into operating, investing and financing activities. •• The cash balances of an entity, including movements between items of cash, is shown in a separate part of the statement of cash flows. •• Cash and cash equivalents are discussed in IAS 7 paras 6–9. •• Operating cash flows can be presented via the direct or indirect method. •• When the direct method is used, local reporting requirements in Australia and New Zealand require entities to reconcile cash flow to operating profit. •• Generally, gross inflows and outflows are shown separately under IAS 7 para. 21. Paragraph 22 sets out when a net basis can be used. In general, the preparation of a statement of cash flows follows the following steps: STEP 1 Define cash and cash equivalents.

STEP 2 Classify the cash flows.

STEP 3 Determine the format of the statement of cash flows.

STEP 4 Prepare the statement of cash flows.

STEP 5 Prepare disclosures relating to the statement of cash flows.

IAS 7 para. 10 requires an entity to present cash flows classified by operating, investing and financing activities. Each classification is summarised in the diagram below. You should read the required reading, IAS 7, for full details.

Unit 2 – Core content

Page 2-15

Financial Accounting & Reporting

Chartered Accountants Program

Summary of IAS 7 statement of cash flows Cash and cash equivalents defined in IAS 7 para. 6 • cash and cash equivalents definition: – readily convertible – into known amounts of cash – insignificant risk of changes in value e.g. deposit, < 3 months maturity from acquisition date • bank overdrafts repayable on demand are part of cash mangement (classed as cash) • most borrowings are financing activities

Operating IAS 7 paras 6, 13–15 • payments to suppliers and employees • receipts from customers • receipts of other revenue • Income tax paid or refunded • Interest paid* (varies) • financial institutions: cash advances and loans made re principal revenue-producing activities

Investing IAS 7 paras 6, 16 • payments to acquire PPE • proceeds from sale of PPE • payments to purchase investments • proceeds from sale investments • cash loans and advances to other parties • interest and dividends received

Financing IAS 7 paras 6, 17 • proceeds on share issue/other equity instruments • outlay for share buy-back • proceeds from short and long term borrowings • repayments of short and long term borrowings • dividends paid* (varies) • cash payments by a lessee to reduce outstanding liability on a lease

* The classification of interest paid and interest and dividends received may vary between enitities

The classification of cash flows, and ‘cash and cash equivalents’ often involves exercising professional judgement. Classifications may differ between entities because of their differing revenue-producing activities, but should be consistent from period to period. Changing a cash flow classification would fall under a change of accounting policy in IAS 8. This is discussed later in this unit.

Operating cash flows: methods and reconciliations Operating cash flows are reported using either the direct method or the indirect method. The standard encourages entities to use the direct method due to the additional information provided. When the direct method is used for operating cash flows, entities in Australia and New Zealand entities need to prepare a note which reconciles the operating cash flow to their profit or loss. These additional requirements are set out in AASB 1054 in Australia and FRS-44 New Zealand Additional Disclosures (FRS-44) in New Zealand.

Disclosures The disclosure requirements of IAS 1 are spread throughout the Standard. There are disclosure requirements under the IAS 1 heading for each financial statement. It is important to read IAS 1, to understand the disclosures required for each financial statement in turn, and remember that other accounting standards will add further disclosure requirements which are often more extensive. Some disclosures must be on the face of the financial statement, however most can be shown within the notes.

Page 2-16

Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

AU

Australia-specific Australia-specific disclosures Many AASB Standards include Australia-specific requirements. Note particularly AASB 101 Presentation of Financial Statements para. Aus19.1, which precludes a departure from AASB Standards by entities that report under Part 2M.3 of the Corporations Act, public and private sector not-for-profit entities, and entities that report under reduced disclosure requirements. AASB 1054 Australian Additional Disclosures contains additional disclosure requirements that relate to financial statements that are prepared in accordance with Australian Accounting Standards (e.g. a breakdown of audit fees required by paras 10 and 11; imputation credits available for use in future reporting periods to frank dividends per para. 13). The reduced disclosure requirements, described in Unit 1, affect the application of the AASB equivalents of IAS 1, IAS 7 Statement of Cash Flow, IAS 8, IAS 10, IAS 24, IFRS 5 and IFRS 8. Required reading AASB 1054 paras 10–16. Further reading Refer to a set of model general purpose financial statements and review each of the financial statements. These can be found on the websites of many of the large accounting firms. An example is given below: KPMG 2016, KPMG Example Public Company Limited: Guide to annual reports – Illustrative disclosures 2016–17.

AU

Australia-specific Additional disclosures required under AASB 1054 In addition to the IAS 7 disclosure requirements, additional consideration that is relevant to Australian entities is contained in AASB 1054. AASB 1054 para. 16 requires Australian entities that use the direct method to present its statement of cash flows (see Step 3 above) in accordance with IAS 7 para. 18(a) to provide a reconciliation of the net cash flow from operating activities to profit/(loss) in the notes to the financial statements. Required reading AASB 1054 para. 16.

NZ

New Zealand-specific Additional disclosures required under FRS-44 FRS-44 para. 10 requires New Zealand entities that use the direct method to present their statement of cash flows in accordance with IAS 7 para. 18(a), to provide a reconciliation of the net cash flow from operating activities to profit/(loss) in the notes to the financial statements. Required reading FRS-44 para. 10. Australia also has additional requirements related to the impact of the goods and services tax (GST).

Unit 2 – Core content

Page 2-17

Financial Accounting & Reporting

AU

Chartered Accountants Program

Australia-specific Impact of GST on the statement of cash flows A further exception to the presentation of gross cash flows in Australia applies to the GST that is payable or recoverable by an entity. In accordance with para. 10 of Australia-specific Interpretation 1031 ‘Accounting for the Goods and Services Tax (GST)’, cash flows are to be included in the statement of cash flows ‘on a gross basis’. This is subject to para. 11, which requires that the ‘GST component of cash flows arising from investing and financing activities which is recoverable from, or payable to, the taxation authority to be classified as operating cash flows’. Required reading Interpretation 1031 paras 6–18. The illustrative examples attached to the standard set out cash flow structures that are easy to follow. In its 2016 financial statements (below), Harvey Norman prepared its operating cash flows using the direct method, as encouraged by IAS 7 para. 19.

Page 2-18

Core content – Unit 2

Chartered Accountants STATEMENT OF CASHProgram FLOWS FOR THE YEAR ENDED 30 JUNE 2018

Financial Accounting & Reporting

Statement of changes cash flows for the year ended 30 June 2018

Note

CONSOLIDATED June 2018 $000

June 2017 $000

Cash Flows from Operating Activities Net receipts from franchisees Receipts from customers Payments to suppliers and employees Distributions received from joint ventures GST paid Interest received

947,058

882,476

2,134,595

1,992,891

(2,388,310)

(2,252,918)

10,125

11,546

(66,102)

(44,621)

5,871

4,971

Interest and other costs of finance paid

(25,619)

(19,420)

Income taxes paid

(166,161)

(152,454)

Dividends received

2,713

2,669

454,170

425,140

Net Cash Flows From Operating Activities

28(b)

Cash Flows from Investing Activities Payments for purchases of property, plant and equipment and intangible assets

(93,895)

(89,366)

Payments for purchase of investment properties

(125,661)

(114,752)

2,422

28,592

Proceeds from sale of property, plant and equipment and properties held for resale Payments for purchase of units in unit trusts and other investments

(107)

(161)

Payments for purchase of equity accounted investments

(4,256)

(8,947)

Proceeds from sale of /(payments for purchase of) listed securities

10,436

(6,537)

2,458

-

(94,882)

(7,594)

(303,485)

(198,765)

Proceeds from insurance claims Loans granted to joint venture entities, joint venture partners and unrelated entities Net Cash Flows Used In Investing Activities Cash Flows from Financing Activities Proceeds from shares issued Proceeds from Syndicated Facility Dividends paid

2,072

1,013

210,000

70,000

(267,337)

(344,962)

Loans (repaid to) / received from related parties

(6,573)

2,075

Repayment of other borrowings

(6,266)

(15,250)

(68,104)

(287,124)

Net Increase / (Decrease) in Cash and Cash Equivalents

82,581

(60,749)

Cash and Cash Equivalents at Beginning of the Year

42,882

103,631

125,463

42,882

Net Cash Flows Used In Financing Activities

Cash and Cash Equivalents at End of the Year

28(a)

The of Cash Flows should be read conjunction with the accompanying notes. Theabove aboveStatement Statement of cash flows should beinread in conjunction with the accompanying notes.

Source: Harvey Norman, 2018 Annual Report.

In the example below: •• the cash and cash equivalents note (note 28) reconciles the end result of the statement of cash flows to the amounts on the balance sheet, as required by IAS 7 para. 45 72 ••

the reconciliation of net cash flow from operating activities to the net profit is also shown (which is prepared to meet local financial reporting requirements when the direct method is used).

Unit 2 – Core content

Page 2-19

Financial Accounting & Reporting

Chartered Accountants Program

NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)

Notes to the financial statements (continued)

CONSOLIDATED June 2018 $000

June 2017 $000

28. CASH AND CASH EQUIVALENTS (a)

Reconciliation to Cash Flow Statement Cash and cash equivalents comprise the following at end of the year: Cash at bank and on hand

124,458

Short term money market deposits

(b)

65,969

46,086

14,255

170,544

80,224

Bank overdraft (Note 18)

(45,081)

(37,342)

Cash and cash equivalents at end of the year

125,463

42,882

380,050

452,966

Reconciliation of Profit After Income Tax to Net Operating Cash Flows Profit after tax Adjustments for: Net foreign exchange gains

(496)

(771)

46,064

21,864

Share of net profit from joint venture entities

(5,792)

(5,200)

Depreciation of property, plant and equipment

65,359

60,710

Amortisation

19,432

17,159

Impairment of equity-accounted investments

20,665

1,148

-

5,022

(51,646)

(107,382)

-

(669)

(663)

(962)

Bad and doubtful debts

Impairment loss on repayment of external finance facility Revaluation of investment properties Property revaluation increment for overseas controlled entity Deferred lease expenses Provision for onerous leases

-

643

4,173

4,992

(2,329)

(6,849)

(766)

2,229

Receivables

(29,595)

(72,818)

Inventory

(29,738)

165

10,303

(19,175)

Executive remuneration expenses Profit on disposal and sale of property, plant and equipment, and the revaluation of listed securities Movements in provisions Changes in assets and liabilities: (Increase)/decrease in assets:

Other current assets Increase/(decrease) in liabilities: Payables and other current liabilities

56,082

72,238

Income tax payable

(26,933)

(170)

Net cash flows from operating activities

454,170

425,140

Source: Harvey Norman, 2018 Annual Report.

Methods of preparing the statement of cash flows There are different methods of preparing a statement of cash flows, the most common of which are the spreadsheet method and the reconstruction method. HARVEY NORMAN HOLDINGS LIMITED | ANNUAL REPORT 2018

113

Spreadsheet method The spreadsheet method is an efficient way of preparing a statement of cash flows from the entity’s trial balance for both the current year and prior year. Once this statement of cash flows spreadsheet has been created, using formulas extensively within it will enable an entity to roll the spreadsheet over from one period to the next. Minimal work will then be required to update the information and produce the next statement of cash flows. Further, the spreadsheet formulas can also incorporate built-in checks to ensure that the information is accurate. Accordingly, the spreadsheet method is generally used by practitioners. Reconstruction method Many candidates are likely to be familiar with the use of the reconstruction method for the preparation of a statement of cash flows from their tertiary studies. This method involves reconstructing T-accounts or ledger accounts to identify and analyse events and transactions that involved operating, investing and financing activities during the period. Page 2-20

Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Further details regarding statement of cash flows can be found in accounting textbooks. Further reading •• Deegan, C 2012, Australian financial accounting, Ch. 19. •• Deegan, C and Samkin, G 2012, New Zealand financial accounting, Ch. 19. •• Picker, R et al. 2013, Applying International Financial Reporting Standards, Ch. 19. Unit 2 Introduction to preparing a statement of cash flows There is a video in myLearning designed to refresh your basic understanding on how to prepare a statement of cash flows using the:

•• reconstruction (T-accounts) method •• addition (formula) method •• spreadsheet method. It is recommended you watch the video prior to attempting Activity 2.1. [Available online in myLearning]

Activity 2.1: Preparing a statement of cash flows [Available online in myLearning] Statement of cash flows: Disclosure As already covered, certain items must be disclosed within the statement of cash flows (e.g. disclosure of income tax paid). In addition to the statement of cash flows itself, there are additional disclosure requirements, including disclosures relating to non-cash transactions, components of cash and cash equivalents (IAS 7 paras 43–52).

Steps in preparing financial statements under International Accounting Standards Learning outcome 2. Prepare, analyse and explain a complete set of financial statements. There are a number of steps involved in the preparation of a set of financial statements and the starting point is with an unadjusted trial balance. Starting with this unadjusted trial balance, the steps to preparing a set of financial statements are: STEP 1 Prepare the year-end adjusting entries

Unit 2 – Core content

STEP 2

STEP 3

Prepare the year-end tax entries

Prepare the final trial balance

STEP 4 Prepare the statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity

STEP 5 Prepare the statement of cash flows

STEP 6 Prepare the notes to the financial statements

Page 2-21

Financial Accounting & Reporting

Chartered Accountants Program

Step 1 – Prepare the year-end adjusting entries Adjustments to the unadjusted trial balance are commonly required in order to obtain a final trial balance that complies with International Financial Reporting Standards (IFRS). Adjustments may include: •• prepayments or accruals •• recognition of adjusting events after the reporting period (Unit 2) •• accounting policies, changes in estimates and errors (Unit 2) •• tax effect accounting (Unit 4) •• impairment write downs on assets (unit 10). Some of these adjustments, such as prepayments and accruals, were covered in your undergraduate studies. Sources of other adjustments will be discussed in later units as we progress through the module. In this unit, we will discuss two areas that may result in adjustments: •• accounting policies, changes in estimates and errors •• events after the reporting period.

Step 2 – Prepare the year-end tax entries The year-end tax entries should always be the final journal entries prepared, as all other entries may potentially affect the tax calculations. The section on income taxes in Unit 4 will explain the preparation of these entries and how they affect the financial statements.

Step 3 – Prepare the final trial balance Once the initial trial balance has been completed, journal entries are prepared for any items that require adjustment to comply with Accounting Standards. The journal entries are then posted to the relevant accounts to obtain the final trial balance. The final trial balance is then used as a basis for preparing the financial statements. You should note that some year-end entries, such as consolidation journals, are not posted to the trial balance. This is discussed in the units on business combinations (Unit 15) and accounting for subsidiaries (Unit 16).

Step 4 – Prepare the statement of financial position, statement of profit or loss and other comprehensive income, and statement of changes in equity This unit has discussed the detailed requirements of IAS 1 in relation to the preparation of the statement of financial position, the statement of profit or loss and other comprehensive income, and the statement of changes in equity. We will revisit these requirements at several points throughout the module to expand your knowledge on how each topic area affects the appearance of the financial statements.

Step 5 – Prepare the statement of cash flows The statement of cash flows is normally prepared after the three other main statements have been prepared. This unit has discussed some of the detailed requirements of IAS 7 and this content is extended further in Activity 2.1 (available on myLearning).

Page 2-22

Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Step 6 – Prepare the notes to the financial statements The final step in preparing the financial statements is to prepare the necessary notes to the financial statements. Below is a useful approach in completing this final step: •• Go to the relevant standard. •• Find the sections headed ’Disclosures’, focusing on the bold paragraphs. •• Review the specific disclosure paragraphs. •• Refer to a set of model financial statements for a suggested layout. This unit discusses the general IAS 1 requirements related to the notes to the financial statements, and looks at the knowledge needed to prepare the following notes: •• Related parties. •• Events after the reporting period. •• Accounting policies, changes in estimates and errors. •• Discontinued operations. Model financial statements can be found on the websites of many of the large accounting firms. Note: Only selected notes are prepared in this unit. Other units in this module also cover the relevant standards’ specific requirements for disclosures of balances, transactions and events in the notes to the financial statements. Most of the detailed disclosure and presentation rules for preparing financial statements are contained in individual standards that prescribe the accounting requirements for different transactions. For instance, IFRS 16 Leases contains the disclosure requirements for leases. However, the basic structure of the financial statements is set out in IAS 1. Activity 2.2: Preparing key financial statements (SPLOCI and SOCE) [Available online in myLearning]

Interim Financial Reporting Some entities need to prepare interim financial reports. According to IAS 34 Interim Financial Reporting, an interim financial report is “a financial report containing either a complete financial report or a condensed financial report for an interim period”.

Which entities must comply with this standard? The simple answer is it depends. The requirement for interim financial reports is determined by a combination of local legislation and securities exchange listing rules.

What are the minimum requirements in interim financial reports? According to IAS 34 para.8, the financial statements shall include a condensed balance sheet, a condensed income statement, a condensed statement of changes in equity, a condensed cash flow statement and selected explanatory notes. The standard has a number of other specific requirements, including: •• basic and diluted Earnings Per share, •• a statement around accounting policies being comparable to last annual financial report, •• explanatory comments about seasonality of interim operations, •• material changes in estimates, •• unusual / material items affecting assets, liabilities, equity, profit or loss or cash flows, ••

movements in debt and equity securities,

•• dividends, •• segment revenue and segment results,

Unit 2 – Core content

Page 2-23

Financial Accounting & Reporting

Chartered Accountants Program

•• material subsequent events (to interim report), •• changes in group structure, acquisition and disposal of subsidiaries, discontinued operations •• changes in contingent liabilities or contingent assets since last annual report Problems in Interim financial reports are attracting increasing attention and legal action from regulators in many jurisdictions. It is therefore important that Chartered Accountants remember their obligations in complying with this standard. Required reading IAS 34 Interim Financial Reporting paras. 1-16A. Further reading IAS 34 Interim Financial Reporting, remainig paragraphs.

Page 2-24

Core content – Unit 2

Chartered Accountants Program

Financial Accounting & Reporting

Standards that impact disclosures and adjustments In this section, we will cover a few of the Accounting Standards and accounting issues that may result in adjustments to the draft trial balance or in additional financial statement disclosures, either on the face of or in the notes to the financial statements. This section does not intend to cover all of the relevant standards – just a few of the important ones.

Accounting policies, changes in accounting estimates and errors (IAS 8) Learning outcome 3. Explain and account for changes in accounting policies, revisions of accounting estimates and errors. IAS 8 covers the following issues affecting financial reports: •• Criteria for selecting and changing accounting policies. •• Accounting and disclosure requirements for: –– changes in accounting policies –– changes in accounting estimates –– corrections of errors.

Selecting accounting policies IAS 8 para. 5 defines accounting policies as: the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.

Selecting an accounting policy for a class of transactions depends on whether an appropriate accounting standard exists. IAS 8 para. 7 states: When an IFRS specifically applies to a transaction, other event or condition, the accounting policy or policies applied to that item shall be determined by applying the IFRS.

If there is no such standard, IAS 8 requires management to use its judgement in developing an accounting policy that produces information that is ‘relevant’ and ‘reliable’. Required reading IAS 8 (or local equivalent).

Unit 2 – Core content

Page 2-25

Financial Accounting & Reporting

Chartered Accountants Program

The following flow chart demonstrates the selection and application of accounting policies. Apply the relevant IFRS

YES Is there an IFRS that specifically applies to the transaction, event or condition?

NO Use judgement to develop and apply a policy

Must be: • Relevant to users • Reliable: – Faithful representation – Reflect economic substance over legal form – Neutral – Prudent – Complete (IAS 8 para. 10) Refer to: • IFRS dealing with similar/related issues • The Conceptual Framework (IAS 8 para. 11)

Consider: • Recent pronouncements in other jurisdictions • Accounting literature • Accepted industry practices (Cannot conflict with IAS para. 11 sources) (IAS 8 para. 12)

Importance of accounting policies Traditionally, the financial statements contains a summary of significant accounting policies in note 1. This note assists the user in understanding the bases on which amounts in the financial statements are determined, by describing (per IAS 1 para. 117): •• The measurement basis (or bases) used to prepare the financial statements. •• Other accounting policies used that are relevant to understanding the financial statements. Accounting standards may allow choices of accounting methods. The application of the Standards often involves professional judgement, taking into consideration the entity’s specific circumstances and the accepted practices within their industry. Describing how this judgement has been exercised provides important information to the user, especially when some users may not be fully conversant with accounting standards. With the increase in the number of entities streamlining or decluttering their financial statements in line with the IASB Disclosure project, accounting policy notes are now often re-ordered, so that all of the relevant information for a particular account is grouped together. For example, for property, plant and equipment, the significant accounting policies may be summarised within the property, plant and equipment note in a set of streamlined financial reports.

Page 2-26

Core content – Unit 2

Further details on the significant judgements considered by management relating to impairment of financial assets are disclosed in Note 7. The impairment loss is disclosed in Notes 4 and 7. (e)

Impairment of equity-accounted investments

The consolidatedProgram entity determines whether there is objective evidence that the investment in the associate or joint venture is impaired. If Chartered Accountants Financial Accounting & Reporting there is such evidence, the consolidated entity calculates the amount of impairment as the difference between the recoverable amount of the associate or joint venture and its carrying value. (f)

Share-based payment transactions

The consolidated entity measures the cost of equity-settled transactions with employees by reference to the fair value of the equity instruments at the date at which they are granted.

Example(g)–Make Accounting policy good provisions

Provisions are recognised the for theselection anticipated costs of future restoration of leased premises. The provision includes future cost estimates This example illustrates and application of an accounting policy: associated with dismantling and removing the assets and restoring the leased premises according to contractual arrangements. These

future cost estimates are discounted to their present value. The related carrying amounts are disclosed in Note 20. NOTES TO THE FINANCIAL STATEMENTS (h)

Onerous lease provisions

1. STATEMENT OF SIGNIFICANT ACCOUNTING POLICIES

…

The provision for onerous lease costs represents the present value of the future lease payments that the consolidated entity is presently obligated to make in respect of onerous lease contracts under non-cancellable operating lease agreements. This obligation may be reduced Information (a) the Corporate by revenue expected to be earned on the lease including estimated future sub-lease revenue, where applicable. The estimate may vary as a result of changes in the utilisation of the leased premises and sub-lease arrangements where applicable. The related carrying amounts Harvey Norman Holdings are disclosed in Note 20. Limited (the “Company”) is a for profit company limited by shares incorporated in Australia and operating in Australia, New Zealand, Ireland, Northern Ireland, Singapore, Malaysia, Slovenia and Croatia whose shares are publicly traded on the Australian Securities Exchangeand (“ASX”) under the ASX code HVN. (iii) Investment in associates jointtrading ventures

(b) associate Basis of An is Preparation an entity over which the consolidated entity has significant influence. Significant influence is the power to participate in the financial and operating policy decisions of the investee, but does not control or have joint control over those policies. The financial report has been prepared on a historical cost basis, except for investment properties, land and buildings, derivative financial instruments, listed shares trading andwhereby available-for-sale which have measured athave fair value. Thethe carrying values A joint venture is a type of held joint for arrangement the partiesinvestments, that have joint control of been the arrangement rights to net assets of of recognised assets andcontrol liabilities that are designated as hedged in fairofvalue hedges that which would exists otherwise carried at amortised the joint venture. Joint is the contractually agreed sharingitems of control an arrangement, onlybe when decisions about the cost are adjusted to record changes in the fair values attributable to the risks that are being hedged in effective hedge relationships. relevant activities require unanimous consent of the parties sharing control. The considerations financial report made is presented in Australian dollarsinfluence and all values are rounded the nearest thousand dollars ($000) unless otherwise The in determining significant or joint control areto similar to those necessary to determine control over stated under the option available to the Company under Australian Securities and Investments Commission Corporations (Rounding in subsidiaries. Financial/Directors’ Reports) Instrument 2016/191. The Company is an entity to which this legislative instrument applies. The consolidated entity’s investments in its associate and joint venture are accounted for using the equity method. The consolidated financial statements of the Company and its subsidiaries (the “consolidated entity”) for the year ended 30 June 2018 was authorised for issue in accordance with a resolution of theordirectors on 28isSeptember 2018. at cost. The carrying amount of the Under the equity method, the investment in an associate joint venture initially recognised investment is adjusted to recognise changes in the consolidated entity’s share of net assets of the associate or joint venture since the (c) Statement acquisition date. of Compliance

The financial report is a equity general-purpose financial report,entity whichdetermines has been prepared accordance the requirements of the Corporations After application of the method, the consolidated whether in it is necessary with to recognise any impairment loss with Act 2001, Accounting Standards and Interpretations, and complies other requirements of the law.the The financial report respect toAustralian the consolidated entity’s net investment in the associates and jointwith ventures. At each reporting date, consolidated entity complies with Australian as issued by the Australian Accounting Standards Board, and International Financial determines whether thereAccounting is objectiveStandards, evidence that the investment in the associate or joint venture is impaired. If there is such evidence, Reporting Standards (IFRS), as issued the International Accounting Standards Board. the recoverable amount of the associate or joint the consolidated entity calculates the by amount of impairment as the difference between venture and its carrying value. Australian Accounting Standards and Interpretations that have recently been issued or amended but are not yet effective have not been HARVEY NORMAN HOLDINGS | ANNUAL REPORT 2018accounting 75 adopted by the consolidated entity for the annual reporting period ended 30 June 2018. ForLIMITED details on the impact of future standards, refer to page 84.

Source: Harvey Norman, 2018 Annual Report. (d)

Basis of consolidation

The consolidated financial statements comprise the financial statements of Harvey Norman Holdings Limited and its controlled entities. Control is achieved when the consolidated entity is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Specifically, the consolidated entity controls an investee if and only if the consolidated entity has all of the following:  Power over the investee (i.e. existing rights that give it the current ability to direct the relevant activities of the investee)  Exposure, or rights, to variable returns from its involvement with the investee, and  The ability to use its power over the investee to affect its returns

Changes in accounting policies

An entity should select and apply its accounting policies consistently for each accounting period for similarWhen transactions, other events and conditions. the consolidated entity has less than a majority of the voting or similar rights of an investee, the consolidated entity considers all relevant facts and circumstances in assessing whether it has power over an investee, including:

contractual arrangement thenecessary other vote holdersto of the investee an accounting policy. Under IAS 8 There may beThe instances wherewith it is change  Rights arising from other contractual arrangements  The consolidated entity’s voting rights and potential voting rights para. 14, an entity can only change its accounting policies if the change: The consolidated entity re-assesses whether or not it controls an investee if facts and circumstances indicate that there are changes to one

or more of the (a) is required bythree anelements IFRS; of orcontrol. Consolidation of a subsidiary begins when the consolidated entity obtains control over the subsidiary and ceases when the consolidated entity loses control of the subsidiary.

(b) results in the financial statements providing reliable andfrom more relevant information about the All intercompany balances and transactions, including unrealised profits arising intra-group transactions, have been eliminated in full. Unrealised losses are eliminated unless costs cannot be recovered. Financial statements of foreign controlled entities presented in effects of transactions, other events or conditions on the entity’s financial position, financial accordance with overseas accounting principles are, for consolidation purposes, adjusted to comply with the consolidated entity’s policy and generally accepted accounting principles in Australia. performance or cash flows. Non-controlling interests are allocated their share of net profit after tax in the income statement and are presented within equity in the

statement of position, separately from the equity of theon owners of the Parent. Losses are attributed to theFor non- example: Accountingconsolidated for a change infinancial accounting policy depends the reason for the change. controlling interest even if that results in a deficit balance.

•• A change in inan resulting from theis initial application an IFRS must be A change the accounting ownership interest ofpolicy a subsidiary (without a change in control) to be accounted for as an equityof transaction. accounted for in accordance with the specific transitional provisions in that IFRS (IAS 8 (e) Summary of Significant Accounting Policies para. 19(a)). Usually, the transitional provisions require any change in accounting policy to (i) Changes in accounting policy, disclosures, standards and interpretations be adjusted through retained earnings. The accounting policies adopted are consistent with those of the previous financial year except as discussed below. The consolidated entity applied for the first time certain standards and amendments, which are effective for annual periods beginning on or after 1 January 2017. •• If an IFRS does not include specific that apply toconsolidated that change These new pronouncements do not have a material transitional impact on the annualprovisions consolidated financial statements of the entity. Theor the entity has not early adopted any other standard, interpretation or amendment that has been issued but is not yet effective. changeconsolidated in an accounting policy is voluntary, then the change is applied retrospectively (i.e. calculated as if the new accounting policy had always been applied (IAS 8 para. 19(b)).

Retrospective application requires an entity to adjust the opening balance of each affected 73 HARVEY NORMAN HOLDINGS LIMITED |and ANNUAL REPORTcomparative 2018 component of equity for the earliest comparative period presented other amounts disclosed. This results in the current and comparative financial years being presented as if the new accounting policy had always been applied (IAS 8 para. 22). When it is impracticable to determine the retrospective effects of the changes in accounting policy, the new accounting policy must be applied from the earliest date practicable (IAS 8 paras 23–25).

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It can sometimes be difficult to decide whether something constitutes a change in accounting policy. IAS 8 para. 16 states that the following are not changes in accounting policies: (a) the application of an accounting policy for transactions, other events or conditions that differ in substance from those previously occurring; and (b) the application of a new accounting policy for transactions, other events or conditions that did not occur previously or were immaterial.

Paragraph 17 goes on to explain that the first time an entity chooses to: •• revalue property, plant and equipment under IAS 16, or •• revalue an intangible asset under IAS 38 Intangible Assets, the revaluation is dealt with as a change in policy under IAS 16 or 38, not under IAS 8. It is also worth noting the paragraph 30 requirements, that is, where an accounting standard has been issued but is not yet effective, an entity must state this and assess the potential impact. This should be disclosed by way of note to the accounts. At present, this would mean entities would need to consider and disclose the potential impacts of IFRS 9 Financial Instruments, IFRS 15 Revenue from Contracts with Customers, and IFRS 16 Leases to name a few (which we will be considering in this module).

Accounting policies versus accounting estimates Being able to distinguish between accounting policies and accounting estimates is important as they are disclosed and treated differently under IAS 8. Accounting policies are the principles by which amounts are recognised and measured. Even using accounting policies, some amounts in the financial statements are not able to be measured precisely. This is where estimates come in. Accounting estimates are the judgements an entity makes in applying an accounting policy. For example, accounting estimates are often required in the following instances: •• Estimating future cash flows in determining the fair value of financial assets and liabilities. •• Estimating the recoverability of trade receivable balances in determining an allowance for impairment loss – trade receivables.

Accounting estimates IAS 8 para. 5 defines a change in accounting estimate as: ... an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors.

A change in accounting estimate results from new information or developments. This means that the original estimates were correct at the time they were made (in contrast with ‘errors’, which are discussed in the next section). This reflects the fact that, by their nature, estimates cannot be measured with precision. As listed in IAS 8 para. 32, the following examples may require accounting estimates: •• Bad debts. •• Inventory obsolescence. •• Fair value of financial assets or financial liabilities. •• Useful lives of depreciable assets. •• Warranty obligations.

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Example – Change in accounting estimates Note 02 Significant accounting estimates and judgements … (vii) Provisions – Long service leave The Group’s net obligation in respect of long term employee benefits is the amount of future benefit that employees have earned in return for their service in the current and prior periods. For long service leave the future benefit is altered to take into account the probability of reaching entitlement and inflationary increases. These benefits are discounted to determine its present value. The discount for long service leave is the yield proximate to the reporting date on the Australian Corporate Bond market. See note 1(v)(ii) & 6(f ). The emergence of a deep high quality corporate bond market as reported by the Milliman report commissioned by the G100 group of companies has required ARTC to move from using the Australian Government Bond rate to the new Australian Corporate Bond rate in line with the relevant accounting standard (AASB 119). As a result of the change in accounting estimate from Australian Government Bond rate to the Australian Corporate Bond rate the balance of the provision was decreased by $0.181m. Source: Australian Railtrack Corporation 2015, 2015 Annual Report, www.artc.com.au → About ARTC → Company Reports → Annual Report 2014 / 2015, p. 65, accessed 16 April 2018.

Applying a change in an accounting estimate Because estimates are correct when they are made, changes in accounting estimates are applied prospectively. A change in accounting estimate is applied prospectively in the: •• Statement of profit or loss and other comprehensive income – in the period of the change, if it only affects the current period, or in the current and future periods, if the change affects both. •• Statement of financial position – by changing the carrying amounts in the period of change.

Example – Accounting for a change in accounting estimate This example illustrates how to account for a change in accounting estimate. XYZ Limited (XYZ) has an accounting policy that requires property, plant and equipment be depreciated over the estimated useful life of the assets. On 1 July 20X1, XYZ acquired a new machine and estimated its useful life to be 10 years. The asset has been depreciated on this basis. It is 30 June 20X4 and due to advances in technology, XYZ has estimated that the remaining useful life of the machine is only a further three years; that is, a revised useful life of six years in total for the machine instead of its original useful life of 10 years. XYZ will adjust the depreciation expense recorded over the next three years so that the asset is written down to its residual value by 30 June 20X7. It would not adjust the depreciation recorded in 20X4 as the reassessment did not occur until year end. The change in depreciation expense has an impact prospectively (i.e. in future periods) and not on expenses already recorded.

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Prior period errors In contrast to changes in accounting estimates, prior period errors relate to information that was available at the time that financial statements were prepared in previous accounting periods. As defined by IAS 8 para. 5: Prior period errors are omissions from, and misstatements in, the entity’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: (a) was available when financial statements for those periods were authorised for issue; and (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.

Errors versus estimates Care should be taken to distinguish between: •• errors – which are mistakes that were made by using estimates or judgements in the preparation of financial statements that were not appropriate at that time, and •• changes in accounting estimates – which are corrections that are required due to new information that was not available at the time the financial statements were prepared.

Example – Estimates and errors This example illustrates the circumstances that would result in a change in an accounting estimate and a prior period error, and the accounting treatment that should be applied to each.

Background XYZ Limited (XYZ) calculates its warranty provision based on the number and value of warranty claims that the entity has dealt with in the past five financial years as a proportion of revenue earned over that period.

Scenario 1 – change in accounting estimate In the current financial year, XYZ experiences a higher than expected number of warranty claims and determines that the warranty provision should be increased as a proportion of revenue. This is a change in accounting estimate which results from new information or developments arising from changed circumstances. It should be accounted for prospectively from the current financial year to reflect the new circumstances.

Scenario 2 – prior period error In the current financial year, XYZ identifies that the calculation of the warranty provision at the end of the prior period was materially incorrect due to an error in the spreadsheet. This is a prior period error because there was a failure to use, or misuse of, reliable information that was available in the prior period. It should be accounted for retrospectively to correct the prior year comparative figures affected by this calculation error.

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Financial Accounting & Reporting

Accounting for prior period errors Prior period errors are adjusted retrospectively in the first set of financial statements issued after they are identified. In the comparatives, if this is when the error occurred or if the errors relate to periods before the earliest comparatives were made, the opening balances for the earliest year of comparison are adjusted. Retrospective adjustments for errors are accounted for in the same way as changes in accounting policies. Where a retrospective adjustment is made, an additional comparative statement of financial position is required (IAS 1 para. 40A). If retrospective application is ‘impracticable’, the entity shall restate the opening balances for the earliest period that retrospective restatement is practicable; however, if this is not practical, restating the comparative information prospectively is permitted (IAS 8 paras 44 and 45).

Disclosures The disclosure requirements of IAS 8 are detailed in paras 28–30, 39–40 and 49. Generally they include the nature of the change, impact on line items for each period, and adjustments at the beginning of the earliest period presented. Below is a brief summary of basic IAS 8 requirements: Issue

Detail

Basic rule under IAS 8

Accounting policy

First time application of standard

Follow transition requirements. If not specified, retrospective

Voluntary change

Retrospective

Material

Retrospective, note

Immaterial

Prospective

Error

Change in accounting estimate

Prospective

Note that all retrospective accounting is required unless impracticable.

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Summary −in changes in accounting policies, changes in accounting Summary – changes accounting policies, changes in accounting estimates and prior period errors estimates and prior period errors IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8)

Accounting policy – principles, bases, conventions, rules and practices applied

Prior period errors –

Accounting estimate – judgements in applying accounting policies

Material errors

Change in an accounting estimate

omissions from or misstatements in financial statements that arise from a failure to use, or misuse of reliable information that was available or could have been obtained and taken into account

Change in accounting policy

Required by IFRS IAS 8 para. 14(a)

Voluntary change provided it results in reliable and more relevant information IAS 8 para. 14(b)

Adjust current and/or future periods(s) (prospective) IAS 8 para. 36

Disclose in notes IAS 8 paras 39 and 40

Follow specific transitional provisions, where initial application IAS 8 para. 19(a)

Retrospective application to adjust prior period(s) (if no specific transitional provisions that apply to the change or the change is voluntary) IAS 8 para. 19(b)

Adjust prior period(s) (retrospective) IAS 8 para. 42

Disclose in notes IAS 8 para. 49

Disclose in notes IAS 8 para. 28

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Disclose in notes IAS 8 para. 29

Additional statement of financial position presented as at the beginning of the earliest comparative period IAS1 Presentation of Financial Statements para. 40A

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Future developments In September 2017, the IASB issued exposure draft ED/2017/5 Accounting Policies and Accounting Estimates which proposes amendments to IAS 8. The objective of the amendments is to better distinguish accounting policies from accounting estimates. The distinction is important given changes in accounting policies are generally applied retrospectively whereas changes in accounting estimates are applied prospectively. Accounting policies

Accounting estimates

Current definition

Current definition

The specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements

Accounting estimates are currently not defined, however a ‘change in accounting estimate’ is defined as:

Proposed definition

Proposed definition

Accounting policies are the specific principles, measurement bases, and practices applied in preparing and presenting financial statements

Accounting estimates are judgements or assumptions used in applying an accounting policy when, because of estimation uncertainty, an item in financial statements cannot be measured with precision

Justification for change:

Justification for change:

An adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors

•• Conventions and rules are vague terms not used elsewhere in IFRS

•• Not defining accounting estimate but having a definition for a change in an accounting estimate obscures the distinction between accounting policies and accounting estimates •• ‘Measurement bases’ rather than ‘bases’ aligns with IAS 8 para 35 which states •• Accounting estimates are used in applying accounting policies that a change in the measurement and the proposed definition confirms this basis applied is a change in an •• Clarifies that selecting an estimation technique, or valuation accounting policy technique, used when an item in the financial statements cannot be measured with precision, constitutes making an accounting estimate

Activity 2.3: Accounting for changes in accounting policies and estimates [Available online in myLearning]

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Related party disclosures Learning outcome 4. Identify and analyse related parties. Related party disclosures enable users of financial statements to fully understand the impact that certain related party relationships and transactions may have on the profit or loss and financial position of an entity. Therefore, identifying related parties and any related party transactions is important to ensure that disclosures are made in accordance with IAS 24. IAS 24 para. 2 states that this Standard is applied in: (a) identifying related party relationships and transactions; (b) identifying outstanding balances, including commitments, between an entity and its related parties; (c) identifying the circumstances in which disclosure of the items in (a) and (b) is required; and (d) determining the disclosures to be made about those items.

IAS 24 applies to consolidated and separate financial statements, as well as individual financial statements (IAS 24 para. 3).

Related party relationships The definition of a ‘related party’ is provided in IAS 24 para. 9. While this definition is factual, it is important to note that it is the substance of the relationship between parties that determines whether they are related, and not merely the legal form (IAS 24 para. 10). A party that is related to an entity can be an individual or another entity. The following diagram provides examples of where related party relationships do and do not exist: • A person (or close family member) who has control of the reporting entity • A person (or close family member) who has joint control of the reporting entity • A person (or close family member) who has significant influence over the reporting entity

DO EXIST

DO NOT EXIST

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• • • • • • •

Key managers of the reporting entity Key managers of the parent entity Parent entities Subsidiaries Fellow subsidiaries Associates or joint ventures of a parent or subsidiary A management entity that provides key management personnel services to the reporting entity

• • • • • •

Two entities simply because they have a common director/key manager Two joint venturers simply because they share joint control of a joint venture Providers of finance Trade unions Public utilities Customers

• Suppliers • Franchisors • Distributors

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Financial Accounting & Reporting

Example – Related party relationships This example illustrates the identification of related parties. Entity A is 100% owned by Mr B who also owns 100% of Entity C. Entity A’s directors are Ms D and Mr E. Ms D is also a director of Entity F. Entity A and Entity H each own and control 50% of a joint venture (Entity G). ENTITY F

DIRECTOR

Mr B

100%

Ms D

100%

ENTITY C

ENTITY A

DIRECTORS Mr E

ENTITY H 50%

ENTITY G

50%

JOINT VENTURE

The following are related parties of Entity A: •• Mr B, as he has control of Entity A (IAS 24 para. 9(a)(i)). •• Entity C, as it is also controlled by Mr B (IAS 24 para. 9(b)(vi)). •• Ms D, as she is a member of the key management personnel (IAS 24 para. 9(a)(iii)). •• Mr E, as he is a member of the key management personnel (IAS 24 para. 9(a)(iii)). •• Entity G, as it is a joint venture of Entity A (IAS 24 para. 9(b)(ii)). The following entities do not have a related party relationship with Entity A: •• Entity F, as its only connection with Entity A is a common director (IAS 24 para. 11(a)). •• Entity H, as it shares joint control of Entity G with Entity A (IAS 24 para. 11(b)). Required reading IAS 24 (or local equivalent).

Related party transactions A related party transaction is defined as ‘a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged’ (IAS 24 para. 9). Relationships between a parent entity and subsidiaries must be disclosed regardless of whether there have been any transactions during the reporting period (IAS 24 para. 13).

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Disclosures The disclosure requirements of IAS 24 are detailed in paras 13–27 and include: •• Disclosure of certain related party relationships. •• Disclosure of related party transactions and balances. Important disclosures concerning related party transactions required by IAS 24 include: •• Key management personnel compensation. •• The nature of related party relationships, details of related party transactions undertaken and details of outstanding balances.

Example – Disclosing related party transactions This example illustrates how to disclose related party transactions to meet the minimum requirements specified by IAS 24. During the year ended 30 June 20X3, Generous Limited advanced interest-free unsecured loans to two of its directors as follows: Director

Amount

Date loan was made

Term of loan

50,000

01 January 20X3

2 years

5,000 To acquire a rental property

4,000

19 April 20X3

2 years

Nil To partially fund a holiday

$ Andrea Anaconda Benjamin Boa

Repayments Purpose of loan received during the year $

The following disclosure meets the minimum requirements of IAS 24 paras 18–19 and 24 for these transactions (comparatives have not been shown although would be required): During the year ended 30 June 20X3, unsecured loans totalling $54,000 were advanced to directors. No interest is payable on the loan and repayment in cash is due within two years from the date the loans were made. At 30 June 20X3, the balance outstanding was $49,000 and is included in ‘trade and other receivables’.

Activity 2.4: Identifying related parties [Available online in myLearning]

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Discontinued operations Learning outcome 5. Explain and account for discontinued operations.

Definition of a discontinued operation IFRS 5 explains how to account for assets held for sale and discontinued operations. IFRS 5 para. 32 defines a ‘discontinued operation’ as: … a component of an entity that either has been disposed of, or is classified as held for sale, and (a) represents a separate major line of business or geographical area of operations, (b) is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations, or (c) is a subsidiary acquired exclusively with a view to resale.

A ‘component of an entity’ must be a clearly distinguished operation with separate financial reporting. When an asset is held for sale, this means that ‘its carrying amount will be recovered principally through a sale transaction rather than through continuing use’ (IFRS 5 para. 6). The held for sale concept is important, therefore, in identifying a discontinued operation. Where a business operation has been discontinued, the financial results and assets and liabilities for that operation are presented separately from those of the continuing operations. This separate presentation allows users of the financial statements to understand the results of the continuing operations when considering an entity’s future results and operations. IFRS 5 provides guidance on: •• Accounting for assets that are ‘held for sale’. •• Presenting and disclosing discontinued operations. The concept of ‘held for sale’ in respect of individual assets is discussed Units 6 and 7.

Measuring the assets and liabilities of a discontinued operation Once an operation qualifies as ‘discontinued’, its assets and liabilities are required to be held at values that reflect the worth of their imminent disposal. Therefore, they are remeasured at the lower of their carrying amount and fair value less costs to sell (IFRS 5 para. 15). The exception to this rule is specific assets that are excluded from the measurement provisions of IFRS 5. The exclusions are identified in IFRS 5 para. 5.

Presentation of discontinued operations As discussed above, the results of discontinued operations are presented separately from those of the continuing operations, in the statement of profit or loss and other comprehensive income. IFRS 5 contains comprehensive presentation and disclosure rules relating to discontinued operations.

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However, the table below provides the main presentation and disclosure requirements: Presentation and disclosure requirements for a discontinued operation Financial statement

Present separately for discontinued operations

IFRS 5 paragraph reference

Statement of profit or loss and other comprehensive income

Profit or loss after tax for the period

33(a)

Statement of profit or loss and other comprehensive income

Revenue, expenses and profit before tax

or

Gain or loss before tax on remeasuring or disposal of assets and liabilities

Notes to the financial statements

Gain or loss after tax on remeasuring or disposal of assets and liabilities 33(b)

Income tax expense on profit or loss for the period

Income tax expense on gain or loss before tax on remeasuring or disposal of assets and liabilities Statement of cash flows or Notes to the financial statements

Net cash flows – presented either in the notes or financial statements, for the following activities:

33(c)

•• Operating •• Investing •• Financing

Statement of profit or loss and other comprehensive income

Amount of income from continuing and discontinued operations attributable to owners of the parent

33(d)

Statement of financial position

Disclose separately, by major class:

38

or

•• Assets held for sale

Notes to the financial statements

•• Liabilities held for sale

or Notes to the financial statements

Required reading IFRS 5 (or local equivalent).

Example – Preparing disclosures for a discontinued operation This example illustrates how disclosures for a discontinued operation can be presented. Fur-Mates Limited (Fur-Mates), a distributor of pet food, originally started operations focusing on rabbit food but later expanded to the more profitable areas of cat and dog food. Results for the rabbit food line for the period July 20X5–August 20X5 are as follows: $ Sales revenue

400,000)

Cost of sales

(260,000)

Distribution expenses

(10,000)

Income tax expense

(39,000)

Profit after tax from the rabbit food line

91,000)

The rabbit food line was discontinued in August 20X5 due to disappointing sales. Fur-Mates sold the rabbit food distribution business and made a $100,000 gain on the sale. The income tax expense relating to the gain is $30,000. Any assets connected with the rabbit food line were redeployed elsewhere within Fur-Mates after the sale.

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This information, concerning the discontinued business, could be presented in either of two ways within the SPLOCI for the year ended 30 June 20X6 to comply with IFRS 5: 1. Include the detail on the face of the SPLOCI. Discontinued operation

$

Revenue

400,000)

Expenses

(270,000)

Profit before tax

130,000)

Income tax expense

 (39,000)

Profit from discontinued operation after tax

91,000)

Gain on sale of discontinued operation

100,000)

Income tax on gain on sale of discontinued operation

 (30,000)

Gain on sale of discontinued operation after tax

 70,000)

2. Include summarised information on the face of the SPLOCI and present the detail in the notes to the financial statements. Discontinued operation Profit from discontinued operation after tax

$ 161,000

Disclosures Apart from the disclosure requirements outlined above, there are additional disclosures specified by IFRS 5 that are detailed in paras 41–42.

Events after the reporting period Learning outcome 6. Explain and account for events after the reporting period. Video resource See the video on events after reporting period on MyLearning to assist your learning in this topic.

Timing of events Inevitably, there is a ‘gap’ between the end of the accounting (reporting) period and completion of the financial statements. Events that occur during this period may need to be reflected in the financial statements for the period just ended. IAS 10 provides guidance as to when such events should be reflected in the financial statements and how to treat them. IAS 10 applies to events that occur after the reporting date and before the date the financial statements are authorised for issue (IAS 10 para. 3).

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Financial statements authorised for issue

End of reporting period

20X8

20X8

JUNE

SEPTEMBER

30

15

EVENT

?

Accounting for events after the reporting period There are two types of events that occur after the reporting period. These events are classified as either: •• adjusting events •• non-adjusting events. Accounting for these types of events is summarised in the following diagram: Events occurring after reporting date

Provides evidence of conditions that existed at end of reporting period

Indicative of conditions that arose after reporting date

‘Adjusting events’

‘Non-adjusting events’

Adjust financial statements for period just ended

Disclose nature of financial effect of material non-adjusting events

The difference between an ‘adjusting event’ and a ‘non-adjusting event’ is key to applying IAS 10, and is discussed below.

Adjusting events An adjusting event confirms the existence of a condition that existed at the end of the reporting period, or provides more evidence about such a condition (IAS 10 para. 3(a)). Therefore, the amounts recognised in the financial statements are adjusted to reflect adjusting events after the reporting period (IAS 10 para. 8).

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Chartered Accountants Program

Financial Accounting & Reporting

Common examples of adjusting events are as follows: •• Legal disputes and court cases that are settled after the reporting date, but which confirm the existence of a present obligation (‘a condition’) that existed at the reporting date. •• Information received after the end of the reporting period that indicates an asset was impaired at the reporting date – for example, an entity finds out that a customer with a trade receivables balance at the reporting date went bankrupt after the reporting date usually confirms that a loss existed at the end of the reporting period. •• Bonuses or profit shares that were determined after the reporting date, but for which a legal or constructive obligation existed at the reporting date.

Non-adjusting events Non-adjusting events are indicative of conditions that arose after the end of the reporting period and therefore do not relate to a condition that existed at the reporting date (IAS 10 para. 3(b)). The amounts recognised in the financial statements are therefore not adjusted to reflect these events (IAS 10 para. 10). However, material non-adjusting events could influence users of the financial statements. Therefore, as stated in IAS 10 para. 21, the following relevant information should be disclosed: (a) Nature of the event. (b) Estimate of the financial effect, or a statement that such an estimate cannot be made.

Common examples of non-adjusting events are: •• An abnormally large decline in the fair value of investments. •• A major business combination. •• Announcement of a major restructure.

Examples – Adjusting and non-adjusting events These examples illustrate adjusting and non-adjusting events. In these examples, assume that the financial reporting period ended at 30 June 20X3 and the financial statements are due to be issued on 31 August 20X3.

Example 1 At 30 June 20X3, Company A is owed $1,000 by Company B from the sale of goods supplied in March 20X3. On 12 August 20X3, Company A receives a letter from Company B’s administrators, which indicates that Company B is likely to enter liquidation and Company A is unlikely to receive payment for the amount it is owed. This is an adjusting event. The condition that existed at 30 June 20X3 was that the trade receivables balance for Company B was probably already impaired.

Example 2 Company X has an investment of shares in a listed company. The fair value of the shares at 30 June 20X3, based on the listed market price at that time, was $2,500. By 30 August 20X3, the listed market price of the shares fell significantly and the fair value of the investment is $1,700. This is a non-adjusting event. The shares trade publicly, so the fall in value is assumed to relate to circumstances that have arisen after the reporting date. This event would only require disclosure if it is considered to be material.

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Example – Determining the treatment of a dividend declared

This example illustrates how a dividend declared after the reporting date is a non-adjusting event. Company X finalises its profit for the year ended 30 June 20X6 by mid-July, resulting in a profit after tax of $5 million. On 22 July 20X6 the directors declare a $1 million dividend in respect of the year ended 30 June 20X6 and the dividend is paid one week later. The declaration of the dividend is a non-adjusting event and therefore the dividend and related liability is not recognised in the financial statements at 30 June 20X6. However, the notes to the financial statements for the year ended 30 June 20X6 will disclose details of the $1 million dividend (IAS 1 para. 137).

Required reading IAS 10 (or local equivalent).

Disclosures The disclosure requirements of IAS 10 are detailed in paras 17–22. Activity 2.5: Accounting for events after the reporting period [Available online in myLearning] Quiz [Available online in myLearning]

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Core content – Unit 2

Unit 3: Revenue Contents Introduction 3-3 Accrual accounting versus cash accounting 3-3 Relevant standards and interpretations 3-4 Overview of IFRS 15 Core principle The five-step revenue model

3-4 3-4 3-5

Step 1: Identify the contract(s) with a customer Identifying the contract Considering the potential combination of contracts

3-7 3-7 3-9

Step 2: Identify the separate performance obligations

3-12

Step 3: Determine the transaction price Variable consideration Constraining estimates of variable consideration Existence of a significant financing component in the contract Non-cash consideration Consideration payable to a customer

3-16 3-19 3-21 3-23 3-24 3-25

Step 4: Allocate the transaction price Allocation of a discount Allocation of variable consideration

3-26 3-27 3-28

Step 5: Recognise revenue when a performance obligation is satisfied Measuring progress towards complete satisfaction of a performance obligation How does revenue recognition under IFRS 15 work when foreign currencies are involved?

3-30 3-33

Disclosure

3-34

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Chartered Accountants Program

Financial Accounting & Reporting

Learning outcome At the end of this unit you will be able to: 1. Identify, measure and recognise revenue from contracts with customers.

Introduction Revenue is a crucial number to users of financial statements in assessing a company’s performance and prospects. Investors often focus on revenue growth and acceleration when they analyse financial statements, because revenue is often an indication of the activity level and capacity of an entity. Revenue is not only one of the most important financial reporting metrics, but it is usually also the largest item in the statement of profit or loss and other comprehensive income. It is prominently presented in the financial statements as the very first item in the statement of profit or loss and other comprehensive income. Revenue (e.g. sales) has a direct impact on an entity’s financial performance (i.e. profit) and this makes the recognition and measurement of revenue a critical issue. But how does an entity determine when to record revenue and how much revenue should be recognised in the profit or loss? The sale of goods for cash is relatively simple – the revenue is recognised on the date the goods are sold and the cash is received. But what happens if the transaction is on credit; or, if the transaction includes a good and a service, such as a mobile phone with calls and data usage, or a new car with a service contract? If a service is rendered over an extended period, when is the revenue recognised? This unit examines the principles that an entity has to apply to report ‘useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from an entity’s contracts with a customer’ (IFRS 15 Revenue from Contracts with Customers para. 1). It discusses the measurement and recognition of revenue and illustrates how to measure and recognise revenue in a range of circumstances. Unit 3 Overview video [Available online in myLearning]

Accrual accounting versus cash accounting Accrual accounting shows the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims, and changes in its economic resources and claims during a period provide a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.

Accrual accounting Revenue recognised

Unit 3 – Core content

≠ ≠

Cash accounting Cash received

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Relevant standards and interpretations The following have been superseded by IFRS 15 Revenue from Contracts with Customers: •• IAS 11 Construction Contracts. •• IAS 18 Revenue. •• IFRIC 13 Customer Loyalty Programs. •• IFRIC 15 Agreements for the Construction of Real Estate. •• IFRIC 18 Transfer of Assets from Customers. •• SIC-31 Revenue–Barter Transactions Involving Advertising Services.

IFRS 15 Revenue from Contracts with Customers IFRS 15 aims to improve the reporting of revenue and overcome the deficiencies of the superseded revenue standards and interpretations by: •• providing a more robust framework for addressing revenue recognition issues •• improving comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets •• simplifying the preparation of financial statements by reducing the amount of guidance to which entities must refer •• requiring enhanced disclosures to help users of financial statements better understand the nature, amount, timing and uncertainty of revenue that is recognised. IFRS 15 has a mandatory effective date for annual reporting periods beginning on or after 1 January 2018. Earlier application is permitted; however, if an entity applies IFRS 15 early, it shall disclose that fact. Required reading Read IFRS 15 paras 5–8 now to understand the scope of IFRS 15.

Overview of IFRS 15 Core principle The core principle of IFRS 15 is to ‘recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services’ (IFRS 5 para. 2). As the title of IFRS 15 suggests, an entity shall only apply IFRS 15 to a contract if the counterparty to the contract is a customer. A customer is ‘a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration’ (IFRS 15 para. 6). It is important to read the paragraphs in the standard as you progress through the unit to understand the material in detail. Candidates may also find the application guidance in IFRS 15 Appendix B helpful in exploring the key concepts. Required reading Read IFRS 15 paras 1–4 now to understand the objective of IFRS 15, and Appendix A to understand key definitions.

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The five-step revenue model IFRS 15 introduces a five-step revenue model to determine when to recognise revenue and at what amount. IFRS 15 determines that an entity recognises revenue in accordance with the core principle by applying the following five steps: STEP 1 Identify the contract(s) with a customer

STEP 2 Identify the separate performance obligations

STEP 3

STEP 4

STEP 5

Determine the transaction price

Allocate the transaction price

Recognise revenue when a performance obligation is satisfied

The following simple example introduces how to apply the five-step IFRS 15 model. Each step will be discussed in detail within the unit. Candidates can revisit the examples to test their understanding, after reading the CSG and required readings from the standard.

Example – Applying the five-step revenue model On 1 March 20X6 Need-a-Van signed a contract to purchase a delivery vehicle from Good Vehicles. The agreed purchase price stated in the signed contract is $20,000. This amount includes two free services of the vehicle. The two free services will be performed six months and nine months after the delivery of the vehicle to Need-a-Van. The selling price of the vehicle, excluding the two free services, is $20,350. The service fee for a six-month service is usually $1,100 and the service fee for a ninemonth service is usually $550. Good Vehicles delivered the vehicle to Need-a-Van on 15 March 20X6 and Need-a-Van paid the full amount due within 10 business days. Good Vehicles will apply the five-step revenue model to determine when to recognise the revenue and how much:

Step 1 – Identify the contract(s) with a customer Good Vehicles signed a contract to sell a delivery vehicle to Need-a-Van.

Step 2 – Identify the separate performance obligations According to the signed sales contract, Good Vehicles has agreed to the following three performance obligations: •• Sale of a delivery vehicle. •• Six-month service of the delivery vehicle. •• Nine-month service of the delivery vehicle.

Step 3 – Determine the transaction price The transaction price is $20,000.

Step 4 – Allocate the transaction price The transaction price of $20,000 is allocated to the three performance obligations, in proportion to the relative stand-alone selling prices at contract inception, as follows: Column 1

Sale of a delivery vehicle (20,350 ÷ 22,000 × 20,000) Six-month service of the delivery vehicle (1,100 ÷ 22,000 × 20,000)

Unit 3 – Core content

Stand‑alone selling Allocate price transaction price $

%

$

20,350

92.5

18,500

1,100

5

1,000

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Column 1

Stand‑alone selling Allocate price transaction price

Nine-month service of the delivery vehicle (550 ÷ 22,000 × 20,000)

$

%

$

550

2.5

500

22,000

100.0

20,000

Step 5 – Recognise revenue when a performance obligation is satisfied Good Vehicles will recognise revenue when the performance obligations are satisfied, as follows: 15 March 20X6

Sale of a delivery vehicle

15 September 20X6

Six-month service of the delivery vehicle

15 December 20X6

Nine-month service of the delivery vehicle

$18,500 $1,000 $500

It is important to note that none of the steps in the five-step revenue model refers to cash received. Therefore, the date of receipt of the cash amount has no impact on the timing of the revenue recognition, and the date of recognition of revenue does not necessarily coincide with the date of receipt of the related cash. The following journal entries illustrate the recognition of revenue in terms of the five-step revenue model, as well as the receipt of the related cash amounts: Date

Account description

15.03.20X6

Trade receivables

Dr $

Cr $

18,500

Revenue from contracts with customers

18,500

Recognition of revenue on the sale of delivery vehicle Date

Account description

25.03.20X6

Bank

Dr $

Cr $

20,000

Trade receivables

18,500

Revenue received in advance (liability)

1,500

Cash received from Need-a-Van in relation to the sale of delivery vehicle Date

Account description

15.09.20X6

Revenue received in advance (liability)

Dr $

Cr $

1,000

Revenue from contracts with customers

1,000

Recognition of revenue on six-month service of the delivery vehicle Date

Account description

15.12.20X6

Revenue received in advance (liability) Revenue from contracts with customers

Dr $

Cr $

500 500

Recognition of revenue on the nine-month service of the delivery vehicle

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Step 1: Identify the contract(s) with a customer

STEP 1

Step 1 consists of two parts, namely: •• Identifying the contract. •• Considering the potential combination of contracts. STEP 1 Identify the contract(s) with a customer

Identifying the contract

+

Considering the potential combination of contracts

Identifying the contract A contract is defined as ‘an agreement between two or more parties that creates enforceable rights and obligations’ (IFRS 15 Appendix A). IFRS 15 para. 9 sets out five criteria for contracts with customers. These criteria must all be met before a contract can be accounted for under IFRS 15. The following decision tree outlines the process to determine whether an entity should account for a contract with a customer: Have the parties to the contract approved the contract (in writing, orally or in accordance with other customary business practices) and are they committed to perform their respective obligations?

NO

YES

Can the entity identify each party’s rights regarding the goods or services to be transferred?

NO

YES

Can the entity identify the payment terms for the goods or services to be transferred?

NO

Therefore no revenue can be recognised.

YES

Does the contract have commercial substance? (That is, is the risk, timing or amount of the entity’s future cash flows expected to change as a result of the contract?)

Do not account for the contract with the customer under IFRS 15.

NO

YES

Is it probable* that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer?

NO

YES

Account for the contract under IFRS 15. Therefore, proceed to step 2 of the five-step revenue model * Probable under IFRSs is regarded as more likely than not to occur (that is, greater than 50% likelihood).

Required reading

STEP 1

Read IFRS 15 paras 9–16 now to understand how to identify a contract.

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Chartered Accountants Program

Contract with a customer not meeting paragraph 9 criteria Where an entity receives consideration from a customer, but the contract with the customer does not meet all the criteria outlined in IFRS 15 para. 9: •• the consideration (e.g. cash received) cannot be recognised as revenue. In such case, the following journal should instead be processed on receipt of the cash: Dr Cash Cr Revenue received in advance (liability) •• the entity shall recognise the cash received as revenue when either of the following events has occurred (IFRS 15 para. 15): –– the entity has no remaining obligation to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is non-refundable; or –– the contract has been terminated and the consideration received from the customer is non-refundable.

The entity will then process the following journal to recognise the revenue:

Dr Revenue received in advance (liability) Cr Revenue Under IFRS 15, entities apply the revenue recognition model if at the start of the contract, it is probable that the entity will collect the consideration to which it expects to be entitled. IFRS 15 para. 9(e) states ‘In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due’. To this effect, entities often perform credit checks to assess whether a potential customer would be able to settle their debt in the future. This requirement is designed to prevent entities from applying the revenue model to problematic contracts and recognising revenue and a large impairment loss at the same time.

Example – Assessing the existence of a contract to sell equipment Equipt-to-Go enters into an agreement with Factory X to sell Factory X manufacturing equipment, and consequently receives $100,000 on the same day. In accordance with Step 1 of the five-step revenue model, Equipt-to-Go identifies the existence of a contract. Equipt-to-Go considers the following factors: •• Factory X’s financial resources through performance of a credit process. •• Factory X’s commitment to the contract, which may be determined based on the importance of the equipment to factory X’s operations (i.e. the contract has commercial substance). •• Equipt-to-Go’s prior experience with similar contracts and buyers under similar circumstances. Equipt-to-Go has been selling similar equipment for five years and it has previously sold equipment to Factory X. •• Equipt-to-Go’s intention to enforce the contractual rights in the contract. It has previously used the legal process to enforce similar contractual rights. •• The payment terms of the arrangement. Equipt-to-Go concludes that the paragraph 9 criteria have been met. Equipt-to-go could then move on to Step 2 of the five-step revenue model. However, if Equipt-to-Go concludes that it is not probable it will collect the amount to which it expects to be entitled, then no contract exists and Equipt-to-Go cannot move forward to the next step of the five-step revenue model to recognise any revenue. If the criteria to identify a contract are not all met, Equip-to-Go will initially account for any cash collected as a deposit liability/revenue received in advance. It would then continue to assess the contract to establish if it meets the criteria in IFRS 15 para. 9.

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Considering the potential combination of contracts

STEP 1

An entity often enters into various contracts with the same customer. Where this happens, the entity has to assess whether these contracts with the same customer should be accounted for individually in terms of IFRS 15 or whether they should be combined and accounted for as a single contract. Required reading Read IFRS 15 para. 17 to understand when to combine contracts. The reason for this assessment is to prevent an entity and its customer entering into a number of legal contracts that manipulate the timing and the amount of revenue recognised. This is demonstrated in the example below:

Example – Combining contracts Seatings Limited (Seatings) and their customer Foodie could enter into the following three separate contracts: Item sold

Delivery date

Agreed selling price $

Product A

1 January 20X8

60,000

Product B

1 June 20X8

25,000

Product C

1 December 20X8

15,000 100,000

However, the Seatings normally sells these three products at the following prices: Item sold

Normal selling price $

Product A

5,000

Product B

15,000

Product C

80,000 100,000

The following table outlines how revenue would be recognised in the books of Seatings under both alternatives (i.e. individually or combined) and clearly illustrates that the three contracts should be combined to eliminate the possible manipulation of revenue recognised: Date of revenue recognition

Amount of revenue recognised – three separate contracts $

Amount of revenue recognised – one combined contract $

Difference

1 January 20X8

60,000

5,000

55,000

1 June 20X8

25,000

15,000

10,000

1 December 20X8

15,000

80,000

(65,000)

100,000

100,000

     –

Total

Unit 3 – Core content

$

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STEP 1

Chartered Accountants Program

The following decision tree should be used to assess whether to combine two or more contracts: NO

Are the contracts entered into at or near the same time? YES

NO

Are the contracts entered into with the same customer (or related parties of the customer)? YES YES

Are the contracts are negotiated as a package with a single commercial objective? NO

Does the amount of consideration to be paid in one contract dependant on the price or performance of the other contract?

YES

Combine the contracts

NO

Are the goods or services promised in the contracts (or some goods or services promised in each of the contracts) a single performance obligation?

YES

NO

No combination of contracts

Example – Combination of contracts During November 20X6, Beautiful Homes Builders entered into the following three contracts: Date of Contract

Name of Client

Description

Contract Normal selling price price $ $

14.11.20X6

Mr A D Parker

Renovation of kitchen at 75 Collingwood Avenue, Hampton. To be completed in December 20X6

150,000

50,000

16.11.20X6

Mrs E C Parker

Renovation of main bathroom at 75 Collingwood Avenue, Hampton. To be completed in July 20X7

10,000

35,000

17.11.20X6

Mr A D Parker

Construction of a pool at 75 Collingwood Avenue, Hampton. To be completed in September 20X7

5,000

80,000

Mr and Mrs Parker have agreed to pay the total amount of $165,000 on 31 October 20X7. To determine when and how much revenue to recognise, Beautiful Homes Builders will apply the five-step revenue model, as follows:

Step 1 – Identify the contract(s) with a customer Beautiful Homes Builders signed three contracts during November 20X6. As part of Step 1, Beautiful Homes Builders has to assess whether to combine these contracts, and it should use the decision tree to make its assessment.

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STEP 1

Beautiful Homes Builders made the following assessment: •• The three contracts are entered into at or near the same time, because they are entered into within the same week. •• The three contracts are entered into with the same customer (or related parties of the customer), because Mr A D Parker and Mrs E C Parker are married and therefore related parties. •• The contracts are negotiated as a package with a single commercial objective, because the three contracts all relate to the renovation of the same property at 75 Collingwood Avenue in Hampton. Therefore, Beautiful Homes Builders has to combine the three contracts. Beautiful Homes Buildings would then go on the complete the remaining four steps in the five step IFRS15 revenue recognition model. These steps are introduced briefly in this example below, and will be examined in more detail later in the following pages.

Step 2 – Identify the separate performance obligations According to the three signed contracts, Beautiful Homes Builders has agreed to the following three performance obligations: •• Renovation of kitchen. •• Renovation of main bathroom. •• Construction of a pool.

Step 3 – Determine the transaction price The transaction price is $165,000.

Step 4 – Allocate the transaction price The transaction price of $165,000 is allocated to the three performance obligations, as follows: $ Renovation of kitchen

50,000

Renovation of main bathroom

35,000

Construction of a pool

80,000 165,000

Step 5 – Recognise revenue when a performance obligation is satisfied Beautiful Homes Builders will recognise revenue when the performance obligations are satisfied: $ December 20X6

Renovation of kitchen

50,000

July 20X7

Renovation of main bathroom

35,000

September 20X7

Construction of a pool

80,000

It is important to note that the combination of the three contracts is aligned to the ‘substance over form principle’ as outlined in the Framework. If the contracts were not combined the revenue from the three separate contracts would be recognised as follows: $ December 20X6

Renovation of kitchen

July 20X7

Renovation of main bathroom

September 20X7

Construction of a pool

Unit 3 – Core content

150,000 10,000 5,000

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STEP 2

Chartered Accountants Program

Step 2: Identify the separate performance obligations Step 2 of the five-step revenue model requires that at the inception of contract, the entity assesses the goods or services promised in a contract with a customer and identifies the separate performance obligations. A performance obligation is: STEP 2 Identify the separate performance obligations

A promise

+

In a contract

+

To transfer

+

A good or service (or a bundle of goods or services) that is distinct OR • A series of distinct goods or services • That are substantially the same, and • That have the same pattern of transfer to the customer

Required reading Read IFRS 15 paras 22–30 now to understand how to identify the separate performance obligations. Read the definition of performance obligation in IFRS 15 Appendix A.

Example – Administrative tasks to set up a contract Exercise Heaven offers annual gym membership to members under the following terms and conditions: •• Joining fee – $600 non-refundable joining fee is payable on the day of entering into the new gym membership contract. The joining fee is to cover the costs of the administrative tasks in enrolling a new member. •• Monthly membership fee – $100 per month, payable in advance. •• Maximum membership period –12 months. Anyone who wishes to continue their membership has to enter into a new annual gym membership contract and again pay the $600 non-refundable joining fee. On 1 January 20X3, Exercise Heaven entered into a new annual gym membership contract with Mrs V Lazy. Exercise Heaven has asked for your assistance in determining the revenue to recognise for January 20X3.

Step 1 – Identify the contract(s) with a customer Exercise Heaven entered into a new annual gym membership contract with Mrs V Lazy.

Step 2 – Identify the separate performance obligations Exercise Heaven only has one performance obligation and that is to provide the use of the gym to Mrs V Lazy for a period of 12 months. The administrative tasks to enrol a new member are not a separate performance obligation, because they do not transfer a service to the customer as the tasks are performed. Exercise Heaven would then go on to apply the remaining steps of the five-step revenue recognition model under IFRS 15. These steps are discussed in more detail in the following pages.

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STEP 2

Step 3 – Determine the transaction price The transaction price is $1,800, which consists of the $600 joining fee and $100 per month for 12 months.

Step 4 – Allocate the transaction price The transaction price of $1,800 is allocated to the one performance obligation.

Step 5 – Recognise revenue when a performance obligation is satisfied The performance obligation is satisfied over the 12 months and therefore the revenue is recognised over the 12 months. The following journal entries illustrate the recognition of revenue in terms of the five-step revenue model, as well as the receipt of cash amounts, during the month of January 20X3: Date

Account description

01.01.20X3

Bank

Dr $

Cr $

600

Revenue received in advance (liability)

600

Joining fee received on signing the new annual gym membership contract

Date

Account description

01.01.20X3

Bank

Dr $

Cr $

100

Revenue received in advance (liability)

100

January gym membership received

Date

Account description

31.01.20X3

Revenue received in advance (liability) Revenue from contracts with customers

Dr $

Cr $

150 150

Recognition of revenue for the month of January ($100 + ($600 ÷ 12 months))

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STEP 2

Chartered Accountants Program

The following decision tree could be used to identify separate performance obligations: Can the customer benefit from the good or service, whether on its own, or with other readily available resources?

NO

YES

Does the entity provide a significant service of integrating the goods or services?

YES

NO

Does the good or service significantly modify or customise the other goods or services?

YES

The good or service is not ‘distinct’ = Combine the good or service with other promised goods or services until a bundle of goods and services that is distinct can be identified

NO

Are the goods or services highly interdependent or highly interrelated?

YES

NO

The good or service is ‘distinct’ = Separate performance obligation

Example – Customer could benefit from a good or service Love-a-Phone sells mobile phone contracts. A mobile phone contract consists of a new mobile phone, access to airtime for phone calls, and access to text messaging. Love-a-Phone also sells mobile phones and airtime separately. Love-a-Phone is one of three mobile phone providers in Australia. On 1 April 20X7, Mr Forgetful enters into a new mobile phone contract with Love-a-Phone. Mr Forgetful can benefit from the mobile phone on its own, because he could buy airtime from another mobile phone provider. Mr Forgetful can benefit from the airtime on its own, because he could continue to use his old mobile phone or buy a mobile phone from another mobile phone provider. Therefore, the phone and the airtime are distinct, and would be treated as separate performance obligations under IFRS 15.

Example– Distinct goods or services The Big Machine sells large specialised manufacturing machinery. Due to the specialised nature of the manufacturing machinery, The Big Machine also installs this machinery. The Big Machine is the only entity that has the specialised knowledge to install these types of specialised manufacturing machinery in Australia and New Zealand. In Step 2 of the five-step revenue model, The Big Machine needs to identify the separate performance obligations. The Big Machine will be performing two activities – the sale and the installation of the specialised manufacturing machinery. Careful consideration should be given to determine whether these two activities lead to the provision of one or two distinct goods or services to the customer. The customer cannot benefit from the specialised manufacturing machinery on its own or with other readily available resources, because The Big Machine is the only entity that has the knowledge and expertise to install the specialised manufacturing machinery. In addition, the specialised manufacturing machinery cannot be used if it is not properly installed and therefore the goods (specialised manufacturing machinery) and the installation services are highly interdependent. The sale of the specialised manufacturing machinery and the installation service should therefore be bundled together as one performance obligation.

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STEP 2

Example – Distinct goods or services Stylish Equipment sells manufacturing machinery. It also installs the manufacturing machinery for their customers. The installation of the manufacturing machinery can also be done by registered builders. In Step 2 of the five-step revenue model, Stylish Equipment needs to identify the separate performance obligations. Stylish Equipment will be performing two activities – the sale and the installation of the manufacturing machinery. Careful consideration should be given to determine whether these two activities lead to the provision of one or two distinct goods or services to the customer. The customer can benefit from the manufacturing machinery on its own or with other readily available resources, because the manufacturing machinery can also be installed by other registered builders. In addition, the manufacturing machinery and the installation services are not highly interdependent or highly interrelated. The sale of the manufacturing machinery and the installation services should therefore be identified as two separate performance obligations.

Example – Distinct goods or services Programming Delights is a listed IT company that specialises in developing, installing and maintaining specialised payroll software for companies throughout Australia and New Zealand. A contract with a customer normally includes the development of specialised payroll software that would interface with the customer’s system. This specialised interface can take up to six months to get ready for usage from the time the contract is signed. The specialised software cannot be redeployed to another customer without significant modification. Only Programming Delights has the specialised knowledge to complete this type of software development and installation. Programming Delights provides a detailed user manual and description of the design of the developed software to the customers, which enables other software providers to also maintain the software system going forward. In Step 2 of the five-step revenue model, Programming Delights needs to identify the separate performance obligations. Programming Delights will be performing three activities – the development, implementation, and maintenance of the specialised software. Careful consideration should be given to determine whether these three activities lead to the provision of one, two or three distinct goods or services to the customer. Due to the specialised nature of the payroll software, only Programming Delights is able to implement the developed specialised payroll software that would interface with the customer’s system. The customer would therefore not be able to benefit from the development of the payroll software unless Programming Delights also implements the software. The development and installation of the specialised payroll software are highly interrelated. The development and installation of the specialised payroll software should therefore be bundled together as one performance obligation. The maintenance of the payroll software system is a distinct service, because Programming Delights and some other software providers can maintain the software system going forward.

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STEP 3

Chartered Accountants Program

Step 3: Determine the transaction price The transaction price is defined in IFRS 15 Appendix A as ‘the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer’. STEP 3 Determine the transaction price

Transaction price

=

Amount of consideration the entity expects to be entitled to

Entities have to consider the following in order to determine the transaction price: •• terms of a contract (e.g. terms specified in a sales invoice) •• the entity’s customary business practices (e.g. a settlement discount of 10% if the customer pays within 30 days). Required reading Read IFRS 15 paras 46–49 now to understand determining the transaction price.

Example – Settlement discount The Shoe Warehouse sells shoes in bulk to small retail stores in major cities across Australia and New Zealand. On 15 June 20X9, Shoe Warehouse sold shoes to Amazing Shoes in Melbourne on credit. The shoes were delivered to Amazing Shoes on 20 June 20X9 and the accompanying invoice indicated that the total sales price was $250,000. The individual sales prices were obtained from the master price list. The Shoe Warehouse normally provides a settlement discount of 5% of the invoiced price if the debtor settles the invoice within 30 days of delivery of the shoes. Amazing Shoes is a regular customer of The Shoe warehouse. Amazing Shoes has consistently settled its debts within the required 30 days. The Shoe Warehouse will process the following journal on 20 June 20X9 (date of delivery) in relation to the sale of the shoes to Amazing Shoes: Date

Account description

20.06.X9

Trade receivables Revenue from contracts with customers

Dr $

Cr $

237,500 237,500

To record the sale to Amazing Shoes

The sales revenue is calculated at the invoice price of $250,000 less the expected settlement discount of $12,500 ($250,000 × 5%), because the transaction price is the amount of consideration the entity expects to be entitled to. Based on past experience, Amazing Shoes will settle its debt within 30 days and therefore the Shoe Warehouse would only be entitled to $237,500. Subsequently, if the amount received from Amazing shoes is higher (e.g. if the payment does not fall within the settlement discount period), any additional revenue could be recognised.

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Financial Accounting & Reporting

STEP 3

Example – Refund liability Basketball Gear sells basketball clothes and equipment to retail stores across Australia and New Zealand. Basketball Gear does not deliver its goods to customers. Customers are required to pay in cash or via electronic funds transfer on the day of sale, which is also the day on which the customer picks up the goods from Basketball Gear’s warehouse. On 12 July 20X1, Basketball Gear sells a number of basketballs, basketball hoops and clothing to a local sports club for $50,000. The basketball club has 30 days to return any unwanted items. If the club returns the goods within the 30 days, it will receive a full refund. Based on past experience with this customer, Basketball Gear estimates that 15% of the goods will be returned within the allowed 30 days. Basketball Gear will process the following journal on 12 July 20X1 (date of cash sale and pick up of goods) in relation to the sale: Date

Account description

12.07.X1

Cash

Dr $

Cr $

50,000

Sales revenue

42,500

Refund liability

7,500

To record the sale less expected refund

Assume that the customer returns 15% of the goods on 31 July 20X1. Basketball Gear will process the following journal on 31 July 20X1: Date

Account description

31.07.X1

Refund liability

Dr $

Cr $

7,500

Cash

7,500

To record refund to customer

IFRS 15 para. 47 states that a transaction price excludes amount collected on behalf of third parties. In Australia and New Zealand, this means a transaction price as defined in IFRS 15 excludes the GST collected.

Transaction price

Unit 3 – Core content

≠

Amounts collected on behalf of third parties, for example the tax office

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Financial Accounting & Reporting

STEP 3

Chartered Accountants Program

Example – Goods and services tax (GST) On 20 November 20X8, A-lot-of-runs Cricket Bats delivered 11 new cricket bats to Cricket Australia. The accompanying invoice indicated that the total sales price is $110,000, including GST of 10%. A-lot-of-runs Cricket Bats does not provide any settlement discounts to customers. A-lot-of-runs Cricket Bats will aprocess the following journal on 20 November 20X8 (date of delivery) in relation to the sale of the cricket bats to Cricket Australia: Date

Account description

20.11.X8

Trade receivables

Dr $

Cr $

110,000

Revenue from contracts with customers

100,000

GST payable

10,000

To record the sale of bats to Cricket Australia Note: this example is included to show amounts collected on behalf of third parties. GST generally is beyond the scope of the FIN module.

The transaction price could consist of a fixed consideration, or a variable consideration, or both.

Transaction price Fixed consideration

Variable consideration

+

OR BOTH IFRS 15 para. 47 states that the ‘consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both’. An entity should consider the effects of all of the following when determining the transaction price:

Variable consideration

Consideration payable to a customer

Constraining estimates of variable consideration Existence of a significant financing component

Non-cash consideration

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Financial Accounting & Reporting

Variable consideration

STEP 3

Discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items could impact the amount of consideration (IFRS 15 para. 50). Consideration can also be contingent on the occurrence or non-occurrence of a future event. Variable consideration could originate from any of the following sources (IFRS 15 para. 52): •• Explicitly stated in the contract. •• The customer has a valid expectation arising from an entity’s customary business practices, published policies or specific statements that the entity will accept an amount of consideration that is less than the price stated in the contract. The entity is expected to offer a price concession, which could be referred to as a discount, rebate, refund or credit. •• Other facts and circumstances indicate that the entity intends to offer a price concession to the customer. An entity needs to estimate the amount of variable consideration by using either of the following two methods: •• Expected value. •• Most likely amount. The method selected would depend on which of the two methods the entity expects to better predict the amount of variable consideration.

Estimation of variable consideration The expected value

OR

The most likely amount

Method

Description

When to use

Expected value

The sum of probability-weighted amounts in a range of possible consideration amounts

An entity has a large number of contracts with similar characteristics

Most likely amount

The single most likely amount in a range of possible consideration amounts (i.e. the single most likely outcome of the contract)

The contract has only two possible outcomes (e.g. an entity either achieves or does not achieve a performance bonus)

Required reading Read IFRS 15 paras 50–55 now to understand variable consideration

Example – The expected value Master Seller enters into a contract with Love-a-Bargain to build an asset for $200,000, with a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance bonus decreases by 5% per week for every week beyond the agreed-upon completion date. The contract requirements are similar to contracts Master Seller has performed previously, and management believes that such experience is predictive for this contract. Master Seller concludes that the expected value method is most predictive in this case. Master Seller estimates that there is a 35% probability that the contract will be completed by the agreed-upon completion date, a 45% probability that it will be completed one week late, and a 20% probability that it will be completed two weeks late.

Unit 3 – Core content

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Financial Accounting & Reporting

STEP 3

Chartered Accountants Program

In accordance with Step 3 of the five-step revenue model, the transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled for the work performed. The total transaction price is $247,875 based on the probability-weighted estimate below: Likely fee % probability $250,000 (fixed fee plus full performance bonus) × 35%

$ 87,500

$247,500 (fixed fee plus 95% of performance bonus) × 45%

111,375

$245,000 (fixed fee plus 90% of performance bonus) × 20%

49,000 247,875

Master Seller will update its estimate at each reporting date. This example does not consider the potential need to constrain the estimate of variable consideration included in the transaction price. Assuming this estimate meets the requirements of IFRS15 para. 56 (discussed in the following pages), the revenue would be recognised via the following journal. Date

Account description

xx.xx.xx

Trade receivables

Dr $

Cr $

247,875

Revenue from contracts with customers

247,875

To recognise sales revenue from Love-a-Bargain

Example – The most likely amount Magnificent Buildings enters into a contract to construct a manufacturing facility for Amazing Creations. The contract price is $500,000 plus a $50,000 award fee if the facility is completed by a specified date. The contract is expected to take 18 months to complete. Magnificent Buildings has a long history of constructing similar facilities. The award fee is binary (i.e. there are only two possible outcomes) and is payable in full upon completion of the facility. Magnificent Buildings will receive none of the $50,000 award fee if the facility is not completed by the specified date. Magnificent Buildings believes that, based on its experience, it is 90% likely that the contract will be completed successfully and in advance of the target date. It is appropriate for Magnificent Buildings to use the most likely amount method to estimate the variable consideration. The contract’s transaction price is therefore $550,000, which includes the fixed contract price of $500,000 and the $50,000 variable consideration in the form of the award fee. The estimate should be updated each reporting date. Assuming this estimate meets the requirements of IFRS15 para. 56 (discussed in the following pages), the revenue would be recognised via the following journal. Date

Account description

xx.xx.xx

Trade receivables Revenue from contracts with customers

Dr $

Cr $

550,000 550,000

To recognise revenue from the Amazing Creations contract

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Financial Accounting & Reporting

Constraining estimates of variable consideration

STEP 3

When including variable consideration in calculating a transaction price, IFRS 15 para. 56 imposes a constraint on when this variable consideration can be recognised. The following decision tree should be used to consider the constraining estimates of variable consideration: Is the consideration variable? NO

Include the fixed consideration in the transaction price

YES

Estimate the amount using the expected value or most likely value

Is it highly probable that a significant revenue reversal will not subsequently occur?* YES

Include variable consideration in transaction price

NO

Do not include variable consideration in transaction price

* IFRS 5 Non-current Assets Held for Sale and Discontinued Operations defines ‘highly probable’ as significantly more likely than probable. The standard does not quantify this. An entity has to consider both the likelihood and the magnitude of the revenue reversal.

Having trouble? The variable consideration constraint is difficult to understand. Watch our video on paragraph 56 to unpack the concept. [Available online in myLearning] The following factors increase the likelihood or magnitude of a revenue reversal (IFRS 15 para. 57): Constraining estimates of variable consideration consideration highly susceptible to outside factors (e.g. market volatility, weather, actions of 3rd parties etc) long period to resolve uncertainty limited experience with similar contracts price concessions vary, changing payment terms contract has large number and broad range of possible consideration amounts

Unit 3 – Core content

Page 3-21

Financial Accounting & Reporting

STEP 3

Chartered Accountants Program

Required reading Read IFRS 15 paras 56–59 now to understand the constraining estimates of variable consideration. Required reading Read IFRS 15 Appendix B paras B20-B33 now to understand sale with a right of return and warranties

Example – Right of return The Art House sells modern art pieces to retail stores across Asia Pacific. The Art House delivers the sold art pieces to the customers. Customers are required to either pay or return the art within 60 days. If customers return the art pieces within 60 days, they will receive a full refund. On 5 March 20X4, The Art House sold a number of art pieces to Funky Art for $100,000. Based on past experience with Funky Art, The Art House estimates that 30% of the goods will be returned within the allowed 60 days. Because the sales contract allows Funky Art to return the art pieces, the consideration is variable. Using the expected value method, The Art House estimates that 70% of the art pieces will not be returned. The Art House will process the following journal on 5 March 20X4 (date of sale and delivery of the art pieces) in relation to the sale: Date

Account description

05.03.X4

Trade receivables

Dr $

Cr $

100,000

Revenue from contracts with customers (70% of $100,000)

70,000

Refund liability (30% of $100,000)

30,000

To record sales revenue and expected refund liability

Assume that Funky Art returns 30% of the goods on 15 April 20X4. The Art House will process the following journal on 15 April 20X4: Date

Account description

15.04.X4

Refund liability Trade receivables

Dr $

Cr $

30,000 30,000

To record return of sales

Example – Volume discount incentive On 1 January 20X3, Bottles Galore enters into a contract with A-lot-of-drinks to sell 1,000 colourful bottles for $3 per bottle. If A-lot-of-drinks purchases more than 5,000 bottles in a calendar year, the sales contract specifies that the price per unit is retrospectively reduced to $2 per unit. On 1 January 20X3, Bottles Galore estimates that A-lot-of-drinks’ purchases will not exceed the 5,000 bottle threshold required for the volume discount in the calendar year. The bottles are delivered to A-lot-of-drinks on 10 January 20X3 and A-lot-of-drinks paid the full amount due on 1 March 20X3. Bottles Galore determines that it has significant experience with the sale of these colourful bottles and with the purchasing pattern of A-lot-of-drinks. Bottles Galore concludes that it is highly probable that a significant reversal in the cumulative amount of revenue recognised will not occur when the uncertainty is resolved, that is, when the total amount of purchases is known by the end of the calendar year.

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Core content – Unit 3

Chartered Accountants Program

Financial Accounting & Reporting

STEP 3

Bottles Galore will process the following journal on 10 January 20X3: Date

Account description

10.01.X3

Trade receivables

Dr $

Cr $

3,000

Revenue from contracts with customers

3,000

To record sale to A-lot-of-drinks

Existence of a significant financing component in the contract A significant financing component exists in a contract if the timing of the cash flows is more than 12 months after the date of recognition of the related revenue. If a significant financing component exists in a contract, the transaction price should be adjusted for the time value of money. As per IFRS 15 para. 61, the objective of adjusting the transaction price for a significant financing component is ‘for an entity to recognise revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (i.e. the cash selling price)’. The discount rate used is the rate that would be used in a separate financing transaction between the entity and the customer. The objective of adjusting the transaction price applies to both in advance and in arrears. In the statement of profit or loss and other comprehensive income, an entity should present the effects of financing (interest revenue or interest expense) separately from revenue from contracts with customers. Required reading Read IFRS 15 paras 60–65 now to understand the existence of a significant component in a contract.

Example – Significant financing component (interest revenue) On 1 January 20X1, The Block sells furniture to a customer on credit for $100,000. The furniture is delivered to the customer on 1 January 20X1. According to the sales agreement the $100,000 is payable on 31 December 20X2. Assume that the present value of the $100,000 is $90,000 on 1 January 20X1 and $96,500 on 31 December 20X1. The Block’s reporting date is 31 December. The $100,000 is received from the customer on 31 December 20X2. The Block will prepare the following journals to record revenue for the contract: Date

Account description

01.01.20X1

Trade receivable

Dr $

Cr $

90,000

Revenue from contracts with customers

90,000

Recognition of revenue on satisfaction of the single performance obligation to sell and deliver furniture

Date

Account description

31.12.20X1

Trade receivable Interest revenue

Unit 3 – Core content

Dr $

Cr $

6,500 6,500

Page 3-23

Financial Accounting & Reporting

STEP 3

Date

Chartered Accountants Program

Account description

Dr $

Cr $

Dr $

Cr $

Recognition of interest revenue for the period 1 January 20X1 to 31 December 20X1 Date

Account description

31.12.20X2

Trade receivable

3,500

Interest revenue

3,500

Recognition of interest revenue for the period 1 January 20X2 to 31 December 20X2 Date

Account description

31.12.20X2

Cash

Dr $

Cr $

100,000

Trade receivable

100,000

Accounting for cash received from the customer

Non-cash consideration If an entity provides goods or services to a customer and the customer promises consideration in a form other than cash, the entity should measure the non-cash consideration (or promise of non-cash consideration) at fair value. Fair value is discussed in Unit 6 and in IFRS 13 Fair Value Measurement. Required reading Read IFRS 15 paras 66–69 now to understand non-cash consideration.

Example – Entitlement to non-cash consideration On 8 September 20X2, Modern Office Furniture sold new office furniture to a large motor vehicle dealership. The agreed selling price is $80,000. The large motor vehicle dealership promised to provide a new delivery vehicle with a stand-alone selling price of $75,000 to Modern Office Furniture as payment for the new office furniture. Modern Office Furniture will process the following journal on 8 September 20X2: Date

Account description

08.09.X2

Trade receivables Revenue from contracts with customers

Dr $

Cr $

75,000 75,000

To recognise the fair value of non-cash consideration received on sale

As the customer is paying Modern Office Furniture by providing a new delivery vehicle, the vehicle is non-cash consideration (as discussed in IFRS 15 para. 66). The fair value of the motor vehicle was $75,000, and this is the amount that should be recognised as revenue, rather than the $80,000 agreed selling price.

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Financial Accounting & Reporting

Consideration payable to a customer

STEP 3

IFRS 15 has specific principles around the treatment of consideration payable to a customer. These payments can be a common feature in certain industries. Examples in the retail sector include retail cash back offers and free giftcards. Consideration payable to a customer includes the following: •• Cash amounts paid or to be paid to customer (e.g. a cash-back offer on an electrical appliance). •• Credits. •• Other items (e.g. a voucher) that can be applied against amounts owed to the entity. The principles to treat consideration payable to a customer are set out in IFRS 15 para. 70 and are summarised below: Consideration payable to a customer General rule • Treat as reduction in transaction price (reduction in revenue) • Recognise when entity recognises revenue and entity promises to pay consideration

Exception • Payment to customer is in exchange for a distinct good or service • Account for it like other purchases from suppliers

Required reading Read IFRS 15 paras 70–72 now to understand consideration payable to a customer.

Example – Consideration payable to a customer On 10 August 20X3, Solid Machines sold a new manufacturing machine to a large manufacturing company in Wellington. The agreed selling price is $100,000. Usually, Solid Machine would also assist with the installation of the manufacturing machine. However, its installation manager has indicated that Solid Machines’ installation team will only be available to do the installation in Wellington in three months’ time due to a staff shortage. Solid Machine has agreed to pay the customer an amount of $5,000 if the customer uses an independent contractor based in Wellington to install the manufacturing machine. In this situation, applying the general rule, the transaction price is $95,000. Once an entity has determined the transaction price under Step 3, it can move on to Step 4 to allocate the transaction price.

Unit 3 – Core content

Page 3-25

Financial Accounting & Reporting

STEP 4

Chartered Accountants Program

Step 4: Allocate the transaction price An entity should follow the following process to allocate the transaction price, as determined in Step 3, to each performance obligation identified in Step 2: STEP 4 Allocate the transaction price

Transaction price

Allocating transaction price to performance obligations: Allocating transaction price to performance obligations General rule • Allocate based on stand-alone selling prices at inception

Exception • Stand-alone selling price not observable: estimate using methods in para. 79

Is the stand-alone selling price of the performance obligation observable? YES

Determine the stand-alone selling price at contract inception of the distinct good or service underlying the performance obligation in the contract.

NO

Estimate the stand-alone selling price using one of the following • Adjusted market assessment approach • Expected cost plus a margin approach, or • Residual approach (only use as a last resort).

Allocate the transaction price in proportion to the stand-alone selling prices An entity should consider the following aspects to determine the stand-alone selling price of a good or service: •• At what price does the entity sell the promised good or service separately to a customer? •• At what price does the entity sell the good or service separately in similar circumstances and to similar customers? •• What is the contractually stated price? (This price may be, but shall not be presumed to be, the stand-alone selling price.) Required reading Read IFRS 15 paras 73–80 to understand allocating the transaction price.

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Financial Accounting & Reporting

STEP 4

Further reading A discussion and examples of methods to estimate stand-alone prices can be found in Unit 3 in myLearning

Example – Stand-alone selling price Smart Kids sells academic books and online access to worked examples and activities for most school subjects. During November 20X6, Bayview School ordered academic books and online access to worked examples and activities for the 20X7 academic year. The contract price amounted to $100,000. The stand-alone selling prices for similar customers online is $80,000 for books and $40,000 for online access to worked examples and activities. In Step 4 of the five-step revenue model, Smart Kids has to allocate the transaction price to the two separate performance obligations. Performance obligation

Transaction price allocation

$

Academic books

80,000 ÷ 120,000 × 100,000

66,667

Online worked examples

40,000 ÷ 120,000 × 100,000

33,333 100,000

In this transaction, there is an inherent discount of $20,000, which does not relate to a specific performance obligation and is therefore allocated to all performance obligations on a relative stand-alone selling price basis. As part of Step 4 to allocate a transaction price, a number of complicating factors must be considered. Two of these are addressed below – the allocation of a discount and allocation of variable consideration.

Allocation of a discount In entering into a contract with a customer, an entity may provide that customer with a discount. In order to apply the five-step revenue recognition process under IFRS 15, the principles for dealing with discounts are discussed in IFRS 15 paras 81–83. Allocating a discount General rule • Allocate proportionately to all performance obligations in the contract

Exception • If criteria in IFRS 15 paragraph 82 are met and there is observable evidence the discount relates to certain performance obligations (but not all performance obligations), allocate to the relevant performance obligations only

Required reading Read IFRS 15 paras 81–83 to understand the allocation of a discount.

Unit 3 – Core content

Page 3-27

Financial Accounting & Reporting

STEP 4

Chartered Accountants Program

Allocation of variable consideration In applying Step 4 of the revenue recognition model, an entity needs to consider the variable consideration in a contract. The variable consideration must be allocated to performance obligations. These principles are discussed in IFRS 15 paras 84–85. Allocating a variable consideration General rule • Allocate to all performance obligations in the contract

Exception • If criteria in IFRS 15 paragraph 85 are met, allocate to one or more performance obligations or one or more distinct good/services in a series

Required reading Read IFRS 15 para. 85 to understand when to use the exception discussed in the diagram above.

Example – Allocation of variable consideration On 1 October 20X5 Software Kings makes a sale to a large global telecommunications company with the following terms and conditions: •• Contract signed: 1 October 20X5 •• Total contract value: $1,000,000 –– Development of software: $750,000 –– Installation of software and coding to clients system: $50,000 –– First year maintenance and support fee: $200,000 •• Installation date: 30 September 20X6 •• If installation does not happen by 30 September 20X6, a $100,000 rebate will be provided back to the customer. •• The software must be installed by Software Kings and coded to the client’s system otherwise the software will not operate. Software Kings has performed many of these contracts before and at the time of signing the contract Software Kings estimated that installation would occur later than 30 September 20X6. The stand-alone selling prices the entity would charge for the same services are: development of software $800,000; installation and coding $80,000; and first year maintenance and support of $250,000. The development and installation of the software are interdependent – without the installation by Software Kings, the software will not operate and will have no value to the client. In accordance with Step 2 of the five-step model, Software Kings has determined that two separate performance obligations exist – development and installation, and maintenance. In accordance with Step 3 of the five-step revenue model, Software Kings has determined that the transaction price is $900,000 ($1,000,000 fixed amount in the contract – $100,000 variable consideration or rebate).

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Core content – Unit 3

Chartered Accountants Program

Financial Accounting & Reporting

In accordance with Step 4 of the five-step revenue model, the transaction price is allocated to the two performance obligations as follows:

STEP 4

General rule – allocate $1million fixed amount to performance obligations Performance obligation

Stand-alone selling price ($)

Fixed contract price allocation

Development and installation

880,000

(880,000/1,130,000) × 1,000,000

778,761

Maintenance

250,000

(250,000/1,130,000) × 1,000,000

221,239

Total

1,130,000

Agrees to total of stand-alone selling prices

$

1,000,000

Agrees to total of fixed amount in contract before application of the exception rule

Exception rule – allocate the rebate to the development and installation performance obligation Performance obligation

Gross transaction price allocation ($)

Allocation of discount Total to specific performance transaction obligations price allocation $

Development and installation

778,761

778,761 – 100,000 rebate

678,761

Maintenance

221,239

N/A

221,239

Total

1,000,000

Agrees to total of fixed amount in contract before application of the exception rule

900,000

Agrees to total of transaction price expected to be received due to payment of rebate

The $100,000 rebate is allocated to development and installation as it can be clearly seen that the variation relates to this part of the contract. This applies the ‘exception’ for allocating the discount, outlined in our earlier diagram.

Unit 3 – Core content

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Financial Accounting & Reporting

STEP 5

Chartered Accountants Program

Step 5: Recognise revenue when a performance obligation is satisfied In the fifth and final step of the revenue model, an entity finally determines when to recognise revenue. FIN fact It should be remembered that all of the five steps are performed at inception of a contract. Required reading Read IFRS 15 paras 31–38 now to understand when a performance obligation is satisfied. The timing of revenue recognition is determined based on whether the entity satisfies the performance obligation(s) (identified in Step 2) over time or at a point in time. An entity should start by considering whether the entity satisfies a performance obligation over time, and if not, it is concluded that the entity satisfies the performance obligation at a point in time. STEP 5 Recognise revenue when a performance obligation is satisfied

KEY QUESTION: Does the entity transfer control of the asset over time? YES

The entity should recognise revenue over time, using a method that depicts its performance

NO

The entity should recognise revenue at a point in time at which it transfers control of the good or service to the customer

The following indicators should be considered to determine whether control of an asset has been transferred: •• Does the entity have a present right to payment for the asset? •• Does the customer have legal title to the asset? •• Has the entity transferred physical possession of the asset to the customer? •• Does the customer have significant risks and rewards of ownership of the asset? •• Has the customer accepted the asset?

Example – Transfer of a promised good or service (i.e. an asset) to a customer On 1 January 20X2, The Great Bus Manufacturer enters into a contract with Seaview Secondary School (Seaview) to provide three new buses to Seaview over the next six months. The agreed delivery dates of the buses are as follows: •• 30 seater bus – 1 March 20X2. •• 20 seater bus – 1 May 20X3. •• 10 seater bus – 31 August 20X3. Page 3-30

Core content – Unit 3

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Financial Accounting & Reporting

In accordance with Step 2 of the five-step revenue model, The Great Bus Manufacturer identified three separate performance obligations –the 30 seater bus, the 20-seater bus and the 10-seater bus. In accordance with Step 5 of the five-step revenue model, The Great Bus Manufacturer will recognise revenue at the following dates when it delivers each bus to Seaview:

STEP 5

•• 1 March 20X2 •• 1 May 20X3 •• 31 August 20X3. Seaview Secondary School will obtain control of the buses at the date of the delivery of the buses. The following decision tree should be used to determine when and how the entity transfers control of the asset: The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs

TRUE

FALSE

The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced

TRUE

FALSE

The entity’s performance does NOT create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date

The entity transfers control over time = The entity should recognise revenue over time, using a method that depicts its performance

TRUE

FALSE

The entity transfers control at a point in time = The entity should recognise revenue at a point in time at which it transfers control of the good or service to the customer

Example – Simultaneous receipt and consumption of the benefits of the entity’s performance On 1 January 20X4, Payroll Made Easy enters into a contract to provide monthly payroll processing services to a customer for one year. The customer agrees to pay $900 per quarter on 31 March 20X4, 30 June 20X4, 30 September 20X4 and 31 December 20X4. Payroll Made Easy’s reporting date is 30 April. In accordance with Step 2 of the five-step revenue model, Payroll Made Easy identified a single performance obligation – the promised payroll processing services. In accordance with Step 5 of the five-step revenue model, Payroll Made Easy determines that the performance obligation is satisfied over time because the customer simultaneously receives and consumes the benefits of the entity’s performance in processing each payroll transaction as and when each transaction is processed. The fact that another entity would not need to re‑perform payroll processing services for the service that Payroll Made Easy has provided to date also demonstrates that the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs the services. Payroll Made Easy therefore recognises revenue over time by measuring its progress towards complete satisfaction of that performance obligation.

Unit 3 – Core content

Page 3-31

Financial Accounting & Reporting

STEP 5

Chartered Accountants Program

Payroll Made Easy would recognise revenue from this contract as follows: •• Financial reporting period ending on 30 April 20X4 = $1,200 [($900 × 4 quarters) × (4 months ÷ 12 months)]. •• Financial reporting period ending on 30 April 20X5 = $2,400 [($900 × 4 quarters) × (8 months ÷ 12 months)].

Example – Creates or enhances an asset that the customer controls as the asset is created or enhanced Good Construction enters into a contract with a customer to build a new architect-designed home on a block of land in Sandringham. The customer purchased the block of land a few months ago and has already demolished the original home. In accordance with Step 2 of the five-step revenue model, Good Construction identified a single performance obligation – the construction of a new home. In accordance with Step 5 of the five-step revenue model, Good Construction determines that the performance obligation is satisfied over time because Good Construction’s performance creates or enhances an asset (property in Sandringham) that the customer controls as the asset (the new home) is created or enhanced. The home is constructed on a block of land owned and controlled by the customer.

Example – Creates or enhances an asset that is NOT controlled by the customer as the asset is created or enhanced Big Developer is developing a multi-unit residential complex in Docklands, Melbourne. A customer enters into a binding sales contract with Big Developer for a specified unit that is under construction. Each unit has a similar floor plan and is of a similar size, but other attributes of the units are different (e.g. the location of the unit within the complex) The customer pays a 10% deposit upon entering into the contract and the deposit is refundable only if Big Developer fails to complete construction of the unit in accordance with the contract. The remainder of the contract price is payable on completion of the contract when the customer obtains physical possession of the unit. If the customer defaults on the contract before completion of the unit, Big Developer has the right to retain the deposit. In accordance with Step 5 of the five-step revenue model, at contract inception, Big Developer determines whether its promise to construct and transfer the unit to the customer is a performance obligation satisfied over time or a point in time. Big Developer determines that the customer does not simultaneously receive and consume the benefits provided by Big Developer’s performance as Big Developer performs (i.e. construct the building), because the customer only gets physical possession of the unit on completion of the building. Big Developer also determines that its performance does not create or enhance an asset that the customer controls as the asset is created or enhanced, because the customer does not own the block of land on which the building is constructed and the customer only gets physical possession of the unit on completion of the building. Big Developer further determines that its performance creates an asset with an alternative use to Big Developer, because it could sell the unit to another buyer/customer. However, Big Developer determines that it does not have an enforceable right to payment for performance completed to date because, until construction of the unit is complete, Big Developer only has a right to the deposit paid by the customer. As Big Developer does not have a right to payment for work completed to date, its performance obligation is not a performance obligation satisfied over time. Instead, Big Developer accounts for the sale of the unit as a performance obligation satisfied at a point in time.

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Measuring progress towards complete satisfaction of a performance obligation

STEP 5

Appropriate methods of measuring progress towards complete satisfaction of a performance obligation include output methods and input methods.

Output methods

Input methods

Appraisals of results achieved

Labour hours

Survey of work completed

Time elapsed

Time elapsed

Machine hours used

Milestones reached

Costs incurred

Units produced or delivered In determining the appropriate method for measuring progress, an entity shall consider the nature of the good or service that the entity promised to transfer to the customer. Required reading Read IFRS 15 paras 39–45 now to understand ways to measure progress.

How does revenue recognition under IFRS 15 work when foreign currencies are involved? Recognising revenue received in foreign currencies is covered in Unit 5 of this Candidate study guide. It is governed by IFRS 15 and by IAS 21 The Effects of Changes in Foreign Exchange rates. IAS 21 paragraph 21 requires an entity to record the transaction in the entity’s functional currency, using the spot exchange rate at the date of the transaction. IAS 21 tells us that this date is the date on which the transaction first qualified for recognition in accordance with the standards. Recently, IFRIC 22 Foreign currency transactions and Advance Consideration has clarified how to determine the transaction date for revenue received in advance. For revenue received in advance, IFRIC 22 tells us the date of the transaction is the initial date when the deferred revenue liability is recognised. If there are multiple receipts in advance, there will be multiple transaction dates under IAS 21. These concepts will be explored further in unit 5. Further reading IFRIC 22 Foreign currency transactions and Advance consideration.

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Disclosure IFRS 15 requires a number of disclosures to ensure users are able to understand revenue and cash flows arising from contracts with customers. Revenue from contracts with customers must be disclosed separately from other sources of revenue. Impairment losses from contracts with customers should be disclosed separately from other impairment losses. Significant judgements made in applying IFRS 15 must be disclosed. Required reading Read IFRS 15 paras 110–129 now to understand disclosure requirements. Further reading Slater and Gordon Limited, 2018 Annual Report, Notes 3.1.1 and 3.1.2, https://assets.slatergordon.com.au/downloads/Slater-Gordon-Annual-Report-2018.pdf Activity 3.1 [Available online in myLearning] Activity 3.2 [Available online in myLearning] Worked example 3.1 [Available online in myLearning] Worked example 3.2 [Available online in myLearning] Quiz [Available online in myLearning]

Working paper A You are now ready to complete working paper A of integrated activity 4, to help you understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

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Core content – Unit 3

Unit 4: Income taxes Contents Introduction

4-3

Tax effect accounting 4-3 Scope 4-4 Overview of IAS 12 4-4 The underlying transaction 4-5 Current tax Methodology for calculating and accounting for current tax Calculating the current tax liability where the entity has derived a taxable income Determining the current tax liability Current tax asset versus current tax liability

4-6 4-6 4-7 4-7 4-14

Deferred tax Methodology for calculating and accounting for deferred tax Step 1 – Calculate temporary differences at end of reporting period Step 2 – Allocate temporary differences Step 3 – Calculate deferred tax balances at the end of the reporting period Step 4 – Apply recognition criteria Step 5 – Calculate movement in deferred tax balances Step 6 – Prepare the journal entry Reversals of temporary differences Complexities with deferred tax Initial recognition exemption for DTAs and DTLs Specific recognition exceptions concerning DTAs and DTLs Changes in prior year taxes due to errors or estimates

4-15 4-15 4-15 4-17 4-19 4-19 4-20 4-21 4-24 4-25 4-26 4-27 4-27

Other tax effect accounting issues Changes in tax rates and tax laws Consolidated financial statements

4-29 4-29 4-29

Presentation 4-30 Offsetting tax balances 4-30 Presenting income tax expense 4-30 Disclosures 4-31 Income tax expense 4-31 Methodology for accounting for income tax expense recognised in profit or loss 4-31 Elements of income tax expense for separate disclosure 4-31 Other disclosure issues 4-32

fin31904_csg_03

APPENDIX: Determining the tax base of an asset or liability that gives rise to a temporary difference 4-33

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Learning outcomes At the end of this unit you will be able to: 1. Explain the purpose of tax effect accounting. 2. Calculate and account for current tax. 3. Calculate and account for deferred tax. 4. Explain and account for changes in prior year taxes. 5. Explain and account for income tax expense.

Introduction This unit deals with the accounting treatment of an entity’s income tax in its financial statements (also commonly called ‘tax effect accounting’ or ‘tax accounting’), as detailed in IAS 12 Income Taxes. Unit 4 overview video [Available online in myLearning]

Tax effect accounting The calculation of accounting profit/(loss) for a particular period usually does not equal the calculation of taxable income/(loss) for that same period. This is because accounting profit/ (loss) is determined under applicable Accounting Standards, whereas taxable income/(loss) is determined in accordance with the taxation laws of the applicable jurisdiction. For example, fines are usually not allowed as a deduction for tax purposes but are expensed when calculating accounting profit/(loss). There is a need to account for these differences in a set of financial statements. The purpose of covering IAS 12 in the FIN module is to see how the standard applies to more common accounting and taxation scenarios. Complex tax situations and their impact on tax effect accounting are beyond the scope of the FIN module. Accordingly, the approach taken in this unit is to demonstrate the typical situations likely to be encountered in practice. The examples throughout this unit are based on a 30% tax rate. The appropriate tax rate will be stated in worked examples, activities and exam questions.

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Scope IAS 12 applies to accounting for income taxes. It does not apply to other taxes such as property taxes and value-added taxes, or goods and services tax. For the purposes of IAS 12, income taxes include: •• All domestic and foreign taxes based on ‘taxable profits’. •• Taxes (including withholding taxes) which are payable by a subsidiary, associate or joint arrangement on distributions to the reporting entity.

Overview of IAS 12 The objective of IAS 12 is to specify the accounting treatment for income taxes. Some key principles of IAS 12 to understand at this stage of the unit can be summarised as follows: Key principles of tax effect accounting

Points to note

Time of recording tax effect journal entries

•• Generally, when preparing the financial statements, tax effect entries are recorded after all other journal entries have been recorded •• Therefore, tax effect entries are recorded on the last day of the reporting period

The tax liability arising from transactions and events occurring in the current reporting period results in the recognition of a current tax liability

The current tax liability represents the current balance of income taxes payable to taxation authorities (i.e. the Australian Taxation Office (ATO) and New Zealand Inland Revenue (IR)) based on the taxable income for the year

Temporary differences arise from the expected future tax consequences of transactions and events occurring in the current reporting period

Temporary differences arise when a transaction or event is recognised in a different period in the financial statements, rather than when they are recognised for taxation purposes IAS 12 requires the related tax for a transaction or event to be recognised. Think of this as an accounting matching concept From a tax viewpoint, the taxation liability occurs in a different period, which creates a mismatch. This mismatch can be shown as follows: Interest revenue and the related tax have been recognised for accounting purposes even though there is no current tax liability in respect of the interest as it has not yet been received

20X6 REPORTING

end

Interest is assessable for tax purposes in this period when it is received A current tax liability is recognised in respect of the interest

To rectify this mismatch, IAS 12 requires the recognition of a deferred tax asset (DTA) or a deferred tax liability (DTL) for most temporary differences

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Financial Accounting & Reporting

Key principles of tax effect accounting

Points to note

Temporary differences generally result in the recognition of a DTA or a DTL

Think of a DTA as representing income tax that has been paid in advance (like a prepayment of tax). The entity will recover this tax benefit (e.g. by paying a lower amount of income tax in a future period) Think of a DTL as representing the receipt of a tax benefit in advance. The entity will have to repay this tax benefit (e.g. by paying a higher amount of income tax in a future period) Referring to the previous diagram, a DTL would be recognised in the first reporting period to reflect there was no tax paid on the revenue in the first period; however, there is tax to be paid in the future when the revenue is received Interest revenue and the related tax have been recognised for accounting purposes even though there is no current tax liability in respect of the interest as it has not yet been received

20X6 REPORTING

end

Interest is assessable for tax purposes in this period when it is received A current tax liability is recognised in respect of the interest

The financial statements need to reflect there is a future tax liability in respect of the interest receivable. A deferred tax liability is recognised

The deferred tax liability reverses. What was a deferred tax liability becomes a current tax liability now that the interest has been received and is assessable for tax purposes

Therefore for temporary differences, it is all a matter of timing

The underlying transaction The ‘Objective’ paragraph in IAS 12 states that an entity should: …account for the tax consequences of transactions and other events in the same way that it accounts for the transactions or other events themselves.…

Accordingly, the approach taken in this unit is that the equity side of a tax effect journal entry follows the underlying transaction. A matrix approach to following the underlying transaction helps to prepare tax effect journal entries correctly: Where is the underlying transaction recognised?

Which account within the equity section of the statement of financial position is the tax effect recognised?

In profit or loss (by recognising revenue and expenses for the year)

Income tax expense1

As a current year reserve movement As a current year equity movement

Tax asset or tax liability Current tax liability

Recognised a current tax liability where the underlying transaction has Offset the related tax effect against a current tax the particular reserve account consequence

DTA or DTL Recognised a DTA or DTL where the underlying transaction gives rise to a future tax consequence

Offset the related tax effect against the particular equity account (e.g. share capital)

Note 1 – Think of income tax expense as an account that matches the tax for the period against the profit recognised for the period. Expenses are recognised within profit or loss, therefore ‘income tax expense’ relates to the tax effect of transactions recognised in profit or loss.

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Required reading The whole of IAS 12 is required reading for this unit. At specified points, you will be directed to read certain paragraphs to enable you to progress through this unit. Read IAS 12 ‘Objective’ paragraph and paras 1–4 before proceeding. The process of applying IAS 12 for the purposes of this unit is shown as follows:

The process of applying IAS 12 Calculate the current tax

Calculate the deferred tax

Consider if there are any other tax effect accounting issues

Present the item in the relevant part of the financial statements (e.g. current liabilities, non-current liabilities, expenses)

Prepare the disclosures for the notes to the financial statements

Current tax Current tax is defined in IAS 12 para. 5 as ‘the amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period’. Required reading Read IAS 12 paras 5–6 and 12–14 before proceeding.

Methodology for calculating and accounting for current tax The calculation of taxable profit/(loss) and the related current tax liability/(asset) is based on local tax laws. For the purposes of this unit, the term ‘taxable income/(tax loss)’ will be used in place of the IAS 12 terminology of ‘taxable profit/(loss)’ when performing the current tax liability/ (asset) calculation, due to the familiarity of Australian and New Zealand candidates with this terminology in their local tax laws. In a straightforward situation, the current year taxable income or tax loss is calculated as follows: Taxable income

=

Assessable income for tax purposes

–

Tax deductions

Tax loss

=

Tax deductions

–

Assessable income for tax purposes

Please note that as candidates studying the FIN module reside and practise in a variety of jurisdictions, the tax treatment to be applied in the FIN module assessment material will always be stated to avoid confusion.

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Financial Accounting & Reporting

Calculating the current tax liability where the entity has derived a taxable income The process of calculating the current tax liability can be shown as follows: Accounting profit/(loss) before income tax

+/–

Adjustments

=

Taxable income

Taxable income

×

Tax rate

=

Net tax payable

Net tax payable

–

Tax offsets/credits

=

Current tax liability/asset

Determining the current tax liability The current tax liability is calculated using a reconciliation method that starts with accounting profit/(loss) before tax and makes a number of adjustments, to arrive at the current tax liability for the period. A template that assists with this reconciliation method is below. Worksheet to calculate the current tax liability Item

$

$

Accounting profit before tax 1.  Non-temporary difference adjustments

2.  Temporary difference adjustments

3.  Equity or OCI adjustments affecting taxable income

Taxable income prior to utilising carryforward tax losses Less: utilisation of carryforward tax losses Taxable income Current tax liability @ tax rate

The template provides a methodical approach to recording the tax effect entry to recognise the current tax liability. The various adjustments to the accounting profit/(loss) after tax figure are discussed further below.

Adjustments In many instances, the tax and accounting treatments of items will differ substantially. It is these adjustments that give rise to the need for tax effect accounting. The accounting treatment is based on the principles of accrual accounting and the requirements of the International Financial Reporting Standards (IFRS), while the income tax treatment is based on the requirements of tax legislation.

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The adjustments to the accounting profit/(loss) before tax figure can be grouped into three broad categories: 1. Non-temporary difference adjustments. 2. Temporary difference adjustments. 3. Equity or OCI adjustments affecting taxable income.

1.  Non-temporary difference adjustments – where the accounting and tax treatments of an item will never be the same IAS 12 does not provide a name for these types of adjustments but for the purposes of the FIN module, they will be called non-temporary differences, to distinguish them from temporary differences. Unlike temporary differences, there is no tax effect accounting for non-temporary differences in future reporting periods. Examples of non-temporary differences include: •• Items included in accounting profit that will never be included in taxable income (e.g. a taxfree capital gain, non-deductible fines, donations or entertainment expenditure). •• Items included in taxable income that will never be included in accounting profit (e.g. government incentives where the allowable tax deduction exceeds actual expenditure).

Example – Where the accounting and tax treatments of an item will never be the same This example illustrates how to calculate current tax when there is a non-temporary difference for an item included in the accounting profit. Blackshaw recorded a $1 million profit for the year ended 30 June 20X7. Included in the profit is $200,000 in entertainment expenses that will never be deductible for tax purposes. The taxable income was calculated as follows: Item

$

Accounting profit before tax

1,000,000

Non-temporary difference adjustments Entertainment expenses

   200,000

Taxable income

1,200,000

The tax effect journal entry to record the current tax liability is: Date

Account description

30.06.X7

Income tax expense

Dr $

Cr $

360,000

Current tax liability

360,000

Recognition of the current tax liability for the year ended 30 June 20X7 ($1.2 million × 30%)

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2.  Temporary difference adjustments – where the accounting and tax treatments of an item are the same but are recognised in different periods These are income and expense items that are included in accounting profit in one period, and in taxable income in a different period. Such items give rise to temporary differences. Examples of temporary differences are provided in the table below: Tax treatment of common temporary differences General examples

Liabilities not tax deductible until paid (and therefore the expense is not deductible)

Treatment in current tax liability calculation Add back the accounting expense, subtract the tax deduction

Liabilities not tax deductible until incurred (and therefore the expense is not deductible)

Add back the accounting expense, subtract the tax deduction

Asset write-downs not tax deductible until a particular future event

Add back the accounting expense, subtract the tax deduction

Specific examples New Zealand

Australia

Accrued tax and accounting fees for services to be performed in a future period

Superannuation contributions (subject to meeting all other conditions for deductibility)

Provision for employee entitlements – holiday pay, long service leave, bonuses not paid within 63 days of balance date

Provision for employee entitlements – long service leave, annual leave (deductible when incurred which is usually when paid) Warranty provisions, bonuses, other accruals (e.g. estimated audit fees)

Allowance for impairment loss – trade receivables – deductible only when debt is written-off as bad Provision for stock obsolescence – only deductible if written down to market selling value or realised on disposal

Allowance for impairment loss – trade receivables – bad debt deduction only when previously brought to account as income and specifically written off as bad

Costs which are expenses for accounting but are capitalised as part of the cost of an asset for tax purposes

Add back the accounting expense, subtract the tax deduction (if any)

Expenses relating to an asset under development

Initial repairs for newly acquired assets

Assets written-off for tax and accounting at different rates

Add back the accounting expense, subtract the tax deduction

Plant and equipment with accelerated tax depreciation

Plant and equipment with accelerated tax depreciation

Costs capitalised as assets for accounting but deductible when paid for tax

Add back any accounting expense recognised (e.g. amortisation of the capitalised cost), subtract the tax deduction

Interest capitalised to an asset under development that is deductible when incurred

Certain prepayments

Expenses capitalised as assets for accounting but tax deductible over a different time period

Add back the accounting expense, subtract the tax deduction

Premium paid to acquire leased land that is deductible over the lease period

Certain borrowing costs deductible over the life of the loan or five years, whichever is shorter

Income not yet derived for tax

Subtract the accounting revenue, add the tax revenue

Income from certain land sales that is not derived for tax purposes until settlement

Accrued interest income on a term deposit

Note: The tax treatment of temporary differences in this table is simplified and the examples are not exhaustive. Temporary differences and their impact on deferred tax are discussed in the section on deferred tax.

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Example – Where the accounting and tax treatment of an item are the same but are recognised in different periods This example illustrates how to calculate current tax when there is a temporary difference for an item included in the accounting profit. Blackshaw recorded a $1 million profit for the year ended 30 June 20X7. Included in the profit is $100,000 in interest revenue that will be assessable for tax purposes when it is received in the next reporting period. The taxable income was calculated as follows: Item

$

Accounting profit before tax

1,000,000

Temporary difference adjustments Interest revenue

  (100,000)

Taxable income

900,000

The tax effect journal entry to record the current tax liability is: Date

Account description

30.06.X7

Income tax expense

Dr $

Cr $

270,000

Current tax liability

270,000

Recognition of the current tax liability for the year ended 30 June 20X7 ($900,000 × 30%)

3.  Equity or OCI adjustments affecting taxable income – when the underlying transaction is recognised outside profit or loss Where adjustments have been accounted for outside profit or loss, the tax consequences of those adjustments must be accounted for in the same way (i.e. the tax effect will follow the accounting treatment) (IAS 12 para. 61A). Required reading Read IAS 12 para. 61A before proceeding. 3A: Equity adjustments affecting taxable income – when the underlying transaction is recognised directly in equity Sometimes a transaction or event is included in the calculation of taxable income; however, it is not included in the accounting profit but is recognised in equity. The tax relating to an underlying transaction recognised directly in equity is recorded against that transaction (IAS 12 para. 61A(b)).

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Financial Accounting & Reporting

Example – Where the underlying transaction is recognised in equity and is included in taxable income This example illustrates how to calculate current tax when there is an item that is deductible for tax purposes that has been recognised directly in equity. Blackshaw recorded a $1 million profit for the year ended 30 June 20X7. Share issue costs of $80,000 were debited against the share capital account (the entry was Dr Share capital $80,000, Cr Cash) as is discussed in Unit 9. These costs are tax deductible. The taxable income was calculated as follows: Item

$

Accounting profit before tax

1,000,000

Equity or OCI adjustments affecting taxable income Share issue costs

   (80,000)

Taxable income

920,000

The tax effect journal entry to record the current tax liability is: Date

Account description

Dr $

30.06.X7

Income tax expense1

300,000

Cr $

Share capital2 Current tax liability

24,000 276,000

Recognition of the current tax liability for the year ended 30 June 20X7 ($920,000 × 30%) Notes 1. The income tax expense is $300,000 as it is the current tax relating to the underlying transactions that have been recognised in profit ($1 million × 30%). 2. The share capital issued during the year, net of the share issue costs and related tax effect, will be disclosed in the statement of changes in equity as was discussed in Unit 2.

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3B:  OCI adjustments affecting taxable income – when the underlying transaction is disclosed in other comprehensive income Sometimes a transaction or event is included in the calculation of taxable income; however, it is not included in the accounting profit but is disclosed in other comprehensive income (OCI). In practice this is quite unusual as items disclosed in OCI generally have deferred tax consequences rather than immediate tax consequences (as discussed in the section on deferred taxes). The tax relating to an underlying transaction that is disclosed in OCI is recorded against that transaction (IAS 12 para. 61A(a)).

Example – Where the underlying transaction is disclosed in OCI and is included in taxable income This example illustrates how to calculate current tax when there is an item that is assessable for tax purposes that has been disclosed in OCI. Blackshaw recorded a $1 million profit for the year ended 30 June 20X7. Disclosed in OCI was a $60,000 gain relating to the fair value movement on a financial asset. The gain was credited to the fair value through OCI reserve account (see note 2 below). For tax purposes, this gain is assessable. The taxable income was calculated as follows: Item

$

Accounting profit before tax

1,000,000

Equity or OCI adjustments affecting taxable income Gain on financial asset disclosed in OCI Taxable income

   60,000 1,060,000

The tax effect journal entry to record the current tax liability is: Date

Account description

Dr $

30.06.X7

Income tax expense1

300,000

Fair value through other comprehensive income reserve2, 3

Cr $

18,000

Current tax liability

318,000

Recognition of the current tax liability for the year ended 30 June 20X7 ($1,060,000 × 30%) Notes 1. The income tax expense is $300,000 as it is the current tax relating to the underlying transactions that have been recognised in profit ($1 million × 30%). 2. The accounting treatment of assets categorised as fair value through OCI is covered in Unit 9. 3. The $60,000 movement in the fair value through OCI reserve, net of the $18,000 tax effect will be disclosed in OCI (as was discussed in Unit 2).

FIN fact Current tax is the current liability owing to the taxation authority in respect of income taxes. The liability is reduced by any tax payments that have already been made (e.g. company tax instalments or pay as you go (PAYG) instalments).

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Utilisation of carryforward tax losses Using/recouping carryforward tax losses has the effect of lowering taxable income, which decreases the current tax liability. Further discussion of the treatment when a tax loss is first incurred is covered in the section on deferred tax, which will clarify the two different scenarios in the example below. You may like to revisit this example after you have studied that section.

Example – Using carryforward tax losses This example illustrates how to account for the recoupment of a carryforward tax loss incurred in the previous year. Blackshaw recorded a $1 million profit for the year ended 30 June 20X7 before recouping $200,000 in carryforward tax losses incurred during the year ended 30 June 20X6. There were no temporary or non-temporary differences for the year. The taxable income was calculated as follows: Item

$

Accounting profit before tax

1,000,000

Taxable income prior to utilising carryforward tax losses

1,000,000



Less: Utilisation of carryforward tax losses

(200,000)

Taxable income

800,000

Current tax liability at 30%

240,000

If the carryforward tax losses had not been recognised at 30 June 20X6 as a deferred tax asset: Date

Account description

30.06.X7

Income tax expense

Dr $

Cr $

240,000

Current tax liability

240,000

Recognition of the current tax liability for the year ended 30 June 20X7 ($800,000 × 30%) including the recoupment of a prior period loss that had not previously been recognised as a DTA

If the carryforward tax losses had been recognised at 30 June 20X6 as a deferred tax asset: Date

Account description

30.06.X7

Income tax expense

Dr $

Cr $

300,000

Deferred tax asset

60,000

Current tax liability

240,000

Recognition of the current tax liability for the year ended 30 June 20X7 ($800,000 × 30%) including the recoupment of a prior period loss that had previously been recognised as a DTA

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Prepare the journal entry to record the current tax liability Using the current tax liability figure calculated in the worksheet, the journal entry is prepared to recognise the current tax liability. The diagram below summarises how to prepare the journal entry: Two key issues to prepare the tax effect journal entry for the current tax liability Issue 1 – liability side Does the tax impact of the underlying transaction create a current tax liability? Yes, there is a CTL current tax impact

Issue 2 – equity side for underlying transaction Determine which bucket to record the tax effect in

P/L – Income tax expense OCI – Related tax offset against that current year reserve movement e.g. fair value through OCI reserve account Equity – Related tax offset against the equity account e.g. share capital account

Current tax asset versus current tax liability A current tax asset may arise where the entity has made payments to the taxation authority throughout the year in expectation of earning taxable income (e.g. where company tax instalments or PAYG instalments have been paid in excess of the finalised current tax liability, which may be $0 where there is a tax loss). To the extent that these payments are refundable by the taxation authority, a current tax asset rather than a current tax liability would be recognised by the entity. Worked example 4.1: Calculating the current tax liability [Available online in myLearning]

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Financial Accounting & Reporting

Deferred tax Deferred tax in the statement of financial position represents the future tax consequences of past transactions or events. As discussed earlier: •• DTA represents income tax that has been paid in advance (like a prepayment of tax). The entity will recover this tax benefit (e.g. by paying a lower amount of income tax in a future period). •• DTL represents receiving a tax benefit in advance. The entity will have to repay this tax benefit (e.g. by paying a higher amount of income tax in a future period). IAS 12 adopts what is effectively a ‘balance sheet’ approach with temporary differences. The carrying amount of an asset or liability in the statement of financial position is compared with its tax base to determine the future tax consequences that must be accounted for under IAS 12. The tax base is the value that would be attributed to an asset or liability for tax purposes if a notional ‘tax balance sheet’ was prepared. As per IAS 12’s ‘Objective’ paragraph, it is inherent in the recognition of an asset or liability that that asset or liability will be recovered or settled, and this recovery or settlement may give rise to future tax consequences which should be recognised at the same time as the asset or liability. Put more simply, if there is a future tax consequence associated with the sale of an asset or the settlement of a liability, then that future tax must also be recognised on the balance sheet. For example, users of the financial statements need to be informed that a future sale of asset will result in a tax liability. Required reading Read IAS 12 paras 7–11, 15–18, 24–26, 46–49, 51 and 57–60 before proceeding.

Methodology for calculating and accounting for deferred tax The following diagram represents the steps in calculating and accounting for deferred tax in a period at the end of the reporting period: STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

Calculate temporary differences

Allocate temporary differences

Calculate deferred tax balances

Apply recognition criteria

Calculate movement in deferred tax balances

Prepare journal entry

Step 1 – Calculate temporary differences at end of reporting period A temporary difference will result in either an increase or a decrease in tax payable in future periods.

STEP 1

The following diagram shows how temporary differences are calculated: Calculating temporary differences at end of reporting period Carrying amount

–

Tax base

=

Temporary difference

Carrying amount The carrying amount at end of reporting period is the net amount of an asset or liability that is recorded in the accounting records of the entity, determined in accordance with the relevant IFRS. The carrying amount is net of any accumulated depreciation/amortisation or allowances (e.g. an allowance for impairment loss – trade receivables).

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Financial Accounting & Reporting

STEP 1

Chartered Accountants Program

Even though the carrying amount may not be apparent, deferred tax should still be accounted for in respect of assets and liabilities that: •• have a nil carrying amount (e.g. items expensed in profit or loss for accounting purposes but that are not deductible for tax purposes until a future period), or •• only exist for tax purposes (e.g. intangibles that are recognised for tax but expensed for accounting purposes). Tax base The tax base at end of reporting period is the amount that is attributed to an asset or liability for tax purposes by following the requirements of the tax legislation. (Think of this as amount that would appear if a tax balance sheet was prepared by the entity). Calculation of the tax base is one of the more challenging aspects of tax effect accounting. In the FIN module we recommend using either of the following two approaches to determine the tax base of an asset or liability: Notional tax balance sheet approach

Formula-based approach

Determine the value that would be recognised for the asset or liability if a notional tax balance sheet was prepared

Apply the appropriate formula to the asset or liability to determine the tax base

You do not have to apply the same approach for each temporary difference. Use the approach that makes more sense to you.

Example – Calculating temporary differences for an asset and liability This example illustrates how to calculate a temporary difference in respect of a depreciable machine and provision for annual leave. The details of the accounting and tax treatment of each item is below: Item

Accounting treatment

Tax treatment

31 Dec 20X8 $ Machine – written down value

125,000 The original purchase price for the machine was $200,000 on 1 Jan 20X6 The machine is depreciated on a straight-line basis over its useful life of eight years

To calculate the tax base of the machine, we need to look at both the machine and the accumulated depreciation using tax depreciation rate. The tax base of the machine is equal to its original cost The asset is being depreciated for tax purposes on a straight-line basis over five years. The tax written down value at 31 Dec 20X8 is $80,000

Provision for annual leave

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(55,000) The provision for annual leave represents entitlements expected to be paid in the following 12 months

Annual leave payments are deductible for tax when they are paid

Core content – Unit 4

Chartered Accountants Program

Financial Accounting & Reporting

STEP 1

The temporary differences are calculated by subtracting the tax base of the item from its accounting carrying amount as follows: Calculation of temporary differences Carrying amount $

Tax base $

Temporary difference $

125,000

80,0001

45,000

55,000

0

55,000

Machine – written down value Provision for annual leave Note

2

Tax base calculation Notional tax balance sheet approach

OR

Formula-based approach

1. Machine

If a tax balance sheet was prepared, the machine’s $80,000 tax written down value would be recognised

$125,000 carrying amount – $125,000 future taxable amounts (capped at the asset’s carrying amount) + $80,000 in future deductible amounts

2. Provision for annual leave

If a tax balance sheet was prepared, there would not be an employee benefits liability for annual leave. Annual leave is a deduction on a cash basis, not carried forward. Therefore the tax base is zero

$55,000 carrying amount – $55,000 in future deductible amounts (the accounting balance sheet tells us we are going to pay $55,000 in annual leave in the future. When paid, this will become a tax deduction. So the future deductible amount is $55,000 + $0 future taxable amounts (as a liability will not be taxable)

Further examples of the tax base of assets and liabilities are provided in IAS 12 paras 7 and 8. Further examples of tax base calculations Appendix: Determining the tax base of an asset or liability that gives rise to a temporary difference [In addition to the Appendix, further examples are available online in myLearning] FIN fact If the accounting carrying amount and the tax base are equal, there will be no temporary difference and, therefore, no deferred tax balance in relation to the item.

Step 2 – Allocate temporary differences

STEP 2

Temporary differences are allocated into: •• Taxable temporary differences (TTDs) – where tax payable in future periods is increased. •• Deductible temporary differences (DTDs) – where tax payable in future periods is decreased. The following diagram outlines the allocation between TTDs and DTDs:

Temporary differences Deductible temporary differences

Taxable temporary differences

Deferred tax asset

Deferred tax liability DTL

Pay tax upfront, tax benefit in the future, therefore an asset

Unit 4 – Core content

DTA

Get the tax benefit upfront, more tax to pay in the future, therefore a liability

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Financial Accounting & Reporting

STEP 2

Chartered Accountants Program

Once the temporary differences for each asset or liability have been calculated (from Step 1), each temporary difference must be allocated as a taxable temporary difference or deductible temporary difference using the following allocation rules: Account

Condition

Type of temporary difference

Temporary difference gives rise to….

Example

Asset

Carrying amount > tax base

TTD

DTL

Assets with a higher rate of depreciation for tax than for accounting

Asset

Carrying amount < tax base

DTD

DTA

Trade receivables net of an allowance for impairment loss (as the allowance is not recognised for tax)

Liability

Carrying amount < tax base

TTD

DTL

Certain compound financial instruments split for accounting purposes (between liability and equity) but not for tax purposes

Liability

Carrying amount > tax base

DTD

DTA

Accounting provisions not deductible for tax until paid

FIN fact To apply the deferred tax rules, we need to first determine whether we looking at an asset or a liability. From there, we compare the carrying amount to the tax base. This tells us which allocation rule is relevant, and in turn, whether a DTA or DTL is the result.

Example – Allocating a temporary difference for an asset and liability This example illustrates how to allocate a temporary difference for a depreciable machine and a provision for annual leave as follows: Allocation of temporary differences Step 1 Carrying Tax base Temporary amount difference

Machine – written down value Provision for annual leave

Applicable allocation rule

$

$

$

125,000

80,000

45,000 Asset rule: Carrying amount > tax base

55,000

0

55,000 Liability rule: Carrying amount > tax base

Step 2 Taxable temporary difference (TTD) $

Deductible temporary difference (DTD) $

45,000

55,000

Using the allocation rules, the temporary difference for the machine and the provision can be correctly allocated as either a TTD or DTD: •• Machine – As this is an asset, and the $125,000 carrying amount is greater than the $80,000 tax base, there is a $45,000 TTD. It is a TTD as more tax will be payable in the future when the asset is fully depreciated for tax purposes (year 5) but continues to be depreciated for accounting purposes for a further three years which will not be tax deductible. •• Provision for annual leave – As this is a liability, and the $55,000 carrying amount is greater than the $0 tax base, there is a $55,000 DTD. It is a DTD as a tax benefit will be received in later years when the annual leave is paid in cash. Further reading IAS 12 para. 52 and IAS 12 Illustrative Examples – Examples of Temporary Differences.

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Core content – Unit 4

Chartered Accountants Program

Financial Accounting & Reporting

Step 3 – Calculate deferred tax balances at the end of the reporting period

STEP 3

Calculating the deferred tax balances involves two steps: •• Calculate the deferred tax liability (DTL) in respect of TTDs. •• Calculate the deferred tax asset (DTA) in respect of DTDs. The treatment to be applied to tax losses that have been incurred is covered later in the unit. Tax rate Applying the measurement criteria in IAS 12 paras 47–51, deferred tax balances are typically calculated at the tax rates that are expected to apply in the reporting period when the temporary difference is expected to reverse. Calculating DTLs TTD

×

Tax rate %

=

DTL

×

Tax rate %

=

DTA

Calculating DTAs DTD

Example – Calculating a deferred tax balance for an asset and liability This example illustrates how to calculate a deferred tax balance in respect of the machine and provision for annual leave by calculating the total temporary differences for TTDs and DTDs and applying the tax rate. Calculation of deferred tax balances Carrying amount $

Tax base $

Temporary difference $

Taxable temporary difference (TTD) $

Deductible temporary difference (DTD) $

125,000

80,000

45,000

45,000

0

55,000

0

55,000

     0

55,000

Total temporary Step 3 differences

45,000

55,000

DTL/DTA at 30%

13,500

16,500

Machine – written down value Provision for annual leave

The TTD of $45,000 x 30% tax rate = $13,500 DTL The DTD of $55,000 x 30% tax rate = $16,500 DTA

Step 4 – Apply recognition criteria

STEP 4

Once the DTA and DTL balances have been calculated, it will need to be determined whether they can be recognised in the financial statements. DTAs and DTLs are only recognised after considering the following: •• General recognition criteria. •• Specific recognition exceptions. Specific recognition exceptions are explained under the heading ‘Complexities with deferred tax’ later in this unit.

Unit 4 – Core content

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Financial Accounting & Reporting

STEP 4

Chartered Accountants Program

General recognition criteria DTAs

DTLs

A DTA relating to a DTD is only recognised to the extent that it is probable that future taxable profit will be available against which the DTD can be utilised (IAS 12 para. 24)

A DTL arising from a TTD should be recognised in all cases unless a specific exception applies (IAS 12 para. 15)

Points to note: •• ‘Probable’ is not specifically defined in IAS 12, but is defined in both IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and IAS 37 Provisions, Contingent Liabilities and Contingent Assets as ‘more likely than not’ •• If DTDs are expected to reverse in the same period as TTDs are expected to reverse, and the TTDs are of greater value than the DTD, then the DTA relating to those DTDs can be recognised. For example, $10,000 in tax deductions (from DTDs) are expected to arise in the same period as when $15,000 in future income will be assessable (from TTDs). As the $15,000 TTD is greater than the $10,000 DTD, a $3,000 DTA relating to the $10,000 in DTDs can be recognised as an asset (IAS 12 para. 28) •• In determining whether it is probable that taxable profits will be available, an entity can take into account any tax planning opportunities that will create taxable profit in appropriate periods •• Any specific tax attributes in respect of the DTA and DTL must be considered (e.g. tax rules that may limit the ability to recover the DTA). For example, in Australia, capital losses can only be used to offset capital gains. Therefore, where an asset is expected to result in a future capital loss (as it has been impaired), the DTA can only be recognised where it is probable that sufficient future capital gains (rather than revenue gains) will be available

STEP 5

Step 5 – Calculate movement in deferred tax balances The movements in deferred tax balances since the prior period need to be calculated. The tax effect journal entry reflects only the movements that arise in the current period in the DTL and DTA balances, as the opening balances in these accounts recognised at the end of the prior reporting period in the statement of financial position will have been carried forward. The current period movement to be recorded in the journal entry is calculated as follows: Closing balance

–

Opening balance

=

Movement in DTA/DTL

Example – Calculating a movement in deferred tax balances This example illustrates how to calculate a movement in the DTA and DTL for the machine and the provision for annual leave. As at 31 December 20X7, the closing deferred tax balances were: •• DTA – $10,500 •• DTL – $9,000 These balances carry forward into the 31 December 20X8 year and are used to determine the movement of the deferred tax balances that will be recorded in the journal entry:

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Core content – Unit 4

Chartered Accountants Program

Financial Accounting & Reporting

STEP 5

Calculation of deferred tax balances Carrying amount

Tax base

Temporary difference $

Taxable temporary difference (TTD) $

Deductible temporary difference (DTD) $

$

$

Machine – written down value

125,000

80,000

45,000

45,000

0

Provision for annual leave

55,000

0

55,000

     0

55,000

Total temporary differences

45,000

55,000

DTL/DTA at 30%

13,500

16,500

Less: Opening balances

(9,000)

(10,500)

Movement

4,500

6,000

The movement in the DTA and DTL are: •• $4,500 increase in the DTL from the opening balance of $9,000 which brings the closing balance at 31 December 20X8 to $13,500 •• $6,000 increase in the DTA from the opening balance of $10,500 which brings the closing balance at 31 December 20X8 to $16,500 FIN fact When a temporary difference reverses, the journal entry will reduce the deferred tax balance. For example, the reversal of a DTA will be recognised by crediting the DTA account. A negative movement from Step 5 indicates that the deferred tax balance is reversing.

Step 6 – Prepare the journal entry

STEP 6

The journal entry is recording the movements in the DTA and DTL for the period so that the closing deferred tax balances agree with the values calculated at Step 3.

Example – Preparing the journal entry to recognise the movement in the deferred tax balances The tax effect journal entry to record the deferred tax asset and deferred tax liability from the preceding example is: Date

Account description

31.12.X8

Deferred tax asset (DTA)

Dr $

Cr $

6,000

Deferred tax liability (DTL)

4,500

Income tax expense

1,500

Recognition of the movement in the deferred tax balances at 31 December 20X8 Notes 1. Notice that the net movement in the deferred tax balances is recognised in income tax expense. This is because the underlying transactions were recognised in profit, and not in other comprehensive income or equity.

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Financial Accounting & Reporting

Chartered Accountants Program

FIN fact As DTAs and DTLs are statement of financial position items, last period’s closing balance will carry forward. Therefore, the journal entry is simply recording the movement in the DTA and DTL to arrive at the closing balance that will be included in the statement of financial position.

Worked example 4.2: Calculating current and deferred tax: an overview [Available online in myLearning]

Calculating deferred tax – When the underlying transaction is disclosed in other comprehensive income Required reading Read IAS 12 paras 61A–65 before proceeding. IAS 12 para. 61A requires current and deferred taxes to be recognised outside profit or loss where these taxes relate to items that are recognised outside profit or loss (in other comprehensive income or directly in equity). IAS 12 paras 62 and 62A outline examples of these items including: •• A change in carrying amount arising from the revaluation of property, plant and equipment (see Unit 7). •• Exchange differences arising from the translation of the financial statements of a foreign operation (see Unit 5). •• An adjustment to the opening balance of retained earnings resulting from either a change in accounting policy that is applied retrospectively, or the correction of an error (see Unit 2). The 6-step process also applies to determining the journal entry for the deferred tax when the underlying transaction is disclosed in other comprehensive income.

Example – Deferred tax balance arising on items disclosed in OCI This example illustrates the treatment of deferred tax arising from the revaluation of a parcel of land. A company purchases a parcel of land on 30 June 20X5 for $400,000. The tax base of the land is equal to its original purchase price of $400,000. The land is revalued for the first time at 30 June 20X8, resulting in a credit to the revaluation surplus of $100,000, by recording this journal entry: Date

Account description

30.06.X8

Land Revaluation surplus (reserve account within equity)

Dr $

Cr $

100,000 100,000

To record the revaluation of the land which will be disclosed in OCI

The 6-steps to calculate a deferred tax balance as at 30 June 20X8 are applied in the same way as described in the previous example. A difference arises when allocating the temporary difference as a TTD or DTD in the worksheet. Since, this temporary difference has arisen due to the revaluation through OCI, IAS 12 para 61A(a) requires the related tax to also be disclosed in OCI and recognised directly against the revaluation surplus account. As a result, when allocating the temporary difference as a TTD, it is recorded in a separate column as a TTD (OCI). This will assist with recording the journal entry to the correct accounts and complying with IAS 12.61A(a).

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Core content – Unit 4

Chartered Accountants Program

Financial Accounting & Reporting

Calculation of deferred tax balances

Land – revalued

Carrying amount $

Tax base

500,000

400,000

$

Temporary Allocation rule difference $

TTD

TTD (OCI) $

$

100,000 Asset rule: Carrying amount > tax base

100,000

Total temporary differences

100,000

DTL/DTA at 30%

 30,000

Less: Opening balances

     0

Movement

30,000

Therefore, the journal to record the deferred tax on this revaluation is as follows: Date

Account description

30.06.X8

Revaluation surplus (reserve account within equity)1, 2

Dr $

Cr $

30,000

DTL

30,000

To record the DTL in relation to items recognised outside profit or loss where the movement in the revaluation surplus (net of tax) will be disclosed in OCI Notes 1. The debit is not taken to income tax expense as the underlying transaction was accounted for outside profit or loss. 2. The tax relating to transactions accounted for outside profit or loss must be separately identified, as the related tax must be separately disclosed (IAS 12 para. 81(a), (ab)).

Calculating deferred tax – When the underlying transaction is recognised directly in equity Again, the same 6-step process applies to determine the journal entry for the deferred tax when the underlying transaction is recognised directly in equity.

Example – Deferred tax balances arising on transaction recognised directly in equity This example illustrates the treatment of deferred tax arising from share issue costs. A company issues $5 million in share capital on 30 June 20X8 and incurs $200,000 in share issue costs that have been debited to the share capital account following the requirements of IFRS 9. (Note: the journal entry for the share issue costs was debit share capital $200,000 and credit cash $200,000.) The $200,000 share issues costs will be deductible for tax purposes in the 30 June 20X9 year. The 6-steps to calculate a deferred tax balance as at 30 June 20X8 are applied in the same way. A difference arises when allocating the temporary difference as a TTD or DTD in the worksheet. Since, this temporary difference has arisen due to the share issue costs being capitalised into equity (rather than being expensed in the profit or loss), IAS 12 para 61A(b) requires the related tax to also be disclosed in equity to follow the underlying transaction. As a result, when allocating the temporary difference as a DTD, it is recorded in a separate column as a DTD (equity). This will assist with recording the journal entry to the correct accounts and complying with IAS 12.61A(b).

Unit 4 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Calculation of deferred tax balances Carrying amount $

Tax base $

01

200,0002

Share issue costs

Temporary difference $

Allocation rule

DTD $

200,000 No applicable rule

DTD (equity) $ 200,0003

Total temporary differences

200,000

DTL/DTA at 30%

 60,000

Less: Opening balances

     0

Movement

60,000

Notes 1. The carrying amount of the share issue costs is $0 as this amount is offset against equity, and not included as an asset or liability. 2. The tax base of the share issue costs represents the future tax deduction available of $200,000. 3. The $200,000 in future tax deductions for share issue costs will make future tax payments smaller. Accordingly, the $200,000 is a DTD.

Therefore, the journal to record the deferred tax on the share issue costs is: Date

Account description

30.06.X8

DTA

Dr $

Cr $

60,000

Share capital

1

60,000

To record the DTA in relation to share issue costs recognised directly in equity Notes 1. The credit is not taken to income tax expense as the underlying transaction was accounted for outside profit or loss. Instead, the credit relating to the future tax deductions for the share issue costs is taken to share capital in accordance with IAS 12.61A(b).

Worked example 4.3: Calculating deferred tax assets and liabilities [Available online in myLearning]

Reversals of temporary differences As the term suggests, temporary differences are just that – temporary. This means that at some point the temporary difference will reverse. When a temporary difference reverses: •• If a DTL had been recognised in respect of the temporary difference in an earlier reporting period, the movement for the year will be debited to the DTL account. •• If a DTA had been recognised in respect of the temporary difference in an earlier reporting period, the movement for the year will be credited to the DTA account.

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Core content – Unit 4

Chartered Accountants Program

Financial Accounting & Reporting

The diagram below summarises the two key issues to consider when preparing the journal entry to recognise deferred tax:

Two key issues to prepare the tax effect journal entry for deferred tax Issue 1 – asset or liability side Does the tax impact of the underlying transaction create a deferred tax asset or deferred tax liability? Yes, there is a future tax impact (temporary difference)

Issue 2 – equity side for underlying transaction Determine which bucket to record the tax effect in

P/L – Income tax expense

DTA

OCI – Related tax offset against that current year reserve movement e.g. revaluation surplus account

DTL

Equity – Related tax offset against the equity account e.g. share capital account

Complexities with deferred tax Required reading Read IAS 12 paras 15, 19–22, 24, 27–31 and 32A–37 before proceeding.

Incurring tax losses Under IAS 12, the carrying forward of tax losses, subject to satisfying the recognition criteria, gives rise to a DTA. Tax losses generally do not give rise to a tax refund.

DTA arising from a tax loss incurred in the current year Where the entity incurs a tax loss in the current year, a DTA, rather than a current tax asset, will arise. This is because the tax loss gives rise to a future tax deduction and therefore it will lower future tax. For the purposes of this unit, the DTA relating to the tax loss to be carried forward and used against future taxable income is calculated as follows: Accounting profit/(loss) before tax

+/–

Adjustments

=

Tax loss

Tax loss

×

Tax rate

=

DTA

Unused tax losses can commonly be carried forward to future tax periods and be utilised (offset) against future taxable income. For the purposes of the FIN module, assume that all requirements of the applicable tax law have been satisfied when calculating and recognising the carryforward tax losses.

Unit 4 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Recognition criteria for DTA in respect of tax losses For unused tax losses, a DTA should only be recognised to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised (IAS 12 para. 34). In assessing this probability, the following are some of the considerations for DTAs relating to tax losses (IAS 12 paras 35–36): •• Whether there is convincing evidence that sufficient taxable profit will be available to utilise the unused tax losses. •• Whether the entity has sufficient TTDs that will increase the entity’s taxable profits before the unused tax losses expire.

For example: –– In Australia, tax losses do not have an expiry date, although there are tests that may limit an entity’s ability to utilise carryforward tax losses. –– In New Zealand, tax losses can be carried forward indefinitely subject to meeting minimum shareholder continuity requirements.

•• Whether the unused tax losses have arisen from events or transactions that are unlikely to recur.

Tax losses The journal to recognise a DTA in respect of a current period loss is as follows: Date

Account description

Dr $

xx.xx.xx

DTA

XX

Income tax expense

Cr $

XX

Recording recognition of the tax effect of current period losses

Worked example 4.4: Accounting for carryforward tax losses [Available online in myLearning]

Initial recognition exemption for DTAs and DTLs Applying IAS 12 paras 15(b) and 24(b), DTAs and DTLs are not recognised on initial recognition of assets or liabilities unless they arise from either: •• A transaction that is accounted for as a business combination. •• A transaction that affects accounting profit or taxable income at the time of initial recognition. Where the initial recognition exception applies, an entity does not recognise subsequent changes in the unrecognised balance (e.g. as the asset is depreciated).

Example – A transaction where the deferred tax consequences are not recognised at the time of initial recognition This example illustrates accounting for a motor vehicle when Australian tax law limits the deductible amount. An Australian entity acquires a motor vehicle costing $75,000. The $75,000 amount is recognised and depreciated for accounting purposes but the taxable deductions will be limited to the luxury car limit of $57,581. As the initial acquisition of the car affects neither accounting profit nor taxable income (because the entry was debit car and credit cash), the deferred tax consequences of the $17,419 difference would not be recognised.

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Financial Accounting & Reporting

Specific recognition exceptions concerning DTAs and DTLs DTAs and DTLs should not be recognised in respect of the following: •• Initial recognition of goodwill (IAS 12 para. 15(a)). •• Investments in subsidiaries, branches, associates and joint arrangements where it is probable that the temporary difference will continue to exist into the foreseeable future (IAS 12 paras 39 and 44).

Changes in prior year taxes due to errors or estimates The rules and principles regarding changes to prior year errors and estimates are contained in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (discussed in Unit 2). There may be a number of estimates and/or minor errors within the calculation of the current tax liability in the financial statements for a particular period as: •• The financial statements are prepared for reporting purposes shortly after year end where auditors of the financial statements seek to detect material errors, omissions or misstatements. •• Income tax returns are commonly prepared after the financial statements are issued. The concept of materiality does not apply in relation to the preparation of tax returns. Therefore: •• More rigorous calculations may be performed in respect of complex transactions or events when preparing the income tax return. This may result in the identification of different or additional tax adjustments to those identified at the time the financial statements were prepared. •• Any changes in estimates or errors identified in the current tax liability calculations would be corrected during the preparation of the tax return after the end of the reporting period. These events can be shown in a timeline diagram as follows: End of reporting period

20X5 JUNE

30 IAS 12 tax calculation and journal entries performed for inclusion in 30 June 20X5 financial statements

End of reporting period

Authorised for issue

20X5

20X6 JUNE

SEPT

30

12 Detailed tax calculations for income tax return detect an error

In the timeline above, an error has been discovered after the accounts have been authorised for issue. To correct this prior period error, a journal entry needs to be recorded to correct the current tax liability (IAS 12 para. 12). Correspondingly, if the error is: •• Immaterial – this journal entry will recognise a current year tax entry in the 30 June 20X6 financial statements. •• Material – this journal entry will make a retrospective adjustment (usually through opening retained earnings) that will be disclosed in the 30 June 20X5 comparative financial statements (IAS 8 para. 42).

Unit 4 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

The journal entry to correct the error should follow the same accounting treatment as the original underlying transaction. In practice, the most common errors you are likely to encounter relate to the tax treatment of items recognised in profit or loss.

Example – Prior year error in current tax liability This example illustrates the journal entry to correct the current tax liability when immaterial errors are discovered in the tax calculation after the prior year financial statements have been issued. Flex-It Limited (Flex-It) finalises and lodges its income tax return for the year ended 30 June 20X5 on 1 December 20X5. When preparing the tax return, two immaterial errors were discovered. The errors resulted in the current tax liability in the 30 June 20X5 financial statements being incorrect. Details of these errors are as follows: Errors in 30 June 20X5 current tax liability calculation Error

Impact on taxable income

Impact on current tax liability (change in taxable income × 30% tax rate)

Dividend revenue (had been treated as assessable for tax purposes)

Decreases taxable income by $80,000

$24,000 decrease

Fine (had been treated as tax deductible)

Increases taxable income by $180,000

$54,000 increase

Net adjustment to current tax liability

$30,000 increase

Neither of the underlying transactions was accounted for outside profit or loss, and they are not material. The adjustment to the current tax liability can therefore be recognised by adjusting the income tax expense. Therefore, the journal entry to correct the errors is: Date

Account description

01.12.X5

Income tax expense

Dr $

Cr $

30,000

Current tax liability

30,000

To record the increase in the current tax liability arising from the correction of the immaterial errors relating to the year ended 30 June 20X5

If the errors were material, Flex-It would need to account for the errors retrospectively and adjust the comparatives as required by IAS 8 para. 42. If an error relates to an item that did not go through profit and loss, for example, the tax effect of share issue costs recognised in equity, the correction follows the original underlying transaction.

Worked example 4.5: Accounting for an underprovision of income tax [Available online in myLearning]

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Core content – Unit 4

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Financial Accounting & Reporting

Other tax effect accounting issues Required reading Read IAS 12 paras 38–45, 46–49 and 60 before proceeding.

Changes in tax rates and tax laws Proposed changes in tax rates and tax laws cannot be applied when calculating current or deferred tax balances, even if the change is to be applied retrospectively. For example, a government announcement of a proposed change in the company tax rate for the 2016 year end would not be sufficient to allow deferred tax balances to be measured at that revised rate. A change in tax rate or tax law needs to be either enacted or substantially enacted by the end of the reporting period before it impacts on tax effect accounting. For a tax rate or tax law change to be substantively enacted, legislation would have to be introduced into the Parliament, and there would have to be majority support for its passage though all Houses of that Parliament. Where the rate of tax applicable to a deferred tax balance (or current tax balance) changes, that balance must be remeasured at the reporting date if the legislation has been enacted or substantively enacted by the end of the reporting period. This is because the balances should be valued at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled. There is a similar impact where a tax law changes with prospective effect and the revised tax law has been enacted or substantively enacted by the end of the reporting period. Current and deferred tax balances at the reporting date must be measured based on the revised tax law.

Consolidated financial statements Consolidated financial statements include the financial statements of the parent entity and the entities it controls. Tax effect accounting entries should be prepared for each entity on a standalone basis and the consolidation then performed in accordance with IFRS 10 Consolidated Financial Statements. Consolidation journal entries are made to produce the consolidated figures without altering the amounts actually recorded in the general ledger of the individual entities within the group. In addition to the normal consolidation adjustments (e.g. to eliminate intragroup transactions), tax effect accounting adjustments will be required to account for differences in the carrying amounts of assets and liabilities in the consolidated financial statements against those of the individual entities (e.g. where the assets or liabilities are carried at cost in the single-entity financial statements but at fair value in the consolidated financial statements). Accordingly, consolidation adjustments may give rise to temporary differences requiring DTAs and DTLs to be recognised. The accounting for consolidations and the tax effect accounting implications flowing therefrom are discussed further in Unit 16.

Unit 4 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Presentation Required reading Read IAS 12 paras 71–77 before proceeding. There are three main issues to consider after completing the tax effect journal entries for the year as follows: •• Offsetting tax balances. •• Separately presenting the income tax expense for the year. •• Providing disclosures within the financial statements (covered in the next section).

Offsetting tax balances Applying IAS 12 para. 74, DTAs and DTLs should be offset (i.e. netted) in the statement of financial position when: •• The entity has a legally enforceable right to offset current tax assets against current tax liabilities. •• The DTAs and DTLs relate to income taxes levied by the same taxation authority on either: –– the same taxable entity –– the different taxable entities whose management intends either to settle current tax assets and liabilities on a net basis, or to realise the assets and settle the liabilities simultaneously. Applying IAS 12 para. 71, current tax liabilities and assets should be offset in the statement of financial position when: •• The entity has a legally enforceable right to offset the recognised amounts. •• The entity’s management intends either to settle on a net basis or to settle the liability and realise the asset simultaneously. An entity will normally have a legally enforceable right to set off a current tax asset against a current tax liability when they relate to income taxes levied by the same taxation authority, and the taxation authority permits the entity to make or receive a single net payment (IAS 12 para. 72). For example: •• In Australia, the above conditions are normally satisfied for income tax payments made to the ATO. •• In New Zealand, the above conditions are normally satisfied for income tax payments made to IR. In practice, creating a journal that separately records both the DTA and the DTL is recommended. The offset can be completed as a separate step in the calculation process. As deferred tax balances generally relate to individual assets or liabilities; they are commonly only offset against each other for financial statement preparation purposes.

Presenting income tax expense The income tax expense relating to profit or loss from ordinary activities is required to be presented as part of the statement of profit or loss and other comprehensive income (IAS 12 para. 77).

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Financial Accounting & Reporting

Disclosures Required reading Read IAS 12 paras 79–86 before proceeding.

Income tax expense Income tax expense is one of the key IAS 12 disclosures and comprises current income tax expense and deferred income tax expense. Income tax expense commonly equals the aggregate of the current tax liability and the movement in deferred tax balance calculations for the period. Disclosure of the components of income tax expense is required by IAS 12 paras 79 and 80. A breakdown of the journal entries made to the income tax expense account is therefore required but may be presented in various ways. It is common in practice for an entity to disclose the component of income tax expense that has been recognised in profit or loss.

Methodology for accounting for income tax expense recognised in profit or loss This section only covers income tax expense recognised in profit or loss, and assumes tax related to items disclosed in other comprehensive income or recognised directly in equity can be separately identified for disclosure purposes. The following diagram shows the elements of income tax expense recognised in profit or loss. Current income tax expense

+/–

Deferred income tax expense

=

Income tax expense

Elements of income tax expense for separate disclosure The following diagram represents the steps in identifying the components of income tax expense. STEP 1

STEP 2

STEP 3

Identify current income tax expense

Identify deferred income tax expense

Offset current income tax expense and deferred income tax expense

Step 1 – Identify current income tax expense Current income tax expense is the sum of the income tax expense that has been recorded when making journal entries to the current tax liability (excluding the tax effect of any transactions accounted for outside profit or loss). Step 2 – Identify deferred income tax expense Deferred income tax expense is the sum of the income tax expense that has been recorded when making journal entries that affect the DTA or DTL accounts (excluding the tax effect of any transactions accounted for outside profit or loss). Step 3 – Offset current income tax expense and deferred income tax expense The sum of the current income tax expense and deferred income tax expense are added together to give the income tax expense recognised in profit or loss.

Unit 4 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Other disclosure issues Other disclosure requirements include: •• The aggregate of current and deferred tax relating to items charged/credited to equity. •• Income tax relating to each component of other comprehensive income. •• A reconciliation of income tax expense and accounting profit multiplied by the applicable tax rate. •• The amount recognised as a DTA and the nature of evidence supporting its recognition. Required reading Read the remaining paragraphs from IAS 12. Activity 4.1: Accounting for income taxes [Available online in myLearning] Quiz [Available online in myLearning]

Working papers I and J You are now ready to complete working papers I and J of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity. You should complete this activity for tax when you have completed Unit 16.

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Core content – Unit 4

Unit 4 – Core content

Determine the value that would be recognised for the asset or liability if a notional tax balance sheet was prepared Paragraph 5 definition The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes

Apply the appropriate formula to the asset or liability to determine the tax base

Paragraph 7

The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset

1

IAS 12 focuses on the future tax consequences of recovering an asset only to the extent of its carrying amount at the reporting date. Accordingly, the future taxable amounts value is capped at the asset’s carrying amount at the reporting date

Asset tax base = carrying amount – future taxable amounts1 + future deductible amounts

Formula

Notional tax balance sheet approach (as per IAS 12 para. 5)

Formula-based approach (as per IAS 12 paras 7 and 8)

Asset

APPENDIX: Determining the tax base of an asset or liability that gives rise to a temporary difference

Chartered Accountants Program Financial Accounting & Reporting

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Page 4-34

Cr Revenue $400,000 Sales revenue recognised

•• Cash received from customers: $0

•• The $50,000 allowance for impairment loss will only be deductible for tax purposes when the debt is actually written off

•• $400,000 is assessable for tax purposes

Tax

•• Closing balance: $350,000 (net)

Impairment of trade receivables

Cr Accumulated impairment losses – trade receivables $50,000

Dr Impairment loss expense $50,000

Dr Trade receivables $400,000

•• Revenue recognised: $400,000

•• Allowance for impairment loss: $50,000 recognised

The tax base is $50,000

Formula-based approach

1

The $50,000 allowance for impairment loss will result in a tax deduction when the receivables are actually written off

= $350,000 carrying amount – $0 future taxable amounts (as the revenue has already been assessed for tax purposes) + $50,000 in future deductible amounts1

The tax base is $400,000

Cr Accumulated depreciation $30,000 = $90,000 carrying amount – $90,000 future taxable amounts (capped at Depreciation of equipment the asset’s carrying amount at the reporting date) + $50,000 in future deductible amounts

Dr Depreciation expense $30,000

Journal entries for the accounting transactions during the year

•• Opening balance: $0

Accounting

Trade receivables

Example 2

•• Closing tax written down value $50,000 (cost $150,000 – $100,000 tax depreciation deductions claimed to date)

•• Tax depreciation for the year $50,000

•• Opening tax written down value $100,000 (cost $150,000 – $50,000 tax depreciation deductions claimed to date)

•• Tax depreciation is deductible for tax purposes

Tax

•• Closing balance: $90,000

•• Depreciation expense for the year: $30,000

•• Opening balance: $120,000 (cost $150,000 – $30,000 accumulated depreciation)

Accounting

Depreciating asset

Example 1

Facts

The $50,000 allowance for impairment loss would not be recognised because a tax deduction only arises when the receivables are actually written off

be recognised

OR trade receivables of $400,000 would

If a notional tax balance sheet was prepared:

The tax base is $400,000

If a notional tax balance sheet was prepared, the depreciating asset’s $50,000 tax written down value OR would be recognised (cost $150,000 – $100,000 tax depreciation deductions claimed to date)

The tax base is $50,000

Notional tax balance sheet approach

Financial Accounting & Reporting Chartered Accountants Program

Core content – Unit 4

Unit 4 – Core content

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes

The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods

Employee entitlements expense

•• A tax deduction arises when employee entitlements are paid

Tax

Payment of employee entitlements

Cr Cash $260,000

Dr Provision (liability) $260,000

Cr Provision (liability) $300,000

•• $260,000 paid during the year

•• Closing balance: $240,000

Dr Expense $300,000

•• $300,000 expensed for the year

Journal entries for the accounting transactions during the year

•• Opening balance: $200,000

Accounting

Provision for employee entitlements

Example 3

Facts

1

The future taxable amounts value for a liability for the purposes of the FIN module under IAS 12 is assumed to be $0

Liability tax base = carrying amount – future deductible amounts + future taxable amounts1

= $240,000 carrying amount – $240,000 in future deductions for this liability when the entitlements are paid + $0 future taxable amounts

The tax base is $0

provision would not be recognised as the tax deduction will only be recognised for tax purposes when the entitlement is paid

If a notional tax balance sheet

OR was prepared, the liability for the

The tax base is $0

Notional tax balance sheet approach

Paragraph 5 definition

Paragraph 8

Formula-based approach

Determine the value that would be recognised for the asset or liability if a notional tax balance sheet was prepared

Apply the appropriate formula to the asset or liability to determine the tax base

Formula (general rule for liabilities)

Notional tax balance sheet approach (as per IAS 12 para. 5)

Formula-based approach (as per IAS 12 paras 7 and 8)

Liability

Chartered Accountants Program Financial Accounting & Reporting

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•• [In a later reporting period when the revenue is recognised for accounting purposes, there will be no further taxation of the $80,000 as it was assessed for tax purposes when received]

•• The revenue is assessable when received

Tax

Revenue received in advance that cannot yet be recognised for accounting purposes

Cr Revenue received in advance (liability) $80,000

•• Closing balance: $80,000

Dr Cash $80,000

•• $80,000 received from a customer during the year but has not yet been recognised for accounting purposes

Journal entries for the accounting transactions during the year

•• Opening balance: $0

Accounting

Unearned income

Example 4

Facts

Revenue received in advance tax base = carrying amount – amount of revenue not taxable in future periods

= $80,000 carrying amount – $80,000 that will not be assessable in the future (as the $80,000 was assessable for tax purposes when received)

The tax base is $0

Formula-based approach

If a notional tax balance sheet was prepared, the liability for revenue OR received in advance would not be recognised as the amount has already been assessed for tax purposes

The tax base is $0

Notional tax balance sheet approach

Determine the value that would be recognised for the asset or liability if a notional tax balance sheet was prepared

Apply the appropriate formula to the asset or liability to determine the tax base

Formula (exception to liability rule for revenue received in advance)

Notional tax balance sheet approach (as per IAS 12 para. 5)

Formula-based approach (as per IAS 12 paras 7 and 8)

Liability

Financial Accounting & Reporting Chartered Accountants Program

Core content – Unit 4

Unit 5: Foreign exchange Contents Introduction

5-3

Accounting for foreign currency Functional currency Presentation currency

5-3 5-4 5-4

Foreign currency transactions and balances Understanding key terms Initial recognition of foreign currency transactions Reporting at subsequent reporting dates Recognising exchange differences

5-5 5-5 5-5 5-5 5-6

Translation of financial statements Determining the functional currency Translating from the functional to the presentation currency

5-8 5-8 5-9

fin31905_csg_02

Disclosures 5-13

Unit 5 – Core content

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Core content – Unit 5

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Financial Accounting & Reporting

Learning outcomes At the end of this unit you will be able to: 1 Explain and account for foreign currency transactions and balances. 2. Determine the functional currency. 3. Explain and account for the translation of financial statements of an entity from its functional currency to its presentation currency.

Introduction It is quite common for entities to conduct their business activities in foreign currencies or in foreign locations. With the revenues generated, assets purchased and investments made overseas, entities have an increased exposure to foreign currencies and are increasingly affected by fluctuating foreign exchange (FX) rates. IAS 21 The Effects of Changes in Foreign Exchange Rates outlines how to account for foreign currency transactions and balances, and discusses how to determine an entity’s functional currency and translate financial statements into an entity’s presentation currency. This unit examines the application of IAS 21. Unit 5 overview video [Available online in myLearning]

Accounting for foreign currency Accounting for the effects of changes in foreign exchange rates on transactions and balances is an integral step in the preparation of financial statements. Where an entity undertakes foreign currency transactions, its financial statements must appropriately reflect the economic consequences of such transactions in its presentation currency. As per para. 3, IAS 21 shall be applied: (a) in accounting for transactions and balances in foreign currencies, except for those derivatives transactions and balances that are within the scope of IFRS 9 Financial Instruments; (b) in translating the results and financial position of foreign operations that are included in the financial statements of the entity by consolidation or the equity method; and (c) in translating an entity’s results and financial position into a presentation currency.

Unit 5 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Functional currency A foreign currency transaction is initially recorded by an entity in its functional currency. The functional currency is the currency of the primary economic environment in which the entity operates, normally where it primarily generates and expends cash. Determining an entity’s functional currency is discussed later in this unit.

Presentation currency An entity may present its financial statements in any currency (IAS 21 para. 38). In practice, for many entities the local currency is the presentation currency. An entity’s presentation currency may be prescribed by local regulatory requirements.

IAS 21 The Effects of changes in Foreign Exchange Rates IAS 21 defines functional currency and presentation currency. The Standard then splits up into two sets of rules

Transactions

Translations

Foreign currency

Subsidiary’s functional currency





Functional currency

Group presentation currency

e.g. buy inventory from our supplier in Italy

e.g. translate the financial report of our French subsidiary from euros €





Pay in euros €, record transaction in our ledger in dollars $

into dollars $

Important concept: Monetary or Non-monetary?

Important concept: Make the balance sheet balance

Accounting: Gain or loss to P&L DO NOT USE FCTR IAS 21 paras 23-24

Accounting: Balancing figure to FCTR (Equity, OCI) IAS 21 paras 38-47

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Chartered Accountants Program

Financial Accounting & Reporting

Foreign currency transactions and balances Learning outcome 1. Explain and account for foreign currency transactions and balances.

Understanding key terms IAS 21 para. 8 provides a list of definitions of the key terms involved in accounting for the effects of changes in foreign exchange rates. The definitions that are particularly important to understand are: •• •• •• •• •• •• ••

Closing rate. Exchange difference. Foreign operation. Functional currency. Monetary items. Presentation currency. Spot exchange rate.

Initial recognition of foreign currency transactions To recognise a foreign currency transaction, the spot exchange rate (the exchange rate for immediate delivery) between the functional currency and the foreign currency is applied to the foreign currency amount (IAS 21 paras 8 and 21) at the date that the transaction first qualifies for recognition in accordance with International Financial Reporting Standards (IFRS).

Reporting at subsequent reporting dates Monetary items ‘assets and liabilities to be received or paid in a fixed or determinable number of units of currency’ IAS 21 para. 8

Non-monetary items

Recognise at spot rate Do not re-translate at closing rate

Recognise at spot rate Re-translate at closing rate Gains & losses to P&L

• • • •

• • • • •

trade payables trade receivables cash loans

inventory property, plant and equipment prepaid rent capitalised development costs brands, goodwill

The following table summarises how to translate foreign currency denominated items at each reporting date (IAS 21 para. 23). Reporting at the end of subsequent reporting periods Item

Translation method

Foreign currency monetary items

Use the closing rate (the spot exchange rate at the end of the reporting period)

Non-monetary items that are measured in terms of historical cost in a foreign currency

Use the exchange rate at the date of the transaction

Non-monetary items that are measured at fair value in a foreign currency

Use the exchange rates at the date when the fair value was measured

Unit 5 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Recognising exchange differences The following table summarises how to recognise exchange differences relating to monetary items (IAS 21 para. 28). Recognition of exchange differences Exchange differences

Recognition method

•• On the settlement of monetary items

Recognise in profit or loss in the period in which they arise

OR •• On translating monetary items at rates different from those at which they were translated on initial recognition during the period or in a previous financial report

Example – Accounting for a foreign currency asset purchase This example illustrates how to account for foreign currency purchases by recording the initial purchase, subsequent payments and any retranslations required at reporting dates by applying IAS 21. On 1 July 20X3, the executive committee of Coolsac Limited (Coolsac) approved the purchase of a new machine used in the production of handbags. The handbags will be sold as accessories in Coolsac’s stores. The machine was purchased from a manufacturer located in Illinois, USA for US$12 million. The key milestones in the purchase contract are: •• Customisation (which will take three months from order). •• Delivery, installation and preparation for use (taking a further three months). An initial deposit of US$6 million is due at the completion of the machine’s customisation, with the balance of US$6 million due when delivery, installation and preparation for use is complete. Under the terms of the purchase contract, Coolsac incurred the liability to pay at the time of purchasing the machine, but cash payments are not due until the milestone dates. Exchange rates Dates

A$

US$

01.07.X3

1.00

0.90

30.09.X3

1.00

0.92

31.12.X3

1.00

0.93

Coolsac has a 30 June year end. IAS 21 para. 21 deals with initial recognition and states that the transaction should be recognised using the spot exchange rate at the date of the transaction. Coolsac incurred the US$12 million liability at the time of entering the contract to build the machine on 1 July 20X3, when the exchange rate was 0.90. The first journal entry is for the recognition of the machine asset and the liability incurred on entering the contract on 1 July 20X3 (US$12 million ÷ 0.90). As the machine has not yet been built, it is common practice to use a capital work in progress account. Date

Account description

01.07.X3

Capital work in progress (WIP) Payables

Dr A$

Cr A$

13,333,333 13,333,333

To record entering into the contract for the acquisition of the machine

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Financial Accounting & Reporting

As the machine is to be paid for in instalments, exchange differences are likely to arise when the payments are made. IAS 21 para. 28 covers the treatment of exchange differences arising on the settlement of monetary items. The second journal entry is to recognise the payment of US$6 million on completion of the first milestone on 30 September 20X3 (US$6 million ÷ 0.92), and reduction of the payable as the first half of the liability is being settled (13,333,333 ÷ 2). The difference of A$144,928 between these two amounts (A$6,666,667 – A$6,521,739) is a foreign exchange gain recognised in profit or loss. Date

Account description

30.09.X3

Payables

Dr A$

Cr A$

6,666,667

Cash

6,521,739

Foreign exchange gain

144,928

To record the payment of first instalment of the machine

The third journal entry is to recognise the final payment of US$6 million on completion of the second milestone on 31 December 20X3 (US$6 million ÷ 0.93), and reduction of the payable as the second half of the liability is being settled (A$13,333,333 ÷ 2). The difference of A$215,053 between these two amounts (A$6,666,666 – A$6,451,613) is a foreign exchange gain recognised in profit or loss. The payable has not been restated since its initial recognition as this only occurs at reporting dates. Date

Account description

31.12.X3

Payables

Dr A$

Cr A$

6,666,666

Cash

6,451,613

Foreign exchange gain

215,053

To record the payment of final instalment of the machine

The last journal entry transfers the capital WIP to property, plant and equipment (PPE) at 31 December 20X3, as the machine is now installed and ready for use. As the capital WIP is a non‑monetary item, it is not restated at the year end. Date

Account description

31.12.X3

PPE (machine used in handbag production) Capital WIP

Dr $

Cr $

13,333,333 13,333,333

To record the transfer of the machine from WIP to PPE on completion

Required reading IAS 21 (or local equivalent).

Unit 5 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Translation of financial statements Learning outcomes 2. Determine the functional currency. 3. Explain and account for the translation of financial statements of an entity from its functional currency to its presentation currency. While an entity must record its foreign currency items in its functional currency, it must present its financial statements in a single currency, known as the ‘presentation currency’. Foreign operations, such as subsidiaries and branches, often have to translate their financial statements from their functional currency into the presentation currency of the reporting entity to facilitate the preparation of consolidated financial statements. IAS 21 para. 39 specifies the method for translating financial statements from the functional currency into the presentation currency, which is covered later in this unit.

Determining the functional currency An entity must determine its functional currency according to its primary economic environment. This may not be its local currency (the currency of the country in which it resides). IAS 21 paras 9–11 set out the primary, secondary and additional indicative factors that management should consider when determining the functional currency of foreign operations. The following table summarises these factors. Factors to consider in determining functional currency Primary indicative factors •• The currency that mainly influences sales prices for the entity’s goods and services (this will often be the currency in which sales prices are denominated and settled) (IAS 21 para. 9(a)(i)) •• The currency of the country whose competitive forces and regulations mainly determine the sales price of the entity’s goods and services (IAS 21 para. 9(a)(ii)) •• The currency that mainly influences labour, material and other costs of providing goods and services (this will often be the currency in which the costs are denominated and settled) (IAS 21 para. 9(b)) Secondary indicative factors •• The currency in which funds from financing activities (i.e. issuing debt and equity instruments) are generated (IAS 21 para. 10(a)) •• The currency in which receipts from operating activities are usually retained (IAS 21 para. 10(b)) Additional indicative factors •• Whether the activities of the foreign operation are conducted as an extension of the reporting entity or autonomously (IAS 21 para. 11(a)) •• Whether transactions with the reporting entity are a high or low proportion of the foreign operation’s activities (IAS 21 para. 11(b)) •• Whether cash flows from the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it (IAS 21 para. 11(c)) •• Whether cash flows from the foreign operation are sufficient to service existing and normally expected debt obligations without funds from the reporting entity (IAS 21 para. 11(d))

There may be instances where the indicative factors are mixed and the functional currency is not obvious. In such cases, management uses its judgement to determine the functional currency that best represents the economic effects of the underlying transactions, events and circumstances. Management must give priority to the primary indicators, because the secondary and additional indicators are not linked to the primary economic environment in which the entity operates and only provide supporting evidence (IAS 21 para. 12).

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As an entity’s functional currency reflects its underlying transactions, events, and conditions; it is not changed unless there is a change in those transactions, events or conditions (IAS 21 para. 13). Activity 5.1: Determining the functional currency of a foreign operation [Available online in myLearning]

Translating from the functional to the presentation currency Where the functional currency of a foreign operation is different from the presentation currency of the reporting entity, the foreign operation must translate its financial statements from its functional currency to the reporting entity’s presentation currency (IAS 21 para. 38).

Translating results and financial position The following table summarises the rules for translating an entity’s financial results and financial position balances (IAS 21 paras 39 and 40). Translation of results and financial position Item

Appropriate translation rate

Assets and liabilities

Closing rate (spot exchange rate at reporting date)

Income and expenses

Exchange rate at date of transaction If items occur regularly throughout the period, an average rate can be used unless the exchange rate fluctuates significantly

Translating equity balances IAS 21 is not explicit on the translation of equity balances when translating from the functional to presentation currency. An approach can be established, drawing on the principles contained elsewhere in IAS 21. The following table summarises the rules commonly applied in practice when translating an entity’s equity balances. Translation of equity balances Item

Appropriate translation rate

Share capital •• Pre-acquisition

•• Spot exchange rate in force at the date of acquisition

•• Post-acquisition movements (e.g. new share issue)

•• Spot exchange rate in force at the dates the amounts were originally recognised in equity

Reserves •• Pre-acquisition balance

•• Spot exchange rate in force at the date of acquisition

•• Post-acquisition transfers (e.g. transfers to/from retained earnings)

•• Spot exchange rate in force at the dates the amounts transferred were originally recognised in equity

•• Post-acquisition movements (e.g. movement in revaluation surplus)

•• Spot exchange rate in force at the date the movement was recognised

Retained earnings •• Pre-acquisition balance

•• Spot exchange rate in force at the date of acquisition

•• Cumulative post-acquisition movements

•• Not independently translated – carried forward from previous year’s translations and current year’s translated profit from the statement of profit or loss

Distributions from retained earnings •• Dividends

•• Spot exchange rate on the date of payment or declaration

•• Transfers to/from reserves

•• Spot exchange rate in force at the dates that the amounts transferred were originally recognised in equity

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Financial Accounting & Reporting

Chartered Accountants Program

Recognising foreign exchange translation differences Foreign exchange translation differences arise because different exchange rates are applied to different balances. To recognise these differences: •• Calculate the exchange difference as a balancing item after the determination of all translated balances. •• Do not include the exchange difference in profit or loss. Instead, disclose the exchange difference as a separate component of other comprehensive income (OCI) (IAS 21 para. 39(c)). Entities will often recognise foreign exchange translation differences in a foreign currency translation reserve in the financial statements. As noted in IAS 21 para. 47, any goodwill arising on the acquisition of a foreign operation and any fair value adjustments arising from the acquisition are treated as assets and liabilities of the foreign operation, and are expressed in the functional currency of the foreign operation. They are translated in the manner set out above. Accounting for the acquisition of an entity is discussed in the unit on business combinations.

Bringing the rules together Distinguishing between when to apply the foreign currency transaction rules and when to apply the translation rules can sometimes be confusing. In practice, an entity often has to apply both sets of rules from IAS 21.

Example – Applying foreign currency transaction and financial statement translation rules This example illustrates how and when the foreign currency transaction and financial statement translation rules under IAS 21 are applied. Dinkum Limited (Dinkum) is an Australian subsidiary of a United Kingdom group, Union Jack Limited. Dinkum was incorporated on 1 July 20X4. Its functional currency is Australian dollars and its presentation currency is pounds sterling. Exchange rates during the year ended 30 June 20X5 were as follows: Exchange rates AUD

NZD

GBP

01.07.X4

1

1.07

0.47

15.05.X5

1

1.08

0.52

30.06.X5

1

1.12

0.48

Average rate for the year ended 30 June 20X5

1

1.06

0.50

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Financial Accounting & Reporting

Dinkum is affected by two very different sets of rules under IAS 21

Dinkum sells inventory to a customer in New Zealand for NZ$5,000 on 15.05.X5. Payment is received in July 20X5 There were A$6,000 in other sales that occurred evenly over the year

Foreign currency transaction

Apply paragraphs 20–37 and 50 Transaction translated to functional currency

Use the spot rate per IAS 21 para. 21 15.05.X5 Dr Trade receivables $4,630 Cr Sales revenue $4,630 (Recognition of sales revenue)

Trade receivables is a monetary item (para. 16) Remeasure at 30 June to NZ$5,000 ÷ 1.12 = $4,464 30.06.X5 Dr Foreign $166 exchange loss Cr Trade receivables $166 (Remeasure trade receivable and recognise loss in profit or loss)

Unit 5 – Core content

Dinkum’s results are reported in GBP (its presentation currency)

Translation of financial statements into the presentation currency

Paragraphs 38–47: Assets and liabilities at closing rates Income and expenses at transaction dates (Average rate may be applied where transactions are regular and a stable exchange rate throughout the period) Exchange differences to the foreign currency translation reserve (FCTR) (movement disclosed in other comprehensive income)

Sales revenue is not remeasured (only certain assets and liabilities can be a monetary item)

See next page for detailed diagram

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Financial Accounting & Reporting

Chartered Accountants Program

Dinkum Limited Functional currency: AUD Statement of financial position as at 30 June 20X5 Assets – current Bank Trade receivables Total assets Net assets

Dinkum Limited Functional currency: AUD Statement of profit and loss for the year ended 30 June 20X5

6,000    4,464 10,464 10,464 ======

Equity Share capital Retained earnings Total shareholders’ equity

4,000 6,464 10,464 ======

Dinkum Limited Presentation currency: GBP Statement of financial position as at 30 June 20X5 Assets – current Bank Trade receivables Total assets Net assets

Sales revenue* Cost of sales Gross profit Foreign exchange loss Net profit

10,630   ( 4,000) 6,630 ( 166) 6,464

*Includes A$6,000 in other sales

Dinkum Limited Presentation currency: GBP Statement of profit and loss for the year ended 30 June 20X5

£

£ 2,880  2,143 5,023 5,023 =====

Equity Share capital FCTR (balancing figure) Retained earnings Total shareholders’ equity

A$

A$

1,880 (185) 3,328 5,023 =====

Sales revenue Cost of sales Gross profit Foreign exchange loss Net profit

5,408   ( 2,000) 3,408 (     80) 3,328

(Use average rates apart from 15.05.X5 rate for the New Zealand sale and 30.06.X5 to translate the foreign exchange loss recognised on that date)

(Use closing rates for assets and liabilities; spot rate when originally recognised for share capital and translated 20X5 profit for retained earnings)

Activity 5.2: Translating from the functional currency to the presentation currency [Available online in myLearning]

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Disclosures The disclosure requirements of IAS 21 are detailed in paras 51–57. An entity is required to disclose the value of exchange differences recognised (para. 52) and narrative notes related to the functional/presentation currency (paras 53–57). An entity also has to clearly disclose the presentation currency in accordance with IAS 1 Presentation of Financial Statements para. 51 (d). Quiz [Available online in myLearning] Now that you have completed Units 1–5, you are ready to integrate these topics and attempt the first integrated activity. These activities help to prepare you for professional practice and the FIN Module exam. Integrated activity 1 The integrated activity is available online in myLearning.

Working paper B You are now ready to complete working paper B of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

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Unit 6: Fair value measurement Contents Introduction 6-3 Why is IFRS 13 needed? 6-3 Purpose of this unit 6-3 Scope of IFRS 13 6-4 Measuring fair value 6-4 Definition 6-4 Step 1 – Determine the asset or liability to be measured 6-4 Step 2 – Measure fair value using an exit price 6-5 Step 3 – In the principal (or most advantageous) market 6-6 Step 4 – Between market participants 6-8 Step 5 – Based on the highest and best use for non-financial assets 6-9 Step 6 – Using an appropriate valuation technique 6-11 Step 7 – Based on inputs from the fair value hierarchy 6-13 Step 8 – To arrive at a fair value measurement 6-15 Considerations specific to liabilities and an entity’s own equity instruments 6-16 Liabilities 6-16 An entity’s own equity instruments 6-16 Measuring fair value for liabilities and own equity 6-16

fin31906_csg_02

Preparing IFRS 13 disclosures

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Learning outcome At the end of this unit you will be able to: 1. Explain and identify the key principles of fair value measurement, along with the related disclosure requirements.

Introduction IFRS 13 Fair Value Measurement establishes a single framework or hierarchy for measuring fair value. This unit outlines the principles of fair value measurement and their general application.

Why is IFRS 13 needed? Similar to IAS 12 Income Taxes, the standard that provides the framework for accounting for income taxes, IFRS 13 provides a single framework to which other accounting standards refer for fair value measurement and disclosure. A range of accounting standards require, or provide as an option, the use of a fair value measurement basis. These standards include: •• IAS 16 Property, Plant and Equipment. •• IAS 36 Impairment of Assets – in relation to recoverable amount determined using fair value less costs of disposal. •• IAS 38 Intangible Assets. •• IAS 39 Financial Instruments: Recognition and Measurement. •• IFRS 3 Business Combinations. •• IFRS 9 Financial Instruments. For example, under IFRS 3, when a parent acquires a subsidiary, most assets and liabilities of the acquired entity are required to be measured at fair value at the acquisition date. When a standard requires or permits a fair value measurement, that standard relies on IFRS 13 for its measurement.

Purpose of this unit The aim of this unit is to enable you to determine what needs to be considered when measuring a fair value. In practice, measuring fair value may require considerable experience and the exercise of professional judgement involving the application of complex valuation techniques. The focus of this unit is on the application of the IFRS 13 framework to the fair value measurement process. The emphasis is not on calculating a correct dollar value. Unit 6 overview video [Available online in myLearning]

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Scope of IFRS 13 Not all fair value accounting under IFRS is covered by IFRS 13. For example, the requirements of IFRS 13 do not apply to: •• Measurement and disclosure requirements under: –– IFRS 2 Share-based Payment. –– IFRS 16 Leases. –– Standards that utilise a similar basis to fair value but that are not fair value, such as IAS 2 Inventories (when net realisable value is applied) and IAS 36 (in relation to recoverable amount determined using value in use). •• Disclosure requirements under: –– IAS 19 Employee Benefits (for plan assets measured at fair value). –– IAS 36 (in relation to recoverable amount determined using fair value less costs of disposal). Required reading IFRS 13 (or local equivalent).

Measuring fair value Definition IFRS 13 para. 9 defines ‘fair value’ as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. The definition is therefore based on a hypothetical transaction. The process of measuring fair value under the Standard can be performed in eight steps, as shown in the following diagram:

STEP 1

STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

Step 1 – Determine the asset or liability to be measured STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

A fair value measurement is for a particular asset or liability (IFRS 13 para. 11). This draws out two key points when considering an orderly transaction between market participants: 1. What the particular item is, is dependent on its unit of account. 2. Factoring in any characteristics of the asset or liability that market participants would consider when pricing the item.

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Unit of account A ‘unit of account’ is defined in Appendix A of IFRS 13 as ‘the level at which an asset or liability is aggregated or disaggregated in a standard for recognition purposes’. For example, a parcel of land may be the unit of account under IAS 16, while a fleet of delivery vehicles may be the unit of account under IAS 16, and a cash-generating unit (CGU) comprising assets and liabilities could be the unit of account under IAS 36.

STEP 1

A fair value measurement is performed on a consistent basis with its unit of account. For example, the fair value of a CGU will be measured when there is an indication of impairment (under IAS 36) that the carrying amount of the CGU may exceed its recoverable amount (covered in Unit 10).

Characteristics of the asset or liability In determining an asset’s or a liability’s fair value, an entity factors in the characteristics of the asset or liability that a market participant would take into account when pricing the asset or liability at the measurement date. Examples of characteristics that should be factored in when measuring the fair value of an asset include: •• The condition and location of the asset. •• Any restrictions on the sale and use of the asset.

Example – Characteristics of a liability This example illustrates how the characteristics of a liability may impact its fair value. Company X has corporate bonds on issue that pay a fixed rate of interest of 8% per annum. The bonds were issued two years ago and will mature in three years’ time. The 8% fixed interest rate is a characteristic of the liability. Assume that the government’s official risk-free interest rate has been falling for the past 12 months and, at 30 June 20X5, is at an historic low of 2%. Companies with a risk profile similar to that of Company X are able to issue corporate bonds with a fixed interest rate of 5% and a maturity of three years. Market participants would price a liability with a high fixed interest rate at a higher fair value than a similar liability with a lower fixed interest rate. Therefore, if Company X is measuring the fair value of the corporate bonds at 30 June 20X5, the 8% fixed interest will be factored into its measurement, as the interest rate is a characteristic of the liability that a market participant would incorporate into the valuation.

Step 2 – Measure fair value using an exit price

STEP 2

STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

Fundamental to the standard is an ‘exit price’ approach to measuring fair value. In this approach, the entity is looking at the valuation from a market participant perspective, an outsider’s view, and not from within the entity.

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Market-participant view

Entity-specific view

The fair value definition refers to an exchange in an orderly transaction. Therefore, this exit price must be based on what would occur in an orderly transaction. For a transaction to be orderly it must: •• assume exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities, and •• be based on market participants who are motivated, but not forced or otherwise compelled, to transact for the asset or liability.

Example – Fair value measurement at initial recognition This example illustrates how the cost of an asset at initial recognition may not represent its fair value. Company X acquired the assets of an existing business, which resulted in a business combination under IFRS 3. As the business was struggling financially, Company X was able to negotiate a low price for the business’s assets. Of the total consideration paid by Company X for the business, the purchase agreement allocated a cost of $500,000 for a particular piece of equipment. Given the condition of the asset and if it was marketed in the usual manner, the fair value would be measured at $700,000. Under IFRS 3, plant and equipment acquired in a business combination must be measured at fair value on initial recognition. Therefore, Company X will recognise the equipment at $700,000 when accounting for the business combination. (Note: The unit on business combinations (Unit 15) explains how the accounting occurs.)

STEP 3

Step 3 – In the principal (or most advantageous) market STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

A key principle of IFRS 13 is the concept of measuring the fair value in the principal market or, in the absence of a principal market, in the most advantageous market. An exhaustive search of all possible markets is not necessary, but the entity should take into account all information that is reasonably available.

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Principal market The principal market is the market with the greatest volume and level of activity for the asset or liability being measured. The market where the entity would normally enter into a transaction to sell the asset, or transfer the liability, is presumed to be the principal market, unless there is evidence to the contrary.

STEP 3

The principal market must be available to, and accessible by, the entity at the measurement date. Access to a market is viewed from the perspective of the entity in question: 1. Which markets can the entity access? 2. The principal market is the market with the greatest volume and activity even if the entity has historically not transacted in that market. For example, if an entity could sell an equity instrument on both an overseas stock exchange and a domestic exchange, the overseas exchange will be the principal market if it has the greatest volume of trades for that equity instrument. The fair value of the equity instrument will be measured by reference to prices on the overseas stock exchange.

Most advantageous market (only used where there is no principal market) There may be some occasions when the principal market for an asset or liability cannot be determined (e.g. information allowing a determination on what market has the greatest volume and level of activity is not reasonably available). In such situation, the transaction is assumed to take place in the most advantageous market for that item. The most advantageous market is where the amount received to sell the asset is maximised, or the amount paid to transfer the liability is minimised.

Identify the most advantageous market Only consider if there is no principal market for the asset or liability Asset

Liability

Identify potential markets Identify potential markets • The most advantageous • The most advantageous market maximises the market minimises the amount received to sell amount that would be the asset paid to settle the liability • Subtract transport costs • Add transaction costs • Subtract transaction costs

Identify which is the most advantageous market

This does not give the fair value! It simply identifies the most advantageous market and then you apply the fair value measurement principles

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Example – Identifying the most advantageous market for an asset This example illustrates how to identify the most advantageous market for an asset. An entity would only follow these steps when there is no principal market for the asset. Company X is measuring the fair value of a particular asset and has determined there is no principal market for it. It has identified two possible markets: Market A $

Market B $

Selling price

100,000

110,000

Sales commission

(10,000)

(25,000)

Delivery costs

 (4,000)

 (5,000)

Net proceeds

86,000

80,000

Market A is the most advantageous market as the amount received to sell the asset is maximised after factoring in transaction and transport costs ($86,000 is higher than $80,000). The measurement of the fair value of this asset is covered in a later example in this unit.

STEP 4

Step 4 – Between market participants STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

A fair value measurement should be based on the assumptions of market participants (i.e. it is not an entity-specific measurement). Market participants are buyers and sellers in the principal (or the most advantageous) market for the asset or liability. Market participants are: •• Independent of each other (not related parties). •• Knowledgeable, having a reasonable understanding of the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary. •• Able to enter into a transaction for the asset or liability. •• Willing to enter into a transaction for the asset or liability (i.e. they are motivated but not forced or otherwise compelled to do so)

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STEP 4

Example – Assumptions of market participants in measuring fair value This example illustrates how the assumptions of market participants are relevant when measuring fair value. Company X is measuring the fair value of an investment property. It acquired the property as it is confident that a new rail station will be built in the area in the future, which will convert it into a vibrant business hub. Despite its confidence, Company X should factor in the assumptions that market participants would make when pricing the property. For example, in applying a suitable valuation technique, a market participant would factor in the risk that the rail station will not be built in the coming years when measuring the property’s fair value.

STEP 5

Step 5 – Based on the highest and best use for non-financial assets STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

The valuation premise for a non-financial asset is based on its highest and best use from a market participant’s perspective, which may differ from its current use within the entity. This means that the entity’s own intentions (e.g. to develop an asset) are not relevant when measuring fair value. It is assumed that market participants would maximise the value of the asset or group of assets, either by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use (IFRS 13 para. 27). Appendix A to IFRS 13 defines the highest and best use as: The use of a non-financial asset by market participants that would maximise the value of the asset or the group of assets and liabilities (e.g. a business) within which the asset would be used.

The highest and best use of an asset must be a use that market participants would consider: •• physically possible (e.g. building a car manufacturing plant on a small piece of land would not be physically possible) •• legally permissible (e.g. zoning restrictions prevent a nightclub being developed on a particular site) •• financially feasible (e.g. building a luxury hotel in a remote location may not be economically sound). When considering a use that is financially feasible, market participants take into account whether the use of an asset that is physically possible and legally permissible would generate a satisfactory investment return after taking into account the costs of converting the asset to that use. An entity’s current use of a non-financial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximise the asset’s value (IFRS 13 para. 29).

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Highest and best use for non-financial assets Entity-specific view

Market-participant view (consider existing use and alternatives)

Existing use

Use must be physically possible, legally permissible and financially feasible The entity needs to determine whether the highest and best use of the asset provides maximum value to market participants either: •• on a stand-alone basis (e.g. freehold land), and therefore the fair value measurement will be calculated at the individual asset level, or •• in combination with other complementary assets (e.g. a specialised piece of machinery used on a production line that operates in conjunction with other assets), and therefore the fair value measurement will be calculated on a combined asset basis.

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STEP 5

Example – Determining the highest and best use for a non-financial asset This example illustrates how to identify the highest and best use for a non-financial asset. Company X owns a plane that is used to operate charter services for large corporations. The plane is carried at value in its financial statements. Company X has two feasible options for the plane: 1. Continue to use the plane for charter flights.

When used for charter services, the value of the plane is $4 million at the reporting date.

2. Refurbish the cabin as a luxury plane.

Refurbishment is estimated to cost $1 million. The plane would then have a value of $6 million. There is strong global demand from celebrities and business tycoons who are keen to own their own luxury plane.

Company X has not commenced any planning to refurbish the plane by the reporting date, but is giving this option careful consideration and has consulted with a US company that specialises in such refurbishments. As option 2 is feasible, the plane’s existing use value is not the only basis considered when determining the value. Fair value of the plane based on its highest and best use Use for charter flights

Refurbished as a luxury plane

Value

$4,000,000

$6,000,000

Less costs of refurbishment

    0

($1,000,000)

$4,000,000

 $5,000,000 Fair value is $5,000,000

From a market participant’s perspective, the plane’s highest and best use is if it were refurbished. Source: Adapted from IFRS 13 Fair Value Measurement Illustrative Examples, January 2012, accessed on 9 April 2018

STEP 6

Step 6 – Using an appropriate valuation technique STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

In bringing together these concepts, the standard explains that when a price for an identical asset or liability is not observable, an entity measures fair value using another valuation technique (IFRS 13 para. 3). The Standard does not specify the use of a particular valuation technique as it is a matter of professional judgement; however, para. 61 requires an entity to apply a valuation technique: •• that is appropriate in the circumstances •• for which sufficient data is available •• for which the use of relevant observable inputs is maximised •• for which the use of unobservable inputs is minimised.

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Three widely used valuation techniques are outlined in IFRS 13, para. 62. However, these techniques are more of an overall approach, whereas practitioners will apply specific valuation methods. The three valuation techniques are as follows: IFRS 13 overall valuation technique

Definition

Typical inputs (assumptions)

Specific valuation methods

Items that may be valued using this technique

Market approach

A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities, such as a business

The fair value and yield to maturity on a corporate bond that is frequently traded on an active market that has a similar credit quality to the instrument being valued

For example, matrix pricing and market pricing based on recent transactions

•• Real estate

A valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost)

Estimated costs using quantity surveyors and builders, remaining useful life estimates reflecting physical and economic/ technological factors

For example, depreciated replacement cost method

•• Tangible assets such as plant and equipment

Valuation techniques that convert future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts

Discount rate, income stream (e.g. rentals, royalties, sales, remaining economic life)

For example, discounted cash flow method and multi-period excess earnings

•• A cashgenerating unit

Cost approach

Income approach

•• Financial instruments such as swaps, debt securities and equity instruments •• Certain intangible assets where there is an active market for a homogenous asset (e.g. a taxi licence)

For a financial instrument, inputs may include current share price, risk-free interest rate, time until option expiration and option strike price

Black-ScholesMerton option pricing model

•• Infrastructure assets (e.g. bridges)

•• Intangible assets that generate an income stream (e.g. royalties)

An awareness of these overall valuation techniques, rather than a practical application of specific techniques, is required for the purposes of this module.

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As indicated in the table above, inputs are used in applying a particular valuation technique. These inputs effectively represent the assumptions that market participants would use to make pricing decisions, including assumptions about risk. Inputs may also include price information, volatility factors, specific and broad credit data, liquidity statistics, and all other factors that have more than an insignificant effect on the fair value measurement.

STEP 6

IFRS 13 distinguishes between observable inputs, which are based on market data obtained from sources independent of the entity, and unobservable inputs, which reflect the entity’s own view of the assumptions market participants would apply. The Standard specifies that regardless of which valuation technique is being applied by an entity for measuring fair value, it should maximise observable inputs and minimise unobservable inputs.

Example – Identification of a suitable valuation technique This example illustrates how to identify a suitable valuation technique to measure fair value. Company X has acquired a subsidiary, NewHope Limited (NewHope), in a business combination. One of NewHope’s assets that has been identified is a brand name. NewHope’s brand is a critical part of its business, attracting many new customers as well as creating brand loyalty with existing customers. Because there has been a business combination, IFRS 3 requires the brand name to be measured at fair value at the date Company X gained control of the subsidiary. Under IAS 38, NewHope is not permitted to recognise the brand name in its own general ledger. To value the brand name, an income approach is the most appropriate valuation technique because the brand name generates inflows in the form of sales, and therefore an income approach aligns with the nature of the asset’s benefits. A market approach would not be appropriate as the brand name is unique to the business and therefore comparable assets will not exist in the market. A cost approach would also not be appropriate as the value of the brand name cannot be easily replicated through a replacement cost calculation and would involve the extensive use of unobservable inputs. (The unit on intangible assets (Unit 8) explains why NewHope could not recognise this asset in its own records.)

STEP 7

Step 7 – Based on inputs from the fair value hierarchy STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

The fair value hierarchy categorises the inputs used in a valuation technique into three levels. The most reliable evidence of fair value is a quoted price (unadjusted) in an active market for identical assets and liabilities (Level 1). When this price is available, the hierarchy specifies that it must be used without adjustment, except in certain specified (and limited) circumstances (IFRS 13 para. 77). When a quoted price in an active market is not available, entities need to use a valuation technique to measure fair value that is appropriate in the circumstances, maximises the use of relevant observable inputs (Level 2) and minimises the use of unobservable inputs (Level 3) (IFRS 13 para. 67).

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Chartered Accountants Program

The classification of inputs within the fair value hierarchy is shown below:

Classification of inputs within the fair value hierarchy

Is there a quoted price for an identical item in an active market?

Are there any significant unobservable inputs?

No Yes

Has the price been adjusted?

No Yes

Level 1 input (Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date) Examples: • Quoted prices for shares listed on the New Zealand Stock Exchange • Commodities such as gold and crude oil

Level 2 input (Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly) Examples: • Interest rates • Valuation multiples • Price per square metre

No Yes

Level 3 input (Unobservable inputs for the asset or liability) Examples: • Forcast cash flows • Estimated useful life of an asset Source: Adapted from KPMG 2011, ‘First Impressions: Fair value measurement’, available at www.kpmg.com/Global/en/ IssuesAndInsights/ArticlesPublications/first-impressions/Documents/First-impressions-fair-value-measurement.pdf, accessed 16 April 2018.

In some cases, the inputs used to measure fair value may be categorised within different levels of the fair value hierarchy. In such instances, the fair value measurement is categorised in its entirety, based on the lowest level input that is significant to the measurement. This is relevant for certain disclosures required by IFRS 13.

Example – Categorisation of inputs into the fair value hierarchy This example illustrates how an input used in a technique to measure fair value is categorised within the fair value hierarchy. Company X has a fixed-rate borrowing that is measured at fair value but is not quoted on a market. A discounted cash flow technique was used to measure the fair value of the contractual cash flows under the borrowing and two particular inputs were included within the calculation of the discount rate that was applied in the measurement: Item

Category of input

Reason

The time value of money based on a yield curve observable at commonly quoted intervals for listed fixed-rate borrowings

Level 2

As the intervals of the yield curve can be corroborated by observable market data (borrowings quoted on active markets are the market evidence), it is a Level 2 input

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STEP 7

Item

Category of input

Reason

Credit risk of Company X

Level 3

The input cannot be corroborated by market evidence and is based on management’s assumptions on the entity’s own credit risk and therefore it is a Level 3 input

Source: Adapted from: PWC 2015, ‘In depth – A look at current financial reporting issues’, www.pwc.co.za/ en/assets/pdf/indepth-ifrs-13-questions-and-answers-march-2015.pdf, accessed 16 April 2018. STEP 8

Step 8 – To arrive at a fair value measurement STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

STEP 6

STEP 7

STEP 8

Determine the asset or liability to be measured

Measure fair value using an exit price

In the principal (or most advantageous) market

Between market participants

Based on the highest and best use for non-financial assets

Using an appropriate valuation technique

Based on inputs from the fair value hierarchy

To arrive at a fair value measurement

The final step is arriving at the dollar value for the item being measured at fair value. Whether a complex valuation technique is applied or a more straightforward measurement technique is used, IFRS 13 para. 24 states that: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.

In measuring this exit price from a market participant’s perspective, IFRS 13 specifies the treatment for certain costs: Cost

Included or excluded in fair value measurement

Reason for treatment

Transport costs

Included

They are relevant to fair value where location, for example, is a characteristic of an asset (IFRS 13 para. 26)

Transaction costs

Excluded

They are entity-specific and can differ depending on how a transaction is structured. They are a feature of the transaction rather than a characteristic of the asset or liability being measured (IFRS 13 para. 25)

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Example – Measuring fair value This example illustrates how to measure fair value for an asset and extends on the earlier example that looked at the situation when there is no principal market for an asset. Company X is measuring the fair value of a particular asset and has determined that there is no principal market for it. It has identified two possible markets: Column 1

Market A $

Market B* $

Selling price

100,000

110,000

Sales commission

(10,000)

(25,000)

Delivery costs

  (4,000)

  (5,000)

Net proceeds

 86,000

 80,000

Market A is identified as the most advantageous market as the amount received to sell the asset is maximised after factoring in transaction and transport costs. However, when measuring fair value within Market A (the most advantageous market), transaction costs are ignored. Accordingly the fair value is $96,000 ($100,000 – $4,000). * The fact that the corresponding value in Market B of $105,000 ($110,000 – $5,000) is higher than the $96,000 fair value in Market A is irrelevant. Market B was not identified as the most advantageous market for the asset. Consequently, fair value is not measured in that market.

Considerations specific to liabilities and an entity’s own equity instruments Measuring fair value for liabilities and an entity’s own equity instruments can be difficult as quoted prices are often not available for the transfers of such items. IFRS 13 provides specific guidance in these circumstances. An awareness of these requirements, rather than performing a valuation, is required for this unit.

Liabilities The definition of fair value as it relates to liabilities is based on the liability being transferred rather than settled. Therefore, IFRS 13 requires the assumption that the liability will be transferred to a market participant at the measurement date. Its fair value must also reflect nonperformance risk – the risk that the entity will not fulfil an obligation, including (but not limited to) the entity’s own credit risk.

An entity’s own equity instruments An example of when a fair value must be measured for an entity’s own equity instruments is in a business combination. The entity may issue shares as all or part of the consideration transferred to acquire a business (covered in Unit 15). As required by IFRS 3, the fair value of these equity instruments is measured by the entity issuing the securities, as this is integral in determining whether goodwill is recognised in the business combination.

Measuring fair value for liabilities and own equity In comparison to assets, active markets for liabilities and equities are less likely to exist as a result of contractual and legal obligations preventing their transfer. When debt and equity securities are quoted on an active market, the market acts as an exit price mechanism for the investor rather than the issuer. Where a quoted transfer price (Level 1 input) is not available for a liability or own equity instrument, IFRS 13 looks to the flipside of Page 6-16

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the transaction and requires the fair value to be measured from the perspective of a market participant that holds the identical item as an asset. The valuation perspective under IFRS 13 of a liability or an entity’s own equity measurement can be explained as follows: Quoted price for transfer of an identical or similar liability/own equity instrument?

YES

Use quoted price

NO

Identical instruments held as an asset by another party?

YES

Value from the perspective of market participant that holds the asset

Use quoted price (adjusted for differences)

YES

NO

Value from the perspective of market participant that owes liability or issued equity instrument

Quoted price in an active market for identical instrument held as asset?

NO

Use an appropriate valuation technique

Source: Adapted from KPMG June 2011, First impressions: Fair value measurement, p. 15, accessed 16 April 2018, www.kpmg.com, search for ‘fair value measurement’.

Preparing IFRS 13 disclosures Disclosures under IFRS 13 are extensive and are grouped under para. 91(a) between recurring and non-recurring disclosures. Paragraph 93 explains the difference between recurring and nonrecurring disclosures as follows: •• Recurring disclosures are those that other accounting standards require or permit in the statement of financial position at the end of each reporting period (e.g. if the fair value measurement of property is re-measured annually under IAS 16). •• Non-recurring disclosures are those that other accounting standards require or permit in the statement of financial position in particular circumstances (e.g. in the event of a business combination under IFRS 3). In addition, para. 91(b) requires disclosure of the effect of the measurement for the reporting period on profit or loss or other comprehensive income where recurring fair value measurements use significant Level 3 inputs. For items measured in the statement of financial position at fair value after initial recognition, para. 93(b) requires an entity to disclose, by class of asset or liability, the level in the fair value hierarchy at which the fair value measurement is categorised. Professional judgement may need to be exercised to determine the significance of the inputs to the fair value measurement. Unit 6 – Core content

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The table below outlines the key IFRS 13 disclosures: Summary of IFRS 13’s disclosure requirements Recurring

Non- recurring

General disclosure requirements Fair value at the end of the period Reasons for the measurement General disclosures relating to the fair value hierarchy The level of the fair value hierarchy in which the valuation falls* The policy for determining when transfer between levels of the hierarchy are deemed to have occurred Reasons for transfers between different levels of the hierarchy A description of the valuation techniques and inputs used in fair value measurements categorised within Levels 2 and 3 of the hierarchy* Fair value hierarchy disclosures specific to Level 3 valuations Quantitative information about significant unobservable inputs in fair value measurements* A reconciliation of changes in fair value movements, disclosing separately changes attributable to: –– Total gains or losses recognised in profit or loss and the line item in which they are recognised –– Total gains or losses recognised in other comprehensive income and the line item in which they are recognised –– Purchases, sales, issues and settlements –– Transfers into or out of Level 3 Total gains or losses included in profit or loss attributable to the change in unrealised gains or losses for measurements within Level 3 A description of the valuation processes used for Level 3 measurements A narrative description of sensitivity analysis for Level 3 measurements The effect of altering an unobservable input where to do so would change the fair value significantly Other disclosure requirement For non-financial assets where highest and best use differs from current use, an explanation of why this is the case *  Disclosure also required for assets and liabilities not measured at fair value but for which fair value is disclosed in the financial statements Adapted from: Grant Thornton, IFRS News, October 2011, Grant Thornton website, accessed 16 April 2018, www.grantthornton.com.au/globalassets/1.-member-firms/australian-website/technical-publications/ifrs/gtil_2011_ifrsmews-ifrs-13-special-edition.pdf accessed 16 April 2018.

Example – Disclosure of recurring fair value measurements This example illustrates how an entity may present disclosures under IFRS 13 paras 93(a) and (b) at the end of the reporting period for assets and liabilities with recurring fair value measurement requirements. The table below categorises a company’s classes of assets and liabilities measured at fair value by the levels in the fair value hierarchy based on the source of inputs.

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30 June 20X3 Recurring fair value measurements at the end of the reporting period using: Item

Quoted prices in active markets for identical assets or liabilities (Level 1) $’000

Significant other observable inputs (Level 2) $’000

Significant unobservable inputs (Level 3) $’000

Total

$’000

Assets Equity securities: classified as fair value through other comprehensive income

220

–

–

220

Investment property: unit in highrise apartment block

–

1,000

–

1,000

Investment property: factory

–

–

2,000

2,000

Property: owner-occupied

–

–

3,000

3,000

220

1,000

5,000

6,220

Total assets Liabilities Forward exchange contracts used for hedging

–

(100)

Contingent consideration arising from business combination

–

–)

(450)

(450)

  –

 (100)

 (450)

 (550)

Total liabilities

–

(100)

In making these disclosures, the preparer would have given consideration to assets and liabilities with inputs in multiple levels of the fair value hierarchy where those inputs were significant to the item’s fair value. An item is classified in the hierarchy based on the level of the lowest significant input. Focusing on the disclosure of the two investment properties, assume that: •• The fair value of the unit in the high-rise apartment block involved the use of a Level 3 input to allow for a specific characteristic such as a custom-designed kitchen. A Level 2 input involved the use of observable prices for similar properties recently sold in the same building. Overall, this property has been categorised as a Level 2 input, as this level is more significant in measuring its fair value under a valuation technique using the market approach than the Level 3 input. •• The factory is classified separately (IFRS 13 para. 94) from the high-rise apartment block unit, due to its different nature, characteristics and risk. It is being held for rental returns and long-term capital appreciation, and therefore a valuation technique using an income approach is appropriate in measuring fair value. A Level 2 input in measuring its fair value is market rent per square metre for similar industrial properties in a similar location. However, Level 3 inputs, such as cash flow forecasts using the company’s own data and yields based on management’s expectations, are more significant in arriving at fair value. Therefore, the factory is categorised as a Level 3 input in the table.

Activity 6.1: Measuring fair value of non-financial assets [Available online in myLearning] Quiz [Available online in myLearning]

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Unit 7: Property, plant and equipment Contents Introduction

7-3

Defining property, plant and equipment Scope exclusions Differentiating PPE classes Recognition of items as PPE

7-4 7-4 7-4 7-5

Accounting for PPE during its useful life 7-6 Measurement at recognition 7-6 Measurement of cost 7-8 Subsequent costs 7-10 Measurement after initial recognition 7-11 Depreciation 7-16 Impairment 7-17 Compensation for impairment/loss of an asset 7-17 Derecognition 7-17 Non-current assets held for sale and discontinued operations 7-18

fin31907_csg_02

Disclosures for PPE, borrowing costs and non-current assets held for sale Disclosures for PPE Disclosures for borrowing costs Disclosures for non-current assets held for sale

Unit 7 – Core content

7-19 7-19 7-19 7-20

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Learning outcomes At the end of this unit you will be able to: 1. Describe the nature of property, plant and equipment. 2. Explain and account for property, plant and equipment during its useful life. 3. Explain and account for borrowing costs in relation to a qualifying asset.

Introduction Regardless of the industry sector in which an entity operates, it most likely will have property, plant and equipment (PPE). PPE is non-financial tangible assets that are used in an entity’s business operations during more than one period. The amount to be recognised for the asset and the impact on profit or loss via depreciation charges or impairment charges over the life of the asset and on disposal/derecognition need to be correctly determined to accurately reflect the asset’s use in the business over its useful life. This unit considers the recognition, measurement, classification, derecognition and disclosure requirements for non-current assets recognised by an entity as PPE. A current asset is defined in IAS 1 Presentation of Financial Statements para. 66 as follows: An entity shall classify an asset as current when: (a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c) it expects to realise the asset within twelve months after the reporting period; or (d) the asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

Paragraph 66 further states that all other assets shall be classified as non-current. In this unit, unless stated to the contrary, PPE are considered to be classified as non-current assets. The unit also covers situations where borrowing costs can be capitalised as part of the cost of a non-current asset, and addresses the implications of non-current assets that are held for sale. Since a standard may require or permit an asset to be measured at fair value, the calculation and disclosure requirements for fair value measurement, as applicable to non-financial tangible assets, is also covered. This unit examines the application of the following standards: •• IAS 16 Property, Plant and Equipment. •• IAS 23 Borrowing Costs. •• IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations. •• IFRS 13 Fair Value Measurement. Unit 7 overview video [Available online in myLearning]

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Defining property, plant and equipment Learning outcome 1. Describe the nature of property, plant and equipment. PPE is defined in IAS 16 para. 6 as: ... tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period.

PPE does not include assets that are classified as investment properties in accordance with IAS 40 Investment Property. Investment properties are discrete assets that are independent of an entity’s principal business activities. Their unique characteristics make them different from PPE assets, which have a distinct connection to, and are an essential element of, an entity’s business activities. IAS 40 prescribes specific accounting and disclosure requirements for certain types of property held for investment, as opposed to property held for resale or occupied by the owner. IAS 40 para. 5 defines an investment property as: ... property (land or a building – or part of a building – or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: (a) use in the production or supply of goods or services or for administrative purposes; or (b) sale in the ordinary course of business.

This unit does not consider non-current assets classified as investment property.

Scope exclusions IAS 16 deals with the accounting and disclosure requirements for most non-financial tangible assets. The exclusions that are covered in other standards are identified in IAS 16 para. 3: This Standard does not apply to: (a) property, plant and equipment classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations; (b) biological assets related to agricultural activity (see IAS 41 Agriculture); (c) the recognition and measurement of exploration and evaluation assets (see IFRS 6 Exploration for and Evaluation of Mineral Resources); or (d) mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources However, this Standard applies to property, plant and equipment used to develop or maintain the assets described in (b)–(d).

Differentiating PPE classes The distinction between items of PPE is important when determining the appropriate classes for measurement after initial recognition and for disclosure purposes.

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Example – Differentiating between items of PPE This example illustrates the distinction between items of PPE. A factory that a drinks company constructs/acquires to manufacture its goods in would be classified as property; the automated production line that bottles the product would be classified as plant; and a forklift used in the factory would be classified as equipment. Property The factory building

Plant The automated production line

Equipment The forklift

Recognition of items as PPE IAS 16 para. 7 requires that the cost of an item of PPE must only be recognised as an asset when: (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably.

An entity is required to use judgement when applying the recognition criteria for PPE. For example, para. 8 identifies that items such as spare parts and servicing equipment usually do not meet the criteria for recognition as PPE, and so are usually classified as inventory (e.g. spare parts inventory) and expensed as consumed. However, it is possible for major spare parts to qualify as PPE when an entity expects to use them for more than one period. Similarly, if the spare parts relate specifically to an asset held by the entity, the costs of those parts are accounted for as PPE.

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IAS 16 does not specify what constitutes an item of PPE, and judgement is required in applying the recognition criteria to an entity’s specific circumstances (para. 9). For example, should an aircraft be classified as a single asset or should the components be recognised separately? To answer this question, an analysis of what will happen to that asset in the future is required. If the asset has a number of distinct components with different useful lives, then the components will need to be accounted for separately to record correctly the pattern of benefits consumed. In the case of an aircraft, the separate components may consist of the engines, the fuselage of the aircraft and the internal fittings.

Example – Aircraft components are recognised separately This example illustrates the different components that may need to be separately recognised.

Required reading IAS 16 (or local equivalent).

Accounting for PPE during its useful life Learning outcomes 2. Explain and account for property, plant and equipment during its useful life. 3. Explain and account for borrowing costs in relation to a qualifying asset.

Measurement at recognition Where an asset can be recognised, IAS 16 para. 15 requires it to be initially measured at cost. Paragraph 6 defines cost as: … the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other IFRSs, e.g. IFRS 2 Share-based Payment.

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Elements of cost IAS 16 para. 16 states that the cost of an item of PPE comprises: •• Its purchase price, including any import duties and non-refundable purchase taxes (e.g. GST) incurred, after deducting any trade discounts or rebates. •• Directly attributable costs. •• An initial estimate of the costs of dismantling and removing the asset and restoring the site. Directly attributable costs are costs that are needed to bring an asset to the location and condition necessary so that it can operate in the manner intended by management. If the purchase price and any directly attributable costs are denominated in a foreign currency, then they are recorded by translating the foreign currency amount using the spot exchange rate at the date of the transaction, in accordance with the requirements of IAS 21 The Effect of Changes in Foreign Exchange Rates. This is classified as a foreign currency transaction and is covered in the unit on foreign exchange. The asset needs to be recorded in the functional currency of the entity. The initial estimate of the costs of dismantling and removing the asset and restoring the site is determined under IAS 37 Provisions, Contingent Liabilities and Contingent Assets and is included in the cost of the asset, in accordance with IAS 16. IAS 37 essentially requires that these estimated costs be discounted back to present value at the time of initial recognition of the PPE. The change over time in the value of the provision resulting from unwinding the discount is discussed further in the unit on accounting for provisions. It does not impact the amount recognised in PPE.

Example – Situations where the costs of dismantling and removing an asset or restoring a site must be capitalised as part of the original cost of an item of PPE This example illustrates when the cost of an asset needs to include a dismantling/restoration provision. The construction of an offshore oil platform, where the law requires the platform to be removed at the end of the oil extraction.

The use of land for mining or farming activities where the land must be restored to its former state at the end of the period of use.

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Inclusions and exclusions of costs The following costs are to be included as directly attributable costs (IAS 16 para. 17): •• Employee benefit costs arising directly from the construction or acquisition of the item of PPE. •• Costs of site preparation. •• Initial delivery and handling costs. •• Installation and assembly costs. •• Costs of testing whether the asset is functioning properly. •• Professional fees. Note that IAS 23 requires that borrowing costs (which include interest) be capitalised as part of the cost of a qualifying asset, as discussed later in this unit. Expenditure on the following is not to be included in the cost of PPE (IAS 16 paras 19 and 20): •• Costs of opening a new facility. •• Costs of introducing a new product or service (including costs of advertising and promotional activities). •• Costs of conducting business in a new location or with a new class of customer (including costs of staff training). •• Administration and other general overhead costs. •• Costs incurred while an item capable of operating in the manner intended by management has yet to be brought into use or is operated at less than full capacity. •• Initial operating losses, such as those incurred while demand for the item’s output builds up. •• Costs of relocating or reorganising part or all of an entity’s operations.

Measurement of cost Once the elements of the cost of an item of PPE have been identified, these amounts need to be measured. In most situations this will be simple to determine; however, deferred payment of the consideration and asset trade-ins can complicate the calculation. IAS 16 para. 23 states that the cost of an item of PPE is the cash price equivalent at the recognition date. Specific matters to consider are: •• Deferred payment of the consideration – if payment is deferred beyond normal credit terms, interest will need to be recognised in profit or loss unless it can be capitalised in accordance with IAS 23 (i.e. only where the asset is a qualifying asset as defined by IAS 23). •• A non-monetary asset, or a combination of non-monetary and monetary assets, may be exchanged to acquire an item of PPE. For example, an old asset may be traded in as part of the consideration to acquire a replacement PPE asset, as often applies with motor vehicles. Paragraphs 24–25 specify how to measure the cost in this situation. •• The value of PPE acquired under a finance lease is measured in accordance with IFRS 16 Leases. This is discussed further in Unit 12. •• A government grant may reduce the amount recognised for PPE under IAS 20 Accounting for Government Grants and Disclosure of Government Assistance.

Capitalisation of borrowing costs on a qualifying asset When determining the cost of an item of PPE, the possibility of capitalising borrowing costs should also be considered. IAS 23 requires borrowing costs to be capitalised into the cost of PPE in certain situations where the asset is a ‘qualifying asset’. A qualifying asset is defined in para. 5 as ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. In practice, ‘a substantial period of time’ is considered to be 12 months or more. Page 7-8

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Paragraph 7 provides further guidance as to what types of assets may be regarded as qualifying assets, and makes clear that qualifying assets do not include those that are ready for their intended use or sale at the time of acquisition. Borrowing costs are defined in para. 5 as ‘interest and other costs that an entity incurs in connection with the borrowing of funds’. Paragraph 6 clarifies that ‘interest’ is the interest expense calculated using the effective interest rate method (discussed further in the unit on financial instruments) and what ‘other costs’ constitute borrowing costs. Paragraph 8 requires that borrowing costs, to the extent that they are directly attributable to the acquisition, production or construction of a qualifying asset, are capitalised. Only borrowing costs that would have been avoided had the expenditure on the qualifying asset not been made are able to be capitalised under this standard. IAS 23 outlines two types of borrowing costs eligible for capitalisation: •• Funds borrowed specifically for the purpose of obtaining a qualifying asset (para. 12). •• Funds borrowed generally and used for the purpose of obtaining a qualifying asset (para. 14). Capitalisation of borrowing costs: •• Commences on the date at which the entity first meets all of the following conditions (para. 17): (a) it incurs expenditures for the asset; (b) it incurs borrowing costs; and (c) it undertakes activities that are necessary to prepare the asset for its intended use or sale.

•• Is suspended when active development of a qualifying asset is halted for extended periods (para. 20). •• Ceases when substantially all of the activities necessary to prepare the qualifying asset for its intended use or sale are complete (para. 22).

Example – Capitalisation of borrowing costs on a qualifying asset This example illustrates the calculation of borrowing costs to be capitalised on a qualifying asset. To increase its production capacity, Smart Limited (Smart) signed a $3,000,000 contract with Binns Limited for a new manufacturing plant that will produce plastic mouldings for use in the car manufacturing industry. The contract was signed on 1 March 20X2. The terms of the contract were as follows: •• 20% paid on signing the contract. •• 70% paid on delivery. •• 10% paid three months after delivery. The plant was delivered on 1 January 20X3 and installation was completed on 31 March 20X3. To help fund the acquisition of the manufacturing plant, Smart obtained a bank loan for $2,000,000 on 1 January 20X3. The loan has a term of two years, with a fixed rate of interest of 5.5% per annum. To determine whether the borrowing costs are capitalised in the cost of the plant, it must be determined whether the plant is a qualifying asset. The contract was signed on 1 March 20X2 and the plant was ready for use on 31 March 20X3. It took 13 months to get the plant ready for use, which is reasonable to assume is a substantial period of time as it exceeds 12 months; it is therefore a qualifying asset. The commencement date for capitalisation is the date when Smart first met all the conditions in IAS 23 para. 17. The contract was signed (i.e. activities were underway) and expenditure was first incurred on the asset on 1 March 20X2; however, borrowing costs were first incurred on 1 January 20X3. The commencement date of the capitalisation of borrowing costs is therefore 1 January 20X3.

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Capitalisation of borrowing costs Period

Calculation

$

01.01.20X3 – 31.03.20X3

$2,000,0001 × 5.5% × 3 ÷ 12

27,500

1. Although the total expenditure on the plant at 1 January 20X3 is $2,700,000 ($600,000 on signing the contract + $2,100,000 on delivery), only $2,000,000 of this has been financed by the loan.

Required reading IAS 23 (or local equivalent).

Summary ­- initial measurement of PPE Initially measure at cost (IAS 16 para. 15)

=

Purchase price

+

(IAS 16 para. 16(a))

Directly attributable condition/ location costs (IAS 16 paras 16(b) and 17)

+

Initial estimate of dismantling, removal and restoration costs

+

Capitalised borrowing costs (IAS 23 para. 8)

(IAS 16 para. 16(c)/ linked to IAS 37 for recognition and measurement)

Certain exclusions from cost (IAS 16 paras 19 and 20)

Subsequent costs The need to repair or replace an item of PPE may require an entity to consider how to account for subsequent expenditure on PPE. IAS 16 para. 12 refers to the recognition principle set out in para. 7 to assess whether subsequent costs should be capitalised or expensed. Day-to-day servicing costs are generally expensed as repair and maintenance expenses. Further guidance about when to capitalise versus when to expense is provided in paras 13 and 14. One approach is to capitalise subsequent costs when they either: •• Extend the useful life of an asset. •• Improve the asset’s quality of output. •• Reduce the operating costs associated with the use of the asset. It is common for major components of an asset to require replacement at regular intervals; therefore, the components are accounted for as separate assets (as discussed earlier) and are depreciated separately over their respective useful lives.

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Example – Accounting for components as separate assets This example illustrates how separate components of an asset may need to be separately recognised. Seats in an aircraft may require replacement several times during the life of the aircraft fuselage; hence, they are accounted for as separate assets.

Expenditure on the replacement of components of an asset that increase the economic benefits to be derived from that asset must be distinguished from expenditure on repairs and maintenance of the asset. When components are replaced and the costs are capitalised, the parts replaced (i.e. the existing components) must be derecognised to avoid double-counting.

Measurement after initial recognition Subsequent to initial recognition, an entity has the option of carrying assets under either the cost model or the revaluation model, as prescribed in IAS 16 para. 29. These models are discussed below. The selection of the cost model or the revaluation model is an accounting policy decision. The Standard prescribes that the policy must be applied to an entire class of PPE, rather than to individual assets (para. 36). An entity may elect to adopt the cost model of measurement for some classes of PPE and the revaluation model for other classes of PPE. Paragraph 37 defines a class of PPE as ‘a grouping of assets of a similar nature and use in an entity’s operations’, and provides the following examples: land, land and buildings, machinery, ships, aircraft, motor vehicles, furniture and fixtures, and office equipment. Under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors para. 14(b), after an entity has elected which model it will apply to a particular class of assets, it can change from cost to revaluation or vice versa if the change will result in an overall improvement in the relevance and reliability of information about the entity’s financial performance and position. Changes in accounting policies are discussed in Unit 2.

Cost model IAS 16 para. 30 requires that all items of PPE measured under the cost model be carried at cost less any accumulated depreciation and any accumulated impairment losses.

Revaluation model In many cases, the calculation of an asset’s carrying amount by reference to its cost may not be a true reflection of the current value of the asset. Therefore, IAS 16 provides entities with the option of adopting the revaluation model for classes of PPE. Under the revaluation model, items of PPE are revalued to fair value.

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For the revaluation model to be adopted, IAS 16 para. 31 requires that the fair values of the assets in question can be measured reliably. IAS 16 para. 6 defines fair value as: ... the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

This definition is consistent with the definition of fair value in IFRS 13. All accounting standards defer to IFRS 13 for fair value measurement issues, as discussed in the unit on fair value measurement. Where the revaluation model is used to measure a class of PPE, IAS 16 para. 31 requires that revaluations be made with sufficient regularity to ensure that the carrying amount of each asset in the class does not differ materially from its fair value at the reporting date. Therefore, there may be no requirement for annual revaluations to be made. The frequency of revaluations depends on the changes in fair value and is discussed in more detail in para. 34. IAS 16 paras 39 and 40 contain the principles for applying the revaluation model. These paragraphs refer to individual items of PPE. Therefore, even though the revaluation model is applied to classes of assets, the accounting under the model is applied on an asset-by-asset basis. Applying the revaluation model There are four steps to applying the revaluation model. Step 1 – Restate or eliminate accumulated depreciation Either proportionally restate accumulated depreciation (IAS 16 para. 35(a)), or eliminate it against the gross carrying amount of the asset (IAS 16 para. 35(b)). Unless otherwise stated, the elimination method is the method adopted in this module. The pro forma journal entry for the elimination method is as follows: Date

Account description

xx.xx.xx

Accumulated depreciation

Dr $

Cr $

XXX

PPE

XXX

Reversal of accumulated depreciation on the revaluation of the PPE

Step 2 – Calculate the amount of revaluation increment/decrement Calculate the amount of revaluation increment/decrement (i.e. the difference between the net amount (from Step 1) and the revalued fair value amount of asset) (IAS 16 para. 35). Step 3 – Classify the revaluation adjustment Classify the revaluation adjustment from Step 2 as revaluation increment or decrement and, as per IAS 16 para. 42, consider the tax accounting implications of IAS 12 Income Taxes. For the purposes of the FIN module, it is assumed that a revaluation increment or decrement does not alter the tax base of the asset. A temporary difference arises resulting in the recognition of a deferred tax asset or deferred tax liability. Step 4 – Prepare adjusting journal entries To prepare the correct journal entries, consider whether there is a previous revaluation increment or decrement relating to the asset. The exact journal entries will depend upon the facts of each case.

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Example – Revaluation of PPE This example illustrates the journal entries for the revaluation of an item of PPE. Assume a tax rate of 30%.

Revaluation increment with no previous revaluation decrement On 1 May 20X3 an item of PPE is revalued for the first time. Its carrying amount after the elimination of depreciation (as per step 1) is $100,000. The fair value of the asset is $150,000. The journal entry to record the revaluation increment is as follows: Date

Account description

01.05.X3

PPE

Dr $

Cr $

50,000

Revaluation surplus (equity account)* ($50,000 × (1 – 30%))

35,000

DTL ($50,000 × 30%)

15,000

Being the revaluation increment for PPE * Disclosed in OCI.

Revaluation decrement with no previous revaluation increment On 1 May 20X3 an item of PPE is revalued for the first time. Its carrying amount after the elimination of depreciation (as per step 1) is $100,000. The fair value of the asset is $70,000. The journal entry to record the revaluation decrement and tax is as follows: Date

Account description

01.05.X3

Revaluation expense (profit or loss) DTA* ($30,000 × 30%)

Dr $

Cr $

30,000 9,000

PPE

30,000

Income tax expense ($30,000 × 30%)

9,000

Being the revaluation decrement for PPE recognised in profit or loss * Recognised to the extent that realisation is probable (IAS 12 para. 24).

Revaluation increment with previous revaluation decrement On 1 May 20X3 an item of PPE is revalued. Its carrying amount after the elimination of depreciation (as per step 1) is $100,000. The fair value of the asset is $120,000. A revaluation decrement of $50,000 had previously been recognised in relation to this asset and it had been assessed that realisation of the resulting DTA was probable. Date

Account description

01.05.X3

PPE

Dr $ 20,000

Revaluation income (profit or loss) Income tax expense ($20,000 × 30%) DTA ($20,000 × 30%)

Cr $

20,000 6,000 6,000

Being the revaluation increment for PPE with a previous revaluation decrement

On 1 May 20X3 an item of PPE is revalued. Its carrying amount after the elimination of depreciation (as per step 1) is $100,000. The fair value of the asset is $160,000. A revaluation decrement of $50,000 had previously been recognised in profit or loss in relation to this asset and it had been assessed that realisation of the resulting DTA was probable.

Unit 7 – Core content

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Financial Accounting & Reporting

Date

Account description

01.05.X3

PPE

Chartered Accountants Program

Dr $

Cr $

60,000

Revaluation income (profit or loss) Income tax expense ($50,000 × 30%)

50,000 15,000

DTA ($50,000 × 30%)

15,000

Revaluation surplus (equity account)* ($10,000 × (1 – 30%))

7,000

DTL ($10,000 × 30%)

3,000

Being the revaluation increment for PPE with a previous revaluation decrement * Disclosed in OCI.

Revaluation decrement with previous revaluation increment On 1 May 20X3 an item of PPE is revalued. Its carrying amount after the elimination of depreciation (as per step 1) is $100,000. The fair value of the asset is $70,000. A revaluation increment of $40,000 had previously been recognised in relation to this asset. Date

Account description

01.05.X3

Revaluation surplus (equity account) ($30,000 × (1 – 30%)) DTL ($30,000 × 30%)

Dr $

Cr $

21,000 9,000

PPE

30,000

Being the revaluation decrement for PPE with a previous revaluation increment

On 1 May 20X3 an item of PPE is revalued. Its carrying amount after the elimination of depreciation (as per step 1) is $100,000. The fair value of the asset is $70,000. A revaluation increment of $20,000 had previously been recognised in relation to this asset. Date

Account description

01.05.X3

Revaluation surplus (equity account) ($20,000 × (1 – 30%)) DTL ($20,000 × 30%) Revaluation expense (profit or loss) ($30,000 – $20,000) DTA* (($30,000 – $20,000) × 30%) Income tax expense (($30,000 – $20,000) × 30%) PPE

Dr $

Cr $

14,000 6,000 10,000 3,000 3,000 30,000

Being the revaluation decrement for PPE with a previous revaluation increment * Recognised to the extent that realisation is probable (IAS 12 para. 24).

Required reading IFRS 13 para. 9.

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Core content – Unit 7

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Financial Accounting & Reporting

Pro forma journal entries for revaluation of property, plant and equipment Revaluation increment No previous revaluation decrement recognised in profit or loss

Previous revaluation decrement recognised in profit or loss

Disclose in other comprehensive income (disclosure purposes only) and accumulate in revaluation surplus account (IAS 16 para. 39)

Recognise in profit or loss to the extent that it reverses a decrement previously recognised in profit or loss (IAS 16 para. 39)

Pro forma journal entry:

Pro forma journal entry:

Date

Account description

XX.XX.XX

PPE

XX.XX.XX

Revaluation surplus1

XX.XX.XX

Deferred tax liability (DTL)

Dr $

Cr $

Date

Account description

XX.XX.XX

PPE

XXX

XX.XX.XX

Revaluation income1

XXX

XXX

XX.XX.XX

Revaluation surplus3

XXX

XX.XX.XX

Deferred tax asset (DTA)

XXX

XX.XX.XX

DTL

XXX

XX.XX.XX

Income tax expense

XXX

Revaluation increment for PPE 1. Net of related tax

Dr $

Cr $

XXX

2

XXX

Revaluation increment for PPE with a previous revaluation decrement 1. Revaluation expense reversed 2. Recognised to the extent realisation is probable 3. Net of related tax

Revaluation decrement No previous revaluation increment recognised in revaluation surplus

Previous revaluation increment recognised in revaluation surplus

Recognise in profit or loss (IAS 16 para. 40)

Disclose in other comprehensive income (disclosure purposes only) to the extent that it reverses a previous revaluation surplus amount (IAS 16 para. 40)

Pro forma journal entry:

Pro forma journal entry:

Date

Account description

Dr $

XX.XX.XX

Revaluation expense

XX.XX.XX

DTA

XX.XX.XX

PPE

XX.XX.XX

Income tax expense

1

Revaluation decrement for PPE 1. Recognised to the extent realisation is probable

Cr $

Date

Account description

Dr $

Cr $

XXX

XX.XX.XX

Revaluation surplus1

XXX

XXX

XX.XX.XX

DTL

XXX

XXX

XX.XX.XX

Revaluation expense

XXX

XXX

XX.XX.XX

DTA

XXX

XX.XX.XX

Income tax expense

XXX

XX.XX.XX

PPE

XXX

Revaluation decrement for PPE with a previous revaluation increment 1. Net of related tax on the amount recognised in other comprehensive income

Unit 7 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Depreciation Depreciation is defined in IAS 16 para. 6 as: ... the systematic allocation of the depreciable amount of an asset over its useful life.

Depreciation is expensed in profit or loss unless it is included in the carrying amount of another asset. For example, where machinery is used on a production line, the machinery depreciation will be part of the cost of inventory and will be capitalised in the cost of inventory to the extent that the inventory is still on hand at period end. The entry to record this would be: DR Inventory WIP; CR Accumulated depreciation. Depreciation is allocated over an asset’s useful life, which is defined in IAS 16 para. 6 as: (a) The period over which an asset is expected to be available for use by an entity; or (b) The number of production or similar units expected to be obtained from the asset by an entity.

Depreciation commences when an asset is available for use by the entity (i.e. when it is in the location and condition necessary for it to be capable of operating in the manner intended by management), and ceases at the earlier of the date when the asset is: •• Reclassified as being held for sale under IFRS 5. •• Derecognised (e.g. sold or scrapped). Depreciation does not cease when an asset becomes idle or is retired from active use unless the asset is fully depreciated. However, the depreciation charge can be zero where the depreciation method is based on usage during periods of non-production (IAS 16 para. 55). Depreciation is calculated on the depreciable amount, which is defined in para. 6 as ‘the cost of an asset, or other amount substituted for cost, less its residual value’. This definition means that a class of PPE measured at fair value is still subject to depreciation.

Depreciation method Each entity is required to select the method, on an asset-by-asset basis, that most closely reflects the expected pattern of consumption of benefits (IAS 16 para. 60). A variety of depreciation methods can be used and IAS 16 para. 62 identifies the following depreciation methods: •• Straight-line method – this results in a constant charge over the asset’s useful life (provided that the residual value does not change). •• Diminishing balance method – this results in a decreasing charge over the asset’s useful life. •• Units of production (usage) method – this results in a charge based on the expected use or output. IAS 16 para. 61 requires a review of the depreciation methods applied to all assets to be conducted at the end of the annual reporting period (as a minimum). If there is a significant variation in the asset’s pattern of consumption, the method of depreciation must be adjusted to reflect this change. Where an annual review results in a change of depreciation rate, depreciation method, or useful life, the effect must be accounted for as a change in an accounting estimate. Under IAS 8, changes in accounting estimates are recognised prospectively, meaning that the effect of the change is included in profit or loss in the: •• Period of the change, if it only affects the current period. •• Current and future years, if the change affects both the current and future years. No adjustments should be made to amounts already recorded in current or previous years. Summary of depreciation Depreciation commences when the asset is in the location and condition necessary for it to operate in the manner intended by management; it is allocated over the asset’s useful life to the entity; it ceases at the earlier of reclassification as held for sale or when the asset is derecognised (IAS 16 para. 55).

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Core content – Unit 7

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Financial Accounting & Reporting

Steps in the depreciation method Determine the depreciable amount of the asset (IAS 16 para. 50).

Determine the useful life by assessing the asset’s expected utility to the entity and consider the: • Expected usage of the asset. • Expected physical wear and tear. • Technical or commercial obsolescence. • Legal restrictions (IAS 16 paras 56−57).

The depreciation method applied should reflect the expected pattern of benefits that will be enjoyed by the entity from using the asset (IAS 16 paras 60 and 62). Common methods include straight-line, diminishing balance and units of production.

Prepare the depreciation journal entry to recognise depreciation in profit or loss unless it is included in the carrying amount of another asset (IAS 16 para. 48).

Review residual values, useful lives and depreciation methods at least annually at each year end. Any change is accounted for as a change in an accounting estimate in accordance with IAS 8 (IAS 16 paras 51 and 61).

Impairment The requirements of IAS 36 Impairment of Assets, as discussed in the unit on impairment of assets, should be applied in determining and accounting for impairment of an asset. PPE cannot have a carrying amount higher than the asset’s recoverable amount.

Compensation for impairment/loss of an asset If compensation is recoverable in relation to the impairment, loss or giving up of an asset, it should be included within profit or loss when receivable (IAS 16 para. 65).

Derecognition Under IAS 16 para. 67, an item of PPE should be derecognised from the statement of financial position when: •• it is disposed of •• no future economic benefits are expected from its use or disposal. A gain or loss on disposal should be recognised in profit or loss upon derecognition as the difference between the net disposal proceeds, if any, and the asset’s carrying amount (IAS 16 para. 71).

Unit 7 – Core content

Page 7-17

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Any balance in relation to the asset recorded in the revaluation surplus account may be transferred to retained earnings upon derecognition of that item of PPE. However, transfers from the revaluation surplus to retained earnings are not made through profit or loss (IAS 16 para. 41). Activity 7.1: Accounting for property, plant and equipment [Available online in myLearning]

Non-current assets held for sale and discontinued operations IFRS 5 contains specific requirements for assets held for sale, and for the presentation and disclosure of discontinued operations (discontinued operations is covered in the unit on presentation of financial statements). The focus in this unit is on the financial reporting requirements when an entity’s intention in holding an individual asset or group of assets alters. A non-current asset is classified as held for sale when its recovery is expected to result principally through a sale transaction, rather than through continuing use. When a non-current asset is classified as held for sale, it is: •• Measured at the lower of its carrying amount and fair value less costs to sell (IFRS 5 para. 15). •• No longer depreciated (IFRS 5 para. 25). •• Classified separately from other assets on the statement of financial position (IFRS 5 para. 38). IFRS 5 provides guidance on the recognition of impairment losses and reversals, and the accounting implications where there is a change to a plan of sale. Required reading IFRS 5 (or local equivalent).

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Core content – Unit 7

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Financial Accounting & Reporting

Disclosures for PPE, borrowing costs and non-current assets held for sale Disclosures for PPE The disclosure requirements for PPE are specified in IAS 16 paras 73–79. Key aspects of the disclosure requirements for each class of PPE include: •• The measurement bases used for determining the gross carrying amount. •• The depreciation method used. •• The useful lives or the depreciation rates used. •• The gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the reporting period. •• A detailed reconciliation of the carrying amount at the beginning and end of the reporting period, which includes (where applicable): –– Additions. –– Reclassification to assets held for sale. –– Acquisitions through business combinations. –– Increments or decrements arising from revaluations. –– Impairment losses and/or reversal of previous impairments losses. –– Depreciation. –– Net exchange differences arising on translation from a functional currency to the presentation currency. –– Other changes. Key aspects of the disclosure requirements for PPE stated at revalued amounts include: •• The date of the revaluation. •• Whether an independent valuer was used. •• For each revalued class of PPE, the carrying amount that would have been recognised if the cost model had been applied. •• Certain details concerning the revaluation surplus. •• The valuation techniques and inputs used to develop fair value measurements (IFRS 13 para. 91(a)). •• For recurring fair value measurements using significant unobservable inputs, the effect of the measurements on profit or loss or other comprehensive income for the period (IFRS 13 para. 91(b)). Required reading IFRS 13 para. 91.

Disclosures for borrowing costs The limited disclosure requirements for borrowing costs are specified in IAS 23 para. 26. An entity is required to disclose the following: •• Borrowing cost capitalised during the period. •• Capitalisation rate used to determine the borrowing costs.

Unit 7 – Core content

Page 7-19

Financial Accounting & Reporting

Chartered Accountants Program

Disclosures for non-current assets held for sale The disclosure requirements for non-current assets held for sale are specified in IFRS 5 paras 30–42. ITL Limited’s 2015 annual report provides an example of the practical application of the IFRS 5 disclosure requirements. Further reading ITL Limited and Controlled Entities 2015, 2015 Annual Report, Consolidated balance sheet (p. 22) and Note 12 (for disclosures concerning assets held for sale, p. 45). Quiz [Available online in myLearning]

Working paper C You are now ready to complete working paper C of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

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Core content – Unit 7

Unit 8: Intangible assets Contents Introduction 8-3 Identifying key characteristics of intangible assets Defining an intangible asset Recognition of intangible assets

8-3 8-3 8-4

Measurement, amortisation and derecognition of intangible assets 8-5 Initial measurement of cost for intangible assets 8-5 Internally generated intangible assets prohibited from recognition 8-8 Accounting for intangible assets after initial recognition 8-8 Amortisation of intangible assets 8-13 Derecognition 8-14 Summary - intangible assets

8-15

fin31908_csg_02

Disclosures 8-16

Unit 8 – Core content

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Core content – Unit 8

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Learning outcomes At the end of this unit you will be able to: 1. Identify and explain the key characteristics of an intangible asset, including whether it can be recognised for financial reporting purposes. 2. Explain and account for an intangible asset.

Introduction Intangible assets are similar to tangible assets (e.g. property, plant and equipment) in that they contribute to an entity’s operations in current and future accounting periods. However, intangible assets are non-monetary assets without physical substance and do not possess concrete features like other assets, but they can demonstrate specific characteristics such as control (i.e. by denying other parties access) and economic benefits through their use. IAS 38 Intangible Assets prescribes the accounting and disclosure requirements for intangible assets. The definition of an intangible asset is quite broad and captures intangible assets ranging from intellectual property (e.g. registered patents) to franchising agreements acquired from external parties. Some intangible assets may be contained in or on a physical substance such as a compact disc (e.g. computer software), legal documentation or film. Therefore, an entity may need to exercise judgement to determine if an asset that incorporates both intangible and tangible elements should be treated as a tangible asset under another accounting standard (e.g. IAS 16 Property, Plant and Equipment) or as an intangible asset under IAS 38. An entity may acquire different types of intangible assets either separately or as part of the acquisition of other businesses. Some intangible assets are not governed by IAS 38 as they are covered by other standards. These include intangible assets held for sale in the ordinary course of business (IAS 2 Inventories and IAS 11 Construction Contracts), financial assets (IAS 32 Financial Instruments: Presentation) and goodwill acquired in a business combination (IFRS 3 Business Combinations). Unit 8 overview video [Available online in myLearning]

Identifying key characteristics of intangible assets Learning outcome 1. Identify and explain the key characteristics of an intangible asset, including whether it can be recognised for financial reporting purposes.

Defining an intangible asset An intangible asset is defined in IAS 38 para. 8 as ‘an identifiable non-monetary asset without physical substance’. IAS 38 paras 9 and 10 set out the principal characteristics of an intangible asset (i.e. identifiability, control over a resource, and existence of future economic benefits). These characteristics are explained below.

Unit 8 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Identifiability An intangible asset must be identifiable to distinguish it from goodwill. IAS 38 para. 12 states that an asset is identifiable if it either: (a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

Control Like other assets, an intangible asset must be controlled by the entity. IAS 38 para. 13 defines this concept as the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. Usually this characteristic will flow from legal rights. In the absence of legal rights it is difficult to demonstrate control.

Future economic benefits Intangible assets must be expected to provide future economic benefits to the entity. The benefits can be presented in many ways, including: •• Revenue from the sale of products or provision of services. •• Cost savings. •• Other benefits resulting from the use of the asset (IAS 38 para. 17).

Recognition of intangible assets An intangible asset is recognised if it has the three essential characteristics of an intangible asset and it satisfies the recognition criteria under IAS 38 para. 21: (a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and (b) the cost of the asset can be measured reliably.

These recognition criteria mirror the recognition criteria for an asset from the Conceptual Framework for Financial Reporting para. 4.44. The ‘probable’ concept is assessed by management based on internal/external evidence and their best estimates of the future economic benefits arising from the intangible asset over its useful life. For separately acquired intangible assets, the ‘probable’ recognition criterion is always considered to be satisfied (IAS 38 para. 25). In most cases, where consideration is in the form of cash or other monetary assets, the cost of separately acquired intangible assets can be measured reliably (IAS 38 para. 26). Required reading IAS 38 (or local equivalent).

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Financial Accounting & Reporting

Measurement, amortisation and derecognition of intangible assets Learning outcome 2. Explain and account for an intangible asset.

Initial measurement of cost for intangible assets An intangible asset is initially measured at cost (IAS 38 para. 24). Intangible assets may be acquired from other entities or may be internally generated.

Intangible assets acquired from other entities An intangible asset may be acquired from other entities through any of the following ways: •• Separate acquisition (IAS 38 paras 25–32). •• Acquisition as part of a business combination (IAS 38 paras 33–43) (covered in Unit 15). •• Acquisition by way of a government grant (IAS 38 para. 44). •• Exchange of assets (IAS 38 paras 45–47). The following diagram presents an overview of the initial measurement of cost for separately acquired intangible assets. Initial measurement of cost for a separately acquired intangible asset Purchase price IAS 38 para. 27(a)

Include • Import duties and non-refundable purchase taxes • Deduct trade discounts and rebates

Directly attributable costs IAS 38 para. 27(b)

Include • Costs of employee benefits (as defined in IAS 19) arising directly from bringing the asset to its working condition • Professional fees arising directly from bringing the asset to its working condition • Costs of testing whether the asset is functioning properly IAS 38 para. 28

Initial cost recognised IAS 38 para. 24

Exclude • Costs of introducing a new product or service (including costs of advertising and promotional activities) • Costs of conducting business in a new location or with a new class of customer (including costs of staff training) • Administration and other general overheads • Costs incurred while an asset capable of operating in the manner intended by management has yet to be brought into use • Initial operating losses, such as those incurred while demand for the asset’s output builds up IAS 38 paras 29-30

Unit 8 – Core content

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Internally generated intangible assets Determining whether internally generated intangible assets meet the IAS 38 key characteristics and recognition criteria can be a challenge, as it can be difficult to establish whether an internally generated intangible asset will generate expected future economic benefits and can be measured reliably. Therefore, additional requirements apply to all internally generated intangible assets. The development of internally generated intangible assets is classified into two phases – a research phase and a development phase. Research phase Research is defined in IAS 38 para. 8 as ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’. IAS 38 para. 56 provides the following examples of research activities: (a) activities aimed at obtaining new knowledge; (b) the search for, evaluation and final selection of, applications of research findings or other knowledge; (c) the search for alternatives for materials, devices, products, processes, systems or services; and (d) the formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services.

An intangible asset is not recognised as the view is that an entity cannot demonstrate that an identifiable intangible asset exists that will generate future economic benefits. Expenditure on the research phase must be expensed when it is incurred (IAS 38 para. 54). Development phase Development is defined in IAS 38 para. 8 as: … the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

IAS 38 para. 59 provides the following examples of development activities: (a) design, construction and testing of pre-production or pre-use prototypes and models; (b) design of tools, jigs, moulds and dies involving new technology; (c) design, construction and operation of a pilot plant…; and (d) design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.

IAS 38 para. 57 states that an intangible asset arising from the development phase can be recognised if, and only if, an entity is able to demonstrate all of the following: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale; (b) its intention to complete the intangible asset and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset; (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and (f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Where an entity demonstrates that all of the above criteria are met, an intangible asset is recognised, as these criteria indicate that there are probable future economic benefits and that the cost can be measured reliably.

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Example – Recognising internally generated intangible assets This example illustrates the recognition and measurement of an internally generated intangible asset. Funkid Limited (Funkid) has been working for a number of years on the development of a new sun cream that only has to be applied every 24 hours and maintains the appropriate level of sun protection during that time. The project commenced in October 20X3 and $1.3 million had been spent on the project up to the 30 June 20X4 year end. At 30 June 20X4, Funkid has made significant progress on the development of the cream, although the inclusion of an expensive ingredient resulted in concerns as to whether the project would be commercially feasible. After spending an additional $550,000 during the six months to 31 December 20X4, Funkid has identified a substitute ingredient that reduces the cost of the sun cream so that it will be able to be marketed at a similar price to other sun creams. The prototype cream has been trialled on a number of volunteers and several companies have expressed an interest in the sun cream. The management of Funkid determined that the requirements of IAS 38 para. 57 were met at this point. Funkid incurred a further $300,000 during the six months ended 30 June 20X5 improving the texture and scent of the sun cream based on feedback from volunteers who had trialled the prototype. The cream is not yet available for sale; however, it is expected that the product will be launched in October 20X5 ready for the summer. An intangible asset will be recognised in relation to the development expenditure when the criteria in IAS 38 para. 57 are met. The criteria are met on 31 December 20X4, and therefore the costs of $300,000 incurred after this date will be capitalised as an intangible asset. Under IAS 38 para. 71, costs previously expensed cannot be reinstated as part of the cost of an asset when recognition criteria are met at a later date. On this basis, the $1.3 million that would have been expensed in prior years and the $550,000 that has been expensed in the current year cannot be capitalised into the cost of the intangible asset.

Cost of an internally generated intangible asset The cost of an internally generated intangible asset comprises all directly attributable costs incurred from the date when the intangible asset first meets all of the recognition criteria (IAS 38 para. 65). Directly attributable costs for internally generated assets are those necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management. These costs are broadly consistent with those outlined for separately acquired assets, but are described in more detail in IAS 38 paras 66–67. Expenditure previously recognised as an expense cannot be reinstated as part of the cost of an intangible asset when the recognition criteria are met at a later date (IAS 38 para. 71).

Website development costs SIC Interpretation 32 Intangible Assets – Web Site Costs (SIC-32) provides guidance, within the context of IAS 38, for entities that incur costs specifically for the development and operation of its own website. The website arising from development is recognised as an intangible asset if the recognition criteria in IAS 38 paras 21 and 57 are met. The entity must be able to demonstrate how the website will generate probable future economic benefits for it to be recognised as an intangible asset. If the website is purely for business promotion and if orders cannot be placed through the website, then the criteria would not be met and the development costs must be expensed in the period in which they are incurred (SIC-32 para. 8). Required reading SIC-32 paras 1–10. Unit 8 – Core content

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Worked example 8.1: Classifying and recognising intangible assets [Available online in myLearning]

Internally generated intangible assets prohibited from recognition IAS 38 has identified some internally generated intangible assets that do not meet the recognition criteria: •• Internally generated goodwill cannot be recognised as an intangible asset. IAS 38 considers that internally generated goodwill cannot be separated from operations nor does it arise from contractual or legal rights, and thus will not satisfy the identifiability criteria. In addition, many factors are beyond the control of an entity and affect the calculation of goodwill, which makes it difficult to measure its cost reliably (IAS 38 paras 48–50). •• Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance are specifically identified as intangible assets that cannot be recognised. This is because IAS 38 considers that they cannot be clearly separated from the cost of the development of an entity’s business as a whole (IAS 38 paras 63–64). When an entity is acquired in a business combination, previously unrecognised intangible assets of the acquiree are recognised at the date of the business combination. Identifiable intangible assets are recognised and measured at fair value at the acquisition date (IAS 38 para. 33). This is covered in more detail in the unit on business combinations.

Accounting for intangible assets after initial recognition Intangible assets satisfying the recognition criteria are initially recognised at cost (IAS 38 para. 24). Subsequently, an entity will choose, on a class of asset basis, between the cost and the revaluation models (IAS 38 para. 72). Under the cost model, the intangible asset, after initial recognition, is carried in an entity’s financial statements at its cost less accumulated amortisation and any accumulated impairment losses (IAS 38 para. 74). Under the revaluation model, the intangible asset, after initial recognition, is carried at a revalued amount, being its fair value at the date of revaluation less any subsequent accumulated amortisation and any accumulated impairment losses. Fair value is measured with reference to an active market (IAS 38 para. 75). IFRS 13 Fair Value Measurement para. 9 and IAS 38 para. 8 define fair value as: ... the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The factors that need to be considered when determining fair value are discussed in the unit on fair value measurement. It is difficult to apply the requirements of the fair value definition to most intangible assets due to their unique nature and thin market conditions. IAS 38 acknowledges this issue and states that an active market could exist for selected intangible assets such as for freely transferable taxi licences, fishing licences or production quotas (IAS 38 para. 78), but cannot exist for intangible assets such as brands or trademarks, as each asset is unique. Consequently, IAS 38 requires the following: •• An intangible asset is carried at cost less accumulated amortisation and impairment losses if no active market exists for the intangible asset and the class of intangible assets to which it belongs has adopted the revaluation model (IAS 38 para. 81). •• If an active market no longer exists, the carrying amount of the intangible asset is its most recent revaluation by reference to the active market less any subsequent accumulated amortisation and impairment losses (IAS 38 para. 82). •• If the fair value of an intangible asset can be measured by reference to an active market at a subsequent measurement date, the revaluation model is applied from that date (IAS 38 para. 84). Page 8-8

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Financial Accounting & Reporting

Applying the revaluation model There are four steps to applying the revaluation model. Step 1 – Either proportionally restate accumulated amortisation (IAS 38 para. 80(a)), or eliminate it against the gross carrying amount of the asset (IAS 38 para. 80(b)). Unless otherwise stated, the elimination method is the method adopted in this module. The following is a pro forma journal entry for the elimination method: Date

Account description

XX.XX.XX

Accumulated amortisation

XX.XX.XX

Intangible asset

Dr $

Cr $

XXX XXX

Elimination of accumulated amortisation against the gross carrying amount on the revaluation of the intangible asset

Step 2 – Calculate the amount of revaluation increment/decrement, being the difference between the net amount (from step 1) and the fair value amount of the asset at the revaluation date (IAS 38 para. 75). Step 3 – Classify the revaluation adjustment from step 2 as revaluation increment or decrement and consider the tax accounting implications of IAS 12. For the purposes of the FIN module, it is assumed that a revaluation increment or decrement does not alter the tax base of the asset. A temporary difference arises resulting in the recognition of a deferred tax asset or deferred tax liability. Step 4 – Prepare adjusting journals.

Example – Revaluation of intangible assets This example illustrates the journal entries for the revaluation of intangible assets. Assume a tax rate of 30%.

Revaluation increment with no previous revaluation decrement On 1 May 20X3 Plenty More Limited (PM), a New Zealand company supplying fresh fish revalued its hoki fishing quota for the first time. The carrying amount after the elimination of amortisation (as per step 1 in applying the revaluation model) is $200,000. Fair value of the asset is $300,000. The journal entry to record the revaluation increment is: Date

Account description

01.05.X3

Intangible asset – fishing quota

Dr $

Cr $

100,000

Deferred tax liability (DTL) ($100,000 × 30%)

30,000

Revaluation surplus* ($100,000 × (1 – 30%))

70,000

Being the revaluation increment for intangible asset – fishing quota * Disclosed in OCI.

Revaluation decrement with no previous revaluation increment On 1 May 20X3 PM revalued its hake fishing quota for the first time. Its carrying amount after the elimination of amortisation (as per step 1 in applying the revaluation model) is $200,000. Fair value of the asset is $140,000.

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The journal entry to record the revaluation decrement is: Date

Account description

Dr $

01.05.X3

Revaluation expense

60,000

Deferred tax asset (DTA)* ($60,000 × 30%)

18,000

Cr $

Intangible asset – fishing quota

60,000

Income tax expense ($60,000 × 30%)

18,000

Being the revaluation decrement for intangible asset – fishing quota recognised in profit or loss * Recognised to the extent that realisation is probable.

Revaluation increment with previous revaluation decrement On 1 May 20X4 PM revalued its ling fishing quota. Its carrying amount after the elimination of amortisation (as per step 1 in applying the revaluation model) is $300,000. Fair value of the asset is $360,000. A revaluation decrement of $150,000 had previously been recognised in relation to this asset and it had been assessed that realisation of the resulting DTA was probable. This journal should include: Date

Account description

01.05.X4

Intangible asset – fishing quota

Dr $

Cr $

60,000

Revaluation income (profit or loss)

60,000

DTA ($60,000 × 30%)

18,000

Income tax expense ($60,000 × 30%)

18,000

Being the revaluation increment for intangible asset – fishing quota with a previous revaluation decrement

On 1 May 20X4 PM revalued its gemfish fishing quota. Its carrying amount after the elimination of amortisation (as per step 1 in applying the revaluation model) is $150,000. Fair value of the asset is $240,000. A revaluation decrement of $75,000 had previously been recognised in profit or loss in relation to this asset and it had been assessed that realisation of the resulting DTA was probable. Date

Account description

01.05.X4

Intangible asset – fishing quota

Dr $

Cr $

90,000

Revaluation income

75,000

DTA ($75,000 × 30%)

22,500

Income tax expense ($75,000 × 30%)

22,500

Revaluation surplus* ($15,000 × (1 – 30%))

10,500

DTL ($15,000 × 30%)

4,500

Being the revaluation increment for intangible asset – fishing quota with a previous revaluation decrement * Disclosed in OCI.

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Financial Accounting & Reporting

Revaluation decrement with previous revaluation increment On 1 May 20X4 PM revalued its squid fishing quota. Its carrying amount after the elimination of amortisation (as per step 1) is $100,000. Fair value of the asset is $70,000. A revaluation increment of $40,000 had previously been recognised in relation to this asset. Date

Account description

01.05.X4

Revaluation surplus* ($30,000 × (1 – 30%)) DTL ($30,000 × 30%)

Dr $

Cr $

21,000 9,000

Intangible asset – fishing quota

30,000

Being the revaluation decrement for intangible asset – fishing quota with a previous revaluation increment * Disclosed in OCI.

On 1 May 20X4 PM revalued its red cod fishing quota. Its carrying amount after the elimination of amortisation (as per step 1 in applying the revaluation model) is $100,000. Fair value of the asset is $70,000. A revaluation increment of $20,000 had previously been recognised in relation to this asset. Date

Account description

01.05.X4

Revaluation surplus* ($20,000 × (1 – 30%)) DTL ($20,000 × 30%) Revaluation expense ($30,000 – $20,000) DTA** (($30,000 – $20,000) × 30%)

Dr $

Cr $

14,000 6,000 10,000 3,000

Income tax expense (($30,000 – $20,000) × 30%) Intangible asset – fishing quota

3,000 30,000

Being the revaluation decrement for intangible asset – fishing quota with a previous revaluation increment * Disclosed in OCI. ** Recognised to the extent that realisation is probable.

The revaluations should be made with such regularity so that the book value is not materially different to the fair value at the end of the reporting period (IAS 38 para. 75).

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Pro forma journal entries for revaluation of intangible assets Revaluation increment No previous revaluation decrement recognised in profit or loss

Previous revaluation decrement recognised in profit or loss

Disclose in other comprehensive income (disclosure purposes only) and accumulate in revaluation surplus account (IAS 38 para. 85)

Recognise in profit or loss to the extent that it reverses a decrement previously recognised in profit or loss (IAS 38 para. 85)

Pro forma journal entry:

Pro forma journal entry:

Date

Account description

XX.XX.XX Intangible asset

Dr $

Cr $

XXX

Date

Account description

XX.XX.XX Intangible asset

Dr $

Cr $

XXX

XX.XX.XX Deferred tax liability (DTL)

XXX

XX.XX.XX Revaluation income1

XXX

XX.XX.XX Revaluation surplus1

XXX

XX.XX.XX Deferred tax asset (DTA)2

XXX

Revaluation increment for intangible asset

XX.XX.XX Income tax expense

1. Net of related tax on the amount recognised in other comprehensive income

XXX

XX.XX.XX Revaluation surplus3

XXX

XX.XX.XX DTL

XXX

Revaluation increment for intangible asset with a previous revaluation decrement 1. Revaluation expense reversed. 2. Recognised to the extent that realisation is probable. 3. Net of related tax on the amount recognised in other comprehensive income

Revaluation decrement No previous revaluation increment recognised in revaluation surplus

Previous revaluation increment recognised in revaluation surplus

Recognise in profit or loss (IAS 38 para. 86)

Disclose in other comprehensive income (disclosure purposes only) to the extent that it reverses a previous revaluation surplus amount (IAS 38 para. 86)

Pro forma journal entry:

Pro forma journal entry:

Date

Account description

Dr $

Cr $

Date

Account description

Dr $

XX.XX.XX Revaluation expense

XXX

XX.XX.XX Revaluation surplus1

XXX

XX.XX.XX DTA1

XXX

XX.XX.XX DTL

XXX

XX.XX.XX Intangible asset

XXX

XX.XX.XX Revaluation expense

XXX

XX.XX.XX Income tax expense

XXX

XX.XX.XX DTA

XXX

Revaluation decrement for intangible asset 1. Recognised to the extent realisation is probable

Cr $

XX.XX.XX Income tax expense

XXX

XX.XX.XX Intangible asset

XXX

Revaluation decrement for intangible asset with a previous revaluation increment 1. Net of related tax on the amount recognised in other comprehensive income

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Financial Accounting & Reporting

Amortisation of intangible assets Whether an intangible asset is amortised depends upon whether the asset’s useful life is finite or indefinite. An intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which it is expected to generate net cash inflows (IAS 38 para. 88). An intangible asset with an indefinite useful life is not amortised (IAS 38 para. 107) but is still subject to an impairment review in accordance with IAS 36 Impairment of Assets (IAS 36), at least on an annual basis and when indicators of impairment exist (IAS 38 para. 108). An intangible asset with a finite useful life is amortised (IAS 38 para. 89) and IAS 38 para. 90 provides a list of factors that management should consider when determining the useful life of an intangible asset. It is also subject to the requirements of IAS 36 (IAS 38 para. 111). The requirements of IAS 36 are covered in the unit on impairment of assets. In addition to an impairment review, intangible assets with indefinite useful lives must be reviewed each year to determine whether events and circumstances still support the use of an indefinite useful life. If not, then the change to a finite life is accounted for as a change in accounting estimate in accordance with IAS 8 (IAS 38 para. 109). Accounting for a change in accounting estimate is discussed in the unit on presentation of financial statements. Key definitions relating to the amortisation of intangible assets follow: Key definitions relating to the amortisation of intangible assets Term

Definition

Amortisation

Systematic allocation of the depreciable amount of an intangible asset over its useful life (IAS 38 para. 8)

Depreciable amount

Cost of an asset, or other amount substituted for cost, less its residual value (IAS 38 para. 8)

Residual value

Estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life (IAS 38 para. 8) Residual value of an intangible asset with a finite useful life is assumed to be zero unless: •• there is an active market for the asset •• the residual value can be determined by reference to that market, and •• it is probable that such a market will exist at the end of the asset’s useful life Alternatively, a residual value can arise when there is a commitment by a third party to purchase the asset at the end of its useful life (IAS 38 para. 100)

Useful life

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 (IAS 38 para. 8) When an intangible asset arises from contractual or legal rights, useful life cannot exceed the period of the contractual or legal rights, including renewal periods only if the renewal does not involve significant cost, but may be shorter depending on the period over which the entity expects to use the asset (IAS 38 para. 94)

The process for amortisation of an intangible asset with a finite life, including key considerations is shown in the following flow chart.

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Process for amortisation of an intangible asset with a finite life Commence amortisation when the intangible asset is in the location and condition necessary for it to operate in the manner intended by management. It ceases at the earlier of: the date when the intangible asset is reclassified as held for sale and the date when the intangible asset is derecognised (IAS 38 para. 97).

Determine the depreciable amount of the intangible asset and decide how it will be allocated on a systematic basis over its useful life (IAS 38 para. 97).

Ensure the amortisation method applied reflects the expected pattern of benefits that will be enjoyed by the entity from using the intangible asset. Choose from straight-line, diminishing balance, and unit of production methods (IAS 38 para. 98). If a pattern of benefits cannot be determined, use the straight-line method (IAS 38 para. 97).

Review the amortisation period and amortisation method at least at each financial year end. Any changes are accounted for as a change in an accounting estimate in accordance with IAS 8 (IAS 38 para. 104).

Prepare the journal entry to recognise amortisation in profit or loss unless it is included in the carrying amount of another asset (IAS 38 para. 99).

Worked example 8.2: Accounting for research and development costs [Available online in myLearning]

Derecognition The carrying amount of an intangible asset is derecognised when: •• it is disposed, or •• no future economic benefits are expected from its use or disposal (IAS 38 para. 112). Any related gain or loss is recognised in profit or loss at the time of derecognition (not classified as revenue) (IAS 38 para. 113) and is calculated as the difference between net disposal proceeds, if any, and the carrying amount of the intangible asset (IAS 38 para. 113). The consideration receivable on disposal is recognised initially at its fair value. If payment for the intangible asset is deferred, the consideration is recognised initially at the cash price equivalent. The difference between the nominal amount of the consideration and the cash price equivalent is recognised as interest revenue in accordance with IFRS 9. If the revaluation model has been adopted, the cumulative amount in revaluation surplus for the intangible asset may be transferred to retained earnings (not through profit or loss): •• when the asset is derecognised, or •• as the asset is used by the entity during its useful life subject to specific calculations (IAS 38 para. 87). Page 8-14

Core content – Unit 8

Chartered Accountants Program

Financial Accounting & Reporting

Activity 8.1: Accounting for intangible assets [Available online in myLearning]

DEFINITION

Summary - intangible assets Intangible asset

An intangible asset can be generated: • As a separate acquisition • As an acquisition as part of a business combination • Internally • As an acquisition by way of a government grant • By exchange of assets

• Identifiable • Non-monetary • Without physical substance IAS 38 para. 8

Recognition

• Identifiability • Control • Future economic benefits IAS 38 para. 10

• Probable future economic benefits • Cost can be measured reliably IAS 38 para. 21

Research costs must be expensed IAS 38 para. 54

Specific recognition criteria for items in development phase IAS 38 para. 57

Initial

USEFUL LIFE Unit 8 – Core content

Prohibition on recognition (unless acquired as part of a business combination): • internally generated goodwill • internally generated brand names, etc. IAS 38 paras 48 and 63

Subsequent

Recognise at cost IAS 38 para. 24

ACCOUNTING MODEL

MEASUREMENT

CRITERIA

Principal characteristics

Accounting policy choice (class by class basis) IAS 38 para. 72

Cost

Revaluation

Cost less accumulated amortisation and accumulated impairment losses IAS 38 paras 74 and 111

Fair value (measured by reference to an active market) less accumulated amortisation and impairment losses IAS 38 paras 75 and 111 IFRS 13 paras 9, 24 and 27

Finite

Indefinite

Amortise over useful economic life IAS 38 para. 97

No amortisation, review at least annually for impairment IAS 38 paras 107–108

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Chartered Accountants Program

Disclosures The key disclosure requirements of IAS 38 are detailed in paras 118–128. The disclosure requirements of IAS 38 are necessary so users of financial statements can understand an entity’s exposure to and accounting for its intangible assets during a particular accounting period. In summary, an entity must disclose the following: 1. General information for each class of intangible assets, distinguishing between internally generated and other intangible assets (IAS 38 paras 118–123), with details of: –– useful life information –– amortisation methods used –– carrying amount movements –– a reconciliation of the carrying amount at the beginning and end of the period. 2. For intangible assets measured using the revaluation model (IAS 38 paras 124–125), with details of: –– valuation information including fair value assumptions and date of revaluation –– carrying amount of revalued intangible assets and the carrying amount that would have been recognised if the cost method had been applied –– revaluation surplus movements. 3. Research and development expenditure recognised as an expense during the period (IAS 38 paras 126–127). Quiz [Available online in myLearning]

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Core content – Unit 8

Unit 9: Financial instruments Contents Introduction 9-3 Applicable standards 9-4 Common terms and concepts 9-4 Navigating this unit 9-4 Financial instruments under IAS 32 9-5 Financial instruments: meeting the definition 9-5 Scope of IAS 32 9-6 Classification of financial instruments under IAS 32 9-7 Distinguishing financial liabilities from equity 9-8 Derivatives 9-13 Financial instruments under IFRS 9 Scope of IFRS 9

9-15 9-15

Classification of financial instruments under IFRS 9

9-16

Classification of financial assets 9-16 Financial asset test 1: Contractual cash flow characteristics (the SPPI test) 9-17 Financial asset test 2: The business model used for managing financial assets 9-20 Investments in equity 9-21 FVTOCI election 9-22 Held for trading (HFT) 9-22 Dividends 9-22 FVTPL election 9-22 Classification of financial liabilities Amortised cost Fair value through profit or loss (FVTPL)

9-23 9-23 9-23

Measurement of financial instruments Initial recognition Initial measurement Subsequent measurement Fair value Gains and losses on financial assets Gains and losses on financial liabilities

9-24 9-24 9-25 9-26 9-29 9-30 9-32

Summary – measurement of financial assets and liabilities

9-34

Impairment of financial assets 9-35 Expected credit losses (ECLs) 9-35 Change in credit risk since initial recognition 9-38 Relationship between changes in credit risk and measurement of impairment and interest revenue 9-39 Recognition of ECLs in the financial statements 9-45 Derecognition 9-46 Derecognition of a financial asset 9-46 Derecognition of a financial liability 9-48 Accounting for equity transactions 9-49 Transaction costs of equity transactions 9-49 Dividends 9-50 Compound financial instruments 9-50

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Financial Accounting & Reporting

Hedge accounting The hedged item, hedged risk and the hedging instrument Overview of hedge accounting Types of hedging relationship Hedge accounting process Fair value hedges Cash flow hedges

Chartered Accountants Program

9-53 9-53 9-55 9-56 9-57 9-62 9-64

Disclosure 9-72 Overview of requirements 9-72 Classes of financial instruments for disclosure purposes 9-72

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Appendix 1 – Definitions of common terms and concepts

9-73

Appendix 2 – Derivatives Net settling Embedded derivatives

9-78 9-79 9-80

Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Learning outcomes At the end of this unit you will be able to: 1. Explain and identify financial instruments and the principles for classifying them as financial assets, financial liabilities or equity instruments of the issuer. 2. Account for financial assets, financial liabilities and equity instruments of the issuer (including derivatives). 3. Explain and account for basic cash flow and fair value hedges. 4. Explain and account for impairment of financial assets. 5. Explain and account for the derecognition of financial assets and financial liabilities.

This unit has been split into two sections for ease of candidate study. Part A provides a broad overview of accounting for financial instruments throughout their life cycle – from identification of financial instruments, classification, initial and subsequent measurement, impairment and finally derecognition of financial instruments. Definitions and scope

Classification

Measurement

Impairment

Derecognition

Part B covers hedging, accounting for equity instruments and compound financial instruments, and disclosure of financial instruments.

Part A Introduction Financial instruments are held by most entities in the form of cash, trade receivables, trade payables, loans or more complex financing structures. Understanding how to identify and account for financial instruments is crucial to your role as a Chartered Accountant.

Unit 9 – Core content

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Financial Accounting & Reporting

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Applicable standards There are a number of Standards that apply to financial instruments, as this diagram shows:

IFRS 9 Financial Instruments • Classification and measurement of financial assets and financial liabilities • De-recognition of financial assets and financial liabilities • Hedge accounting • Impairment

IFRS 7 Financial Instruments: Disclosure • Disclosure requirements for financial instruments • Explanation of the risks of an instrument

It may be helpful to think of IAS 32 as the doorway to accounting for financial instruments – once you are through the door you have met the definition of a financial instrument and are ready to look to IFRS 9 and IFRS 7 for the correct accounting and disclosure principles. In addition to the above standards, the measurement of fair value of financial instruments and disclosures about fair value are addressed by IFRS 13 Fair Value Measurement. The fair value standard, IFRS 13, is covered in Unit 6. The first part of this unit will focus on the requirements of IFRS 9 to classify, measure and account for financial instruments including impairment. The second part will focus on accounting for hedges. At the end of the unit we will briefly examine the disclosure requirements of IFRS 7.

Common terms and concepts To understand financial instruments and the application of the relevant accounting standards, it is necessary to understand the different terms used to describe these instruments. Appendix 1 to this unit contains a list of some of the more common terms and concepts. These are shown in bold in the material the first time they are used. Appendix 2 to this unit contains further information about derivatives. Required reading IFRS 9 Appendix A Defined terms.

Navigating this unit Throughout this unit you will find examples that illustrate the principles explained in the material. In addition, you will have the opportunity to apply your knowledge by working through a case study based on Fly-by-day, a regional airline. It is recommended that you treat this case study as a series of mini activities that you can attempt as you work through the unit to confirm your understanding.

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Financial Accounting & Reporting

Financial instruments under IAS 32 Learning outcome 1. Explain and identify financial instruments and the principles for classifying them as financial assets, financial liabilities or equity instruments of the issuer. IAS 32 outlines the definition of a financial instrument. It also provides guidance on whether a financial instrument is a financial asset, financial liability, or equity instrument, or whether it is a compound instrument that includes both liability and equity components. IAS 32 also addresses the presentation of interest and dividends (within the scope of the FIN module), and the offsetting of financial assets and financial liabilities (beyond the scope of the FIN module). An overview of the key principles in IAS 32 is presented as follows:

Overview IAS 32

Is the instrument a ‘financial instrument’ within the scope of IAS 32? YES

NO

Refer to other relevant standards

Determine classification of financial instrument as one of the following:

Financial asset

Financial liability

Equity

Compound instrument

Financial instruments: meeting the definition A financial instrument is defined in IAS 32 para. 11 as ‘any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity’. One entity

Another entity

Financal asset

Financal liability or equity

As per the definition, a financial instrument is made up of a number of components, as follows: •• a contract (i.e. an agreement between two or more parties) •• a financial asset, and •• a financial liability or equity instrument.

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To meet the definition of a financial instrument, a contract must result in a financial asset of one entity, and a financial liability or equity of another. This is illustrated in the table of examples below:

Example – Financial instruments definition Contract

Financial instrument (arrows point to financial instruments)

Contract for purchase of inventory on credit

Chopsters Limited (Chopsters) has entered into a contract to purchase inventory from a supplier, Big Smoke Limited (Big Smoke). The inventory has been delivered, which results in inventory being recognised on Chopsters’ statement of financial position, as well as in trade payables (being the amount owing for the inventory). Big Smoke has recognised trade receivables (being the amount owing by Chopsters for the inventory) and sales Chopsters

Big Smoke

Inventory – non-financial asset

Trade receivables – financial asset

Trade payables – financial liability

Sales – income

Loan issued by a bank Chopsters is in the process of expanding its business and part-funds the expansion with a loan from Safe Bank. Chopsters recognises the loan with Safe Bank as a liability and also recognises the cash received in the bank account it holds with Safe Bank, as an asset Safe Bank recognises the loan it has made to Chopsters as well as liability for the funds in the Chopsters bank account with Safe Bank

Shares issued by a company

Chopsters

Safe Bank

Loan from Safe Bank – financial liability

  Loan to Chopsters – financial asset

Cash – financial asset

  Borrowings – financial liability

Chopsters raises the remainder of the funds it needs for the expansion of its business by conducting a rights issue to its existing shareholders. Wealthy Superfund is one of the investors who takes up its entitlement under the rights issue and recognises the additional investment in its statement of financial position Chopsters

Wealthy Superfund

Shares issued – equity

  Investments – financial asset

It is important to note in the example above that the inventory contract itself is not a financial instrument as it does not result in a right or obligation of either party to receive, deliver or exchange a financial asset. It is the resulting impacts on trade payables and trade receivables that are financial instruments. Before a financial instrument is classified as a financial asset, financial liability or equity, it is important to determine whether the financial instrument is within the scope of IAS 32.

Scope of IAS 32 IAS 32 applies to all types of financial instruments apart from the following exceptions, outlined in IAS 32 para. 4 and summarised briefly below: Scope exception

Applicable standard

•• Interests in subsidiaries, associates and joint ventures

•• Accounted for under IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements or IAS 28 Investments in Associates and Joint Ventures

•• Employers’ rights and obligations under employee benefit plans

•• IAS 19 Employee Benefits

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Financial Accounting & Reporting

Scope exception

Applicable standard

•• Certain rights and obligations under an insurance contract as defined in IFRS 4 Insurance Contracts

•• IFRS 4 Insurance Contracts

•• Certain financial instruments, contracts and obligations under share-based payment transactions

•• IFRS 2 Share-based Payments

Classification of financial instruments under IAS 32 Financial asset

Financial liability

Equity

Compound instrument

IAS 32 provides guidance on how to determine whether the financial instrument is a financial asset, a financial liability, equity or a compound instrument. The first three classifications are outlined below. Compound instruments are discussed in Part B of the unit.

Financial asset A financial asset is a contractual right arising from a past transaction that provides future economic benefit to an entity and results in a financial liability or equity of another entity. The following are financial assets as defined in IAS 32: Financial asset

Example

Cash

Bank account

Contractual right to receive cash or another financial asset

Trade receivables, or investments in bonds or

Equity shares in another entity

Investments in listed shares

Contractual right to exchange financial instruments under potentially favourable conditions

Purchased call or put options, which an entity would only exercise if conditions were in its favour

Contract that may or will be settled in the entity’s own equity instruments and is:

These types of financial assets are not covered in the FIN module

convertible notes

(i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments (ii) a derivative that will or may be settled other than by the exchange of either a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments

Financial liability A financial liability is a type of contractual obligation arising from a past event that is expected to result in an outflow of economic benefits and results in a financial asset of another entity. The following are financial liabilities as defined in IAS 32: Financial liability

Example

Contractual obligation to deliver cash or another financial asset to another entity

Trade payables, borrowings, or issuance of bonds

Contractual obligation to exchange financial assets or financial liabilities under potentially unfavourable conditions

Written call or put options, which an entity would exercise under conditions favourable to it (i.e. unfavourable to another entity)

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Financial liability

Example

Contract that will or may be settled in the entity’s own equity instruments and is:

Issue of a convertible note by an entity that converts to a fixed value of shares of the entity (e.g. $5,000 worth of ordinary shares). The number of shares received will, however, vary (e.g. if the share price is

(i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments

$2 the holder will receive 2,500 shares; if the share (ii) a derivative that will or may be settled other than price is $1.60 the holder will receive 3,125 shares) by the exchange of either a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments

Equity instrument An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Shares issued by a company are an equity instrument of that company. Refer to Part B of the unit for accounting for equity instruments.

Distinguishing financial liabilities from equity The classification of financial instruments as a liability or equity has a significant impact on the value of net assets presented by an entity, and thus on an entity’s gearing, debt ratios and reported earnings. Determining whether a financial instrument should be classified as a financial liability or equity can often be difficult. The critical feature in distinguishing between the two is the existence of a contractual obligation of the issuer of the financial instrument to the holder to: •• deliver cash •• deliver another financial instrument, or •• exchange another financial instrument with the holder under conditions potentially unfavourable to the issuer. Where such a contractual obligation exists, the financial instrument is likely to be a financial liability. The key factor for classification is the discretion of the issuer to make payments to the holder. If the issuer has a contractual obligation to make payments to the holder, it is likely that the financial instrument is a liability not equity.

Example – Classification of financial instruments

Page 9-8

Ordinary shares

Generally classified as equity by the issuer, as ordinary shares represent the residual interest in the issuer’s net assets. Ordinary shares are perpetual (i.e. have no maturity date), and dividend payments are made at the full discretion of the company, so there is no contractual obligation

Debt

Debt instruments issued by an entity are generally classified as financial liabilities as they carry contractual obligations to repay the principal amount in addition to interest payments

Preference shares

While many preference shares receive a ‘fixed’ dividend, it is still likely that this is entirely at the discretion of the company and, accordingly, is not a contractual obligation (even if ordinary share dividends cannot be paid until preference share dividends are paid). However, some features may lead preference shares to be classified as financial liabilities. These include mandatory dividend payments, redemption at the holder’s request, and conversion at the holder’s option to a fixed value (variable number) of ordinary shares (a condition potentially unfavourable to the issuer)

Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Apply your knowledge Liabilities and equity Fly-by-day Airlines Limited (Fly-by-day) is a regional airline based in Dubbo, NSW which operates flights to 45 airports throughout Australia. It also has operations in New Zealand, based in Nelson. Fly-by-day has been listed on the Australian Securities Exchange for a number of years. You are the senior accountant reporting to Sarah March, the chief financial officer (CFO). Sarah advises you that the board is considering raising $20 million of additional capital to fund aircraft purchases. The board is thinking about a couple of financial instruments, but is not sure how these instruments will impact the company’s financial statements. Sarah has asked you to advise which category of the statement of financial position the following funding options will be classified under (i.e. financial liability or equity): •• Bank loan – this would be arranged with Fly-by-day’s bank. The loan would incur interest at 5% per annum. The principal would be repaid on maturity in 10 years. •• Preference shares – dividend rate fixed at 6% per annum. If Fly-by-day does not declare a preference share dividend in any given year, it is not permitted to pay dividends to ordinary shareholders. Fly-by-day is prohibited from paying dividends on its ordinary shares until any missed dividends on the preference shares are paid

Answer Bank loan Fly-by-day has a contractual obligation to make principal and interest payments to the bank. It has no discretion over this obligation and accordingly, the bank loan would be classified as a financial liability.

Preference shares There is no contractual obligation on the part of Fly-by-day to make a dividend payment every year. The only obligations regarding dividends are as follows: •• The dividend is at a specified rate. •• If a dividend is declared, Fly-by-day has to pay the dividend to preference shareholders before it pays dividends to ordinary shareholders. •• If no dividend is declared, these payments have to be ‘caught up’ before payments can be made to ordinary shareholders. In addition, the shares have no maturity date, so there is no contractual obligation to repay the principal amount invested by holders. Accordingly, these preference shares will be classified as equity as they are not a financial liability.

Required reading IAS 32 paras 11, 15–16, 28 and 35–40.

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Financial Accounting & Reporting

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Chartered Accountants Program

Below is an extract from the Woolworths 2018 Annual Report, which shows clearly each of the financial instruments it holds as at 24 June 2018.

Consolidated Statement of Financial Position

Current assets Cash and cash equivalents Trade and other receivables Inventories Other financial assets Assets held for sale Total current assets Non‑current assets Trade and other receivables Other financial assets Property, plant and equipment Intangible assets Deferred tax assets Total non‑current assets Total assets Current liabilities Trade and other payables Borrowings Current tax payable Other financial liabilities Provisions Liabilities directly associated with assets held for sale Total current liabilities Non‑current liabilities Borrowings Other financial liabilities Provisions Other non‑current liabilities Total non‑current liabilities Total liabilities Net assets Equity Contributed equity Reserves Retained earnings Equity attributable to equity holders of the parent entity Non‑controlling interests Total equity

Financial asset Refer detail in note extracts below

2018

2017

NOTE

$M

$M

4.5 3.1

1,273 801 4,233 53 6,360 821 7,181

909 745 4,207 16 5,877 1,244 7,121

3.1 3.2 3.3 3.4 3.6.3

93 522 9,026 6,465 271 16,377 23,558

72 507 8,438 6,533 372 15,922 23,043

3.7 4.6.3

6,960 604 110 50 1,451 9,175 21 9,196

6,812 254 81 314 1,470 8,931 21 8,952

4.6.3 3.8 3.9 3.10

2,199 61 942 311 3,513 12,709 10,849

2,777 116 1,011 311 4,215 13,167 9,876

4.3 4.4

6,055 353 4,073 10,481 368 10,849

5,615 357 3,554 9,526 350 9,876

3.2 5.2

Refer detail in note extracts below

3.8 3.9

Financial liability

Equity instruments

5.2

The above Consolidated Statement of Financial Position should be read in conjunction with the accompanying Notes to the Consolidated Financial Statements.

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Core content – Unit 9

75

3

Financial Accounting & Reporting

ASSETS AND LIABILITIES 3.1

Trade and other receivables

Current Trade receivables1 Provision for impairment

7

Trade and other receivables are financial assets

Other receivables1 Provision for impairment

Notes to the Consolidated Financial Statements Total 1

$M

138 (9) 129

121 (15) 106

311 (20) 291

324 (19) 305

381 801

334 745

16 77 93

1 71 72

894

817

Includes supplier rebates of $100 million (2017: $99 million).

 SIGNIFICANT ACCOUNTING POLICIES

3.2 Other financial assets

TRADE AND OTHER RECEIVABLES

2017 $M

16 16

3

4 5

OTHER INFORMATION

389 79 38 1 507 523

2

FINANCIAL REPORT

2018 Trade and other receivables are recognised initially at fair value and are subsequently measured at amortised cost using the effective interest method, less an allowance for impairment. They generally have terms of up to 30 days. $M Current IMPAIRMENT OF TRADE AND OTHER RECEIVABLES Derivatives and listed equity Derivatives 53 The Group assesses at the end of each reporting period whether there is objective evidence that the Group’s receivables securities are financial assets 53 are impaired. Non‑current The recoverable amount of the Group’s receivables is calculated as the present value of estimated future cash flows, Derivatives 366 discounted at the original effective interest rate (that is, the effective interest rate computed at initial recognition of these Listed equity securities 96 is not financial assets). Receivables with a short duration are notInvestments discounted. A provision for impairment of receivables in associates are Investments associates 57 recognisedinuntil objective evidence is available that a loss event has occurred. specifically excluded from IFRS 9 Other 3 522 Total 575

1

DIRECTORS' REPORT

SIGNIFICANT ACCOUNTING POLICIES

 

DERIVATIVES

Refer to Note 4.7 for details of derivatives. 85

LISTED EQUITY SECURITIES

The Group’s investments in listed equity securities are designated as financial assets at ‘fair value through other ASSETS AND comprehensive income’. Investments are initially measured at fair value net of transaction costs and in subsequent periods, LIABILITIES are measured at fair value with any change recognised in other comprehensive income. Upon disposal, the cumulative gain or loss recognised in other comprehensive income is transferred within equity.

3.3 Property, plant and equipment 3.7 Trade and other payables

2018

FREEHOLD LAND, WAREHOUSE, DEVELOPMENT RETAIL AND OTHER PROPERTIES PROPERTIES $M $M

Financial liability

LEASEHOLD IMPROVEMENTS $M

(2)

(8)

(4)

4,906 1,437 1 2018 $M (40) (37) 50 (894) –– 50 3 (13)

5,195 14,745 1,419 (5,719) 198 9,026 6,812

1

8,438 1,950 1 2017 $M (123) (154) 63 (922) 251 (163) 314 26 Page 9-11 (27)

2

BUSIN REVIE

Non‑current Effect of movements in foreign exchange rates

5,316 9,870 1,435 (4,507) 209 5,363 6,960

2017 TOTAL $M2 $M

PERFORMANCE HIGHLIGHTS

Trade payables Cost 1,335 if it arises 2,899 Only a641 financial liability from a Accruals Less: accumulated depreciation/amortisation (1) (110) (1,101) contract e.g. rent accrual Unearned income Carrying amount at end of period 640 1,225 1,798 Movement: Not a financial liability as it is settled Carrying amount at start of period 518the delivery 1,318 through of services,1,696 not cash 3.8 Other financial liabilities Additions 217 19 277 Acquisition of businesses – – – (48) (19) (16) Disposals1 Current from/(to) assets held for sale Transfer (10) (115) 8 Derivatives expense Depreciation – (28) – Put option held over non‑controlling interest in Hydrox Holdings Amortisation expense – Pty Ltd – (163) Unit 9 – Core Transfers andcontent other (35) 58 –

2018 PLANT AND EQUIPMENT $M $M

3

WOOLWORTHS GROUP ANNUAL REPORT 2018

s

76

Non‑current Prepayments Other receivables Total non‑current trade and other receivables

2017

$M

BUSINESS REVIEW

7

M

.

Prepayments are not financial assets as they are settled through the delivery of service, not cash

Prepayments Total current trade and other receivables

2018

PERFORMANCE HIGHLIGHTS

M

1 3 4 8 0

WOOLWORTHS GROUP ANNUAL REPORT 2018

Chartered Accountants Program

G

2 0) 8) 4

3

ASSETS AND LIABILITIES

Financial Accounting & Reporting

Chartered Accountants Program

Apply your knowledge Identification of financial instruments Sarah asks you to provide some information, which will be included in a paper for the board, that explains which items on the statement of financial position IAS 32 will apply to and why. The board is especially focused on the following items: •• Cash at bank. •• Trade receivables. •• Inventory – consumable spares. •• Prepayments. •• Deferred tax assets. •• Goodwill. •• Trade payables. •• Revenue received in advance from passengers. •• Borrowings. •• Provisions for employee benefits.

Answer You review the items listed and provide the following explanation for inclusion in the board paper: Item

Does IAS 32 apply?

Explanation

Cash at bank

Yes

Cash at bank is a financial asset – a contractual right to obtain cash from the bank and a corresponding financial liability of the bank

Trade receivables

Yes

These are contractual rights to receive cash from another entity. There will be a corresponding financial liability in the other entity’s books

Inventory – consumable spares

No

This is not a financial asset as there is no contract in place. Future economic benefit is obtained through the use of the spares in the maintenance of aircraft, rather than to receive cash or another financial asset from another entity

Prepayments

No

These are not a financial asset as the economic benefit of prepayments is realised through the receipt of services or goods, rather than the receipt of a financial asset

Deferred tax assets

No

These are not a contractual right to receive a financial asset, but rather relate to a statutory obligation imposed by the Government, and accordingly, these are not a financial asset

Goodwill

No

The economic benefit of goodwill is achieved through the opportunity to earn increased profits, rather than through a contractual right to receive cash or another financial asset. Accordingly, it is not a financial asset

Trade payables

Yes

These are a contractual obligation to deliver cash to another entity and accordingly is a financial liability

Revenue received in No advance from passengers

This is a contractual obligation to deliver services to customers (i.e. flights) rather than a financial asset provided there is no requirement to repay. Accordingly, this is not a financial liability

Borrowings

These are a financial liability as they involve a contractual obligation to deliver cash or another financial asset to another entity

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Yes

Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Item

Does IAS 32 apply?

Explanation

Provisions for employee benefits

No

Provisions are a constructive obligation (i.e. one that arises out of an entity’s actions) rather than a contractual obligation and may be settled through the delivery of services rather than a financial asset (e.g. permitting staff not to work for a period of time whilst still paying them). Accordingly, these are not a financial liability. They are also not within the scope of IAS 32

Derivatives A derivative ‘derives’ its value from underlying financial instruments, commodities, prices or an index (IFRS 9 Appendix A Defined Terms). They are widely used by entities to manage financial risk. Key features of a derivative are that: •• Its fair value changes based on changes in value of an agreed underlying variable.

For example, fair value changes in interest rate swaps are based on movements in the underlying interest rate; whilst the fair value changes in a forward rate contract are based on the underlying foreign exchange rate or commodity price.

•• It requires little or no net initial investment.

The cost to enter into a derivative is usually zero, particularly for the common derivatives referred to in the FIN module, such as interest rate swaps or forward rate contracts.

•• It is settled at a future date. FIN fact An instrument that is a derivative and also a financial instrument can be a financial asset or a financial liability depending on how its value changes over time Appendix 2 to this unit contains further information and examples of common derivative financial instruments.

Apply your knowledge Derivatives Sarah, the CFO, wants you to start working on how the financial instruments Fly-by-day enters into should be classified. Sarah explains to you that understanding which instruments are derivatives and which are not is important to our subsequent classification and accounting To make sure you are both in agreement, she provides you with a list of contracts and asks you to identify which ones are derivatives accounted for under IFRS 9 and why. •• Interest rate swap. •• FX forward rate contract (FX forward). •• Contract to buy jet fuel in six months’ time. •• Futures contract to buy USD in three months’ time. •• Short-term debt securities issued by Fly-by-day. •• Rental contract with rental increases based on consumer price index (CPI).

Unit 9 – Core content

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Financial Accounting & Reporting

Contract

Financial instrument?

Chartered Accountants Program

Derivative?

Explanation

Interest rate swap Yes

Yes

The value of an interest rate swap is based on an underlying notional value and the relevant interest rates in the contract. It has no initial net investment

FX forward

Yes

Yes

The value of a forward FX contract is based on an amount of currency to be purchased or sold and an agreed exchange rate. It has no initial net investment

Contract to buy jet fuel in six months’ time

No

No

This is a contract for the delivery of goods and accordingly is not a financial instrument or a derivative (specifically excluded as the contract is entered into for the purpose of delivering a non-financial item (jet fuel) in accordance with Fly-by-day’s expected usage requirements)

Futures contract to buy USD in three months’ time

Yes

Yes

The value of the futures contract is based on an amount of currency to be purchased in the future. There is minimal initial net investment, although movements in the value of the contract are settled daily

Short-term debt securities

Yes

No

This is a contract to repay an amount of money on specified terms. It is not a derivative

The only derivatives Fly-by-day needs to be concerned about with regard to the application of IFRS 9 are those that are also financial instruments as IFRS 9 does not apply to derivatives that are not financial instruments

FIN fact Derivatives are commonly used as a tool to hedge financial risks and are an important part of hedge accounting which is discussed later in this unit.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Financial instruments under IFRS 9 Learning outcome 1. Explain and identify financial instruments and the principles for classifying them as financial assets, financial liabilities or equity instruments of the issuer. Once it is determined that a financial instrument is a financial asset or financial liability in accordance with IAS 32, the next step is to establish the principles for the financial reporting of the instrument as outlined in IFRS 9 Financial Instruments.

Scope of IFRS 9 IFRS 9 applies to all types of financial instruments apart from the following exceptions outlined in IFRS 9 para 2. The scope of IFRS 9 is different to that of IAS 32 and needs to be separately considered. The scope requirements are summarised briefly below: Scope exception

Applicable standard

•• Interests in subsidiaries, associates and joint ventures •• Accounted for under IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements or IAS 28 Investments in Associates and Joint Ventures •• Employers’ rights and obligations under employee benefit plans

•• IAS 19 Employee Benefits

•• Certain rights and obligations under an insurance contract as defined in IFRS 4 Insurance Contracts

•• IFRS 4 Insurance Contracts

•• Certain financial instruments, contracts and obligations under share-based payment transactions

•• IFRS 2 Share-based Payments

•• Financial instruments issued by an entity that meet the definition of equity or are required to be classified as equity under IAS 32

•• IAS 32 Financial Instruments: Presentation

•• Rights and obligations under most leases, (although there are some aspects of leases that are covered by IFRS 9 that are beyond the scope of the FIN module)

•• IFRS 16 Leases

•• A forward contract between an acquirer and a selling shareholder to buy or sell an entity that will result in a business combination

•• IFRS 3 Business Combinations

•• Some loan commitments, although aspects of these require the application of IFRS 9 •• Rights to payments to reimburse an entity for expenditure required to settle a liability recognised as a provision

•• IAS 37 Provisions, Contingent Liabilities and Contingent Assets

•• Rights and obligations within the scope of IFRS 15 Revenue from Contracts with Customers that are financial instruments

•• IFRS 15 Revenue from Contracts with Customers

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Classification of financial instruments under IFRS 9 Financial asset

Financial liability

Fair value through profit or loss (FVTPL)

Amortised cost

Fair value through OCI (FVTOCI)

Amortised cost

Fair value through profit or loss (FVTPL)

Financial instruments are classified under IFRS 9 using a principles-based approach. There are three main categories for financial assets and two categories for financial liabilities. Required reading IFRS 9 paras 4.1–4.2

Classification of financial assets Under IFRS 9 there are three principal classifications available for financial assets: •• Fair value through profit or loss (FVTPL). •• Fair value through other comprehensive income (FVTOCI). •• Amortised cost.

Financial asset

Amortised cost

Fair value through profit or loss (FVTPL)

Fair value through OCI (FVTOCI)

FVTOCI (investment in equity)

FVTOCI (other than investment in equity)

Never be recycled

May be recycled

FVTOCI has two sub-categories: •• FVTOCI for investments in equity. •• FVTOCI for other financial assets that are not investments in equity The sub-classification determines whether the gains or losses that are recognised in OCI may be reclassified (recycled) to the profit or loss on disposal of the investment or in any other circumstance; or may never be reclassified to the profit or loss. Knowing the correct type of FVTOCI classification for a financial asset is important in order to get the accounting and disclosures right.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

The following flow chart illustrates the process for determining the classification of a financial asset.

Election available

Choose to designate at FVTPL to eliminate accounting mismatch?

YES

NO

Financial asset test 1: Contractual cash flow characteristics

Cash flows solely payments of principal and interest (SPPI) on specified dates

NO

Is the asset anYES investment in equity? E.g. shares

YES

Financial asset test 2: Business model for managing assets

YES

NO

Held to collect contractual cash flows YES

YES Is it held for trading (HFT)?*

NO

NO

Election available Objective to collect contractual cash flows and sell financial assets

YES

Choose to designate at FVTOCI?

NO

NO YES

YES

FVTOCI

Amortised cost

FVTOCI

(other than investments in equity)

(Investments in equity)

FVTPL

* Refer definition in Appendix A.

It can be seen from the flowchart that: •• the classification of financial assets is determined by two primary criteria: –– asset test 1– the contractual cash flow characteristics (SPPI test), and –– asset test 2 – the entity’s business model for managing the financial asset. •• After failing asset test 1, there is a separate path for financial assets that are defined as investments in equity including the availability of a FVTOCI election. •• There is a FVTPL election available to eliminate an accounting mismatch. FIN fact ••

All derivatives are at FVTPL

••

Investments in equity have only 2 options – FVTPL or FVTOCI (Investments in equity)

••

Investments in debt have 3 options – FVTPL, FVTOCI (Investments other than equity) or amortised cost

Financial asset test 1: Contractual cash flow characteristics (the SPPI test) Contractual cash flow characteristics On specified dates

Payments of principal

Payments of interest on the principal outstanding

The SPPI test asks whether the cash flows from the financial asset are, on specified dates, solely payments of principal, and payments of interest on the principal outstanding (SPPI).

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Contractual cash flows that meet the SPPI test are consistent with a basic lending arrangement. In a basic lending arrangement, interest payments predominantly reflect the time value of money and the credit risk of the principal outstanding, although there may be other risks and costs that meet the definition of interest for the purposes of this test (see below). When assessing the cash flow characteristics, the focus should be on what the interest is compensating for, rather than on how much it is. The SPPI test is applied on an instrument-by-instrument basis in the currency in which the financial asset is denominated. Specified dates The contractual cash flows occur on specified dates as outlined in the contract: for example, interest is paid monthly. If the dates of the financial asset’s cash flows are not contractually specified, then it cannot meet the SPPI test: for example, dividend payments are not usually specified. Principal Principal is defined as the fair value of the financial asset at initial recognition. The fair value may change over the life of the asset (e.g. if there are repayments of principal). Interest IFRS 9 states that interest is consideration for the: •• time value of money •• credit risk associated with the principal amount outstanding during a particular period of time •• other basic lending risks and costs (e.g. liquidity risk and administrative costs) and •• profit margin. In a basic lending arrangement, interest payments are consideration for the time value of money and the credit risk of the principal outstanding, but can also include other basic lending risks, costs and a profit margin. Such interest payments will meet the SPPI test. Conversely, cash flows that are unrelated to a basic lending arrangement, such as exposure to changes in equity prices or commodity prices, do not represent payments solely of principal and interest on the principal and therefore fail the SPPI test. Some instruments (e.g. trade receivables) do not legally bear interest. In these cases, the SPPI test is still met as the principal is the amount resulting from the sales transaction, and there is no significant financing component, so the interest is deemed to be zero.

Example – Fixed rate loan receivable ABC bank issues a $1 million loan to a customer. The loan is repayable over five years with a fixed interest rate of 5.5%. Principal and interest payments are made monthly in arrears

As long as the interest rate reflects compensation for the time value of money and credit risk for the term of the loan, the contractual cash flows of the fixed rate loan are solely payments of principal and interest (SPPI)

However, some financial assets have cash flows that may not represent payments of principal and interest. Examples are: Equity instruments

Page 9-18

Derivatives

Notes convertible into a fixed number of shares

Interest payments in different currency than principal amount

Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Apply your knowledge The SPPI test Fly-by-day invests its surplus cash in a portfolio of short-term debt instruments. Ben, the group treasurer, wants to understand the implications of IFRS 9 on this portfolio and whether there will be any volatility introduced into earnings due to their classification. Ben asks you to consider whether the following will pass the SPPI test: •• AUD bank bills. •• Deposits with banks. •• Investments in ASX-listed shares. •• Bonds convertible into a fixed number of ordinary shares of the issuer at maturity. •• New Zealand Government short-term bonds •• Interest rate swap asset.

Answer Instrument

Pass SPPI test?

Explanation

AUD bank bills

Yes

These are contracts that require the investment of a discounted amount (e.g. $95) and the repayment of the face value of the bill (e.g. $100) on maturity, which represents the principal and interest thereon

Deposits with banks

Yes

These are contractual obligations requiring repayment from a bank of principal and the interest on the principal at an agreed interest rate

Investments in ASX-listed shares

No

Shares do not contractually deliver payments on specified dates, and payments (when made) are dividends rather than principal and interest. Accordingly, investments in equity do not meet the SPPI test

Bonds convertible into a fixed number of ordinary shares of the issuer at maturity

No

Since the amount received on maturity is variable (based on the share price at the time), the cash flows do not represent solely payments of principal and interest on the principal amount outstanding

New Zealand Government short-term bonds

Yes

These give rise to cash flows on specified dates that are solely principal and interest on the principal amount outstanding

Interest rate swap asset

No

The interest rate swap is a derivative asset and its fair value is derived from changes to the underlying interest rate. Therefore, it fails the SPPI test as payments are not solely principal and interest

Financial assets that fail the SPPI test will be classified as FVTPL (unless an election for FVTOCI for investments in equity is available, which is discussed later in this unit). This means any subsequent movements in fair value will be recognised in profit or loss. The instruments that pass the SPPI test can then be assessed to determine their classification under the business model test. Depending on this, they will be classified at amortised cost, FVTOCI or FVTPL FIN fact Derivatives fail the SPPI test and are measured at fair value through profit or loss (FVTPL) unless the derivative is designated as a hedging instrument and hedge accounting is applied (hedge accounting is discussed later in this unit). If a financial asset passes the SPPI test, an entity needs to determine if the financial asset should be classified as measured at amortised cost or fair value. To do this, an entity assesses the business model that is used for managing the financial asset using asset test two.

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Financial asset test 2: The business model used for managing financial assets The business model test (asset test 2) is only used where the cash flows of the instrument meet the SPPI test. The business model reflects how an entity manages its financial assets in order to generate cash flows, and determines whether cash flows are collected contractually, arise from selling the financial asset, or both. This test is performed for groups of financial assets at a portfolio or business level.

Business model for managing financial assets Solely to collect contractual cash flows

Collect contractual cash flows and sell financial assets

Solely to sell financial assets

Amortised Cost

FVTOCI (other than investments in equity)

FVTPL

The following table summarises the key factors relating to the business model test: Hold to collect contract cash flows

Hold to collect contractual cash flows and sell financial assets

Sell financial assets

Business model objective

The business model aims to collect cash flows over the life of the asset; sales are incidental

The business model aims to The business model aims to buy and collect cash flows and sell sell financial assets. Sales are integral assets. Both are important to the business model, driven by focus on fair values; collecting the cash flows is incidental

Example

Trade receivables held with primary purpose of collecting the cash flows outstanding

Day-to-day liquidity management achieved through collecting cash flows and selling assets as required

Asset fair values are used to evaluate asset performance leading to buying and selling of assets to realise these fair values

Classification

Amortised cost

FVTOCI (other than investments in equity)

FVTPL

An entity’s business model is determined at a level that reflects how groups of financial assets are managed together to achieve a particular business objective. An entity may have more than one business model for managing its financial instruments and so this assessment does not need to occur at the entity level. The business model used by an entity is a matter of fact that can be observed in the way an entity is managed and in the information provided to management. It is not a matter of choice or assessment. Evidence can be obtained from: •• How the performance of the business model and the financial assets within it are evaluated and reported. •• The risks that impact performance of the business model and how those risks are managed. •• How the managers of the business are compensated. Business models are likely to remain unchanged for extended periods of time. A change in the method of generating cash flows from an asset does not impact on the classification of the financial asset. However, when evaluating a new financial asset, an entity will have regard to how cash flows were realised in the past.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Apply your knowledge Business model Ben, the group treasurer, understands that the SPPI test is not the only factor that will dictate how much volatility is introduced to the P&L from the cash portfolio. He understands it also depends on the business model Fly-by-day uses. Ben lets you know that the short-term debt instruments are ‘plain vanilla’ (i.e. they are standard instruments with no special or extra features), which means they pass the SPPI test. The portfolio is held for liquidity purposes and the cash inflows (interest and principal repaid on maturity) from the investments will be used to fund the cash outflows of the business. Fly-by-day will sell investments prior to maturity if the need arises due to unplanned cash needs, and also to actively manage the return on the portfolio. The performance of the portfolio is monitored including gains and losses from the sale of the investments. Ben asks for your advice on how the portfolio will be classified under IFRS 9.

Answer In this situation, it is clear that the investments that make up the cash portfolio are not managed solely to collect contractual cash flows. The following evidence supports this: •• The fact that the investments may be sold prior to maturity is inconclusive as the frequency and value of sales is not known. An entity may have a business model objective of holding financial assets to collect contractual cash flows and still have an expectation of selling some of those assets prior to maturity. •• The performance of the portfolio is measured using both the returns from the investments held and the gains and losses from the sale of the investments. It appears from this that the objective of the portfolio is to maximise its return as well as meet Fly-by-day’s everyday liquidity needs, and that selling investments as well as collecting contractual cash flows is integral to this business model. The evidence suggests that the investment portfolio should be classified as FVTOCI. This means that gains and losses in fair value of the investments will be posted to OCI instead of to profit or loss.

Investments in equity An investment in equity is defined as one that meets the definition of an equity instrument in IAS 32 para 11, that is: any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. This means that the holder of an investment in equity must assess whether the investment meets the definition of equity from the perspective of the issuer. This assessment is beyond the scope of the FIN module. For the purposes of this module, an investment in equity is an investment in shares of another entity and it can be assumed that it meets the definition in IAS 32.

Investments in equity e.g. shares in a listed company

Choose the election and not HFT

FVTOCI

(Investments in equity)

Held for trading

Do not choose election

FVTPL

Never be recycled

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

FVTOCI election IFRS 9 para 5.7.5 provides an option for an entity, at initial recognition, to present subsequent changes in fair value of the investment in equity in other comprehensive income (OCI) as long as the instrument is not held for trading (HFT) (discussed below). This is an irrevocable election by an entity and is made on an instrument-by-instrument basis. For investments in equity for which the FVTOCI election is made, all gains and losses (including those relating to foreign exchange) are recognised in an account in OCI and remain there permanently, even when the asset is derecognised (i.e. the FVTOCI account relating to the investment in equity is not recycled to the profit or loss). Accordingly, there is no need to test for impairment for investments in equity held under the FVTOCI election (refer to the impairment section later in this unit for further discussion). If an entity chooses not to use the FVTOCI election, the investment in equity will be classified at FVTPL.

Held for trading (HFT) An investment in equity is held for trading when it meets the Appendix A of IFRS 9 definition as a financial asset or financial liability that is: •• acquired or incurred for the purpose of selling or repurchasing in the near term •• part of a portfolio where there is an actual pattern of short-term profit taking, or •• is a derivative financial instrument (except those in effective hedging relationships – this is explained later in this unit). Where an investment in equity is held for trading, it will be classified at FVTPL. All subsequent changes in fair value of the financial asset will be taken to profit or loss.

Dividends Regardless of whether investments in equity are accounted for under the FVTOCI election or FVTPL, the dividend revenue on the financial asset is recognised in profit or loss.

FVTPL election An entity may, at initial recognition, choose to designate a financial asset as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (often referred to as an ’accounting mismatch’) that would otherwise arise from measuring assets and liabilities on different bases (IFRS 9 para.4.1.5). This election is only available at initial recognition and is irrevocable (i.e. an entity cannot change its mind once it has made this election).

Example – Accounting mismatch Big Bank Limited has an investment in bonds. It has funded this investment using a bank loan. Both the bond investment and the bank loan are susceptible to interest rate risk that generate opposite changes in fair value. For example, as interest rates increase, Big Bank will receive more interest income from the bond investment but pay more interest expense on the bank loan (i.e. the interest movements offset each other). However, the bond investment is classified at FVTPL. This means that changes in the fair value of the asset are recognised in profit or loss. The bank loan is measured on a different basis at amortised cost. In order to avoid an accounting mismatch caused by the two different measurement methods, Big Bank can designate the bank loan as measured at FVTPL. This will give it the same measurement basis as the bond investment which will mean that the economic substance of the two transactions is recognised appropriately in the financial statements.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Classification of financial liabilities Financial liability

Amortised cost

Fair value through profit or loss (FVTPL)

Under IFRS 9 there are two classifications available for financial liabilities: •• Amortised cost. •• Fair value through profit or loss (FVTPL).

Amortised cost Amortised cost is the default classification for financial liabilities.

Fair value through profit or loss (FVTPL) There are two primary circumstances under which a liability can be classified as FVTPL: 1. The liability is held for trading (HFT) (same definition as discussed above), or 2. it is initially designated as FVTPL by the entity (FVTPL election). FVTPL election An entity may, at initial recognition, choose to designate a financial liability as measured at FVTPL if any of the following conditions are met: •• The designation eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities, or recognising the gains and losses on them on different bases. •• A group of financial liabilities, or financial assets and financial liabilities is managed and their performance evaluated on a fair value basis in accordance with a documented risk management or investment strategy of the entity’s key management personnel, or •• The contract is a hybrid contract that contains an embedded derivative that significantly modifies the cash flows otherwise required by the contract. Practical application is beyond the scope of the FIN module. This election is made on initial classification of a financial liability. It is a one-time option that is irrevocable until the liability is derecognised. Activity 9.1: Classification of financial instruments [Available online in myLearning] Unit 9 video – Classification [Available online in myLearning]

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Measurement of financial instruments Learning outcome 2. Account for financial assets, financial liabilities and equity instruments of the issuer (including derivatives). IFRS 9 provides guidance on the recognition and measurement of financial instruments at different points in their lifecycle including: •• when to first recognise a financial instrument (initial recognition) •• how to measure the financial instrument upon initial recognition (initial measurement) •• how to measure the financial instrument on an ongoing basis (subsequent measurement), and •• when to derecognise a financial instrument. Each of these is discussed further below, except for the derecognition requirements which are covered at the end of Part 1 of Unit 9. Required reading IFRS 9 paras 3.1.1, 5.1–5.4.1 and 5.7.1–5.7.3, 5.7.5, 5.7.7 and 5.7.10 – 5.7.11

Initial recognition The initial recognition guidance in IFRS 9 outlines when a financial instrument should be first recognised on the statement of financial position. IFRS 9 para 3.1.1 provides that an entity shall recognise a financial asset or liability when, and only when, it becomes a party to the contractual provisions of the instrument.

Example – Trade receivables A company that sells crockery to restaurants recognises a trade receivable on its statement of financial position when it has a legal right to receive cash from the restaurant to which it has made a sale. This usually occurs when the crockery has been delivered to the customer.

Example – Firm commitments A company that places an order for coffee beans will not recognise the payable on its statement of financial position until it has received the coffee beans (i.e. they have been delivered). Until that point, it is a firm commitment only and is not recognised because at least one of the parties has not performed under the agreement.

Example – Forward contracts A forward contract to purchase a financial asset (e.g. foreign currency) is recognised as an asset or liability as soon as the entity becomes a party to it, rather than on the date of settlement. These contracts are often entered into at zero cost. Initially there may be nothing to recognise, even though subsequent changes in fair value would be recognised

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Initial measurement The initial measurement requirements of IFRS 9 detail the value at which the financial instrument will be accounted for upon initial recognition. IFRS 9 para. 5.1.1 specifies that financial assets and financial liabilities shall be initially measured at fair value plus or minus transaction costs, unless they have been classified at fair value through profit or loss (FVTPL), in which case, transaction costs are expensed. The requirements are summarised in the table below: Financial assets

Statement of financial position (B/S)

Initial measurement Statement of profit or loss (P&L)

Financial liabilities

Amortised cost

FVTPL

FVTOCI

Amortised cost

FVTPL

Fair value + transaction costs

Fair value

Fair value + transaction costs

Fair value + transaction costs

Fair value

–

Transaction costs

–

–

Transaction costs

Generally, the fair value is the cost or consideration given or received for the asset or liability. Transaction costs are costs directly attributable to the acquisition, issue or disposal of a financial asset or liability (e.g. fees and commissions payable to brokers), but do not include financing or internal administrative costs.

Example – Initial measurement of financial asset InvestCo has invested in a $1 million debt security and incurred transaction costs of $20,000.

Amortised cost/FVTOCI If a debt security was classified at amortised cost or FVTOCI, the value at initial recognition includes the transaction costs. The journal entry would be: DR Debt security

$1,020,000

CR Cash

$1,020,000

Initial recognition of debt security at fair value plus transaction costs

FVTPL If a debt security was classified at FVTPL, the journal entry at initial recognition would be: DR Debt security DR Transaction costs expense (P&L)

$1,000,000 $20,000

CR Cash

$1,020,000

Initial recognition of debt security at fair value and expense of transaction costs

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Example – Initial measurement of financial liability LoanCo has borrowed $1 million from a bank and incurred transaction costs of $20,000.

Amortised cost If the bank loan was classified at amortised cost, the value at initial recognition is net of the transaction costs. The journal entry would be: DR Cash

$980,000

CR Bank loan

$980,000

Initial recognition of bank loan at fair value less transaction costs ($1m – $20,000)

FVTPL If it was classified at FVTPL, the journal entry at initial recognition would be: DR Cash

$980,000

DR Transaction costs expense (P&L) CR

Bank loan

$20,000 $1,000,000

Initial recognition of debt security at fair value and expense of transaction costs

FIN fact Remember that when recognising financial liabilities at amortised cost, the liability recognised on the statement of financial position will be reduced by the amount of transaction costs (because the liability is a credit and the transaction costs are a debit). FIN fact A derivative, such as a forward contract or interest rate swap, is usually entered into at zero cost and its fair value at initial recognition is usually zero. This means that there is no entry to recognise such derivatives at initial recognition.

Subsequent measurement Under IFRS 9, the two bases under which financial assets and financial liabilities can be measured after initial recognition and measurement are amortised cost, and fair value.

Amortised cost Amortised cost applies to both financial assets and financial liabilities. The effective interest rate method (EIM) is the method that uses the effective interest rate to: •• calculate the amortised cost of a financial asset or financial liability, and •• allocate and recognise interest revenue or interest expense in the profit or loss over the relevant period. The effective interest rate is calculated at initial recognition of a financial asset or financial liability. It is the internal rate of return of the financial asset or liability; that is, it is the rate that exactly discounts the estimated future cash flows through the expected life of the instrument to the carrying amount at initial recognition (fair value at initial recognition). Please note that in the FIN module, the effective interest rate will be provided and candidates will not be required to calculate it.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Amortised cost calculation

Financial assets Amortised cost of financial asset

=

Amount at initial recognition

-

Principal repayments

-

Interest cash receipts

+

EIM interest revenue

+

EIM interest expense

-

Loss allowance (i.e. impairment)

Financial liabilities Amortised cost of financial liability

=

Amount at initial recognition

-

Principal repayments

-

Interest cash receipts

The above diagram shows the components used in the calculation of the amortised cost balance. A table, such as the example below, is often used to facilitate the calculation of the amortised cost for each reporting period. Reporting period

Opening balance $

Principal repayments $

Interest receipts/ payments $

Interest accrued using EIM $

Closing balance $

Interest receipts and payments Interest receipts/(payments) are the cash receipts or cash payments made in accordance with the contractual terms of the instrument. These interest receipts or payments are based on the face value of the instrument, not the accounting value, and represent ‘real world’ cash flows. Interest accrued using EIM To calculate the effective interest accrued in each reporting period, the effective interest rate is applied to the amortised cost of the asset or liability at the previous reporting date (i.e. to the opening balance). When applying the effective interest method, interest is recognised in profit or loss in the period to which it relates, regardless of when the actual cash transaction occurs. Therefore, interest is recognised for accounting purposes in the period in which it accrues, even if the cash payments are in advance or deferred.

Example – Calculating interest payments and interest accrual using EIM InvestCo has invested in a $1 million debt security with annual interest payments of 5%. The effective interest rate has been calculated at 4.2755%. Investco incurred transaction costs of $20,000.

Interest receipts Each year, InvestCo receives cash interest receipts on its investment of $50,000 ($1 million × 5%). This is calculated on the face value of the debt security, ignoring transaction costs.

Interest accrued using EIM For accounting purposes, interest is accrued using the effective interest rate (EIR) of 4.2755%. The interest revenue for the first year of the loan would be $43,610 ($1,020,000 × 4.2755%). This is calculated based on the value of the loan at initial recognition (i.e. fair value plus transaction costs) × EIR.

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

In subsequent years, the interest accrual is calculated on the opening balance of the debt security (i.e. its amortised cost at the beginning of the period). You will see a more detailed example of this below. Closing balance This represents the amortised cost of the financial asset or financial liability for the relevant reporting period. It is the amount that will be shown on the statement of financial position for the period. It is calculated by applying the formulae shown above to each row of the table as demonstrated in the example below.

Example – Calculating the amortised cost for a financial asset InvestCo has invested in a $1 million debt security with annual interest payments of 5%. The effective interest rate has been calculated at 4.2755%. Investco incurred transaction costs of $20,000. Recap: Initial recognition: $1,020,000 Interest receipts: $50,000 Interest accrued using EIM: $43,610

Statement of cash flows

Amortised cost calculation:

Reporting period

Opening balance $

Statement of financial position

Statement of profit or loss

Principal Interest receipts/ repayments payments $ $

Interest accrued using EIM $

Closing balance $

Initial – Year 0

1,020,000

Year 1

Amortised cost of financial asset

1,020,000

=

Amount at initial recognition

–

-

Principal repayments

50,000

-

Interest cash receipts

+

43,610

EIM interest revenue

-

1,013,610

Loss allowance (i.e. impairment)

The amortised cost is calculated by adding across the table in accordance with the formula. Amortised cost = $1,020,000 – 0 – 50,000 + 43,610 – 0

= $1,013,610

Recognition of amortised cost The EIM, using the effective interest rate, provides: •• the amortised cost of a financial asset or financial liability at balance date, and •• the EIM accounting interest accrual amounts. The difference between the cash interest and the accounting EIM interest accrual for the period is the amortisation of the financial instrument for the period. Over the life of the asset, this amortisation reflects a constant periodic return on the carrying amount of the asset or liability.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Example – Recognition of amortised cost for a financial asset InvestCo has invested in a $1 million debt security with annual interest payments of 5%. The effective interest rate has been calculated at 4.2755%. InvestCo incurred transaction costs of $20,000.

Summary: Initial recognition: $1,020,000 Interest receipts: $50,000 Interest accrued using EIM: $43,610 Amortised cost Year 1: $1,013,610 Date

Description

Dr $

31.12.X1

Cash at bank

50,000

Cr $

Debt security

6,390

Interest revenue

43,610

Being recognition of interest revenue as at 31 December 20X1 as per amortisation table and receipt of interest

Financial statement impact for Year 1:

Reporting period

Opening balance $

Statement of cash flows: Interest receipts

Principal repayments $

Statement of profit or loss: Interest revenue

Interest receipts/ payments $

Statement of financial position: Debt security

Interest accrued using EIM $

Initial – Year 0

Closing balance $ 1,020,000

Year 1

1,020,000

–

50,000

43,610

1,013,610

Year 2

1,013,610

–

50,000

43,337

1,006,947

Year 3

1,006,947

1,000,000

50,000

43,053

0

Over the life of the asset, the asset’s value is amortised in a constant periodic manner to equal its maturity amount so that when the instrument is settled (i.e. principal is repaid at the end of its life) the closing balance will be zero.

Worked example 9.1: Recognition of interest [Available online in myLearning]

Fair value After initial recognition and measurement, a financial asset or financial liability that is not classified at amortised cost is measured subsequently at fair value. The fair value of financial assets and liabilities is determined in accordance with IFRS 13. The price used to measure financial assets and liabilities may be directly observable, as in an active market with quoted prices, or may be determined using valuation techniques if no active market exists. Transaction costs associated with transferring the financial asset or liability are not to be included in the subsequent measurement of fair value as they are not a characteristic of the asset or liability, but are specific to the transaction itself. This topic is discussed in more detail in Unit 6.

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Gains and losses on financial assets The gains or losses on a financial asset that is measured at fair value shall be recognised as follows (except if it is part of a hedging relationship): Financial assets FVTPL

FVTOCI (Investment in equity)

FVTOCI (Other than investment in equity)

Fair value movement gains and losses

Profit or loss

OCI

OCI

Gains or losses relating to impairment

Profit or loss

OCI

Profit or loss

Gains or losses relating to foreign exchange

Profit or loss

OCI

Profit or loss

FVTPL IFRS 9 para 5.1 states that a gain or loss on a financial asset measured at fair value through profit or loss (FVTPL) is recognised in profit or loss. This includes impairment gains or losses and foreign exchange gains or losses. Interest revenue is not separately disclosed – it forms part of the fair value movement gain or loss in the profit or loss.

Example – Subsequent measurement of shares held for trading InvestCo purchased $1 million investment in shares of ShareCo on 1 January 20X1 and paid transaction costs of $20,000. The shares are held for trading and are therefore classified as FVTPL. At 31 December 20X1, the fair value of the investment is $1,100,000.

Calculate gains and losses The carrying amount of the investment at initial recognition:

$1,000,000

Fair value at 31 December 20X1: $1,100,000 Gain on fair value $100,000 The journal entry to recognise the gain on the investment fair value is: DR Shares held for trading

$100,000

CR Gain on FVTPL assets (P&L)

$100,000

Recognition of the gain in fair value at 31 December 20X1

FVTOCI – investments in equity All subsequent changes in the fair value of an investment in an equity instrument that is not held for trading are presented in other comprehensive income in accordance with IFRS 9 para. 5.7.5. They are never reclassified to the profit or loss.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Example – Subsequent measurement of investment in equity InvestCo purchased $1 million investment in shares of ShareCo on 1 January 20X1 and paid transaction costs of $20,000. At 31 December 20X1, the fair value of the investment is $1,100,000.

Calculate gains and losses The carrying amount of the investment at initial recognition: $1,020,000 Fair value at 31 December 20X1: $1,100,000 Gain on fair value $80,000 The journal entry to recognise the gain on the investment fair value is: DR Investment in shares

$80,000

CR FVTOCI reserve

$80,000

Recognition of the gain in fair value at 31 December 20X1

FVTOCI – other than investments in equity IFRS 9 para 5.7.10 states that a gain or loss on a financial asset (other than an investment in equity) that is measured at fair value through other comprehensive income (FVTOCI) shall be recognised in OCI, except for impairment gains or losses and foreign exchange gains and losses, until the asset is derecognised or reclassified. Impairment gains and losses and foreign exchange gains and losses are recognised in the profit or loss. For the purposes of the FIN module, the treatment of the foreign exchange gains or losses is beyond the scope of the module. Interest calculated using the effective interest method is recognised in the profit or loss as if the financial asset had been measured at amortised cost.

Example – Subsequent measurement of debt security InvestCo invested in a $1 million debt security with annual interest payments of 5% on 1 Janurary 20X1. The effective interest rate has been calculated at 4.2755%. InvestCo incurred transaction costs of $20,000. The fair value of the security at 31 December 20X1 is $1,100,000.

Recap: Amortised cost at 31 December 20X1: $1,013,610

Calculate gains and losses The carrying amount of the debt security prior to revaluation: $1,013,610 Fair value at 31 December 20X1: $1,100,000 Gain on fair value $86,390 The journal entry to recognise the gain on the security fair value is: DR Debt security

$86,390

CR FVTOCI reserve

$86,390

Recognition of the gain in fair value at 31 December 20X1

Note, that the amortised cost entry to recognise the EIM interest accrual has been recorded and the carrying amount of the security prior to the revaluation is its amortised cost. (Refer to the example in amortised cost section for the entry). After the fair value gain is recognised, the security is carried in the statement of financial position at its fair value of $1.1 million.

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Gains and losses on financial liabilities There are two reasons a financial liability is classified as FVTPL – it is held for trading, or it is designated as FVTPL on initial recognition. The treatment of the fair value gain or loss on the financial liability depends on which category it falls into. FVTPL – held for trading All gains or losses on a financial liability that is held for trading, assuming they are not part of a hedging relationship, are recognised in the profit or loss. Interest expense is not separately disclosed – it forms part of the fair value movement gain or loss in the profit or loss.

Example – Subsequent measurement of interest rate swap LoanCo entered into an interest rate swap on 1 January 20X1. As the swap is a derivative, it meets the definition of held for trading and is classified at FVTPL. At 31 December 20X1, the fair value of the swap is $(100,000).

Calculate gains and losses The carrying amount of the swap at initial recognition:

$0

Fair value at 31 December 20X1 is a liability of: $100,000 Loss on fair value $100,000 The journal entry to recognise the loss on the swap fair value is: DR Loss on FVTPL liabilities (P&L)

$100,000

CR Interest rate swap liability

$100,000

Recognition of the loss in fair value at 31 December 20X1

FVTPL – designated at initial recognition IFRS 9 para 5.7.7 requires a gain or loss on a financial liability that is designated at fair value through profit or loss (FVTPL) (due to the election at initial recognition) to be measured as follows: •• The amount of change in fair value that relates to a change in the credit risk of the liability is presented in other comprehensive income (OCI), and •• The remaining amount of change in the fair value of the liability is presented in the profit or loss. The subsequent measurement and accounting of financial liabilities in this category is beyond the scope of the FIN module.

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Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Apply your knowledge Measurement After reviewing the various funding alternatives received, Ben Scorby, the group treasurer of Fly-byday, considers the 10-year bank loan with a 5% interest coupon as a better instrument to use as he believes there will be greater appetite from lenders for this type of instrument. However, he is unsure of the difference it will make if it is measured at fair value or amortised cost. He asks you to provide him with the impact on the earnings of Fly-by-day for the first three years under each measurement basis, assuming the loan is issued on 1 July 20X7. He expects transaction costs to be 2% of the notes issued, and interest coupons will be paid annually. The effective interest rate will be 5.2623%.

Answer Measurement basis

Initial measurement

Subsequent measurement

Fair value

Initial measurement will be at fair value

Subsequent measurement will be at fair value, which will be determined at each reporting date. The change in fair value will be recognised in profit or loss as the loan will be classified as FVTPL

Transaction costs of $400,000 (being $20 million × 2%) will be expensed as the loan will be classified as FVTPL Amortised cost

Initial measurement will be at fair value Transaction costs of $400,000 (being $20 million × 2%) will be deducted from the fair value of the loan when it is recognised as a liability in the statement of financial position

Subsequent measurement will be at amortised cost. Interest expense will be calculated based on the EIM – refer below for calculation

Opening balance

Principal repayments

Interest payments

$

$

$

Interest accrued using EIM (amount recognised in P&L) $

01.07.20X7

Closing balance $ 19,600,000

30.06.20X8

19,600,000

–

(1,000,000)

1,031,411

19,631,411

30.06.20X9

19,631,411

–

(1,000,000)

1,033,064

19,664,475

30.06.20Y0

19,664,475

–

(1,000,000)

1,034,804

19,699,279

From a profit or loss perspective, the primary difference between amortised cost and fair value is the timing of recognition of transaction costs (ignoring the impact of fair value changes). If the loan is classified as FVTPL, transaction costs are recognised initially as an expense. If the loan is classified as amortised cost, transaction costs are recognised over the life of the loan, so the total expense is the same under each classification.

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Summary – measurement of financial assets and liabilities The following table summarises the measurement of financial assets and liabilities based on their classification under IFRS 9.

Financial asset

Financial liability

Classification

Initial measurement

Subsequent measurement

Gains/Losses

Interest and dividends

Amortised cost

Fair value + transaction costs

Amortised cost + Profit or loss impairment test only when asset derecognised

Use EIM to recognise interest revenue in profit or loss

FVTOCI – other than investments in equity

Fair value + transaction costs

Fair value

OCI (refer to OCI video to refresh knowledge) until asset is derecognised then cumulative amount is transferred to profit or loss

Use EIM to recognise interest revenue in profit or loss

FVTOCI – Fair value + investments in transaction equity where costs election is made to present changes in fair value in OCI

Fair value

OCI (and never reclassified to profit or loss)

Profit or loss

FVTPL

Fair value*

Fair value

Profit or loss

Interest revenue recognised in profit or loss as part of change in fair value (if applicable, for example derivatives will not have interest revenue)

Amortised cost

Fair value – transaction costs

Amortised cost

Profit or loss only when liability derecognised

Use EIM to recognise interest expense in profit or loss

FVTPL – initial designation

Fair value*

Fair value

Amount is attributable to change in credit risk – OCI (and never reclassified to profit or loss)

Interest expense is recognised in profit or loss as part of the change in fair value

Remaining gain or loss – profit or loss FVTPL – HFT

Fair value*

Fair value

Profit or loss

Interest expense is recognised in profit or loss as part of the change in fair value

*  Transaction costs are recognised as an expense for these categories.

Activity 9.2: Basic accounting comparing FVTPL and FVTOCI [Available online in myLearning] Activity 9.3: Basic accounting under amortised cost [Available online in myLearning]

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Core content – Unit 9

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Financial Accounting & Reporting

Impairment of financial assets Learning outcome 4. Explain and account for impairment of financial assets. IFRS 9 adopts a forward-looking expected loss model for measuring impairment of financial assets. It anticipates that credit losses will be recognised prior to a financial asset becoming credit-impaired or an actual default occurring. Required reading IFRS 9 paras 5.5. A credit loss occurs when an entity receives lower cash flows than the amount that is contractually due to it. IFRS 9 requires an entity to recognise a loss allowance in the statement of financial position for expected credit losses on: •• Financial assets measured at amortised cost (IFRS 9 para 4.1.2) or FVTOCI (other than equity instruments) (IFRS 9 para. 4.1.2A). •• Lease receivables. •• Contract assets – under IFRS 15 Revenue from Contracts with Customers contract assets are defined as an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditional on something other than the passage of time (e.g. the entity’s future performance). •• Loan commitments that are not measured at FVTPL. •• Financial guarantee contracts that are not measured at FVTPL. This means that a loss allowance is not recognised for: •• financial assets measured at FVTPL, or •• equity instruments measured at FVTOCI. An impairment gain or loss will be recognised in profit or loss for the amount of the expected credit loss that is required to adjust the loss allowance at the reporting date to the amount required under IFRS 9. The effect of the impairment provisions of IFRS 9 is to ensure changes in expected credit losses are recognised in profit or loss. FIN fact For financial assets measured at FVTPL, the market’s expectations of the impact of expected credit losses on future cash flows is already recognised in profit or loss, and accordingly, a separate loss allowance is not required.

Expected credit losses (ECLs) A credit loss is the difference between all contractual cash flows that are due to an entity and all cash flows the entity expects to receive, all discounted at the original effective interest rate of the financial instrument. The difficulty with this definition is measuring the cash flows the entity expects to receive. In approaching this problem, entities should take the following into account: •• The period over which to estimate expected credit losses (ECLs). Entities must consider the maximum contractual period over which the entity is exposed to risk, including extension options exercisable by the borrower, the term of contractual commitment under financial guarantees, and undrawn loan commitments.

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•• Unbiased probability-weighted outcomes. Although entities do not need to take into account every possible scenario, they need to take account of the possibility that a credit loss will occur, even if that possibility is low (as opposed to being the most likely outcome). •• The time value of money. Expected cash flows are discounted to the reporting date using the effective interest rate determined at initial recognition, or the current effective interest rate if the financial asset has a variable interest rate. •• Reasonable and supportable information. Entities need to consider all information that is reasonably available at the reporting date without undue cost and effort. This information will include information about past events, informed by an analysis of current conditions and forecasts of future economic conditions. Entities should regularly review the methodology and assumptions used to estimate ECLs to reduce differences between estimates and actual credit loss experience. •• Collateral. Estimates of ECLs must reflect the cash flows expected to be received from collateral and other credit enhancements that are part of the contractual terms of the financial asset, even if these cash flows are realised beyond the contractual maturity of the contract. In measuring ECLs, entities may use practical expedients such as a provision matrix for trade receivables.

Example – Practical expedients Easybits Industries (Easybits) has historically experienced the following credit loss rates on its trade receivables: Not past due

1%

0–30 days past due

2%

31–90 days past due 5% 91–180 days past due 15% > 180 days past due

25%

All of its customers come from similar geographical regions and experience economic conditions in a similar way, so Easybits does not sub-categorise its trade receivables for the purposes of assessing ECLs. Easybits has reviewed current and forecast economic conditions and does not believe these will have any material impact on its historical loss experience. Accordingly, Easybits intends to use its historical loss experience to estimate ECLs on trade receivables for its current reporting period. Lifetime ECLs are the expected credit losses that result from all possible default events over the expected life of a financial asset. This means that an entity needs to estimate the probability of default occurring over the contractual life of the financial asset. Twelve-month ECLs are a portion of lifetime ECLs. They represent only the loss arising from possible default events for the next 12 months after the reporting date.

Example – Measuring ECLs Easybits’ liquidity portfolio includes a $1 million investment in a debt instrument that matures in five years. Easybits estimates that the probability of default over the lifetime of the investment is 10%, while the probability of default over the next 12 months is only 3%. Easybits estimates that the total loss on this investment in the event of a default would be $500,000. Accordingly, Easybits would measure its 12-month expected credit loss as 3% × $500,000 = $15,000. If it were to recognise a lifetime credit loss, it would calculate this as 10% × $500,000 = $50,000.

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FIN fact IFRS 9 impairment requirements and the measurement of ECLs applies to related party/ intercompany loan receivables In applying the IFRS 9 requirements, an entity can use one of the following approaches, as applicable:

1

2

3

4

General approach

Simplified approach

Low credit risk simplification

12 month or lifetime ECL’s

Purchased or originated credit impaired approach

Lifetime ECL’s

12 month ECL’s

It’s complicated: Limited scope in FIN module

(1) The general approach to impairment The following diagram summarises the general approach: Stage 1

Stage 2

Stage 3

Loss Allowance…

12-month expected credit losses

Lifetime expected credit losses

Lifetime expected credit losses

Effective interest rate applied to…

Gross carrying amount

Improvement

Significant increase in credit risk

Gross carrying amount

Objective evidence of impairment

Change in credit risk since initial recognition

Net carrying amount

Deterioration

Adapted from Deloitte IFRS e-learning module IFRS 9 (4) Impairment, accessed on 26 April 2018, www. deloitteifrslearning.com/description.asp?id=ifrs94_v15&mod=ifrs

Under the general approach there are a number of stages in recognising expected credit losses: •• Initial recognition of the financial asset. No loss allowance for expected credit losses recognised as the asset is initially recognised at fair value, thereby incorporating the credit risk of the asset. •• Each reporting date: –– Stage 1: If there is no significant increase in credit risk since initial recognition, entities provide for expected credit losses that may result from default events possible within the next 12 months (i.e. ’12-month expected credit losses’). –– Stage 2: If there has been a significant increase in credit risk since initial recognition, entities provide for expected credit losses that may result from default events possible over the entire expected life of the financial instrument (i.e. ‘lifetime expected credit losses’). In addition, if there is objective evidence of impairment of the financial asset, Stage 3 applies, whereby interest on the financial asset is calculated based on the gross carrying amount of the asset adjusted for any loss allowance (i.e. the net carrying amount) (thus reducing the income recognised from the asset). Under the general approach, an entity recognises a loss allowance based on either 12-month ECL or lifetime ECL, depending on whether there has been a significant increase in credit risk since initial recognition. Accordingly, an entity is required to monitor the change in credit risk of financial assets at each reporting date. Unit 9 – Core content

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Change in credit risk since initial recognition The assessment of whether a financial asset has experienced a significant increase in credit risk is crucial to establishing the point at which an entity switches from using 12-month ECLs to using lifetime ECLs to measure a loss allowance. A significant increase in credit risk is based on the change in risk of default that has occurred since initial recognition of the asset. It is important to note that this is not the same as an increase in the amount of expected credit losses. Significant judgement is required in the assessment of whether an increase in credit risk is significant, and the assessment should be based on reasonable and supportable information. IFRS 9 does not provide a definition of default for the purposes of determining whether the risk of default has changed significantly. Accordingly, an entity will need to establish its own policies for determining what it considers to be a default. The standard provides a non-exhaustive list of indicators an entity should consider in determining whether a significant change in credit risk has occurred. These are summarised below: External market indicators Increased credit risk of other financial instruments Internal price indicators

Changed external credit rating

Adverse operating results

Adverse environment changes

Adverse economic conditions

Adverse change in value of collateral

Further details on these can be obtained from IFRS 9 para B5.5.17. There are a number of operational simplifications and presumptions an entity may make in assessing significant increases in credit risk: •• Low credit risk operational simplification (discussed below). •• If forward-looking information is not available without undue cost or effort, an entity may use past due information to determine whether there have been significant increases in credit risk. There is an assumption in IFRS 9 that credit risk has increased significantly when contractual payments are more than 30 days past due. This assumption can be overturned if the entity has reasonable and supportable information to the contrary. •• The change in risk of a default occurring in the next 12 months may often be used as an approximation for the change in risk of a default occurring over the remaining life. •• The assessment may be made on a collective basis or at the level of the counterparty. Lifetime credit losses are generally expected to be recognised before a financial instrument becomes past due as credit risk has likely increased significantly prior to that date. However, an entity may not be able to identify changes in credit risk for individual financial instruments and may choose to recognise lifetime ECLs on a collective basis. To do this, an entity can group financial instruments on the basis of shared credit risk characteristics (e.g. instrument type, credit risk ratings, collateral type, industry, geographical location). A significant increase in credit risk relates to the change in probability of default rather than to the absolute probability of default. At any given moment in time, two financial assets may have the same absolute probability of default but one may have increased or decreased significantly since initial recognition whereas the other may not have.

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The probability of default tends to be higher the longer the expected life of a financial asset. For example, the risk of default in relation to a 10-year AAA rated bond is higher than that of a 5-year AAA rated bond. These two concepts link together when considering how the probability of default for a financial asset changes over time. If the probability of default remains constant over time, it is likely that the credit risk has increased as it would be expected that the probability of default would reduce as an instrument gets nearer to maturity. The probability of default may also be impacted by the timing of payments. If there are significant payment obligations close to maturity (e.g. for a corporate bond) the risk of default may not necessarily decrease over time. FIN fact An entity compares the current risk of default at the reporting date with the risk of default on initial recognition. For example, the credit risk relating to a financial asset that improves from initial recognition could result in moving from Stage 2 back to Stage 1.

Relationship between changes in credit risk and measurement of impairment and interest revenue Each stage of the impairment model determines how the loss allowance and interest revenue should be calculated. In stages 1 and 2, interest recognition and impairment are de-coupled as interest recognition is based on the gross carrying value of the financial asset despite the fact that the asset has been impaired. In Stage 3, interest recognition is re-coupled with the asset impairment and is based on the amortised cost of the financial asset, which is the gross carrying value adjusted for any loss allowance. Each stage is discussed below. Stage 1: A loss allowance equal to 12-month expected credit loss is recognised if the credit risk on a financial asset has not increased significantly since initial recognition. Interest revenue is calculated based on the gross carrying amount of the asset (i.e. as per standard amortised cost calculation).

Example – Stage 1 A debt security has a carrying amount of $500,000 at 30 June 20X8. There is loss allowance of $20,000 at 30 June 20X8. You are assessing the changes in credit risk of the debt security to determine how to measure any changes to the loss allowance and interest revenue at 30 June 20X9.

Assessment There has not been a significant increase in credit risk since initial recognition. 12-month ECLs have been calculated at $22,000 as at 30 June 20X9. This requires an increase to the loss allowance of $2,000.

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The effective interest rate is 2.5%. Loss allowance at 30 June 20X9 Impairment expense for the 30 June 20X9 year (movement in loss allowance $22,000 – $20,000) Interest revenue calculation: Gross carrying amount × EIR = $500,000 × 2.5%

$22,000 $2,000 $12,500

Statement of financial position

Statement of profit or loss

Stage 2: A loss allowance equal to lifetime ECLs is recognised where there is a significant increase in credit risk since initial recognition. Interest revenue is calculated based on the gross carrying amount of the asset (as per standard amortised cost calculation).

Example – Stage 2 A debt security has a carrying amount of $500,000 at 30 June 20X8. There is loss allowance of $20,000 at 30 June 20X8. You are assessing the changes in credit risk of the debt security to determine how to measure any changes to the loss allowance and interest revenue at 30 June 20X9.

Assessment There has been a significant increase in credit risk since initial recognition. 12-month ECLs have been calculated at $22,000 as at 30 June 20X9 and lifetime ECLs have been calculated at $30,000. Due to the significant increase in credit risk, the loss allowance must be equal to the lifetime ECLs. This requires an increase of the loss allowance of $10,000. The effective interest rate is 2.5%. Loss allowance at 30 June 20X9

$30,000

Impairment expense for the 30 June 20X9 year (movement in loss allowance $30,000 – $20,000)

$10,000

Interest revenue calculation: Gross carrying amount × EIR = $500,000 × 2.5%

$12,500

Statement of financial position

Statement of profit or loss

The loss allowance and impairment expense are greater than the Stage 1 example due to the significant change in credit risk. However, the interest revenue is the same as in Stage 1 since it is calculated on the same basis. Stage 3: A loss allowance equal to lifetime ECLs is recognised where there is objective evidence of impairment, (note, this is the same loss allowance recognised in Stage 2). In addition, the interest on the financial asset is calculated based on the net carrying amount of the asset (i.e. carrying amount less the loss allowance) which reduces the income recognised from the asset.

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Example – Stage 3 A debt security has a carrying amount of $500,000 at 30 June 20X8. There is loss allowance of $20,000 at 30 June 20X8. You are assessing the changes in credit risk of the debt security to determine how to measure any changes to the loss allowance and interest revenue at 30 June 20X9.

Assessment There is objective evidence of impairment of the debt security. 12-month ECLs have been calculated at $22,000 as at 30 June 20X9 and lifetime ECLs have been calculated at $30,000. Due to the significant increase in credit risk and the objective evidence of impairment, the loss allowance must be equal to the lifetime ECLs. This requires an increase of the loss allowance of $10,000. The effective interest rate is 2.5%. Loss allowance at 30 June 20X9

$30,000

Impairment expense for the 30 June 20X9 year (movement in loss allowance $30,000 – $20,000)

$10,000

Interest revenue calculation: Net carrying amount × EIR = $470,000 ($500,000 –$30,000) × 2.5%

$11,750

Statement of financial position

Statement of profit or loss

The loss allowance and impairment expense are the same as in Stage 2 as they are both based upon lifetime ECLs. However, the interest revenue is less than in stages 1 and 2 because the loss allowance is factored into the effective interest rate calculation (i.e. the EIR is applied to the net carrying amount).

(2) The simplified approach to impairment The simplified approach does not require the tracking of changes in credit risk, but instead requires the recognition of lifetime ECLs at all times (i.e. Stage 2 recognition). The simplified approach applies to trade receivables and contract assets, as long as they do not contain a significant financing component. It is worth noting that for trade receivables and contract assets due within 12 months, the 12-month ECL is the same as the lifetime ECL anyway. An entity may also apply the simplified approach to the following assets if it chooses as its accounting policy to measure the loss allowance as an amount equal to lifetime credit losses: •• Trade receivables that contain a significant financing component. •• Contract assets that contain a significant financing component. •• Lease receivables. FIN fact A contract asset is the right to consideration in exchange for goods or services that is conditional on something other than the passage of time (i.e. performance of another obligation). This is unlike a trade receivable which is an unconditional right to receive consideration. FIN fact Using the simplified approach, an entity may calculate lifetime ECLs by specifying fixed rates from a provision matrix depending on the number of days that a trade receivable is past due.

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(3) Low credit risk operational simplification If a financial asset is determined to have low credit risk at the reporting date, an entity can assume that the credit risk has not increased significantly since initial recognition, and accordingly can continue to recognise a loss allowance of 12-month ECL. In order to make such a determination, an entity may apply its internal credit risk ratings or other methodologies using a globally comparable definition of low credit risk. It may also use external credit ratings, in which case a financial asset rated ‘investment grade’ is an example of an asset with low credit risk. IFRS 9 indicates that a financial asset is considered to have low credit risk if: •• There is a low risk of default by the borrower. •• The borrower has a strong capacity to meet its contractual cash flow obligations in the near term. •• Adverse changes in economic and business conditions in the longer term may, but not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations. A financial asset is not considered to carry low credit risk merely due to the existence of collateral, or because a borrower has a lower risk of default than the risk inherent in an entity’s other financial assets or lower than the credit risk of the jurisdiction in which the entity operates.

Example – Low credit risk simplification Easybits Industries (Easybits) has an investment in a three-year corporate bond issued by Hardcore Limited (Hardcore). The bond had a credit rating of BBB when it was acquired on 20 May 20X4. On 28 October 20X6 the bond lost its investment grade credit rating and was downgraded to BB+. Despite the credit rating downgrade, Easybits does not consider that a two-notch reduction in the credit rating is a significant increase in the credit risk of the asset. The bond is due for maturity in less than six months and Easybits believes Hardcore has a strong capacity to meet its contractual obligations. Accordingly, Easybits continues to recognise a 12-month ECL for this financial asset.

FIN fact Low credit risk operational simplification enables an entity to recognise a loss allowance for 12-month ECL (i.e. Stage 1 recognition as explained under the general approach).

(4) Purchased or originated credit-impaired approach A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence of creditimpairment includes: •• Significant financial difficulty of the issuer or borrower. •• A breach of contract (e.g. default or past due event). •• The lender has granted to the borrower a concession, due to borrower’s financial difficulty, that the lender would not otherwise consider. •• It is probable the borrower will enter bankruptcy or other financial reorganisation. •• The disappearance of an active market for that financial asset because of financial difficulties. For a financial asset that is considered to be credit-impaired on acquisition or origination: •• The fair value at initial recognition already takes into account lifetime ECLs so there is no need for an additional 12-month ECL allowance. •• The effective interest rate is calculated by taking into account the initial lifetime ECLs in the estimated cash flows. •• The only credit loss required to be recognised is any change to the lifetime ECL that was incorporated into the initial fair value of the asset. Page 9-42

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Example – Credit-impaired assets Chocolate Factoring has recently acquired a portfolio of non-performing trade receivables from Meltdown Limited to provide Meltdown with some much-needed cash. The receivables in the portfolio are in breach of their credit terms, all are past due, and the fair value of the portfolio acquired by Chocolate Factoring reflects the expected credit losses. Chocolate Factoring considers this to be a portfolio of credit-impaired financial assets as at least one event has occurred that has had a detrimental impact on the estimated future cash flows of these receivables (i.e. a past due event). At future reporting dates, Chocolate Factoring will only recognise any change in lifetime ECL compared to that incorporated into the initial fair value recognised. The following flowchart illustrates the application on a reporting date of the impairment requirements combining all three approaches: Is the financial asset a purchased or originated credit-impaired financial asset?

YES

NO

Is the simplified approach for trade receivables, contract assets and lease receivables applicable?

Calculate a credit-adjusted interest rate and recognise a loss allowance for changes in lifetime ECL

NO

Does the financial asset have a low credit risk at the reporting date? YES

NO

Has there been a significant increase in credit risk since initial recognition?

YES

NO

NO

YES

Recognise lifetime ECL (Stage 2)

Is low credit risk simplification applied? YES

Recognise 12-month ECL and calculate interest revenue on gross carrying amount (Stage 1)

AND

Is the financial asset a credit-impaired financial asset? NO

YES

Calculate interest revenue on amortised cost (Stage 3)

Calculate interest revenue on gross carrying amount (Stage 2) Adapted from Deloitte IFRS 9 Financial Instruments Illustrative Examples, July 2014, accessed on 24 April 2018, www.aasb.gov.au/admin/file/content105/c9/IFRS9_IE_7-14.pdf

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Apply your knowledge Impairment The CFO, Sarah March, is concerned about the new rules for impairment and how complicated they will be to implement, even though Fly-by-day only has a few different types of financial assets. She asks you to explain how IFRS 9 will apply for each of the following financial assets: •• Cash at bank. •• Cash portfolio (measured at FVTOCI). •• Trade receivables (maximum payment terms are 90 days). •• Fair value of derivative assets used for hedging.

Answer Financial Asset

Do IFRS 9 Approach impairment adopted provisions apply?

Application of IFRS 9

Cash at bank

Yes

General approach with low credit risk operational simplification

This is an asset held at amortised cost since cash flows (the balance of the account and interest on the account) are solely principal and interest on the principal, and it is held in order to collect contractual cash flows (repayment of the balance or a portion of it when required). Accordingly, the impairment provisions of IFRS 9 apply. As our primary bank is rated AA+, it has a very low risk of default, and we have a strong expectation that, going forward, the bank would be able to meet any withdrawals we made. This means we can apply the low credit risk operational simplification and we just have to calculate the 12-month ECL. Given our confidence in our bank, we could assume this to be zero

Cash portfolio

Yes

General approach potentially with low credit risk operational simplification

These assets are held at FVTOCI and accordingly the impairment provisions of IFRS 9 apply. The approach we adopt will depend on the quality of assets held. If high quality (investment grade) we could adopt the low credit risk approach (as with cash at bank), which means we just have to calculate the 12-month ECL. If not high quality, we would need to adopt the general approach. This would require an initial calculation of 12-month ECL, but also ongoing monitoring to determine if there has been a significant increase in credit risk and lifetime ECL is required to be calculated The 12-month ECL calculation (under either approach) will require us to determine a probability of default in the next 12 months together with a lifetime loss given that default for each investment asset we hold

Trade receivables

Yes

Simplified approach

Trade receivables are held at amortised cost and IFRS 9 permits us to adopt a simplified approach in applying the impairment provisions. This means we are not required to track credit risk of the trade debtor and can just recognise lifetime ECL. Since our trade receivables are all due within 90 days, lifetime is only 90 days anyway. In addition, we can use a provision matrix based on our historical experience of credit losses

Derivative assets

No

N/A

These are derivatives which are measured at FVTPL. This means that the fair value will already incorporate the market’s expectations of the impact of expected credit losses. Accordingly, separate recognition of a loss allowance is not required

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Recognition of ECLs in the financial statements The recognition of ECLs in the financial statements can be summarised as follows: Asset at amortised cost

Asset at FVTOCI (other than equity instruments)

Unrecognised asset (e.g. financial guarantee)

Profit or loss

Expected credit loss recognised as impairment gain/loss

Expected credit loss recognised as impairment gain/loss

Expected credit loss recognised as impairment gain/loss

Other comprehensive income

N/A

At each reporting date changes in expected credit losses are isolated and transferred from OCI to P&L as an impairment gain/loss

N/A

Balance sheet

Loss allowance included in amortised cost

Fair value already reflects expected credit losses

Loss allowance recognised as a provision

At each reporting date, an entity recognises the movement in the loss allowance as an impairment gain or loss in the SPLOCI. The carrying amount of financial assets measured at amortised cost includes the loss allowance relating to that asset. Assets measured at FVTOCI (other than equity instruments) are recognised at fair value with changes in fair value recognised in OCI. Changes in fair value include a number of factors, including the change in credit risk of the asset. At reporting date, the amount relating to the change in credit risk is transferred from OCI to profit or loss. Investments in equity instruments are outside the scope of the IFRS 9 impairment requirements because they are accounted for at either: •• FVTPL or •• FVTOCI where fair value gains and losses are recognised in OCI with no reclassification to profit or loss. For financial assets that are unrecognised (e.g. loan commitments yet to be drawn, financial guarantees), a provision for loss allowance is created in the statement of financial position to recognise the loss allowance.

Example – Recognition of credit losses Easybits Industries (Easybits) manages its liquidity by investing in a range of short-term debt instruments. On 26 July 20X6 it purchased a one-year debt instrument with a fair value of AUD500,000, which is classified as FVTOCI. The instrument carries an interest rate of 4.5%, and has a 4.5% effective interest rate. The asset was not credit-impaired when purchased. On 31 December 20X6 (the reporting date) the fair value of the instrument had fallen to AUD480,000 as a result of changes in market interest rates. Easybits determines there has not been a significant increase in credit risk since initial recognition and that ECL should be measured at 12-month ECL, which amounts to AUD5,000. The journal entries that should occur on 31 December 20X6 are: Date

Description

31.12.X6

FVTOCI reserve

Dr $

Cr $

20,000

Financial asset [FVTOCI]

20,000

Being recognition of the change in fair value of the financial asset at 31 December 20X6

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Date

Description

31.12.X6

Impairment loss [profit or loss]

Chartered Accountants Program

Dr $

Cr $

5,000

FVTOCI reserve

5,000

Being recognition of the loss allowance for the financial asset at 31 December 20X6 (i.e. recognising the expected credit loss portion of the fair value movement in profit or loss, not OCI)

Derecognition Learning outcome 5. Explain and account for the derecognition of financial assets and financial liabilities. Derecognition refers to the removal of a previously recognised financial asset or financial liability from an entity’s statement of financial position. Required reading IFRS 9 paras 3.2.1–3.2.6, 3.3.1–3.3.4

Derecognition of a financial asset In general terms, a financial asset is derecognised when the holder’s contractual rights to its cash flows expire, or the asset is transferred in such a way that all the risks and rewards of ownership are substantially transferred. Establishing whether a financial asset is transferred involves looking at the substance of a transaction (rather than at its legal form). In order for derecognition to be available for a financial asset, all the following criteria need to be fulfilled: •• The rights to receive cash flows from the asset have expired (e.g. at the end of a loan term) or been transferred (e.g. by sale or assignment). •• Substantially all the risks and rewards of ownership of the asset have been transferred. •• The entity no longer has control of the asset (i.e. no practical ability to make a unilateral decision to sell the asset to a third party). Most financial assets are derecognised because they have been disposed of, or because they have expired at the end of their life. There are some more complex arrangements that an entity may enter into (e.g. securitisation) where meeting the criteria can be the subject of much judgement. These arrangements will not be explored further in this unit.

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Consolidate all subsidiaries (including any SPE) [Paragraph 3.2.1]

Preliminary

Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets) [Paragraph 3.2.2]

Step 1

Have the rights to the cash flows from the asset expired? [Paragraph 3.2.3(a)]

YES

Derecognise the asset

NO

Has the entity transferred its rights to receive the cash flows from the asset? [Paragraph 3.2.4(a)] NO

YES

Has the entity assumed an obligation to pay the cash flows from the asset that meets the conditions in paragraph 3.2.5? [Paragraph 3.2.4(b)]

NO

Continue to recognise the asset

YES

Step 2

Has the entity transferred substantially all risks and rewards? [Paragraph 3.2.6(a)]

YES

Derecognise the asset

NO

Has the entity retained substantially all risks and rewards? [Paragraph 3.2.6(b)]

YES

Continue to recognise the asset

NO

Step 3

Has the entity retained control of the asset? [Paragraph 3.2.6(c)]

NO

Derecognise the asset

YES

Continue to recognise the asset to the extent of the entity’s continuing involvement

Adapted from IFRS 9 Financial Instruments para. B3.2.1, July 2014, accessed on 26 April 2018, www.aasb.gov.au/admin/ file/content105/c9/IFRS9_BC_7-14.pdf

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Apply your knowledge Derecognition of a financial asset Didier is the financial accountant of Cashstrapped Limited. He comes to you with a proposal to sell a portfolio of underperforming trade receivables to a third party, Logical Factoring Company. Cashstrapped will receive cash upfront for the sale. Once the sale is completed, Logical will deal directly with the debtors in collecting the trade receivables and will have no rights against Cashstrapped should a debtor default. Didier is writing a paper for the board and wants to know if the above arrangements will qualify for derecognition under IFRS 9.

Answer The derecognition principles are applied to the entire portfolio of underperforming trade receivables being sold.

Have the rights under the asset expired or been transferred? In this case, Cashstrapped will no longer have any rights to receive cash flows from the trade receivables, and accordingly, the rights under the asset have been transferred.

Have the risks and rewards of asset ownership been transferred? Following the sale of the trade receivables to Logical, Cashstrapped will no longer have any rights to receive cash flows from the debtor (i.e. no rewards of asset ownership). In addition, Cashstrapped will no longer be exposed to the primary risk of the trade receivables, which is credit risk, as Logical will be collecting the funds from the debtor and will be exposed to the risk of debtor default. Accordingly, substantially all the risks and rewards of the asset have been transferred.

Has control been maintained? Following the sale of the trade receivables to Logical, Cashstrapped will no longer control any of the debtors and cannot direct how the benefits of the asset are to be realised. Logical will have this control.

Conclusion The criteria for derecognition are satisfied. Therefore, the portfolio of trade receivables will be removed from the statement of financial position in exchange for cash. Any difference between the two amounts will be recognised in profit or loss as a gain or loss.

Derecognition of a financial liability The derecognition rules that are applicable to a financial liability are simpler than those for a financial asset. A liability is derecognised when it is extinguished (i.e. when the obligation specified in the contract is discharged, cancelled or expires). An exchange of an existing financial liability for a new one with substantially modified terms, or a substantial modification to the terms of a financial liability are treated as an extinguishment of the existing liability and recognition of a new financial liability. Substantial modification of terms occurs when the present value of the remaining original cash flows is more than 10% different from the modified cash flows.

Example – Modified terms Brightstar Limited has an existing loan with five years remaining until maturity. Due to a restructure of its financing facilities, it wishes to extend the term of the loan to 10 years, although the interest rate on the loan will remain the same. This is a substantial modification of the terms of the loan, resulting in a derecognition of the original loan and a recognition of the new loan.

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Part B Accounting for equity transactions IFRS does not have any specific measurement rules related to equity, other than in respect of: •• Transaction costs of equity transactions. •• Dividends. •• Compound instruments. •• Own equity instruments acquired, reissued or cancelled (beyond the scope of the FIN module).

Transaction costs of equity transactions Transaction costs of an equity transaction are accounted for as a deduction from equity in accordance with IAS 32 paragraph 35; that is they are not treated as an expense in the statement of profit or loss but are capitalised on the statement of financial position as a debit to equity. Transaction costs are incremental costs that are attributable directly to an equity transaction (i.e. costs that would have been avoided if the equity transaction had not occurred). For example, if an entity is issuing new shares and incurs legal fees and tax fees relating to the share issue, these costs may be recognised in equity.

Example – Transaction costs of equity transaction On 1 November 20X8, Sfoglia Limited (Sfoglia) issued 1 million ordinary shares for $2 million as a private placement to an institutional investor. Share issue costs of $200,000 were incurred on the date of transaction. The journal entries recognised in respect to the private placement are as follows: Date

Description

Dr $

01.11.20X8

Cash at bank

2,000,000

Ordinary share capital [equity]

Cr $

2,000,000

Being recognition of the share issue in equity Date

Description

01.11.20X8

Ordinary share capital Cash at bank

Dr $

Cr $

200,000 200,000

Being recognition of share issue costs [refer para. 35 of IAS 32]

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Dividends Dividend distributions to holders of an equity instrument are recognised by the entity directly in equity (IAS 32.35) and are not an expense in the statement of profit or loss.

Example – Dividends Sfoglia Limited (Sfoglia) has 1 million ordinary shares on issue. At 31 December 20X8, Sfoglia declared a 15c per share dividend, payable on 15 March 20X9. For the year ended 30 June 20X9, the following journal entries would have been prepared to recognise the dividend transactions: Date

Description

31.12.20X8

Dividend paid [equity]

Dr $

Cr $

150,000

Dividend payable

150,000

Being recognition of the dividend payable when declared Date

Description

15.03.20X9

Dividend payable

Dr $

Cr $

150,000

Cash at bank

150,000

Being recognition of the payment of the dividend to the institutional investor

Compound financial instruments From the issuer’s perspective, some non-derivative financial instruments contain characteristics of both a financial liability (e.g. an obligation to make interest payments) and equity (e.g. some conversion features in a convertible note). These types of instruments are called compound financial instruments. Under IAS 32, compound financial instruments must be classified separately into their liability and equity components and accounted for separately by the issuer. The issuer is required to determine the fair value of the financial liability at the date of its initial recognition. The amount allocated to the equity component is the residual amount of the compound instrument. These initial values of each component may not be subsequently revised. The following figure illustrates how the fair value of a compound instrument is allocated into its components: Step 1: Fair value of compound instrument Determine fair value of the compound instrument as a whole (generally the issue price)

LIABILITY

EQUITY

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Step 2: Fair value of liability Determine the fair value of the liability component at the issue date (i.e. the present value of the contracted future interest and principal cash flows) Step 3: Balance equity Deduct fair value of the liability component from the fair value of the compound instrument as a whole. The resulting residual amount represents fair value of the equity component

Core content – Unit 9

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Transaction costs arising on issuing compound instruments are allocated to the liability and equity components in proportion to the allocation of proceeds. Subsequent to initial recognition, the liability and equity components are separately accounted for as per the normal requirements: •• For liability – amortised cost or fair value through profit or loss – IFRS 9. •• Equity – recognised at initial recognition but is not remeasured – IAS 32. This is often termed ‘split accounting’. FIN fact Only the issuer accounts for the instrument as a compound financial instrument. The investor will recognise a financial asset (and there is no split accounting).

Example – Convertible note that is a financial liability Some convertible notes provide for final repayment either in cash or conversion into the equivalent value of the issuer’s shares, depending on the share price at the time. This means that the number of shares received by the holder will be variable, but their value will be fixed. This type of convertible note is a financial liability as the issuer has a contractual obligation to deliver cash or another financial instrument at maturity.

Example – Convertible note that is a compound financial instrument A note that is convertible, either mandatorily or at the holder’s option, into a fixed number of the issuer’s ordinary shares has the legal form of a debt contract. However, its substance is that of two instruments: (a) Financial liability – there is a contractual obligation to deliver cash by making scheduled payments of interest and principal; the obligation exists as long as the note is not converted. (b) Written call option – grants the holder of the note the right to convert it into a fixed number of the issuer’s ordinary shares. The value of these shares (and thus the value received by the holder) will change based on the share price at the time. (Given that the face value of the note has already been determined, this represents a ‘fixed for fixed’ derivative that is not a liability under IAS 32 and is therefore an equity instrument.)

Conversion into a fixed or variable number of shares [Available online in myLearning]

Apply your knowledge Compound financial instruments Razer Limited is considering raising funds through the issue of convertible notes at their face value of $20 million. These would pay interest at 5% per annum until they mature in eight years. On maturity, the noteholders have the option of converting their holding to ordinary shares of Razer. The noteholders will receive a fixed number of shares. The effective interest rate for a similar note without a conversion feature would be 7%, which would give a discounted value of the notes of $17,611,481. (You can find the workings behind these calculations in the ‘further reading’ folder in myLearning.) The financial accountant of Razer wants to know how to account for the convertible notes at the time of issue and redemption/conversion. Razer has the accounting policy of classifying any financial liabilities at amortised cost.

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Answer Is there a contractual obligation to deliver cash? Razer makes interest payments annually at a specified rate, and will repay the notes at maturity. These characteristics are a contractual obligation, making the notes a financial liability.

Is there a written call option? Is there a fixed for fixed derivative? The convertible notes also contain a conversion feature whereby the noteholder can elect to either receive cash at maturity or a fixed number of shares. The choice the noteholder makes will depend on the share price at the time and upon whether conversion of the notes to ordinary shares provides the noteholder with a greater return than receiving cash. The nature of this conversion feature does not fall within the definition of a liability and accordingly should be classified as equity. This means the notes are a compound financial instrument. The liability and equity components need to be valued and accounted for separately.

Fair value of the compound instrument The fair value of the instrument is the issue price of $20 million.

Fair value of the liability portion In order to value the liability portion, the cash flows of the note are discounted to present value at the effective interest rate of 7%. This amounts to $17,611,481, which is the fair value of the liability component of the note.

Balance is the equity component The difference between the liability amount of $17,611,481 and the issue price of $20 million is $2,388,519. This becomes the fair value of the equity component (i.e. it is the residual amount).

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Hedge accounting Learning outcome 3. Explain and account for basic cash flow and fair value hedges. Most organisations are subject to financial risks that may impact on the profit or loss their business generates.

Changing commodity prices impact the amount paid for inventory Changing interest rates impact interest expense on a floating rate loan

ORGANISATION

Changing FX rates impact the amount paid for a piece of imported equipment

These risks may be managed by various means, including the use of financial instruments to reduce the risk. Derivatives are the primary tool entities use to hedge financial risks such as interest rate risk, foreign exchange risk and commodity price risk. In this section, a risk will be referred to as a hedged risk.

The hedged item, hedged risk and the hedging instrument The concepts of a hedged item, hedged risk and a hedging instrument are critical to an understanding of hedge accounting.

Hedged risk The risk relating to the hedged item that the entity chooses to manage Hedged item Think of this as the real transaction that is subject to a type of risk

Unit 9 – Core content

Hedging instrument Typically a derivative is the hedging instrument. Think of this as the tool that is used to manage the hedged risk on the hedged item

In the FIN module you will be told what type of derivative is being used as hedging instrument

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A hedged item can be: •• A recognised asset or liability (financial or non-financial). •• An unrecognised firm commitment (a binding agreement with specified quantity, price and date/s). •• A highly probable forecast transaction (uncommitted but anticipated future transaction). •• A net investment in a foreign operation (not covered in this module).

Example – Hedged items and hedged risk Category of hedged item

Hedged item (transaction)

Hedged risk

Recognised asset

USD-denominated trade receivables Foreign exchange risk – the risk that receivables will decrease in value in AUD due to movements in exchange rates

Recognised liability

An AUD floating rate loan

Interest rate risk – the risk that interest payments will increase due to increases in interest rates

Unrecognised firm commitment

An order has been received to deliver 10,000 tonnes of iron ore to an offshore customer at the iron ore price on the delivery date.

Commodity price risk – the risk that the price of iron ore will fall prior to the delivery date

Highly probable forecast transaction

An Australian company forecasts Foreign exchange risk – the risk €1 million in inventory purchases for that the inventory will cost more the next six months. in AUD due to movements in exchange rates

Economic relationship between the hedged item and the hedging instrument Hedging is a strategy that an entity may use to manage a specific risk. IFRS 9 requires there to be an economic relationship between the hedged item and the hedging instrument with the expectation that the value of the hedging instrument and the value of the hedged item would move in the opposite direction because of the same risk, which is the hedged risk. The diagram below shows an example of a hedging strategy: Wheat price rises

at Wheases h c pur more are nsive e exp dged (he m) ite

Gain e h on t ative v deri dging ) (he ment ru inst

Commodity price risk of the wheat price rising for a flour mill

Wheat price falls

W pur heat cha a ses che re (hedaper g item ed )

Lo on ss der the i (h vativ inst edging e rum ent)

A hedge enables an entity to create certainty about uncertain future events (the hedged risk). Hedge accounting can be applied when a risk has been economically hedged

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FIN fact Hedge accounting is optional. Subject to satisfying certain requirements, an entity can choose to designate a hedging relationship between a hedging instrument and a hedged item for the hedged risk.

Overview of hedge accounting The purpose of the hedge accounting provisions in IFRS 9 is to ensure that the accounting matches the economic substance of the underlying transactions (i.e. the hedging instrument and hedged item) that have been designated in a hedging relationship. This looks like an economic relationship Commodity price risk of the wheat price rising for a flour mill

Hedged item Wheat purchase order

Hedging instrument Wheat futures contract

The flour mill can designate a hedging relationship between the hedged item and hedging instrument In general, •• Hedge accounting can only be applied if certain eligibility and qualification criteria are satisfied. •• The accounting for the hedged item and hedging instrument in a designated hedge relationship is recorded in a different way to the normal classification and measurement rules for financial instruments. –– The accounting modifies the normal basis for recognising gains and losses (or revenues and expenses) on associated hedging instruments and hedged items, so that both are recognised in the statement of profit or loss and other comprehensive income in the same reporting period. –– Hedge accounting effectively matches the hedged item with the hedging instrument to reflect the economic relationship, and eliminates or reduces the volatility in the statement of profit or loss and other comprehensive income. •• Without hedge accounting, all derivatives are classified as FVTPL and all revaluation gains and losses are recognised in profit or loss. Required Reading IFRS 9 paras 6.1.1–6.1.2, 6.2.1–6.2.3 and 6.3.1–6.5.12 Unit 9 video – Hedging [Available online in myLearning]

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Types of hedging relationship IFRS 9 specifies three types of hedging relationships, as follows: •• Fair value hedge. •• Cash flow hedge. •• Hedge of a net investment in a foreign operation. Types of hedging relationships under IFRS 9

Fair value hedge

Cash flow hedge

Hedge of a net investment in a foreign operation (beyond the scope of the FIN module)

This unit focuses on the first two types of hedging relationships. To properly understand how hedging relationships are accounted for, one must first understand these two different hedging relationships.

Fair value hedge A fair value hedge is defined in IFRS 9 para. 6.5.2(a) as: …a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

In a fair value hedge, the risk being hedged is the change in the value of the hedged item. A fair value hedge can be designated in respect of the following hedged items: Hedged items in a fair value hedge relationship

Value of a recognised asset

Value of a recognised liability

Value of an unrecognised firm commitment

FX risk of an unrecognised firm commitment

Example – Designating a fair value hedge relationship Alpha has an investment in DeltaCo’s corporate bonds that have been classified as FVTOCI. Alpha receives fixed interest of 4% per annum on these corporate bonds. If market interest rates rise, the fair value of Alpha’s investment in DeltaCo’s corporate bonds will fall, as market participants may choose to invest in more attractive investments than DeltaCo’s corporate bonds. If Alpha wishes to manage the interest rate risk on its DeltaCo corporate bonds (a recognised asset), it could create an economic hedge by using a derivative (such as a forward rate agreement) and designate a fair value hedge relationship.

Cash flow hedge A cash flow hedge is defined in IFRS 9 para. 6.5.2(b) as: …a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable-rate debt) or a highly probable forecast transaction, and could affect profit or loss.

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In a cash flow hedge, the entity does not hedge the asset, the liability or the highly probable forecast transaction itself, but rather the potential variable cash flows that any of those items might generate, provided that they ultimately impact on profit or loss. A cash flow hedge can be designated in respect of the following hedged items: Hedged items in a cash flow hedge relationship

Cash flows of a recognised asset

Cash flows of a highly probably forecast transaction

Cash flows of a recognised liability

FX risk of an unrecognised firm commitment

Example – Designating a cash flow hedge relationship Beta is a company that sells bicycles. As part of the recent expansion of its premises it borrowed $1 million from its local bank. The loan has floating interest coupons payable every six months. If market interest rates rise, Beta will pay more interest on the loan, and if they fall, Beta will pay less interest. Beta has a risk that its interest rate cash flows will increase if interest rates increase. If Beta wishes to manage the interest rate risk on its loan (a recognised liability), it could create an economic hedge by using a derivative (such as an interest rate swap that converts its floating interest rate payments to fixed payments) and designate a cash flow hedge relationship.

Hedge accounting process To determine whether hedge accounting may be applied, there are a number of steps an entity must go through, as shown in the figure below. Step 1

What is the risk management strategy?

Identify the risk to be hedged

Step 2

Step 4

Identify the hedged item?

What is the risk management objective that links item and instrument?

Is the hedge effective?

Identify the hedging instrument?

NO

Step 3

Rebalancing/ discontinuation

YES

Step 5

Apply the correct accounting treatment

Fair value hedge

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Cash flow hedge

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Preliminary step – Documentation at the inception of the hedging relationship The shaded boxes in the flowchart must be formally documented at the inception of the designation of the hedging relationship. The following items should be included in the hedge documentation: •• The risk management objective. •• Why the hedge is being undertaken (strategy). •• The hedging instrument. •• The hedged item. •• The risk being protected against. •• The type of hedge (e.g. fair value or cash flow). ••

How hedge effectiveness will be assessed (including potential sources of ineffectiveness and how the hedge ratio will be determined – discussed at Step 4).

A failure to document this information at the inception of the hedging relationship means that hedge accounting under IFRS 9 cannot be applied (IFRS 9 para. 6.4.1(b)).

Step 1 – Risk management strategy, objectives and identification of risks An entity’s risk management strategy identifies the risks to which an entity is exposed and how the entity will respond to those risks. It is normally established at the highest level at which the entity determines how to manage risk and then cascaded down through the entity through policies that contain more specific guidelines. A risk management strategy is generally in place for a longer period of time and may include some flexibility in order to provide management with the ability to react to changing circumstances.

Example – Managing currency risk changed Valueplus Aviation (Valueplus) has identified that it is exposed to the risk of changing exchange rates on its USD expenses, which primarily relates to jet fuel purchases. In order to manage that risk, it has a risk management strategy to hedge up to 80% of its monthly USD forecast expenses. In contrast, the risk management objective is set at the level of the individual hedging relationships and will specify how a particular hedging instrument will be used to hedge a particular exposure that has been designated as a hedged item. This will also include consideration of whether the hedge is a cash flow or fair value hedge. Accordingly, a risk management strategy may involve many different hedging relationships whose risk management objective relate to executing the overall risk management strategy.

Example – Executing a risk management strategy Valueplus currently has a monthly exposure of approximately USD2 million. It has entered into FX forward contracts that mature at the end of each month. These contracts hedge USD1.6 million of the monthly exposure, which is the maximum permitted under Valueplus’ policy (80%). A dramatic fall in the price of crude oil has reduced the forecast monthly USD expenses to USD1.5 million. This has resulted in Valueplus being overhedged and in breach of its policy. Accordingly, Valueplus decides to reduce its FX forward contracts so they cover USD1.2 million of its monthly USD expenses. The risk management strategy has not changed but the execution of that strategy has changed. The risk management objective in relation to the original USD2 million monthly expenses has also changed.

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Step 2 – Eligible hedged items To qualify for hedge accounting, the hedging relationship must only be between eligible hedged items and eligible hedging instruments. An eligible hedged item must be a contract with a party external to the entity. It must also be reliably measurable. Hedged items include a recognised asset or liability, an unrecognised firm commitment and a highly probable forecast transaction. A hedged item can be a single item such as a contract to buy 10,000 barrels of oil. IFRS 9 also permits the hedged item to be a group of items (e.g. a number of iron ore sales transactions occurring within a month) or a component of an item or group of items. The focus in the FIN module is on the hedged item being a single item. Ineligible hedged items There are some items that do not qualify as hedged items, including: Credit risk

Firm commitment to acquire a business (except FX risk)

Transactions in a company’s own equity

Inflation risk (unless specified in the contract)

Step 3 – Eligible hedging instruments A hedging instrument is a designated instrument whose fair value or cash flows is expected to offset the changes in the fair value or cash flows of the eligible hedged item. The following are eligible hedging instruments: •• Derivatives (other than net written options) can be used as hedging instruments provided they are: –– designated by the entity for the entirety of their duration to maturity –– with a party external to the entity. •• Non-derivative financial assets may be designated as hedging instruments. Non-derivative financial liabilities measured at FVTPL may also be designated as hedging instruments if they are held for trading. The focus in the FIN module is on using a derivative as a hedging instrument.

Apply your knowledge Hedging instruments Ben Scorby, the group treasurer, wants to discuss with you the hedging rules. Ben talks to you about an exposure and hedging recommendation he has received from a bank Fly-by-day uses frequently for derivative transactions. He wants you to check if the hedging instrument recommended and the proposed hedging strategy would qualify under IFRS 9. Here is the information he has received: Fly-by-day exposure

Proposed hedging instrument

•• Interest rate risk on a $3 million floating rate AUD denominated bank loan – policy indicates that 50% of debt should be fixed rate

Interest rate swap that pays fixed and receives floating interest rates for $1.5 million notional principal

Answer $3 million floating rate loan The exposure here is to the adverse changes in AUD interest rates. Derivative instruments are permissible under IFRS 9 to be used to hedge this interest rate exposure – so an interest rate swap will qualify under IFRS 9. In addition, it is permissible to hedge only part of the total exposure. So an interest rate swap that covers the risk of $1.5 million of the $3 million loan will hedge 50% of the interest rate risk, which will enable the company to comply with its policy.

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Step 4 – Hedge effectiveness The principles of hedge effectiveness assessment can be summarised in the following diagram:

Hedge effectiveness Economic relationship between hedged item and hedging instrument

Credit risk does not dominate value changes

Economic hedging ratio

=

Accounting hedge ratio

Qualitative and/or quantitative assessment A hedging relationship qualifies for hedge accounting only if it meets all of the following hedge effectiveness requirements: •• There is an economic relationship between the hedged item and the hedging instrument. •• The effect of credit risk does not dominate the value changes that result from that economic relationship. •• The hedge ratio satisfies certain requirements. Hedge ratio is explained further below. Hedge effectiveness is the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item. Hedge ineffectiveness, however, is the extent to which the changes in the fair value or cash flows of the hedging instrument are greater or less than those on the hedged item. It is common for there to be some hedge ineffectiveness from an accounting perspective while still satisfying the principles of the hedge effectiveness assessment. Accounting for fair value and cash flow hedges under Step 5 illustrates this. Economic relationship As explained earlier, it is generally expected that the values of the hedged item and the hedging instrument will move in opposite directions because of the hedged risk. Accordingly, it would be expected that the underlying risks of the hedged item and hedging instrument are economically related. Effect of credit risk Even if there is an economic relationship between the hedged item and the hedging instrument, the level of offset may become erratic due to changes in the credit risk of either the hedged item or the hedging instrument. Hedge effectiveness will not be met if the effect of credit risk dominates the value changes in the economic relationship between the hedged item and the hedging instrument.

Example – The impact of changes in credit risk on hedge effectiveness Klonks Oil Refinery hedges its purchases of crude oil in one year’s time by entering into a forward contract with Island Bank, which is rated AA. Following a financial crisis in Asia, Island Bank suffers a severe deterioration in its credit standing, which is reduced to BBB. This increased risk that Island Bank will not be able to honour the contract has an impact on the value of the forward contract that outweighs the effect of changes in the crude oil price on the forward contract. This hedging relationship will no longer be effective as the fair value of the forward contract is impacted by the change in credit standing of Island Bank. With the change in credit standing, credit risk comes to dominate the hedging relationship and the hedge is no longer effective.

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Hedge ratio The hedge ratio is the ratio between the quantity of the hedged item and the quantity of the hedging instrument. The ratio documented for hedge accounting purposes is established by looking at the amount of the hedging instrument actually used to economically hedge the required amount of the hedged item. The ratio is set to maximise the effectiveness of the hedge and is often 1:1, but may not always be.

Example – Hedge ratio On 21 October 20X8 Cluster places a purchase order for a new machine costing USD900,000 to be delivered and paid for in four months’ time. On the same day as placing the order, Cluster designates a cash flow hedging relationship between the FX risk on the unrecognised firm commitment with an FX forward contract (the hedging instrument) to buy USD900,000 for AUD1,200,000 in four months’ time. The hedge ratio is 1:1 as the quantity of the hedged item is USD900,000 and the quantity of the hedging instrument is also USD900,000.

Assessment of hedge effectiveness IFRS 9 contains no prescriptive measures of hedge effectiveness. An entity should use a method that captures the relevant characteristics of the hedging relationship, including any sources of hedge ineffectiveness. The method used can be qualitative or quantitative, and details should be included in the documentation of the hedging relationship at the inception of the hedge. •• Qualitative assessment: This may involve an assessment of the critical features of the hedged item and the hedging instrument (e.g. term, nominal value, underlying price index or instrument). If they match or are closely aligned, it may be possible for an entity to conclude that the fair values or cash flows will move in opposite directions because of the same risk, and accordingly an economic relationship exists and the hedge is effective. •• Quantitative assessment – if the critical terms are not closely aligned, there may be a level of uncertainty around the extent of offset. In this case, an entity may only be able to conclude on effectiveness by undertaking a quantitative assessment (e.g. dollar offset or regression analysis). Practical application of quantitative assessment is beyond the scope of the FIN module. Assessments of hedge effectiveness should be made at the inception of the hedge and on an ongoing basis (at least at every reporting date). Effectiveness cannot be assumed just because critical terms match. The assessment relates to expectations of hedge effectiveness and therefore is only forward-looking.

Example – Assessment of hedge effectiveness – qualitative assessment Cluster prepares its annual financial statements on 31 December 20X8. At that date it performs a qualitative assessment of hedge effectiveness on the cash flow hedge relationship relating to the future cash flow to be paid for the new machine. It documents that the hedging relationship is expected to continue to be effective as the term and nominal value of the hedging instrument are equal and opposite to those of the hedged item. Additionally there has been no change in the credit risk of the issuer of the hedging instrument.

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Consequences of ineffectiveness following initial hedge recognition – rebalancing/ discontinuation Measurement of retrospective (or past) hedge ineffectiveness is recorded in the profit or loss in accordance with how the hedge is accounted for, and is dealt with in the next section. Following initial recognition of a hedging relationship, effectiveness is also assessed prospectively on an ongoing basis and at least at every reporting date. Once assessed, there are a number of actions an entity can take to deal with prospective hedge ineffectiveness, as follows: •• Continue hedge accounting and recognise any hedge ineffectiveness in the profit or loss. •• Rebalance the hedge ratio. •• Derecognise the hedge either partially or fully. Only an awareness of these actions is required for the FIN module. Discontinuation of a hedge is not voluntary and is only permitted if the risk management objective has changed; there is no longer an economic relationship between the hedged item and the hedging instrument; or, credit risk is dominating the hedge relationship.

Step 5 – Accounting for designated hedges Under IFRS 9 an entity may apply hedge accounting to hedging relationships that meet the qualifying criteria.

Fair value hedges When a hedging relationship is designated as a fair value hedge: •• the normal classification rules for the hedged item are suspended •• any gain or loss on the hedged item is recognised in profit or loss •• any gain or loss on the hedging instrument is recognised in profit or loss. Accordingly, any hedge ineffectiveness is automatically presented in profit or loss (as the net debit or credit from recognising the fair value movement on both the hedged item and hedging instrument).

Accounting for a fair value hedge relationship The table below shows the operation of fair value hedge accounting. Accounting choice

Hedged item

Hedging instrument

Overall impact on profit or loss

Designated fair value hedge relationship

Fair value movements on the hedged item are recognised in profit or loss (including fair value movements on an unrecognised firm commitment – e.g. a purchase order)

Fair value movements on the hedging instrument (derivative) are recognised in profit or loss

To the extent that the hedge is ineffective, there will be a net difference recognised in profit or loss (e.g. if a gain on the hedged item exceeded a loss on the hedging instrument)

Example

An $80,000 gain on the fair value movement on a purchase order

A $70,000 loss on the fair value movement on the derivative hedging instrument

A net $10,000 gain is recognised in profit or loss (hedge ineffectiveness)

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To appreciate the impact of designating a fair value hedge relationship, it is helpful to consider the accounting treatment if an entity did not choose to apply hedge accounting. Assume a derivative was entered into to manage the risk on the specific item Accounting choice

Hedged item

If hedge accounting •• If the hedged item is is not applied a recognised asset or liability then only those classified as FVTPL will have changes in fair value recognised in profit or loss (e.g. if recognised at amortised cost then no fair value movements are recognised)

Hedging instrument

Overall impact on profit or loss

Fair value movements on the hedging instrument (derivative) are recognised in profit or loss

There would be volatility in profit or loss due to the differing accounting treatment for the hedged item and the hedging instrument

There is a $70,000 loss on the fair value movement on the derivative

A $70,000 loss is recognised in profit or loss

•• If the item is an unrecognised firm commitment (e.g. a purchase order), no changes in its fair value are recognised as the unrecognised firm commitment itself would not yet qualify for recognition in the financial statements Example

A purchase order is not recognised on the statement of financial position. There is no impact recognised in profit or loss if there is a fair value movement relating to the purchase order

Volatility arises in profit or loss when hedge accounting is not applied, even though the risk has been economically hedged via the derivative

The process for accounting for a fair value hedge can be broken down into the following steps:

Hedging instrument

Hedged item

Step 1

Step 3

Determine the fair value of the hedging instrument at the reporting date

Determine the gain or loss on the hedged item that is attributable to the hedged risk

Step 2

Step 4

Recognise the change in fair value in profit or loss since the last reporting date:

Adjust the carrying amount of the hedged item and recognise any gain or loss in profit or loss:

Dr/Cr

Hedging instrument

Cr/Dr

Gain or loss on hedging instrument

Unit 9 – Core content

Dr/Cr

Hedged item

Cr/Dr

Gain or loss on hedged item

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Financial Accounting & Reporting

Chartered Accountants Program

Cash flow hedges In a cash flow hedge the focus is on the change in the fair value of the hedging instrument and how much of this change may be recognised in a reserve account rather than P&L. In a cash flow hedge, the effective portion of the fair value change in the hedging instrument is recognised in the cash flow hedge reserve (CFHR) with the current year movement in the CFHR disclosed in OCI. Note: The concept of cash flow hedging can be difficult to understand. You may wish to review the explanation above after working through the ‘May-Son’ example below. The ‘lower of’ test In a cash flow hedge, the effective portion of the hedge that can be deferred to the CFHR is limited to the lesser of (in absolute amounts) the: •• cumulative gain or loss on the hedging instrument from inception of the hedge, and •• cumulative change in fair value of the hedged item from inception of the hedge. This can be referred to as the ‘lower of’ test. The ineffective portion is the balancing figure in the cash flow hedge reserve journal entry and is recognised in profit or loss. The ‘lower of’ test is applied to work out where the change in the value of the hedging instrument should be recognised – in the CFHR or P&L. This can be illustrated as follows:

Hedged Item 50

Hedging Instrument 50

ged Hed Item 50

For an item being hedged that moves by 50, a hedging instrument (derivative) that changes in fair value by the same amount (i.e. 50) perfectly offsets the fair value change of the item being hedged

ging Hed ment u r t Ins 40

If the fair value change of the hedging instrument (derivative) is less (e.g. 40), this is less economically effective, but no amount will be recognised in profit or loss

Hed g Item ed 50

He Inst dging rum e 60 nt

If the fair value change of the hedging instrument (derivative) is more (e.g. 60), then the additional change compared to the change in fair value of the hedged item (i.e. 10) will be recognised in profit or loss. Think of this as being over-hedged

Where the change in value of the hedging instrument is recognised using the ‘lower of’ test Fair value movement of hedged item

Fair value movement of hedging instrument (derivative)

Cash flow hedge reserve

Profit or loss

Debit/(Credit)

Debit/(Credit)

Debit/(Credit)

Debit/(Credit)

50

(50)

50

-

50

(40)

40

-

50

(60)

50

10 loss*

(50)

50

(50)

-

(50)

40

(40)

-

(50)

60

(50)

(10) gain*

* This is because the change in value of the hedging instrument is greater than the amount recognised in the CFHR – the difference is recognised in P&L

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Financial Accounting & Reporting

FIN fact Correctly applying the ‘lower of’ test is critical to correctly accounting for a cash flow hedge. When applying the test, you must interpret the information provided to calculate the cumulative values since the inception of the hedge rather than just the movement since the last reporting date. Treatment of the balance in the CFHR for a qualifying hedge relationship The balance in the CFHR remains in equity until the end of the qualifying hedging relationship, at which time it is: Recognised in profit or loss

OR

When the hedged item affects profit or loss (i.e. when the hedged item is sold, settled or otherwise realised)

Used to adjust the initial carrying value of the asset or liability

When the hedged item is a forecast transaction that results in the recognition of a non-financial asset (e.g. inventory) or a non-financial liability.

Accounting for a cash flow hedge relationship The process for accounting for a cash flow hedge can be broken down into the following steps: Cash flow hedge accounting Hedged item

Hedging instrument and recognition of CFHR balance

Step 1 – Current fair value Apply normal IFRS standards to Determine the fair value of the hedging instrument at the account for the hedged item e.g. IAS 21 reporting date (FX), IAS 16 (PP&E), IAS 2 (Inventory) There will be no entries to initially record for a firm commitment or a highly probable forecast transaction Determine the fair value of the hedged item at the reporting date (whether recognised or not) Step 2 – Cumulative change in value since inception Determine the cumulative change in fair value of the hedged item since inception of the hedge

Determine the cumulative change in fair value of the hedging instrument since inception of the hedge

Step 3 – CFHR balance Apply the ‘lower of’ rule (IFRS 9 para. 6.5.11) to determine the balance that can be recognised in the CFHR. The CFHR balance is the lower of: •• The cumulative gain or loss on the hedging instrument from inception of the hedge, AND •• The cumulative change in fair value of the hedged item from inception of the hedge Use absolute values (i.e. change negatives to positives) Step 4 – Change in value since last reporting date Determine since the last reporting date the: •• change in fair value of the hedging instrument, and •• change in value of the CFHR required to achieve the balance calculated in Step 3

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Chartered Accountants Program

Cash flow hedge accounting Hedged item

Hedging instrument and recognition of CFHR balance

Step 5 – CFHR journal entry Prepare the journal entry to recognise the fair value of the hedging instrument at the reporting date: Dr/Cr Hedging instrument – this is the movement in the hedging instrument since the last reporting date calculated at Step 4 Cr/Dr CFHR (effective portion) – this is the movement in the CFHR since the last reporting date calculated in Step 4 to bring the CFHR to the ‘lower of’ balance calculated in Step 3 Hint: If the hedging instrument is an asset then the balance in the CFHR will be a credit (and vice versa) If the journal entry balances then there is no hedge ineffectiveness. If the journal entry does not balance then recognise: Cr/Dr Gain or loss on hedging instrument (ineffective portion – profit or loss) Step 6 – Has cash flow been recognised? Determine if the cash flow being hedged is recognised in the current period as an asset or liability (e.g. inventory or PPE), or impacts profit or loss (e.g. sales or interest payments). This means the hedging relationship has now finished and the hedging instrument will be settled. If so, move to Step 7 Step 7 – Reclassification of CFHR balance Settle the hedging instrument with the counterparty (eg Dr Cash, Cr Hedging Instrument) Depending on the cash flow being hedged, reclassify the accumulated amount calculated in Step 3 against: The value of the asset / liability (if the cash flow is recognised as an asset or liability)

OR

Profit or loss (if the cash flow impacts P&L)

Dr/Cr CFHR

Dr/Cr CFHR

Cr/Dr The asset or liability

Cr/Dr Gain or loss on hedging instrument reclassified to profit or loss

This entry gives effect to the purpose of the hedge by matching the effective hedging instrument movement with the cash flow being hedged

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Example – Cash flow hedge accounting May-Son has received a sales order from a customer in Singapore on 29 May 20X7. The sale is denominated in Singapore dollars (SGD) and totals SGD4,000,000. May-Son’s functional currency is the Australian dollar (AUD). May-Son has a risk management strategy of minimising the risk relating to foreign currency cash flows. In accordance with this strategy and to create certainty over the AUD value of the cash flow, May-Son hedges the cash to be received from the customer from the invoiced sale. It entered into an FX forward contract to be settled net in cash on 15 July 20X7 when the customer is expected to pay the invoiced amount upon recognition of the sale. The FX forward contract specifies that May-Son will sell SGD4,000,000 for AUD3,603,604 based on a forward exchange rate of AUD1 = SGD1.11. The FX forward contract settled on 15 July 20X7, which was the date the sale was recognised and the customer paid the invoice. All required hedge documentation was in place at the inception of the hedge when a cash flow hedge relationship was designated between the firm commitment and the FX forward contract. The hedge was effective for its entire term. The following information pertaining to the cash flow hedge was obtained from May-Son’s treasury department: Changes in the value of the future cash flow of SGD4,000,000 Date

Spot rate

Forward exchange rate to 15.07.X7

Fair value of the firm commitment

AUD

Cumulative change in fair value of the firm commitment since inception AUD

Change in fair value of the firm commitment since last reporting date AUD

29.05.X7

AUD1=SGD1.12

AUD1=SGD1.11

3,603,604

0

0

30.06.X7

AUD1=SGD1.15

AUD1=SGD1.14

3,508,772

(94,832)

(94,832)

15.07.X7

AUD1=SGD1.18

AUD1=SGD1.18

3,389,831

(213,773)

(118,941)

Changes in the fair value of the hedging instrument Date

Fair value of Change in fair the FX forward value of the FX contract* forward contract since last reporting date AUD AUD

29.05.X7

0

0

30.06.X7

104,000 asset

104,000

15.07.X7

213,773 asset

109,773

* These values are provided and cannot be derived from the other information in the table.

Journal entries to be recognised over the life of the hedging relationship: 29 May 20X7 Hedged item Step 1 – The fair value of the firm commitment is $3,603,604. There is no entry to be recognised as the firm commitment does not result in the recognition of a transaction in the financial statements.

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Hedging instrument Step 1 – When the FX forward contract was entered into on 29 May 20X7, it had a fair value of zero and accordingly, there is no transaction to be recognised. 30 June 20X7 Hedged item Step 1 – the fair value of the firm commitment is $3,508,772. There is no entry to recognise Hedging instrument Date

Description

Dr $

30.06.20X7

FX forward contract [statement of financial position]

Cr $

104,000

Cash flow hedge reserve [equity]*

94,832

Gain on hedging instrument (ineffectiveness) [P&L]

9,168

To measure the FX forward contract asset at fair value. The effective portion of the hedge is recognised in the CFHR (disclosed in OCI); the ineffective portion in profit or loss *Disclosed in OCI

Step 1 – the FX forward contract is a derivative and must be measured at fair value, which at 30 June 20X7 is a $104,000 asset. Step 2 – the cumulative change in fair value of the cash flow being hedged since inception of the hedge is $94,832 (being $3,508,772 – $3,603,604, and also provided in the table). The cumulative change in fair value of the FX forward since its inception is $104,000 (being the fair value of $104,000 – $0). Step 3 – Amount to be recognised in the CFHR at 30 June 20X7 Apply the ‘lower of’ test (in absolute terms, i.e. make negative values positive) Cumulative gain or loss on the hedged item* since the beginning of the hedge (*the future cash flow to be received from the customer)

Cumulative gain or loss on the hedging instrument* since the beginning of the hedge (*the FX forward contract)

$94,832

$104,000

This is the lower value and is the amount to be recognised in the CFHR

Step 4 – since the last reporting date, the change in value of the FX forward is $104,000 Dr (since this is the first period of the hedge, this is the same as its cumulative change in value since inception). The balance in the CFHR at the last reporting date is zero. The balance it needs to be at 30 June 20X7 is $94,832 Cr (from Step 3 – a credit because the value of the FX forward is a debit), so the change in value required is $94,832 Cr. Step 5 – the journal entry is therefore to Dr the FX forward by $104,000 and Cr the CFHR by $94,832. Does the journal entry balance at this stage? No. There is a debit of $104,000 and a credit of $94,832. This means there is hedge ineffectiveness, so the difference of $9,168 Cr must be recognised in P&L. Step 6 – the cash flow being hedged has not yet been recognised in P&L, so no further journal entries are required.

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15 July 20X7 Hedged item Step 1 – the hedged item transaction is now recognised and impacts P&L (sales revenue). Date

Description

15.07.20X7

Cash

Dr $

Cr $

3,389,831

Sales revenue

3,389,831

Being recognition of sale and receipt of cash from Singapore customer at the FX spot rate (SGD4,000,000 ÷ 1.18)

Hedging instrument Date

Description

Dr $

15.07.20X7

FX forward contract [statement of financial position]

Cr $

109,773

Cash flow hedge reserve [equity]*

118,941

Loss on hedging instrument (ineffectiveness) [P&L]

9,168

To measure the FX forward contract asset at fair value. The effective portion of the hedge is recognised in the CFHR (disclosed in OCI); the ineffective portion in profit or loss *Disclosed in OCI

Step 1 – the FX forward contract is a derivative and must be measured at fair value, which at 15 July 20X7 is a $213,773 asset. Step 2 – the cumulative change in fair value of the cash flow being hedged since inception of the hedge is $213,773 (being $3,389,831 – $3,603,604, and also provided in the table). The cumulative change in fair value of the FX forward since its inception is also $213,773 (being the fair value of $213,773 – $0). Step 3 – Amount to be recognised in the CFHR at 15 July 20X7 Apply the ‘lower of’ test (in absolute terms, i.e. make negative values positive) Cumulative gain or loss on the hedged item* since the beginning of the hedge (*the future cash flow to be received from the customer)

Cumulative gain or loss on the hedging instrument* since the beginning of the hedge (*the FX forward contract)

$213,773

$213,773

Both values are the same therefore $213,773 is the amount to be recognised in the CFHR

Step 4 – since the last reporting date (30 June 20X7), the change in value of the FX forward is $109,773 Dr (since the asset has increased in value from $104,000 to $213,773). The balance at 30 June 20X7 (the last reporting date) in the CFHR is $94,832 Cr (from the journal entry above at 30 June 20X7). The balance it needs to be at 15 July 20X7 is $213,773 Cr (from Step 3), so the change in value required is $118,941 Cr. Step 5 – the journal entry is therefore to Dr the FX forward by $109,773 and Cr the CFHR by $118,941. Does the journal entry balance at this stage? No. There is a debit of $109,773 and a credit of $118,941. This means there is hedge ineffectiveness, so the difference of $9,168 Dr must be recognised in P&L.

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Step 6 – the cash flow being hedged has been recognised in P&L in the current period as sales revenue (ie on 15 July 20X7). Step 7 – the FX forward contract was an asset and will be settled on 15 July 20X7 by May-Son receiving cash of $213,773. Date

Description

15.07.20X7

Cash

Dr $

Cr $

213,773

FX forward contract

213,773

Being settlement of the FX forward contract asset, settled net in cash

The hedging relationship has now finished, so the accumulated amount in the CFHR ($213,773 Cr) needs to be reclassified to P&L since the cash flow being hedged was recognised in P&L. IFRS 9 para 6.5.11(d)(ii) requires the reclassification of the CFHR balance to profit or loss to correspond with the timing of the profit or loss impact of the hedged cash flow from the customer, that is, when the sale is recognised. Date

Description

15.07.20X7

CFHR

Dr $

Cr $

213,773

Gain on hedging instrument reclassified to profit or loss [P&L]

213,773

Being reclassification of CFHR balance on settlement of the hedge from equity to profit or loss

Overall impact of the cash flow hedging relationship What did the cash flow hedge relationship achieve? AUD$3,389,831

Cash received from the customer

AUD$213,773

Cash received when the FX forward contract was settled

Total $3,603,604

This is equivalent to SGD4 million ÷ 1.11 forward exchange rate

The cash receipt from the customer was locked in at AUD$3,603,604

Key points to note about cash flow hedges: •• They are used to manage the variability in cash flows for a hedged item. •• A highly probable forecast transaction can only be designated as a hedged item in a cash flow hedge relationship but not in a fair value hedge relationship. •• The normal IFRS accounting rules are applied to the accounting for the hedged item. •• Special rules are applied when accounting for the hedging instrument (‘lower of’ rule and reclassification of the CFHR balance).

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Financial Accounting & Reporting

The hedging relationships explained in this unit can be summarised as follows: Hedge

Fair value hedge

Cash flow hedge

Hedged items

Value of recognised asset

Cash flows of recognised asset

Value of recognised liability

Cash flows of recognised liability

FX risk of unrecognised firm commitment

FX risk of unrecognised firm commitment

Value of unrecognised firm commitment

Cash flows of highly probable forecast transaction

Worked example 9.2: Hedge accounting for a cash flow and fair value hedge [Available online in myLearning]

Unit 9 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Disclosure Required reading IFRS 7 paras 6–42

Overview of requirements IFRS 7 disclosures encompass two broad areas. Under IFRS 7 entities are required to disclose information that enables users to understand and evaluate: 1. The significance of financial instruments to an entity’s financial position and performance. 2. The nature and extent of risks arising from financial instruments to which the entity is exposed, and how these are managed. Broadly, IFRS 7 achieves the first of these by mandating the specific disclosure of information that is based on accounting records and classifications. These disclosures are detailed but relatively straightforward. As to the second, IFRS 7 attempts to provide users with an ‘inside view’ of the risks to which an entity is exposed. This requires the entity’s management to disclose information based on how it views these financial risks, with a minimum standard of information being required by IFRS 7. Because there are many different ways to view and report risk, and much of this information is not directly available in the accounting system, providing these IFRS 7 disclosures can be quite challenging for entities. In addition, IFRS 13 requires disclosure of the valuations, techniques and inputs used to measure the fair value of financial instruments, as well as the effect of fair value measurements using Level 3 inputs on profit or loss or other comprehensive income for the period.

Classes of financial instruments for disclosure purposes Some of the IFRS 7 disclosures are required to be made by ‘class of financial instrument’, taking into account the nature and characteristics of those financial instruments. A class of financial instrument may require the disaggregation or aggregation of items at a more detailed level than that which is presented in the statement of financial position or in the financial instrument categories under IFRS 9. Significant judgement may be required to achieve an appropriate balance between the quantity and depth of information that is disclosed, and the usefulness of the information. The classes used will therefore vary between different entities, but are often similar to the classes used for common financial instruments covered earlier in the unit. For example, an entity’s classes of financial instruments might include cash and cash equivalents, trade receivables, corporate bonds, and government bonds. Further reading The preparation of disclosures relating to financial instruments is beyond the scope of this unit. An example of financial instrument is contained in the Woolworths 2018 annual report, available at www.woolworthsgroup.com.au/page/investors/our-performance/reports/Reports/Annual_ Reports/ Working paper E You are now ready to complete working paper E of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

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Financial Accounting & Reporting

Appendix 1 – Definitions of common terms and concepts Common financial instruments Type of instrument

Features

Bank bills

A short-term money market security with maturities generally ranging from 30 to 180 days. Generally offered at a discount to its expected value when it matures

Bonds

Debt securities that are issued for a period greater than one year (and up to 30 years) for the purpose of raising capital. The most common bonds are those issued by governments and corporations. Bonds involve a repayment of principal amount (sometimes called face value) at the maturity date, and (usually) payments of interest at a fixed rate (sometimes called coupons) over the term of the bond The interest rate on a bond is determined by the perceived repayment ability of the borrower. The fair value of a bond may also change based on market interest rates and inflation in an inverse relationship (i.e. higher market interest rates compared to the interest rate on the bond and inflation lead to lower bond prices)

Cash and cash equivalents

‘Cash and cash equivalents’ is an accounting concept that includes cash on hand, demand deposits and short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value

Convertible bonds or notes

Types of corporate bonds that can be converted into ordinary or preference shares of the issuer at some point in the future, usually at the option of the holder

Debt securities

At their most basic, debt securities are written promises to repay debts on specified terms. Sometimes called interest-bearing securities, they come in a variety of forms, two of the most common being bonds and notes. They are generally tradeable securities

Derivative

Collective term for an instrument with the following features: •• Its value changes according to changes in value of an agreed underlying asset, index or security (such as bonds, commodities, currencies, interest rates, market indices or shares) •• It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors •• It is settled at a future date Derivatives may be traded directly between counterparties (over-the-counter (OTC)) and tailored specifically to their individual needs, or on an exchange with standard terms and conditions relating to aspects such as contract size, maturity date and the underlying asset (exchange-traded)

Forward rate agreement (FRA)

A financial instrument used to hedge interest rate risk, and is based on a notional principal amount. In that sense, it is similar to an interest rate swap. FRAs are relatively simple, short-term (up to one year) OTC instruments with one settlement date

Futures

A futures contract is a legally binding agreement to buy or sell a commodity or financial asset at a fixed price at a specific time in the future. All futures contracts have the following features: •• They are standardised (each futures contract of a certain type is identical in terms of quality, quantity and delivery date) •• They are traded on an exchange •• Their prices are quoted •• Their settlement is through a clearing house

Loans

Unit 9 – Core content

Advances of money from lenders to borrowers over a period of time, with repayment of the principal amount either at intervals during the loan period or at the end of the loan. Interest rates that apply to loans may be fixed or variable. In contrast to debt securities, loans are not tradeable

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Common financial instruments Type of instrument

Features

Notes

Short-term to medium-term debt securities, usually maturing within five years or less. Interest rates that apply to notes may be fixed or variable

Options

A contract conveying to the option holder the right (not the obligation) to buy or sell a specified asset at a fixed price before or at a future expiration date. The price of an option is called a premium There are two types of options: •• A call option confers on the holder the right to buy (i.e. call) the underlying asset at a fixed price •• A put option confers on the holder the right to sell (i.e. put) the underlying asset at a fixed price A European option is exercisable only on the option’s expiry date. An American option is exercisable at any time up to the option’s expiry date

Ordinary shares

Residual ownership in a company. Ordinary shares give the holder an entitlement to a share of any dividends issued by the company, and the right to vote in its annual general meetings. Shares may be traded either privately or on an exchange (if the company is listed), and the value is determined by market forces

Preference shares

A form of shares issued by a company where, depending on the terms of the share issue, the holders are usually entitled to a fixed dividend before dividends are paid to ordinary shareholders, but do not usually have voting rights. In the event of a company winding up, preference shares rank above ordinary shares

Swaps

An OTC contract between two parties to exchange multiple payments over periods greater than one year (and up to 15 years) based on a notional principal amount The most common form of swap is an interest rate swap. This involves the exchange of fixed and floating interest payments based on a notional principal amount and is generally entered into as a hedge against interest rate risk Swaps may also be cross-currency, which involves an exchange of interest payments in one currency for interest payments in another currency based on the respective notional principal amounts

Trade payables

Amounts owing by an entity for goods and services it has received on credit. Also referred to as accounts payable

Trade receivables

Amounts that are due to an entity from another entity for goods and services it supplied on credit. Also referred to as accounts receivable

Finance and accounting terms Term

Non-accounting definition

Bank bill swap rate (BBSW)

The rate at which banks in Australia commonly lend to each other. It is derived from a compilation and average of market rates of bank bills supplied daily by Australian banks for specific maturities up to six months

Basis risk

The risk that two different financial instruments in a hedging strategy will not experience exactly offsetting price or rate movements

Bid price

The price that a buyer is willing to pay for shares

Dividends or distributions Portion of an entity’s earnings that is distributed to its shareholders (or a class thereof ). Often expressed in terms of an amount per share Exchange

Organised marketplace where securities, commodities, derivatives and other financial instruments are traded. May also be called ‘stock exchange’, ‘futures exchange’ etc. based on the type of instrument(s) being traded

Gains/losses

Increase/decrease in the value of an asset, or decrease/increase in the value of a liability

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Finance and accounting terms Term

Non-accounting definition

Interest

Charge exacted on money that is borrowed, or income received for money that is lent. Usually expressed as an annual percentage of the principal or notional amount. In accounting terms, interest is treated separately from any gain or loss

Net settlement

In relation to a derivative, a payment settlement system within a contract where only the net differential is transferred between the two parties to conclude the contract

Nominal value

Stated value of an issued security, sometimes known as face value or par value. The nominal value of a security remains fixed for the duration of its life, in contrast to its market value, which varies. For example, a bond may have a nominal value of $1,000 (being the amount repaid at maturity), but will be issued, and traded, at a different market value based on its terms, market interest rates, inflation, and so on

Notional value

Total value of a leveraged position’s assets at the current price. (Leverage is the use of financial instruments or borrowings to increase the exposure to an investment, increasing the potential risk and return on the investment.) Often used in the derivatives markets because a very small amount of money can be used to control a large position. As an example, one S&P 500 Index* futures contract obligates the buyer to purchase 250 units of the S&P 500 Index (or settle in cash). If the index is trading at $1,000, the futures contract equates to an investment of $250,000 (250 × $1,000). Therefore, $250,000 is the notional value underlying the futures contract, as compared to its actual value, which would be substantially lower

Offer price

The price that a seller is willing to accept for shares. Also referred to as ‘ask price’

Settlement date

The date that an asset is delivered to or by an entity. Generally, financial instruments ‘settle’ within a few days of the trade date

Spot price

The current price at which a particular item can be bought or sold

Trade date

The date that an entity commits itself to purchase or sell an asset

Transaction costs

Under IFRS 9, transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or liability An incremental cost is one that would not have been incurred if the entity had not acquired, issued, or disposed of the financial instrument

Underlying item

In derivatives, the index, security or other asset – such as shares or commodities – on which the contract is based

*  Standard & Poor’s 500, which is a stock market index of the top 500 US companies

Terms relating to financial instruments Term

Definition

Amortised cost

The amount at which the financial asset of liability is measured at initial recognition minus principal amount repayments, plus or minus the cumulative amortisation (using the effective interest rate method) of any difference between that initial amount and the maturity amount minus (for financial assets) any reduction for impairment or uncollectability

Compound financial instrument

A financial instrument that contains both a financial liability and an equity component from the issuer’s perspective

Credit loss

The difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (i.e. all cash shortfalls), discounted at the original effective interest rate

Credit risk

The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation

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Terms relating to financial instruments Term

Definition

Effective interest rate

The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, through a shorter period to the net carrying amount of the financial asset or liability

Effective interest rate method (EIM)

A method of calculating amortised cost and interest income or interest expense using the effective interest rate of a financial asset or financial liability (or group of financial assets or financial liabilities)

Embedded derivative

A feature within a host non-derivative contract such that the cash flows associated with that feature behave in a similar fashion to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified based on a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable In the same way that derivatives must be accounted for at fair value in the statement of financial position with changes recognised in the statement of comprehensive income, so too must some embedded derivatives. IFRS 9 requires that an embedded derivative be separated from its host contract and accounted for as a derivative in certain prescribed circumstances

Equity instrument

Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities

Fair value

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

Financial asset

Any asset that is: •• cash •• an equity instrument of another entity •• a contractual right to –– receive cash or another financial asset from another entity –– exchange financial instruments with another entity under conditions that are potentially favourable •• a contract that will or may be settled in the entity’s own equity instruments if it is: –– a non-derivative for which the entity is or may be obliged to receive a variable number of its own equity instruments –– a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments

Financial guarantee contract

A contract that requires the issuer to make specified payments to reimburse the holder for a loss they incur because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument

Financial instrument

Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity

Financial liability

Any liability that is: •• a contractual obligation to –– deliver cash or another financial asset to another entity –– exchange financial instruments with another entity under conditions that are potentially unfavourable •• a contract that will or may be settled in the entity’s own equity instruments where the contract is either a non-derivative for which the entity may have to deliver a variable number of own equity instruments, or a derivative that will be settled other than by exchange of a fixed amount of a financial asset for a fixed number of own equity instruments

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Financial Accounting & Reporting

Terms relating to financial instruments Term

Definition

Financial liability at fair value through profit

A financial liability that

or loss

(b) upon initial recognition is designated by the entity as at fair value through profit or loss in accordance with IFRS 9 para. 4.2.2 or 4.3.5

(a) meets the definition of held for trading

(c) is designated either upon initial recognition or subsequently as at fair value through profit or loss in accordance with IFRS 9 para. 6.7.1 Held for trading

A financial asset or liability that is: (a) acquired or incurred principally for the purpose of selling or repurchasing it in the near term (b) on initial recognition, part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking (c) a derivative (except for a derivative that is a designated and effective hedging instrument)

Hybrid contract

A contract that includes a non-derivative host and an embedded derivative. An example is a convertible debt instrument which combines an interest-bearing debt instrument (a non-derivative) with an option on equity shares (a derivative)

Insurance contract

A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder

Past due

A financial asset is past due when a counterparty has failed to make a payment when that payment was contractually due

Regular way contracts

Contracts for the purchase or sale of financial assets that require delivery of the assets within the time frame generally established by regulation or convention in the marketplace concerned

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Appendix 2 – Derivatives Derivatives ‘derive’ their value from underlying financial instruments, commodities, prices or an index and are widely used by entities to manage risk. Examples of common derivatives are in the following table: Common derivatives Derivative

Definition and explanation

Forward rate contract

A contract that places an obligation on one party to buy a financial instrument, commodity or currency, and another party to sell that instrument, commodity or currency at a specified future date. Also called a ‘forward’. Forwards are OTC financial instruments, whereby the terms of the contract are determined by the buyer and seller As a forward involves an obligation to make an exchange, the value of the contract may be either positive or negative to the holder if the price of the underlying item changes during the term of the forward

Futures

These are a form of forward contract traded on a formal exchange. As such, futures have standardised terms to facilitate trading. They are often ‘closed’ by making an offsetting trade on the exchange, or settled in cash without taking or making delivery of goods

Option

A contract that gives the buyer/holder the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price (the ‘exercise price’ or ‘strike price’) at or within a specific period of time, regardless of the market price of that instrument. There are many different types of options, but the two most common are put options and call options (see below) The seller/writer of the option is in the opposite position to the buyer, in that they have the obligation to deliver or purchase the underlying item (or settle in cash) if the option is ‘exercised’ by the buyer Unlike many other derivatives, for the buyer there is an initial price (or premium) for purchasing the option. The buyer’s potential loss is limited to this amount, because if the movement in the value of the underlying item is unfavourable from the buyer’s perspective, they simply will not exercise the option and it will ‘expire’. Therefore, for the option holder, the value of the option cannot be less than zero. For the seller, the potential loss is unlimited and the value of the option may be negative

Call option

An instrument that gives the buyer/holder the option to buy an underlying item at a specific price (exercise or strike price). The option becomes more valuable to the buyer/ holder as the market price of the underlying item goes up, and less valuable as the price goes down. When the market price is above the exercise price, it is said to be ‘in the money’. For example, if the market price of a security is $7, the holder of a call option on that security with a strike price of $5 could exercise the option and buy the security from the option writer for $5, being $2 below the current market value If the market price is below $5, the option is ‘out of the money’ and would not be exercised by the holder as it would be cheaper to buy the security on the market

Put option

An instrument that gives the buyer/holder the option to sell the underlying item at a specific price (exercise or strike price). The option becomes more valuable as the price of the underlying item falls, and less valuable as the price goes up. When the market price is below the exercise price, it is said to be ‘in the money’. For example, if the market price of a security is $7, the holder of a put option on that security with a strike price of $9 could exercise the option and sell the security to the option writer for $9, being $2 above the current market value If the market price is above $9, the option is ‘out of the money’ and would not be exercised by the holder as they would be better off selling the security on the market

Swap

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Exchange of streams of payments over time according to specified terms. The most common types of swaps are interest rate swaps and currency swaps (see below)

Core content – Unit 9

Chartered Accountants Program

Financial Accounting & Reporting

Common derivatives Derivative

Definition and explanation

Interest rate swap

A swap in which the two counterparties agree to exchange interest rate flows over a period, but without any principal being exchanged. Typically, one party agrees to pay a fixed interest rate on a specified principal amount (the notional principal) on a specified series of payment dates, and the other party pays a floating rate on the notional principal based on a market benchmark interest rate on those payment dates. The value of the swap to both parties will change depending on the movement in the market benchmark interest rate after the swap commences. For example, if the market benchmark interest rate goes up, the swap party paying the fixed rate of interest will be better off as they will receive higher interest payments going forward, while their obligations will not change – for them, the swap will have positive value. In contrast, the swap will have negative value for the party paying the floating rate. Often, interest rate swaps are net-settled

Currency (foreign exchange (FX)) swap

A swap that involves the exchange of a series of cash flows in one currency (e.g. US dollars) for a series of cash flows in another currency (e.g. Japanese yen) on a specified schedule of dates between two parties The value of the swap will change depending on the movement in the relative values of the currencies, and can be either positive or negative for either party at any given time

Under IFRS 9, derivatives are held for trading financial instruments and are measured at fair value through profit or loss, unless they are designated hedging instruments in a hedging relationship. They are used predominantly as a means of managing financial risk that entities become exposed to through their day-to-day operations.

Example – Derivative George Miller grows wheat. He is concerned about the price he will obtain for this year’s crop. The current price of wheat is $5.50 per bushel and the standard contract size in the futures market is 5,000 bushels. George hopes the price will rise by the time he wants to sell his wheat crop in six months. He has 500,000 bushels to sell. The market expects the price of wheat to be $6.00 per bushel in six months. George could take no action now, and just hope the price increases by the time he comes to sell his wheat. Another option is to hedge his price risk by selling the wheat forward in the futures market so that he locks in a selling price of $6.00 per bushel. To do this he would sell 100 futures contracts for delivery at $6.00 per bushel in six months’ time. In six months, the price may fall lower than $6.00 per bushel. In this case, George has made more on his wheat than he would have if he had not hedged his price risk. On the other hand, the price may rise to above $6.00 per bushel. George would have been better off if he hadn’t hedged, but he thinks the cost of the certainty he has created through hedging is worth paying to ensure he does not receive less than $6.00 per bushel.

Net settling If an entity enters into contracts to buy or sell non-financial items for the purpose of receipt or delivery of those items in accordance with the entity’s normal business requirements, these contracts are outside the scope of IFRS 9. However, if the contracts can be settled net in cash or another financial instrument, an entity may designate the contract as a derivative and IFRS 9 applies to it. The ability to settle net in cash may not be explicit in the terms of the contract, but an entity may have a practice of settling similar contracts net in cash. This may be done by entering into offsetting contracts or by selling the contract before its exercise or lapse.

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Example – Net settling Black Sheep Coal Mines (Black Sheep) enters into a futures contract to sell 50,000 tonnes of coal in four months for a fixed price. Black Sheep frequently manages its coal price risk in this manner, and has a practice of settling such contracts net in cash by entering into an offsetting buy contract close to settlement date. Black Sheep accounts for this futures contract as a financial instrument. If Black Sheep were in the practice of delivering coal in settlement of the contract, then the contract would not be a financial instrument and would be outside the scope of IFRS 9.

Embedded derivatives An embedded derivative is a component of a hybrid contract that also includes a non-derivative host. The effect is that some of the cash flows of the contract vary in a way similar to a standalone derivative. Examples of embedded derivatives are provided below. •• A lease contract contains a provision for rentals to increase each year in line with inflation. The entire lease contract is a hybrid contract containing a lease contract host and an embedded derivative of the adjustment for inflation •• A company in Australia sells iron ore in USD to a company in China with a functional currency of Renminbi. The hybrid contract is the entire sale contract. The host contract is the sales contract and the embedded derivative is the foreign exchange USD/CNY forward rate implicit in the contract. Embedded derivatives are not covered in detail in this unit.

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Unit 10: Impairment of assets Contents Introduction 10-3 Scope of IAS 36 10-3 Key concepts What is an impairment loss Impairment loss rules may be applied to an individual asset or to a cash generating unit (CGU) When to undertake impairment testing under IAS 36 Determining whether there is any indication that an asset may be impaired Determining the recoverable amount Determining whether to assess impairment at an individual asset level or at a CGU level

10-4 10-4 10-4 10-5 10-5 10-6 10-7

Accounting for an impairment loss under IAS 36 – individual assets

10-8

Determining and accounting for impairment losses under IAS 36 – CGUs and goodwill Identifying a CGU Consistency in determining the carrying amount and recoverable amount for a CGU Complications with CGUs

10-9 10-10 10-10 10-12

Reversal of an impairment loss under IAS 36 Reversal of an impairment loss for an individual assets Reversal of an impairment loss in a CGU

10-15 10-16 10-19

Other complications Interim financial reporting and impairment Existence of a non-controlling interest and the impact on goodwill impairment

10-20 10-20 10-20

fin31910_csg_02

Disclosures 10-20

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Learning outcomes At the end of this unit you will be able to: 1. Explain and account for an impairment loss for an individual asset. 2. Identify, explain and account for an impairment loss for a cash-generating unit (CGU) including impairment of goodwill. 3. Explain and account for reversals of impairment losses.

Introduction The value of an entity’s assets may fluctuate, particularly in challenging economic times. Because of the risk of overstatement of assets, corporate regulators, including the Australian Securities and Investments Commission (ASIC), often focus on compliance with IAS 36 Impairment of Assets. As per ASIC’s media release: The recoverability of the carrying amounts of assets such as goodwill, other intangibles and property, plant and equipment continues to be an important area of focus. (Source: ASIC 2017, (Attachment to 16-428MR: ASIC calls on directors to apply realism and clarity to financial reports), media release, December, accessed 16 April 2018, http://asic.gov.au/about-asic/mediacentre/find-a-media-release/2016-releases/16-428mr-asic-calls-on-preparers-to-focus-on-useful-andmeaningful-financial-reports/)

The main purpose of IAS 36 is to ensure that the carrying amount of an asset does not exceed its recoverable amount in the statement of financial position. The standard requires the recognition of an impairment loss when this occurs. Unit 10 overview video [Available online in myLearning]

Scope of IAS 36 Paragraphs 2–5 of IAS 36 identify the scope of the standard, which can be summarised as follows: Assets in scope of IAS 36 include: • Property, plant and equipment • Identifiable intangible assets • Goodwill

Assets out of scope of IAS 36 include: • Financial assets (limited exceptions)

IFRS 9

• Certain contract assets with customers

IFRS 15

• Inventories

IAS 2

• Deferred tax assets

IAS 12

• Non-current assets (or disposal groups) classified as held for sale

IFRS 5

These other standards establish their own valuation rules

FIN fact An impairment loss is never allocated to a liability. Only assets can be impaired. Required reading IAS 36.

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Key concepts This section outlines some key concepts from IAS 36 that are critical to calculating and accounting for an impairment loss.

What is an impairment loss An impairment loss is defined in IAS 36 para. 6 as the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable amount. The method for calculating impairment loss can be shown as follows:

Carrying amount

Impairment loss

Recoverable amount

Higher of*

Fair value less costs of disposal (FVLCOD)

Value in use (VIU)

* It is not always necessary to determine both an asset’s fair value less costs of disposal and its value in use. If either of these amounts exceeds the asset’s carrying amount, the asset is not impaired and it is not necessary to estimate the other amount (IAS 36 para 19).

Impairment loss rules may be applied to an individual asset or to a cash generating unit (CGU) The rules in IAS 36, which will be explained in detail in this unit, determine whether there is an impairment loss either for an individual asset or for a cash-generating unit (CGU). This can be illustrated as per the diagram below: Application of impairment loss rules Individual asset

CGU (e.g. a division of a business) A CGU is defined as…the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets

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The limousine is an individual asset that generates cash inflows from being hired

The factory is a CGU as the factory assets work together to generate cash inflows

An impairment loss is recognised for the limousine if it is impaired

An impairment loss is recognised for the factory CGU if it is impaired. The CGU impairment loss is then allocated to the individual factory assets

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When to undertake impairment testing under IAS 36 An entity is required to conduct impairment tests on its assets to determine whether it has incurred any impairment losses. However, this does not mean that all its assets need to be tested every reporting period. The general rule under IAS 36 para. 9 states that an entity needs to assess at each reporting date whether there is any indication that an asset may be impaired. If there is an indication that an asset may be impaired, the entity has to estimate the recoverable amount of the asset. If there is no indication that an asset may be impaired, the entity is not required to make a formal estimate of the recoverable amount of that asset. When to test for impairment All assets within the scope of IAS 36 At the end of the reporting period is there any indication of impairment for an asset (IAS 36 para. 9)? Yes

Estimate the recoverable amount of the asset to determine whether there is an impairment loss

Additional rules for certain assets

No

No action to be taken

Identifiable intangible assets • Intangible assets with an indefinite life • Intangible assets that are not yet ready for use (e.g. capitalised development costs) Perform impairment test annually which may be at any time during an annual period, provided it is performed at the same time every year (IAS 36 para. 10(a))

Goodwill Perform impairment test annually following rules detailed later in the unit (IAS 36 para. 10(b))

Determining whether there is any indication that an asset may be impaired It may be quite obvious from simply looking at a particular asset, or knowing its history, that it is no longer worth what it was previously. IAS 36 provides a list of indications that management should, at a minimum, consider when assessing whether there is any indication of impairment of an asset. Under IAS 36 para. 12, indications of impairment may come from the following two sources of information: •• External sources. •• Internal sources. From these sources of information, the entity needs to consider the following when assessing whether there is any indication of impairment:

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External sources

Internal sources

•• Significant decline in the market value of an asset

•• Evidence of obsolescence or physical damage of an asset

•• Significant changes that adversely affect the entity in the technological, market, economic or legal environment in which it operates •• Increases in market interest rates or other market rates of return that are likely to affect the discount rate used to assess the present value of the future cash flows from the asset

•• Significant change in the use of an asset that adversely affects the entity •• Declining economic performance, which might be indicated by larger than expected maintenance costs or lower than expected profits, from the use of an asset

•• When the carrying amount of the entity’s net assets exceeds the market capitalisation of the entity

Determining the recoverable amount The recoverable amount of an asset is defined in IAS 36 paras 6 and 18 as the higher of its fair value less costs of disposal (FVLCOD) and value in use (VIU). When measuring either FVLCOD or VIU, the following definitions apply: •• FVLCOD – the definition of fair value in IAS 36 para. 6 replicates the fair value definition in IFRS 13 Fair Value Measurement (see Unit 6). •• VIU – IAS 36 para. 6 defines VIU as ‘…the present value of the future cash flows expected to be derived from an asset or cash-generating unit’. Note that although IAS 36 paras 18–57 set out the requirements for measuring recoverable amount for ‘an asset’, these provisions apply equally to an individual asset or CGU.

Fair value less costs of disposal The following should be considered when calculating FVLCOD: •• IFRS 13 is applied in measuring fair value for the purposes of the FVLCOD calculation. Measuring fair value under IFRS 13 is covered in Unit 6. •• ‘Legal fees, stamp duty or similar transaction taxes, costs of removing the asset and direct incremental costs’ to bring the asset into a saleable condition, are deducted in measuring FVLCOD (IAS 36 para. 28). •• Costs that arise after the sale of an asset are not direct incremental costs (e.g. taxation consequences, termination benefits under IAS 19 Employee Benefits, and ‘costs associated with reducing or reorganising a business following the disposal of an asset’) (IAS 36 para. 28).

Value in use (VIU) IAS 36 provides detailed requirements for calculating VIU. Typically this is performed by applying a discounted cash flow approach. (Performing a VIU calculation is beyond the scope of the FIN module.) The elements listed below must be reflected in a VIU calculation, as specified in IAS 36 para. 30: (a) an estimate of the future cash flows the entity expects to derive from the asset; (b) expectations about possible variations in the amount or timing of those future cash flows; (c) the time value of money, represented by the current market risk-free rate of interest; (d) the price for bearing the uncertainty inherent in the asset; and (e) other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset.

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Any projections based on budgets or forecasts should ‘cover a maximum period of five years, unless a longer period can be justified’. Projections for periods beyond the budgets or forecasts are extrapolated using ‘steady or declining growth’ rates for subsequent years, unless another rate can be justified (IAS 36 para. 33). Further reading IAS 36 Appendix A.

Determining whether to assess impairment at an individual asset level or at a CGU level Determining whether to assess impairment at an individual asset level or at a CGU level depends on the circumstances, as illustrated in the diagram below: Conducting impairment test at the individual level or the CGU level Does the individual asset generate cash inflows that are largely independent from the cash inflows from other assets or groups of assets? Yes

Determine the recoverable amount for the individual asset (IAS 36 para. 22)

No

Determine the recoverable amount at the CGU level (IAS 36 paras 65–103) unless

The individual asset’s FVLCOD can be determined and it is higher than the individual asset’s carrying amount (which means that the individual asset is not impaired) (IAS 36 para. 22(a))

Adapted from: Grant Thornton 2014, Impairment of Assets: A guide to applying IAS 36 in practice, accessed 16 April 2018, www.grantthornton.com.au.

The individual asset’s VIU can be estimated to be close to the amount measured for its FVLCOD (IAS 36 para. 22(b))

Recognise any impairment loss at the individual asset level (this would be rare given this asset does not generate largely independent cash flows)

This unit will look first at accounting for an impairment loss for an individual asset and then look at how the rules are applied for assets within a CGU.

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Accounting for an impairment loss under IAS 36 – individual assets Learning outcome 1. Explain and account for an impairment loss for an individual asset. The process for recognising an impairment loss calculated for an individual asset is shown as follows: Recognising an impairment loss for an individual asset (IAS 36 paras 60-61) Does the impairment loss relate to an asset measured on a revaluation basis (e.g. under IAS 16)? No

Recognise the impairment loss immediately in profit or loss

Yes

Does a revaluation surplus already exist for this asset? No

Recognise the impairment loss as a revaluation decrement in profit or loss

IAS 36 para. 60 – follow the rules for revaluation decrements in Units 7 and 8

Yes

Recognise the impairment loss: • As a reversal of the revaluation surplus in respect of that asset (and disclosed in OCI) • With any remaining impairment loss recognised as a revaluation decrement in profit or loss

Adapted from: Grant Thornton 2014, Impairment of Assets: A guide to applying IAS 36 in practice, accessed 16 April 2018, www.grantthornton.com.au.

Example – Recognising an impairment loss for an individual asset This example illustrates how to calculate and recognise an impairment loss for an individual asset. Cumquat owns equipment that has a carrying amount of $400,000 at the reporting date. There are indications of impairment for this asset. In addition, its FVLCOD has been measured at $340,000 and its value in use is estimated at $370,000. The equipment’s recoverable amount is its $370,000 value in use, as this is higher than the $340,000 FVLCOD. The impairment loss is $30,000 ($400,000 carrying amount – $370,000 recoverable amount). The journal entry to recognise the impairment loss under the cost model is as follows: Date

Account description

xx.xx.xx

Impairment losses Accumulated depreciation and impairment losses – equipment

Dr $

Cr $

30,000 30,000

To record impairment loss

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Refer to Units 7 and 8 for the journal entry to recognise a revaluation decrement for an asset measured on a revaluation basis.

Subsequent depreciation/amortisation ‘After the recognition of an impairment loss, the depreciation (amortisation) charge for the asset shall be adjusted in future periods to allocate the asset’s revised carrying amount, less its residual value (if any), on a systematic basis over its remaining useful life’ (IAS 36 para. 63). As the carrying value of the asset has been reduced, future depreciation/amortisation charges will be lower. This applies to assets measured at cost or on a revaluation basis. Accounting for a change in depreciation/amortisation is discussed in Units 7 and 8.

Summary of recognition of impairment loss for an individual asset The key steps involved in recognising an impairment loss for an individual asset can be summarised as follows: STEP 1 Are there indictions of impairment?

STEP 2

STEP 3

If yes, determine the asset’s recoverable amount

Is the asset impaired? (carrying amount > recoverable amount)

STEP 4 If yes, calculate impairment loss (carrying amount – recoverable amount)

STEP 5 Recognise impairment loss

Worked example 10.1: Accounting for impairment of an individual asset [Available online in myLearning]

Determining and accounting for impairment losses under IAS 36 – CGUs and goodwill Learning outcome 2. Identify, explain and account for an impairment loss for a cash-generating unit (CGU) including impairment of goodwill. It is common to have some assets that, while necessary to run a business, do not individually generate cash inflows. For instance, in a manufacturing environment, the machinery used to produce the inventory may be directly linked to the cash that is generated from the sale of the manufactured goods. However, some items of machinery may work in conjunction with other assets to produce the inventory. This machinery does not of itself generate a direct cash inflow. Similarly, the head office of a manufacturing operation would not individually generate cash inflows. IAS 36 para. 66 requires that when it is not possible to identify an individual asset’s recoverable amount, its recoverable amount must be determined in the context of the CGU to which the asset belongs. Recall that the definition of a CGU from IAS 36 para. 6 is: … the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

Accordingly, an impairment loss is generally calculated at the CGU level rather than for individual assets within the CGU.

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The accounting for an impairment loss calculated for a CGU can be shown as follows: Impairment loss (calculated for a CGU) e.g. $100,000

The CGU impairment loss is allocated to the relevant individual assets within the CGU (following IAS 36 rules)

Asset 1 Reduced by $70,000

Asset 2 Reduced by $20,000

Asset 3 Reduced by $10,000

The impairment loss journal entry reduces the carrying amount of the individual assets within the CGU by the appropriate amount

Identifying a CGU The following are key to identifying a CGU: •• The requirement to identify the ‘smallest identifiable group of assets’ – for example, this may mean drilling down below divisional management reporting lines to determine cash inflows at a specific product or service level. •• The generation of cash inflows rather than requiring the CGU to produce a net cash inflow. You will find guidelines for, and useful examples of, the identification of CGUs in IAS 36 paras 67–73 and in IAS 36 Illustrative Example 1. These guidelines and examples are a useful reference; however, the identification of a CGU still requires professional judgement. In practice, management should document the factors and internal management reporting structure that support how the entity’s CGUs have been identified. The focus in the FIN module is on the calculation and recognition of an impairment loss for a CGU rather than the identification of an entity’s CGUs.

Consistency in determining the carrying amount and recoverable amount for a CGU IAS 36 para. 75 requires that the carrying amount of a CGU is determined on a basis consistent with the determination of the recoverable amount. When assessing whether there is an impairment loss, it is not necessary to calculate both the FVLCOD and the VIU for a CGU. As a minimum, only one of these two values is required if that value exceeds the CGU’s carrying amount. Please note that in the FIN module, a CGU’s recoverable amount will always be stated and you will not be required to perform the calculation of a CGU’s FVLCOD and VIU. IAS 36 does not specify how the recoverable amount of a CGU should be determined. Determining the recoverable amount of a CGU requires professional judgement to be applied and decisions to be made, including decisions on: •• how the cash flows are generated by the CGU – as this is relevant to the calculation of VIU calculation •• how the CGU will be sold (e.g. will a purchaser buy the inventory along with the noncurrent assets of the CGU) – as this impacts the measurement of FVLCOD.

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To ensure consistency in determining if there is an impairment loss, you will need to consider how to calculate the carrying amount of the CGU based on the information provided for the CGU’s recoverable amount. Consistency can be demonstrated by considering the following examples.

Example – Applying consistency when determining the carrying amount and recoverable amount for a CGU This example illustrates how consistency is needed when determining the carrying amount and recoverable amount for a CGU. Stellar has two CGUs, Meteor and Comet, both of which are being tested for impairment.

Meteor– the recoverable amount has been determined on a VIU basis The VIU for Meteor was determined by including the present value of the future cash flows relating to Meteor’s: •• assets within the scope of IAS 36 •• trade receivables •• inventory •• less trade payables. The carrying amount of the Meteor CGU will be calculated by including the carrying amount of the Meteor’s: •• assets within the scope of IAS 36 •• trade receivables •• inventory •• less trade payables. The VIU and carrying amount of the Meteor CGU are consistent when the two values are compared to determine if there is an impairment loss for the Meteor CGU.

Comet– the recoverable amount has been determined by calculating its FVLCOD The FVLCOD for Comet was determined by including the fair value of its inventory as management assessed that a purchaser would buy Comet’s inventory as well as its other assets. Therefore, the FVLCOD was measured as Comet’s: •• assets within the scope of IAS 36 •• inventory. The carrying amount of the Comet CGU will be calculated by including the carrying amount of Comet’s: •• assets within the scope of IAS 36 •• inventory. The FVLCOD and carrying amount of the Comet CGU are consistent when the two values are compared to determine if there is an impairment loss for Comet.

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The impairment loss for the CGU can only be applied to assets within the scope of IAS 36 Despite the fact that the recoverable amount and carrying amount of a CGU may include values for balance sheet items such trade receivables, inventory and trade payables, an impairment loss for a CGU can only be allocated to assets within the scope of IAS 36. Therefore, the following items cannot be impaired under IAS 36: Item

Reason

Trade receivables

Expected credit losses on trade receivables are recognised under IFRS 9 Trade receivables cannot be impaired under IAS 36 as they are outside the scope of IAS 36

Inventory

Inventory is carried at the lower of cost and net realisable value under IAS 2 Inventory cannot be impaired under IAS 36 as it is outside the scope of IAS 36

Trade payables

Trade payables are a financial liability. Liabilities are not impaired and cannot have impairment losses allocated to them IAS 36 only applies to those assets within its scope

FIN fact A CGU’s carrying amount and recoverable amount should be calculated on the same basis, with the same inclusions and exclusions. Consistency of the two calculations is the key issue.

Complications with CGUs 1. Assessing goodwill for impairment It is not possible to determine the recoverable amount of goodwill on its own as goodwill does not produce cash flows independently of other assets. Therefore, goodwill is always tested for impairment at a CGU level. IAS 36 para. 80 requires that goodwill be allocated to each acquirer’s CGU, or groups of CGUs, that are expected to benefit from the synergies of the business combination to which the goodwill relates. Note that CGUs cannot be larger than an operating segment as defined by IFRS 8 Operating Segments. If there are assets that constitute a CGU (or group of CGUs) to which goodwill has been allocated that require impairment testing, IAS 36 para. 97 requires that those assets be tested for impairment before the CGU (or group of CGUs) containing the goodwill is tested. Impairment of goodwill when preparing consolidated financial statements is explained in Unit 16.

2. Corporate assets Corporate assets are assets other than goodwill that do not independently generate cash inflows but are integral to the cash flows generated by a CGU, along with those of other CGUs. An example of a corporate asset is a company’s head office. When testing a CGU for impairment, IAS 36 para. 102(a) requires that corporate assets, or a relevant portion thereof, be allocated to the CGU under review on ‘a reasonable and consistent basis’. Where an allocation cannot be made on such a basis, IAS 36 para. 102(b) provides appropriate guidance.

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Example – Determining an impairment loss for a CGU with a corporate asset This example illustrates the concept of how a corporate asset is allocated to a CGU when determining whether there is an impairment loss for the CGU. Head office supports: • The paper division (60%) • The plastics division (40%)

There are indicators of impairment for the plastics division CGU, but none for the highly profitable paper division CGU 40% of the head office’s carrying amount is allocated to the plastics division CGU when determining the impairment loss for the plastics division CGU

A portion of the impairment loss for the plastics division CGU is allocated to the head office asset because of its 40% support to this division

There is no impairment loss in respect of the head office relating to its 60% support for the paper division CGU, as that CGU is not impaired

Allocating an impairment loss for a CGU The allocation process for an impairment loss in relation to a CGU can be explained as follows: Allocating an impairment loss to individual assets within a CGU (IAS 36 paras 104-105)

• Reduce any goodwill STEP 1

STEP 2

FLOOR

• Allocate any remaining impairment loss to other assets in the CGU (including corporate assets) on a pro-rata basis BUT

No asset can be reduced below the HIGHEST of: • Its FVLCOD (if measurable) • Its VIU (if determinable) • $0

Only allocate the remaining impairment loss to other assets in the CGU that are in the scope of IAS 36 e.g. no impairment loss would be allocated to inventory

Adapted from: Grant Thornton 2014, Impairment of Assets: A guide to applying IAS 36 in practice, accessed 16 April 2018, www.grantthornton.com.au.

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Example – Allocating an impairment loss against the assets in a CGU This example illustrates how to allocate an impairment loss calculated for a CGU. A $600,000 impairment loss has been determined for the Merryvale CGU. Details of the CGU’s assets are provided in the table below. It has also been determined that Merryvale’s property has a FVLCOD of $1.8 million; however, the recoverable amount for other individual assets within the CGU cannot be estimated.

Allocation of impairment loss CGU asset details

Carrying amount $

Property1

2,000,000

Plant and equipment

Proportion

Allocation of impairment loss $

Revised carrying amount $

200,000

1,800,000

700,000

$700,000/($700,000 + $300,000) × $400,000

280,000

420,000

Licence

   300,000

$300,000/($700,000 + $300,000) × $400,000

120,000

   180,000

Total impairment loss

3,000,000

600,000

2,400,000

1. If a proportionate allocation of the $600,000 impairment loss were made to the property, then the carrying amount of the property would be reduced by $400,000 ($2 million / $3 million × $600,000) to $1.6 million. This would reduce the property below the floor prescribed by IAS 36 para. 105 as the property cannot be reduced below the $1.8 million FVLCOD. Therefore only $200,000 of the total impairment loss can be allocated to the property and the $400,000 remaining impairment loss (i.e. $600,000 – $200,000) is allocated to the remaining assets of the CGU.

The journal entry to recognise the impairment loss is as follows: Date

Account description

xx.xx.xx

Impairment loss

Dr $

Cr $

600,000

Accumulated depreciation and impairment losses – property

200,000

Accumulated depreciation and impairment losses – plant and equipment

280,000

Accumulated amortisation and impairment losses – licence

120,000

To record the allocation of the CGU impairment loss

FIN fact IAS 36 para. 105 specifies a floor for an impairment loss allocated to an individual asset within a CGU. The asset cannot be written down below this floor.

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Summary of recognition of impairment loss for a CGU The key steps involved in recognising an impairment loss for a CGU can be summarised as follows: STEP 1

STEP 2

STEP 3

Are there indications of impairment? (if the CGU contains goodwill the CGU will be tested annually for impairment)

If yes, determine the CGU’s recoverable amount

Determine the CGU’s carrying amount (including its share of any corporate assets)

STEP 4 Is the CGU impaired? (carrying amount > recoverable amount)

STEP 5

STEP 6

If yes, calculate impairment loss (carrying amount – recoverable amount)

Allocate impairment loss on a proportionate basis to CGU assets within the scope of IAS 36 (apply IAS 36 para. 105 floor limits)

Calculate on a consistent basis

STEP 7 Recognise impairment loss

Worked example 10.2: Accounting for impairment for a simple CGU [Available online in myLearning] Worked example 10.3: Accounting for impairment for a CGU with goodwill [Available online in myLearning]

Reversal of an impairment loss under IAS 36 Learning outcome 3. Explain and account for reversals of impairment losses. An entity which has recorded an impairment loss may find that the indicators that initially required the asset or CGU to be impaired have reversed in a subsequent reporting period. Therefore, IAS 36 para. 110 requires that: An entity shall assess at the end of each reporting period whether there is any indication that an impairment loss recognised in prior periods for an asset other than goodwill may no longer exist or may have decreased.

Watch out for the need to reverse an impairment loss in a later reporting period IAS 36 para. 111 requires an entity to consider external and internal sources of information that indicate that an impairment loss recognised in prior periods (either for an individual asset or a CGU) may no longer exist or may have decreased

An impairment loss for goodwill cannot be reversed (IAS 36 para. 124)

Has the situation changed during the current reporting period? Consider…

External source of information For example, a sustained increase during the reporting period in the selling price of a CGU’s product

Unit 10 – Core content

Internal Internalsource sourceof ofinformation information E.g. capital expenditure incurred during For example, capital expenditure incurred during the thereporting reportingperiod periodthat thatimproves improvesan an asset’s asset’sperformance performance

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The conditions for reversing an impairment loss are restrictive with IAS 36 para. 114, specifying that: An impairment loss recognised in prior periods for an asset other than goodwill shall be reversed if, and only if, there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment loss was recognised. If this is the case, the carrying amount of the asset shall, except as described in paragraph 117, be increased to its recoverable amount. That increase is a reversal of an impairment loss.

The amount of an impairment loss reversal is restricted by the requirements of IAS 36 (which are explained below).

Reversal of an impairment loss for an individual assets The diagram below illustrates the process for reversing an impairment loss for an individual asset: Reversing an impairment loss for an individual asset (IAS 36 paras 117-120) At the end of the reporting period is there any indication for reversing an impairment loss that was recognised in a prior period? No

Yes

No action to be taken

Calculate the recoverable amount for the asset Yes

Would the reversal of the impairment loss cause the new carrying amount to exceed the asset’s carrying amount (after depreciation/amortisation) had no impairment loss been initially recognised?

No

Yes

Is the asset measured on a revaluation basis?

Is the asset measured on a revaluation basis? No Yes

Recognise the impairment loss reversal in profit or loss

IAS 36 para. 119 – follow the rules for revaluation increments in Units 7 and 8

Yes

Recognise the impairment loss reversal: • In profit or loss to the extent that it was initially recognised in profit or loss • With any remaining revaluation increment recognised in the revaluation surplus account (disclosed in OCI)

No

Apply the ceiling: Recognise the impairment loss reversal up the asset’s carrying amount (after depreciation/amortisation) had no impairment loss been initially recognised

Adapted from: Grant Thornton 2014, Impairment of Assets: A guide to applying IAS 36 in practice, accessed 16 April 2018, www.grantthornton.com.au.

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Example – Reversing an impairment loss for an individual asset This example illustrates an impairment loss reversal for an individual asset.

Facts •• An asset has a cost of $12,000. •• It is being depreciated over four years on a straight-line basis. •• At the end of year one: –– It has a carrying amount of $9,000 ($12,000 cost – $3,000 accumulated depreciation). –– There are indications of impairment and the recoverable amount for the asset is determined to be $6,000, which results in the recognition of a $3,000 impairment loss ($9,000 carrying amount – $6,000 recoverable amount). –– The remaining useful life is assessed at three years. •• At the end of year two –– The asset has a carrying amount of $4,000 ($6,000 at the end of year one – $2,000 depreciation for year two). –– The indications of impairment that gave rise to the impairment loss has been eliminated, and the recoverable amount has been determined. This enables an impairment loss reversal to be recognised. –– If the impairment loss at the end of year one had not been recognised, the carrying amount would have been $6,000, calculated as follows: Year

Opening carrying amount $

Depreciation $

Closing carrying amount $

End of year 1

12,000

3,000

9,000

End of year 2

9,000

3,000

6,000

Scenario 1 – The recoverable amount is $5,000 at the end of year 2 Applying IAS 36 para. 117 at the end of year 2, the asset’s carrying amount cannot be increased above the lower of: •• its $5,000 recoverable amount, and •• its $6,000 carrying amount, as if the impairment loss had not occurred. As $5,000 is the lower of these two values, the impairment loss reversal is $1,000 ($5,000 ceiling for reversal of the impairment loss – $4,000 actual carrying amount at the end of year two). This situation can be shown as follows:

Ceiling

$6,000

Notional carrying amount (the asset’s carrying amount (after depreciation) as if there had been no impairment loss)

$5,000

Recoverable amount Impairment loss reversal

$4,000

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Actual carrying amount

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The following journal entry would be recorded. Date

Account description

Dr $

xx.xx.xx

Accumulated depreciation and impairment losses

Cr $

1,000

Impairment reversal – gain

1,000

To record reversal of impairment loss

Scenario 2 – The recoverable amount is $8,000 at the end of year 2 Applying IAS 36 para. 117 at the end of year 2, the asset’s carrying amount cannot be increased above the lower of: •• its $8,000 recoverable amount, and •• its $6,000 carrying amount, as if the impairment loss had not occurred. As $6,000 is the lower of these two values, the impairment loss reversal is $2,000 ($6,000 ceiling for reversal of the impairment loss – $4,000 actual carrying amount at the end of year two). This situation can be shown as follows:

Ceiling

$8,000

Recoverable amount

$6,000

Notional carrying amount (the asset’s carrying amount (after depreciation) as if there had been no impairment loss) Impairment loss reversal

$4,000

Actual carrying amount

The following journal entry would be recorded. Date

Account description

xx.xx.xx

Accumulated depreciation and impairment losses Impairment reversal – gain

Dr $

Cr $

2,000 2,000

To record reversal of impairment loss

Subsequent depreciation and amortisation When the carrying value of an asset has been increased as a result of an impairment loss reversal, any future depreciation or amortisation charges will increase (refer to Units 7 and 8 for the appropriate accounting treatment).

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Reversal of an impairment loss in a CGU If the impairment loss was recorded on a CGU, rather than an individual asset, the reversal is allocated to the assets of the CGU (except for goodwill) pro rata with the carrying amounts of the assets. The reversal is then regarded as the reversal of an impairment loss for individual assets and accounted for as per the journal entry above (IAS 36 para. 122). The process for reversing an impairment loss in a CGU is explained below: Reversing an impairment loss for a CGU (IAS 36 paras 122-123) At the end of the reporting period is there any indication for reversing an impairment loss for a CGU that was recognised in a prior period? No

Calculate the recoverable amount for the CGU and compare with the CGU’s carrying amount to determine the amount of Yesthe reversal of the impairment loss for the CGU

No action to be taken

Impairment loss reversal on goodwill is not permitted (IAS 36 para. 124)

Yes

Allocate the impairment loss reversal to the individual CGU assets on a pro-rata basis Ceiling Would the allocated reversal of the impairment loss cause the new carrying amount of any individual asset to exceed the lower of that asset’s: 1. recoverable amount, and 2. carrying amount (after depreciation/ amortisation), had no impairment loss been Yes initially recognised (‘the ceiling’)? No

Recognise the impairment loss reversal in profit or loss for the individual asset

Yes

Calculation of the ceiling value: the asset’s notional carrying amount at the end of the reporting period (after depreciation/ amortisation) as if there had been no impairment loss

• Limit the allocation of the impairment reversal for that individual asset to the lower of 1. and 2. • Allocate the excess that would otherwise have been allocated to the asset on a pro rata basis to the other assets of the CGU so that no individual asset exceeds the ‘ceiling’

Adapted from: Grant Thornton 2014, Impairment of Assets: A guide to applying IAS 36 in practice, accessed 16 April 2018, www.grantthornton.com.au.

Activity 10.1: Accounting for impairment and subsequent reversal for a CGU [Available online in myLearning] FIN fact IAS 36 specifies a ceiling for an impairment loss reversal for individual assets (para. 117) and assets within a CGU (para. 123). The reversal cannot result in the individual asset be written up above a specified value.

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Other complications Interim financial reporting and impairment Where an entity must prepare an interim financial report, IAS 36 applies to that interim report. Sometimes, an assessment will be made and an impairment loss will be recognised at the interim date, yet additional information is available by year end that changes that assessment and indicates that the loss could be reversed. IFRIC 10 Interim Financial Reporting and Impairment provides guidance in this situation. IFRIC 10 was originally written to the old financial instruments standard IAS 39 Financial Instruments: Recognition and Measurement. It provides clarity on the application of the IAS 36 principles to interim financial reports. IFRIC 10 has now been amended for IFRS 9, as IFRS 9 has its own expected credit loss model (discussed further in Unit 9). Under IFRIC 10, an entity cannot reverse impairment losses on goodwill recognised in interim reports, even if circumstances change by the end of the full year reporting period. This is the same treatment as specified in IAS 36 para. 124, which prohibits the reversal of an impairment loss on goodwill. Further reading IAS 36 Illustrative Example 4. IFRIC 10 paras 3–9.

Existence of a non-controlling interest and the impact on goodwill impairment Where a non-controlling interest (NCI) in relation to a parent’s investment in a subsidiary arises in accordance with IFRS 10 Consolidated Financial Statements (discussed in Unit 16) and the entity uses the ‘partial goodwill method’ in accordance with IFRS 3 Business Combinations (as described in Unit 15) to recognise goodwill, the amount of goodwill needs to be grossed up to include a notional amount of goodwill that is attributable to the NCI when testing the goodwill for impairment. An example of the calculation of this impairment of goodwill issue is outlined in Unit 16.

Disclosures The disclosure requirements of IAS 36 are located in paras 126–137. Required reading IAS 36 Illustrative Example 9. Activity 10.2: Impairment and ethical implications [Available online in myLearning] Quiz [Available online in myLearning]

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Unit 11: Provisions (including employee benefit entitlements), contingent liabilities and contingent assets Contents Introduction

11-3

Provisions (other than employee benefits) Recognising provisions Distinguishing provisions from other liabilities Measuring provisions Applying recognition and measurement rules Decommissioning, restoration and similar liabilities

11-3 11-4 11-4 11-4 11-5 11-6

Contingent liabilities

11-7

Contingent assets

11-8

Employee benefits Recognising and measuring employee benefits

11-10 11-10

fin31911_csg_05

Disclosures 11-17

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Learning outcomes At the end of this unit you will be able to: 1. Explain and account for a provision. 2. Identify and explain a contingent liability. 3. Identify and explain a contingent asset.

Introduction IAS 37 Provisions, Contingent Liabilities and Contingent Assets prescribes the accounting and disclosure requirements for provisions and provides guidance on when and how to disclose contingent liabilities and contingent assets. Some provisions are not governed by IAS 37, as they fall under other standards. These include employee benefits, including termination benefits, which are covered by IAS 19 Employee Benefits. All provisions, however, have one thing in common: they are based on estimates of future cash flows and, therefore, their measurement and recognition are subject to significant professional judgement. As a result, they are susceptible to over-optimism, over-cautiousness or error. Common problems that may arise with provisions include: •• Using provisions for profit smoothing (i.e. debiting or crediting a provision, with a corresponding credit or debit to profit, to achieve the profit outcome desired by management). •• Increasing provisions to cover any possible future liability. •• Creating ‘big bath’ provisions – a term used to describe the practice of recognising certain expenses immediately (i.e. debit expense, credit provision) and thus making future profits appear stronger. Unit 11 overview video [Available online in myLearning]

Provisions (other than employee benefits) Learning outcome 1. Explain and account for a provision. A provision is defined as ‘a liability of uncertain timing or amount’ (IAS 37 para. 10). Examples of typical provisions include provisions for: •• Warranty costs. •• Decommissioning and restoration. •• Restructuring costs.

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Recognising provisions A provision exists and must be recognised when all of the following criteria are met: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognised (IAS 37 para. 14).

Critical to the recognition of a provision is the requirement for there to be a present obligation. A past event that leads to a present obligation is called an obligating event. An obligating event is an event that creates a legal or constructive obligation, and therefore the entity has no realistic alternative to settling the obligation created by the event. This is the case only: •• where the settlement of the obligation can be enforced by law, or •• in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will discharge the obligation. A constructive obligation arises if past practice creates a valid expectation on the part of a third party, for example, a retail store that has a long-standing policy of allowing customers to return goods within a specified period. The fact that an entity is under a legal obligation to do something in the future does not create a present obligation. For example, a realistic alternative for an entity may be for it to dispose of an asset before the legal obligation relating to the asset arises. Examples 6, 11A & 11B in Part C of the guidance on implementing IAS 37 provides further illustration of this point.

Distinguishing provisions from other liabilities Provisions can be distinguished from other liabilities (e.g. accruals and trade payables) due to the uncertainty concerning the timing or amount of the future expenditure required for their settlement. It is important to correctly determine whether a present obligation is a provision or a liability, as both measurement and disclosure requirements may differ. Required reading IAS 37 (or local equivalent). Worked example 11.1: Recognising provisions [Available online in myLearning]

Measuring provisions Having determined that a provision should be recognised, the next step is to measure it. In practice, this can be one of the most difficult and contentious areas of financial reporting for the entity. The amount recognised must be the best estimate of the expenditure required to settle present obligations at the reporting date, taking into account the risks and uncertainties that surround the events and circumstances affecting the provision. It should reflect the amount that an entity would rationally be required to pay to settle the obligation at the reporting date, or to transfer to a third party at that time (IAS 37 paras 36 and 37). The amount of the provision is estimated using the judgement of management, supplemented by experience of similar transactions and, in some cases, reports from independent experts. Events after the reporting date should also be considered (IAS 37 para. 38).

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If settlement is expected to occur after more than one year, and the effect of the time value of money is material, the amount should be discounted using a pre-tax rate specific to the liability. The discount rate is not adjusted for risks that have already been taken into account in the cash flow estimates (IAS 37 paras 45–47). Note that gains from the expected disposal of assets are not included in the measurement of the provision (IAS 37 para. 51). At each reporting date, the provision needs to be remeasured and adjusted to reflect the current best estimate. If the provision is measured using discounted cash flows, the carrying amount of the provision will increase each year to reflect the passage of time and, hence, the unwinding of the discount. This increase is recognised as a borrowing cost and treated as an expense (IAS 37 paras 59 and 60). Worked example 11.2: Measuring provisions [Available online in myLearning]

Applying recognition and measurement rules IAS 37 provides guidance on how to apply the recognition and measurement rules for specific matters.

Future operating losses Provisions shall not be recognised for future operating losses as the entity does not have a present obligation as a result of a past event (IAS 37 para. 63).

Onerous contracts As per IAS 37 para. 10: An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

An onerous contract meets the three criteria for recognising a provision and, therefore, a provision should be recognised for the unavoidable costs under the contract. The unavoidable costs reflect the least net cost of exiting the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it (IAS 37 paras 66 and 68).

Restructuring provisions Restructuring is a program, planned and controlled by management, which materially changes the scope of a business undertaken by an entity or the manner in which that business is conducted (IAS 37 para. 10). As per IAS 37 para. 70, restructuring may occur due to: •• the sale or termination of a portion of the entity’s business •• a relocation of business activities from one country or region to another •• a change in management structure. A provision for restructuring costs can only be recognised where the three recognition criteria are met (IAS 37 para. 71). A constructive obligation to restructure only arises where management has developed a formal plan for the restructure and has communicated that plan to those affected. The mere intention of management to carry out such a plan is not enough for a provision to be recognised (IAS 37 para. 72).

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A restructuring provision shall only include incremental expenditures arising directly from the restructure. Examples of costs that may be included in the measurement of a restructuring provision are: •• consulting fees relating to the restructure (e.g. legal fees) •• employee termination costs that relate directly to the restructure (e.g. redundancies) •• contract termination costs (e.g. lease termination penalties) •• onerous contracts Employee termination costs are included within a redundancy provision if they meet the requirements under IAS 37. However, the termination costs will be measured under IAS 19 Employee Benefits. This is discussed later in the unit. As per IAS 37 paras 80–83, a restructuring provision does not include any items which are associated with the ongoing activities of the entity, such as: •• Retraining or relocating continuing staff. •• Marketing. •• Investment in new systems and distribution networks. •• Identifiable future operating losses up to the date of restructure. •• Gains on the expected disposal of assets.

Decommissioning, restoration and similar liabilities IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities contains guidance on accounting for changes in decommissioning, restoration and similar liabilities that have previously been recognised both as part of the cost of an item of property, plant and equipment under IAS 16 Property, Plant and Equipment and as a provision (liability) under IAS 37. An example would be a liability recognised by the operator of a coal mine for costs it expects to incur in the future for restoring the site when the mining has been completed. Due to the typically long interval between the obligation for the liability arising (on creation of the mine) and the ultimate settlement of the liability (at the end of the mine’s life), there is a large degree of subjectivity in accounting for such provisions. IFRIC 1 addresses changes to the amount of the liability subsequent to its initial recognition. Such changes can arise from the following: (a) a change in the estimated outflow of resources embodying economic benefits (e.g. cash flow) required to settle the obligation; (b) a change in the current market-based discount rate as defined in paragraph 47 of IAS 37 (this includes changes in the time value of money and the risk specific to the liability), and (c) an increase that reflects the passage of time (also referred to as the unwinding of the discount). (IFRIC 1 para. 3)

In relation to item (c) above, IFRIC 1 para. 8 requires the effect of the unwinding of the discount to be recognised in profit or loss as a finance cost, as it occurs regardless of the model used to account for property, plant and equipment. Many entities account for property, plant and equipment using the cost model, whereby an increase in the provision arising under (a) and (b) above is capitalised as part of the cost of the related asset and depreciated over the remaining life. A decrease in the provision is deducted from the cost of the asset but is restricted to the asset’s carrying value; any excess is recognised immediately in profit or loss. Where entities account for property, plant and equipment using the revaluation model (fair value), a change in the liability arising under (a) or (b) above does not affect the valuation of the item for accounting purposes. The effect of the change in the liability is treated consistently with the revaluation surplus or deficit previously recognised on that asset, where:

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•• An increase in the liability is recognised as an expense in profit or loss, except to the extent of a revaluation surplus relating to that asset, when it will reduce the revaluation surplus. •• A decrease in the liability is recognised as an increase in the revaluation surplus relating to the asset, except to the extent that it reverses a revaluation deficit that has previously been recognised in profit or loss. •• A decrease in the liability that exceeds the carrying amount that would have been recognised had the asset been carried under the cost module, the excess is recognised immediately as income in profit or loss. Required reading IFRIC 1 paras 1–8.

Contingent liabilities Learning outcome 2. Identify and explain a contingent liability. A contingent liability is defined in IAS 37 para. 10 as: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability.

A contingent liability is not recognised in the financial statements; however, disclosure is required, unless the possibility of an outflow of benefits is remote (IAS 37 paras 27–28). The above definition considers three broad circumstances when a contingent liability arises. The table considers each of these in turn: Part of contingent liability definition

Explanation

Para. 10(a) – possible obligation not There is no present obligation; wholly within control of the entity however, a future event may create an obligation for the entity

Example

The future event must not be wholly within the control of the entity

Where an entity is jointly and severally liable for an obligation, such as in a partnership between two parties shared on a 60:40 basis. The 40% obligation that is expected to be met by the other partner is an example of a possible obligation to the 60% partner

Para. 10(b)(i) – present obligation arising from a past event where settlement is not probable

There is a present obligation resulting from an earlier event, but the probability of an outflow is 50% or lower

A legal claim against an entity in which the entity concludes that it is liable but it is likely to successfully defend the case

Para. 10(b)(ii) – present obligation arising from a past event where the amount cannot be reliably measured

There is a present obligation resulting from an earlier event; however, estimates of the outflow required to settle the obligation are difficult to measure

An entity is being sued and it is unsure whether it will be able to successfully defend the case. If it is unsuccessful, the amount of any damages are uncertain (Note that these situations are considered to be rare)

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Unit 15 discusses the importance of the distinction between the sub-categories of contingent liabilities. Certain contingent liabilities are recognised when performing the accounting for a business combination.

Example – Contingent liability versus provision This example illustrates the distinction between a contingent liability and a provision. A company is undergoing a tax audit. It has received independent advice that there are no issues, but the local tax authority has expressed concern about some of the deductions the company has claimed. Given the concerns expressed by the tax authority about the deductions claimed, a contingent liability should be disclosed as there is a possible obligation that will only be determined at a later stage in the tax audit. The mere fact of undergoing a tax audit does not, of itself, mean that there is a contingent liability or a provision. If the local tax authority has not expressed any specific concerns, the possibility of an obligation arising is remote; therefore, no disclosure or recognition of a provision is required. On the other hand, if the company is undergoing a tax audit and has received independent advice that there is a problem with some of the deductions claimed by the company, then the likelihood of the company having to pay additional tax can be assessed as probable. In this case, a provision should be recognised rather than a contingent liability being disclosed. The requirements of IAS 37 para. 14 would be satisfied.

Contingent assets Learning outcome 3. Identify and explain a contingent asset. A contingent asset is defined in IAS 37 para. 10 as: … a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

A contingent asset arises where the entity may receive an inflow of economic benefits. As per IAS 37 paras 31–34, if the inflow is: •• Virtually certain, then the asset is not contingent and should be recognised, normally as a receivable. •• Probable, then a contingent asset is disclosed. •• Possible, but not probable, then no disclosure is required. A contingent asset cannot be recognised as an asset in the statement of financial position. An example of a contingent asset that would require disclosure is a court case brought by an entity where the chance of a judgement in favour of the entity is uncertain but probable. Activity 11.2: Provisions, contingent liabilities and contingent assets [Available online in myLearning]

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The following decision tree summarises the main recognition requirements of IAS 37 for provisions and contingent liabilities:

Start

Present obligation as a result of an obliging event?

NO

YES

Probable outflow?

NO

YES

NO

YES

Reliable estimate?

Possible obligation?

Remote?

YES

NO NO (rare)

YES

Provide

Disclose contingent liability

Do nothing

Adapted from AASB 137 Provisions, Contingent Liabilities and Contingent Assets, page 35, accessed on 6 August 2019, <www.aasb.gov.au/admin/file/content105/c9/AASB137_07-04_COMPjun14_04-14.pdf>

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Employee benefits Employee benefits are defined in IAS 19 para. 8 as: … all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment.

IAS 19 does not provide a definition of the term ‘employee’; however, it specifies that employees include ‘directors and other management personnel’ and that an employee may provide services to an entity on a full-time, part-time, permanent, casual or temporary basis (para. 7). In practice, it can be difficult to distinguish employees from contractors, and this is an issue where there are related regulations (e.g. pay-as-you-go (PAYG) withholding tax in Australia, or pay as you earn (PAYE) obligations in New Zealand). The following table shows the different types of employee benefits. Types of employee benefits Employee benefit

Examples

Short-term (IAS 19 para. 9)

•• Wages, salaries and social security contributions •• Paid annual leave and paid sick leave •• Profit-sharing and bonuses (if payable within 12 months of the end of the period) •• Non-monetary benefits (e.g. medical care, housing, cars and free or subsidised goods or services) for current employees

Other long-term (IAS 19 para. 153)

•• Long service leave or sabbatical leave

(Note: these are other than post‑employment benefits)

•• Jubilee or other long-service benefits •• Long-term disability benefits •• Profit-sharing, bonuses and deferred compensation

Termination benefits (IAS 19 para. 159)

•• The entity’s decision to terminate an employee’s employment before the normal retirement date •• An employee’s decision to accept voluntary redundancy

Post-employment (IAS 19 para. 26) (outside the scope of this module)

•• Pensions and other retirement benefits •• Post-employment life insurance •• Post-employment medical care

Employee benefits may be based on a number of sources, including enterprise agreements, legislative requirements or informal practices giving rise to a constructive obligation to the employee. Employee benefits can be provided to either employees and/or their dependants. They may be settled by payments or the provision of goods or services made directly to the employee, or to their spouse, children or other dependants, or to others such as insurance companies. IAS 19 governs the recognition, measurement and disclosure requirements relating to employee benefits. It applies to all employee benefits except for those within the scope of IFRS 2 Share‑based Payment. The requirements of IFRS 2 are discussed in the unit on share-based payments.

Recognising and measuring employee benefits The main requirement of the Standard is that an employer must recognise a liability when employees have provided services for which benefits will be paid in the future. An expense is required to be recognised when the entity consumes the economic benefits relating to the service provided by the employee.

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Short-term employee benefits IAS 19 para. 8 defines ‘short-term employee benefits’ as: ... employee benefits (other than termination benefits) that are expected to be settled wholly before twelve months after the end of the annual reporting period in which the employees render the related service.

As these benefits are due within 12 months of the reporting date, they are measured on an undiscounted (nominal) basis and recognised as both a liability (net of any amount already paid) and an expense (unless permitted to be recognised in the cost of an asset) (IAS 19 para. 11). Short-term paid absences An entity may pay employees for absences for various reasons (e.g. sick leave or jury service) (IAS 19 para. 14). Key terms in relation to short-term paid absences are listed below: •• Accumulating – paid absences that can be carried forward and used in future periods if the current period’s entitlement is not used in full. •• Vesting – employees are entitled to a cash payment for unused entitlement on leaving the entity. •• Non-vesting – employees are not entitled to a cash payment for unused entitlement on leaving the entity. The expected cost of an accumulating paid absence is recognised when the employee performs a service that increases their right to future paid absences. This rule applies regardless of whether the entitlement is vesting or non-vesting. However, a non-vesting entitlement is only included as a liability at reporting date if it is probable the entity will be required to pay the employee for the entitlement in the future. The expected cost of a non-accumulating paid absence is recognised when the absences occur (IAS 19 para.13). The following decision tree can be applied to determine when a short-term paid absence should be recognised. Accumulating benefit Yes

Recognise when absences occur

Vesting Yes Recognise when employee renders service

No

No Recognise when employee renders service but consider probability of employee leaving before entitlements used

An issue that arises on the measurement of employee benefits relates to the ‘on-costs’ associated with employment. On-costs can include superannuation or KiwiSaver obligations, payroll tax and workers’ compensation premiums. The compensated absences should be recognised based on the expected cost to the entity, which therefore includes the on-costs related to the payment.

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Application of recognition and measurement rules for short-term benefits Employee benefit

Recognition and measurement

Annual leave

Annual leave is an accumulating absence. Recognition occurs when the employee renders the service that increases their entitlement to future compensated absences (IAS 19 para. 13). The benefit is measured at the expected cost of the leave entitlement (IAS 19 para. 16) If the entity does not expect an employee to take their leave entitlement within 12 months, then the entity measures the leave entitlement by applying the rules for long-term liabilities

Sick leave

Sick leave is recognised as a liability in two situations: •• Where the sick leave is accumulating and vesting (i.e. the employee is entitled to the leave either throughout their employment or when they finish employment), or •• Where the sick leave is accumulating and non-vesting and it is anticipated the employee will take the accrued sick leave in the future There is an assumption in IAS 19 that an employee uses the most recent sick leave accrued first, and only uses sick leave accrued from previous years if they need more sick leave than their current year entitlement. In other words, unused entitlements give rise to a liability only when it is probable that sick leave taken in the future will be greater than entitlements that will accrue in the future. When making this assessment, employees should be considered on a group basis, rather than considering individual employees. This situation is illustrated in IAS 19 para. 17 Most employees are entitled to accumulating and non-vesting sick leave and generally do not exceed their sick leave entitlements in any one reporting period. As a result, sick leave entitlements are generally not recognised as a liability, but recognised as an expense when taken by the employee

Profit-sharing and bonus plans

A liability is recognised for profit-sharing and bonus plans in accordance with IAS 19 para. 19 when: •• The entity has a present legal or constructive obligation (i.e. established by past practice) or otherwise has no realistic alternative but to settle the liability as a result of past events, and •• A reliable estimate of the obligation can be made A reliable estimate can be made when at least one of the following conditions is met (IAS 19 para. 22): •• There are formal terms in the plan for determining the amount of the benefit •• The entity determines the amounts to be paid before the financial statements are signed off •• Past practice gives clear evidence of the amount of the entity’s obligation If the profit-sharing and bonus payments are not due wholly within 12 months after the end of the reporting period, they are accounted for as ‘other long-term employee benefits’ (IAS 19 para. 24)

Non-monetary benefits

IAS 19 is unclear as to how the costs of non-monetary benefits (e.g. interest-free loans, discounts on products purchased from the employer, or use of motor vehicles) should be measured. One approach is to measure the expense based on the net cost to the employer. For example, when a manufacturing company sells goods to employees at less than cost, an expense should be recognised equal to the difference between the selling price and the marginal production cost. Given the lack of guidance, other approaches may be considered by entities accounting for these non-cash forms of remuneration

Example – Calculating a provision for sick leave This example illustrates how to measure a provision for sick leave. Piper Limited (Piper) is a snowboard manufacturing company with 200 employees who are each entitled to 10 days of sick leave per year. Unused sick leave can be carried forward for one year. As at 30 June 20X3, the average unused entitlement was three days per employee.

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The expectation for the year ended 30 June 20X4 is that 180 employees will take 10 or less days of sick leave. The remaining 20 employees will take an average of 12 days of sick leave for the year. Based on these facts, the liability for sick leave would be calculated as: •• Zero for the 180 employees who are expected to take 10 or less days per year. •• 20 × (12 – 10) = 40 days for the 20 employees whose entitlement of two days carried forward will be used in the year ended 30 June 20X4. Therefore, a liability that should be recognised at 30 June 20X3 for 40 days, which is the sick leave in excess of the annual entitlement that employees are expected to utilise in the following period. The liability will be measured by reference to the expected cost.

Required reading IAS 19 paras 8–24 (Definitions of employee benefits only in para. 8).

Other long-term employee benefits Other long-term employee benefits include items that are not expected to be settled wholly before 12 months after the end of the reporting period in which the relevant service is rendered. Generally, other long-term employee benefits should be recognised at the present value (PV) of the estimated future cash outflows to be made by the employer for services provided by employees up to the reporting date. The discount rate used in the PV calculation is the market yield at reporting date on highquality corporate bonds. Where there is not a deep market in such bonds, the market yields on government bonds are used to discount amounts. Australia A 2015 research commissioned by the Group of 100 and Actuaries Australia, and conducted by actuarial firm Milliman Australia (Milliman), concluded that Australia now has a sufficiently deep market in high quality corporate bonds and so corporate bond rates should be used to discount long-term employee obligations. To support the report, Milliman will regularly publish periodic yield curves that will be available for use in valuing employee liabilities. Further reading CA ANZ 2015, ‘Employee discount rates and AASB 119’, Accounting and Assurance News Today, www.charteredaccountants.com.au → News & media → Newsletter → Archive → 05 June 2015. New Zealand It is generally agreed that New Zealand does not have a sufficiently active and liquid market for high-quality corporate bonds, and so the market yield on the appropriate government bonds is used to discount amounts denominated in New Zealand currency. The bonds must be consistent with the currency that the liability is to be settled in, and the estimated term of the liability (IAS 19 para. 83). The Treasury of New Zealand publishes a table of risk-free discount rates that can be used. Please note that for the purposes of the FIN module only, candidates will be provided with the appropriate rates in a given scenario when answering a question. Long service leave The most common other long-term employee benefit is long service leave (LSL). The calculation for LSL is simpler than the calculation of other long-term benefits due to the higher level of certainty of the service value for the employee.

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An example of how to calculate LSL is shown below.

Example – Calculating long service leave liabilities This example illustrates how to calculate an LSL liability. The financial controller at Piper Limited (Piper) has been provided with the following information about an employee, Ms D: •• Ms D earns $99,000 per year, including her superannuation contributions. She has worked at Piper for five years and will be entitled to 13 weeks LSL after 15 years. •• Ms D’s salary is anticipated to increase at 5% per year, including inflation and promotions. •• Employees in the company usually take their LSL after 17 years’ employment; therefore, Ms D is expected to be paid her LSL in 12 years, as she has already worked for Piper for five years. •• The appropriate bonds with a period to maturity of approximately 12 years have a rate of 6% per year. •• Employees in the company who have been employed for five years have a 30% probability of remaining with the company until they are entitled to their LSL. To calculate the LSL liability for Ms D, a series of four steps should be followed:

Step 1: Calculate the ‘service value’ for Ms D The service value is the employee’s salary at reporting date plus any employee-related costs (e.g. superannuation), multiplied by the proportion of LSL entitlement they have accrued through service provided to the reporting date. Ms D’s service value is: $99,000 × 5 ÷ 15 × 13 ÷ 52 = $8,250 Note: Dividing by 52 converts the annual salary to a weekly salary.

Step 2: Inflate the service value to the anticipated future cash flow when the LSL is taken Note: The date that Ms D is entitled to the LSL is not important; it is when she is expected to take the leave that dictates when the cash flow will take place. Ms D’s anticipated future cash flow, based on her employment to date, is: $8,250 × (1.05)12 = $14,816 or $8,250 × 1.7959 = $14,816

Step 3: Discount the cash flow to present value using the appropriate rate The discounted cash flow is: $14,816 ÷ (1.06)12 = $7,364 or $14,816 ÷ 2.012 (using compound value tables factor) = $7,364 or $14,816 × 0.497 (using present value tables factor) = $7,364

Step 4: Multiply the cash flow by the probability that Ms D will receive her LSL benefit (i.e. will still be employed when her LSL becomes payable) to calculate the LSL liability Ms D’s LSL benefit is therefore: $7,364 × 30% = $2,209 Note: This can be combined into one equation as follows: LSL liability = current salary × years of service × entitlement rate × growth in salary factor × discount factor × probability: $99,000 × 5 × (1 ÷ 15 × 13 ÷ 52) × (1.05)12 ÷ (1.06)12 × 0.3 = $2,209

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In accordance with IAS 19 para. 156, when recognising an expense to record the LSL obligation, the total expense must be allocated between: •• Service cost. •• Net interest. •• Remeasurement of the liability. Service cost comprises: •• Current service cost, being the increase in the present value of the entitlement earned during the year. •• Past service cost being the changes in the present value of entitlements due to a change in legislation or workplace agreement conditions (e.g. LSL becoming payable at a rate of 13 weeks after 10 years, not 15 years) or a curtailment (a significant reduction by the entity in the number of employees covered by a plan), and any gain or loss on settlement. Net interest is the movement in benefit due to the unwinding of discount factors applied to previous periods (i.e. the previous year’s liability multiplied by the discount rate). Remeasurement of the liability may include actuarial gains and losses arising from a change in assumptions in relation to discount rates, retention rates, expected salary increases and the like. For example, if the probability of an employee receiving their LSL benefit changed from 30% to 25% then part of the movement in the liability would not be due to current service but to changes in the actuarial assumptions, and would be disclosed as a remeasurement of the liability. It is beyond the scope of the FIN module to have practical application of the LSL expense allocation. Required reading IAS 19 paras 156–171. Activity 11.1: Calculating employee benefit liabilities [Available online in myLearning]

Termination benefits Another common employee benefit arises when employee services are terminated. This type of employee benefit differs from those considered previously: it is the termination, rather than the service by the employee that gives rise to the obligation. Termination benefits result from either an entity’s decision to terminate employment or an employee’s decision to accept an entity’s offer of voluntary redundancy. Termination benefits do not include employee benefits resulting from termination of employment at the request of the employee without an entity’s offer, or as a result of mandatory retirement arrangements, because those benefits are post-employment benefits. (IAS 19 paras 159-160). The requirements for recognising and measuring a termination benefit liability are provided in IAS 19 paras 165–170. IAS 19 is used to measure employee termination benefits that form part of a restructuring provision, where that restructuring provision meets the criteria for recognition under IAS 37. Recognising termination benefits To recognise a liability for termination benefits, an entity must be demonstrably committed to either terminating the employment of employees before their normal retirement date or providing termination benefits as a result of an offer made to encourage voluntary redundancy. In accordance with IAS 19 para. 165, a liability and expense for termination benefits should be recognised at the earlier of the following dates: (a) when the entity can no longer withdraw the offer of those benefits; and

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(b) when the entity recognises costs for a restructuring that is within the scope of IAS 37 and involves the payment of termination benefits.

Further guidance on the date at which the entity can no longer withdraw the offer of benefits is provided in IAS 19 paras 166–167. Measuring termination benefits Measurement of a termination benefit depends on when the termination will occur. If payment is expected to be less than 12 months from reporting date, then the liability is calculated based on the nominal value of benefits in the same way as other short-term benefits. If payment is expected to be more than 12 months from the reporting date, the liability is calculated by discounting the estimated cash flows in the same way as other long-term benefits. Where voluntary redundancies are offered, the measurement of the termination benefits will also require an estimation of the number of employees expected to accept the offer. However, where uncertainty exists regarding the number of employees who may accept voluntary redundancy, a contingent liability may exist, disclosure of which may be required under IAS 37 para. 28 (discussed later in this unit).

Example – Identifying liabilities for redundancy This example illustrates when and how to recognise a termination benefit. ClickOnMe Limited (ClickOnMe) recently acquired 100% of StickOnMe Limited (StickOnMe), with an acquisition date of 15 March 20X3. ClickOnMe has a financial year end of 30 June. On 15 June 20X3, the chief executive officer (CEO) of ClickOnMe advised that, following the acquisition, the following redundancies would occur: •• ClickOnMe: 10 administrative employees from head office, with an average annual salary of $50,000 and an average of five years’ service. These redundancies were as a result of the acquisition. •• StickOnMe: 20 distribution employees from the Hamilton branch, with an average annual salary of $30,000 and an average of four years’ service. These redundancies were in accordance with a decision made by the StickOnMe board before the acquisition and would have occurred even had the acquisition not gone ahead. The redundancy package for each employee will be four weeks’ pay for each year of service. The CEO of ClickOnMe expects the redundancies of StickOnMe employees to be completed by 31 July 20X3. In addition, 10 employees of StickOnMe were offered voluntary redundancy on the same terms as the forced redundancies. These employees had an average annual salary of $40,000 and an average of 10 years’ service. Management was uncertain as to how many of these employees would accept the offer. The board of ClickOnMe only decided on 15 June 20X3 that ClickOnMe employees would be made redundant, and as at 30 June 20X3 had not yet held discussions with employee representatives or made any public announcement. A public announcement was subsequently made on 11 July 20X3. The redundancy liability that should be recognised at 30 June 20X3 is calculated as follows: (i) StickOnMe

Four weeks pay = $30,000 ÷ 52 × 4 = $2,308 per person per year



Redundancy liability = $2,308 × 4 years service × 20 employees = $184,640



The voluntary redundancies will not be recognised as a liability at 30 June 20X3 because there is uncertainty as to the number of employees that will accept the offer. A disclosure as a contingent liability under IAS 37 para. 86 may be required.

(ii) ClickOnMe

There is no redundancy liability that can be recognised.



ClickOnMe was not demonstrably committed to the redundancies of its employees at 30 June 20X3. Under IAS 19, a detailed formal plan needed to exist before the reporting

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date for a present obligation to arise for the redundancies. Discussions with employee representatives had not occurred as at 30 June 20X3 and it is possible that the eventual number and terms of the redundancies could vary significantly from the original proposal.

As the announcement by directors was made on 11 July 20X3, there is no obligation as at 30 June 20X3.

Disclosures The key disclosure requirements of IAS 37 are located in the following paragraphs: •• Provisions: paras 84, 85, 87 and 88. •• Contingent liabilities: paras 86, 87, 88 and 91. •• Contingent assets: paras 89, 90 and 91. IAS 37 para. 92 provides some relief from compliance with the disclosure requirements where: ... some or all of the information … can be expected to prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset.

Where this exemption is applicable, the general nature of the dispute, together with the fact and reason why the information has not been disclosed, must be stated in the financial report. IAS 19 does not require specific disclosures for short or long-term employee benefits or termination benefits; however, other Standards may require further disclosures. Quiz [Available online in myLearning]

Working paper F You are now ready to complete working paper F of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

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Unit 12: Leases Contents

fin31912_csg_03

Introduction 12-3 Background of IFRS 16 12-4 IFRS 16 overview Scope of IFRS 16 Navigating IFRS 16

12-5 12-6 12-6

Identifying a lease Understanding the characteristics of a lease Does the contract contain a lease?

12-7 12-7 12-7

Lessee accounting Recognition of the lease Initial measurement of the lease liability Initial measurement of right-of-use asset Subsequent measurement Other issues for lessees Recognition exemptions for certain leases Complex issues for lessees Presentation and disclosure for lessees

12-8 12-9 12-9 12-11 12-12 12-13 12-14 12-15 12-16

Lessor accounting Classifying a lease as an operating or a finance lease Accounting for a finance lease Accounting for operating lease Presentation and disclosure for lessors Sale and leaseback transactions

12-16 12-17 12-19 12-20 12-21 12-21

Tax effect implications of leases

12-24

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Learning outcomes At the end of this unit you will be able to: 1. Discuss the characteristics of a lease. 2. Explain and account for lease transactions (for lessees). 3. Explain and account for lease transactions (for lessors). 4. Explain and account for sale and leaseback transactions.

Introduction Leasing is a common way for entities to obtain the use of assets without having to purchase the assets outright. It is therefore an important source of medium- and long-term finance. For the purposes of the FIN module, this unit will cover the accounting for lease contracts but will not extend to cover the accounting for subleases and lease modifications. IFRS 16 Leases prescribes the accounting and disclosure requirements for leases for both lessees and lessors. IFRS 16 replaces the current treatment of accounting for leases under the existing Accounting Standard IAS 17 Leases. The application of IFRS 16 to an entity with a 30 June annual reporting year end is as follows:

IFRS 16 implementation for an entity with a 30 June annual year end

1 January 2019

1 July 2019

30 June 2020

First year the entity applies IFRS 16

IFRS 16 applies to annual reporting periods commencing on or after 1 January 2019 An entity can adopt IFRS 16 early; however, if it does it must also apply IFRS 15 Revenue from Contracts with Customers on or before it adopts IFRS 16.

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Transitioning to IFRS 16 has major implications for lessees, as it permits a lessee to choose between two approaches when first applying IFRS 16:

Year ended 30 June 2020 financial statements

The retrospective lease transition approach

1 July 2018

30 June 2019

30 June 2020 comparative financial statements apply IFRS 16

The modified retrospective lease transition approach

30 June 2020 1 July 2018

Apply IFRS 16

30 June 2019

30 June 2020 comparative financial statements apply IAS 17

30 June 2020

Apply IFRS 16

Timing of adjustment to opening retained earnings to transition to IFRS 16 The selected transition approach must be applied consistently to an entity’s leases

The FIN module will not examine the IFRS 16 transition approaches. Unit 12 overview video [Available online in myLearning]

Background of IFRS 16 One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet. Sir David Tweedie, Former Chairman of the IASB, April 2008, accessed 16 April 2018, www.pwc.com/gx/en/communications/pdf/communications-review-april-2017.pdf

The IFRS 16 project was started as a joint project between the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board. It was the boards’ original intention to develop a fully converged Standard; however, ultimately the two boards chose different models. It took the IASB 10 years to develop and finalise IFRS 16.

The need for a new leasing standard The key reasons for developing a new leasing standard are explained below: Reason

Explanation

A significant source of finance was not recognised on the statement of financial position

In 2014 the estimate of ‘off balance sheet’ lease commitments approximated US$3 trillion for listed companies reporting under IFRS or US Generally Accepted Accounting Principles (GAAP) An analysis by region revealed long-term lease liabilities were understated by 32% of entities in Asia/Pacific, 26% in Europe and 22% in North America Source: IFRS Foundation 2016, IFRS 16 Leases – Project Summary and Feedback Statement, accessed 16 April 2018, www.ifrs.org

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Reason

Explanation

Lack of comparability in financial statements

The accounting for a lease by lessees under IAS 17 differed between entities and often by industry or region Compound this difference in accounting treatment with the accounting treatment that applies when an entity borrows funds to purchase an asset outright. In that situation, the asset and liability are both recognised on the statement of financial position. Ultimately, an entity is gaining economic benefits from the use of an underlying asset. The accounting treatment should not vary significantly when finance is used to obtain the benefits from the use of an asset As a result, market analysts and investors were not able to properly compare entities that borrow to buy assets with those that lease assets without having to make adjustments that involve significant estimates This lack of comparability is in contrast with one of the IFRS Foundation’s objectives in their mission statement, which states: IFRS Standards bring transparency by enhancing the international comparability and quality of financial information, enabling investors and other market participants to make informed economic decisions (Source: IFRS Foundation, www.ifrs.org)

IFRS 16 adopts a balance sheet approach, whereas the accounting treatment for a lessee under IAS 17 was based on categorising the lease either as a finance lease (recognised on balance sheet) or an operating lease (not recognised on balance sheet). This lease categorisation required the exercise of significant professional judgement, with varying approaches taken in practice and resulted in significantly different accounting treatment for the lessee as explained below: Category of lease

Explanation

Lessee accounting treatment

Finance lease

A lease that transfers substantially all the risks and rewards of ownership

A leased asset and lease liability are recognised on the statement of financial position Interest expense and depreciation of the leased asset are recognised in profit or loss

Operating lease

Any other lease

Operating lease expenses are expensed when incurred over the life of the lease

IFRS 16 overview IFRS 16 was developed to address the problems of off–balance sheet financing and lack of comparability in financial statements. The treatment for most leases under IFRS 16 is that the lessee must now recognise a right-of-use asset and lease liability on the statement of financial position. The impact of this accounting treatment extends beyond journal entries. Applying this accounting methodology has implications for an entity in areas such as: •• Financial ratios and performance metrics (e.g. gearing ratios, return on capital employed, and earnings before interest, tax, depreciation and amortisation (EBITDA)). •• Loan covenants, as adverse movements in financial ratios may cause an entity’s loan covenant to be breached. Loan covenants would need to be renegotiated with lenders to prevent adverse impacts, such as higher interest rates and the potential for borrowings to be immediately repaid. •• Employee incentive (bonus) schemes and share-based payment arrangements, which could be adversely impacted by reductions in profit.

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Interestingly, lessor accounting under IFRS 16 is largely consistent with that under IAS 17, that is, by accounting for a lease as either an operating or a finance lease. The focus in this unit is on accounting for new lease transactions under IFRS 16 rather than how an entity applies the transitional provisions of IFRS 16 for existing leases as it moves from the IAS 17 accounting requirements. Required reading Read IFRS 16 paras 1–4 and 9–21 before proceeding.

Scope of IFRS 16 IFRS 16 applies to most common types of leases; however, there are various exclusions from its scope, including: •• Rights held by a lessee under a licensing agreement (e.g. for the use of a patent or copyright accounted for under IAS 38 Intangible Assets). •• Licenses for the use of intellectual property granted by a lessor (e.g. use of software, music and trademarks accounted for under IFRS 15 Revenue from Contracts with Customers). •• Leases to explore for or use minerals, oil and natural gas.

Navigating IFRS 16 The table below maps the key parts of IFRS 16 that will be covered in this unit. It also outlines the paragraphs that details lease accounting, which should be read as you progress through this unit: Key part of IFRS 16

Paragraphs (required reading)

Definitions

Appendix A

Objective and scope

Paras 1–4

Recognition exemptions

Paras 5–8

Identifying a lease

Paras 9–17

Lease term

Paras 18–21

Lessee accounting •• Recognition and measurement

Paras 22–46

•• Presentation and disclosure

Paras 47–60

Lessor accounting •• Classification of leases

Paras 61–66

•• Finance leases – recognition and measurement

Paras 67–80

•• Operating leases – recognition and measurement

Paras 81–87

•• Presentation and disclosure Sale and leaseback transactions

Paras 88–97 Paras 98–103

Candidates may also find the application guidance in IFRS 16 Appendix B helpful in exploring the key concepts.

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Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Identifying a lease Understanding the characteristics of a lease A lease is defined in IFRS 16 as: A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration

The two parties to a lease are: •• The lessee – the entity that obtains the right to use an underlying asset for a period of time in exchange for consideration. •• The lessor – the entity that provides the right to use an underlying asset for a period of time in exchange for consideration. Typically, the lessor has legal title of the asset, and the lease agreement will: •• assign the right to use an asset for a specified time •• specify payment amounts and dates •• specify whether legal ownership will pass to the lessee at the end of the lease •• specify other contractual obligations, including responsibility for maintenance and insurance of the asset.

Does the contract contain a lease? An entity must determine whether a contract is a lease or contains a lease under IFRS 16. A contract is a lease or contains a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. The flowchart below illustrates the points where an entity will need to apply judgement. For each of the decision points in the flowchart, there are additional explanations and guidance given in IFRS 16 Appendix B. Is there an identified asset?

No

Yes

Does the customer have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use?

No

Yes

Customer

Does the customer, the supplier, or neither party, have the right to direct how and for what purpose the asset is used throughout the period of use?

Supplier

Neither

Yes

Does the customer have the right to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions? No

Did the customer design the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use?

No

No Yes

The contract contains a lease

The contract does not contain a lease

Adapted from IFRS 16 Appendix B para. B31.

Unit 12 – Core content

Page 12-7

Financial Accounting & Reporting

Chartered Accountants Program

Example – Identifying a lease This example illustrates how to identify a lease under IFRS 16. Aqua Limited is currently planning the set-up of a new administration centre. It has received a proposal for a five-year rental contract for office space from Lordover Limited and Aqua needs to determine how the contract would be classified. Under the terms of the arrangement, Aqua will have exclusive rights to the second and third floors in an identified office block during the life of the contract. Lordover will be responsible for any general building maintenance. The contract contains a lease of office space as: •• Is there an identified asset – Aqua has the right to use the identified floors for five years, and this is explicitly identified in the contract. •• Substantially all of the economic benefits from use over the contract term – Aqua has exclusive rights to the office space over the contract term. •• Right to direct how and for what purpose the asset is used – Aqua can decide how and for what purposes the office space is used during the contract. Worked example 12.1: Identifying a lease under IFRS 16 [Available online in myLearning] Further reading IFRS 16 Appendix B – Application guidance paras B9–B31.

Lessee accounting Lessee accounting has changed significantly with the introduction of IFRS 16. This diagram provides an overview of the key aspects a lessee will consider when accounting for a lease. Analyse the lease contract

Does a recognition exemption apply?

Yes

Page 12-8

No

Recognise the lease on the statement of financial position Exemption — short-term asset lease OR Exemption — low-value asset lease

Apply appropriate accounting treatment Prepare appropriate presentation and disclosures

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

A lessee entering into a lease contract for the use of an underlying asset will analyse the lease agreement, which will determine its accounting treatment. The general accounting treatment for a lessee reflects that, at the start of a lease, the lessee obtains both a right-of-use asset and a lease liability. Later in this unit, we will consider exemptions from this general accounting treatment. Required reading Read the definitions of the following terms from IFRS 16 before proceeding: • Commencement date of the lease. • Economic life. • Fixed payments. • Inception date of the lease. • Initial direct costs. • Interest rate implicit in the lease. • Lease incentives. • Lease payments. • Lease term. • Lessee’s incremental borrowing rate. • Residual value guarantee. • Unguaranteed residual value. Required reading Read IFRS 16 paras 22–38 before proceeding.

Recognition of the lease The lease is initially recognised on the statement of financial position as follows: Right-of-use asset

Lease liability

Initial recognition on the statement of financial position

Initial measurement of the lease liability To determine the value of the right-of-use asset to initially recognise, the value of the lease liability must first be calculated. The measurement is performed as follows: Lease liability – initial measurement at commencement date

Fixed payments less any lease incentives receivable

Variable lease payments that are based on an index or rate

Amounts expected to be payable under residual value guarantees

Purchase option exercise price where lessee is reasonably certain to exercise

Penalties for termination of lease (but only where lease term reflects early termination)

Discounted at interest rate implicit in the lease (if not known then use the lessee’s incremental borrowing rate) Adapted from: Grant Thornton 2016, Major reforms to global lease accounting, accessed 16 April 2018, www.grantthornton.ie/globalassets/1.-member-firms/ireland/insights/publications/grant-thornton---ifrs-16-leasesspecial-edition.pdf.

Unit 12 – Core content

Page 12-9

Financial Accounting & Reporting

Chartered Accountants Program

Example – Identifying the interest rate to apply when measuring the lease liability This example illustrates how to identify the interest rate that a lessee should apply to determine the lease liability at the commencement date of the lease. Re-read the definitions of ‘interest rate implicit in the lease’ and the ‘lessee’s incremental borrowing rate’ to assist in understanding this scenario. Boaty-Mac Limited is a lessee that enters into a lease arrangement for a ship from Deep Pockets Limited. The lease contract does not specify the interest rate implicit in the lease and Boaty-Mac does not know the initial direct costs that Deep Pockets incurred in entering into the lease. Boaty-Mac has to estimate its own incremental borrowing rate and does so by calculating an interest rate that reflects: •• the interest rate that would be charged if Boaty-Mac was to borrow over a similar term for an asset of a similar value to the right-of-use asset embodied in the ship •• the security it would need to provide to obtain such a borrowing •• a similar economic environment Boaty-Mac determines its incremental borrowing rate to be 8% and uses this when calculating the lease liability at the commencement date and the interest expense on the lease liability. [In the FIN module the interest rate implicit in the lease and/or the lessee’s incremental borrowing rate will be stated. You will not have to perform these calculations.] Example of items to be included in the initial measurement of the lease liability at the commencement date:

†

Item

Included? Yes or No

Explanation

Monthly lease payments under a three-year lease term

Yes

This is a fixed payment

Lease payments that will increase in line with increases in the consumer price index

Yes

This is a variable lease payment that is based on an index

A fixed final payment that will result in the transfer of the legal ownership of the underlying asset at the end of the lease. The payment is considerably lower than the estimated value of the underlying asset at the end of the lease term and the lessee is intending to make this payment

Yes

This is a purchase option which the lessee is reasonably certain to exercise

Reimbursement of agent's commission to be made by the lessor to a lessee relating to a premises under a lease

Yes

This is a lease incentive receivable

Substantial penalties to be paid for early termination of a lease; however, the lessee intends to complete the lease term

No

The lessee intends to use the underlying asset for the lease term and therefore termination penalties would not apply

Legal costs incurred by the lessee for reviewing a lease contract

No

These will be included in the initial measurement of the right-of-use asset but are not included in the lease liability

Compensation to be paid by a lessee to the lessor if the value of the underlying asset is below a specified amount at the end of the lease†

Yes

This is a residual value guarantee

It expects it will pay this compensation based on how it has used similar assets in the past.

Page 12-10

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Example – Calculating the lease liability at the commencement date This example illustrates how to calculate the lease liability at the commencement date. Alpha Limited (Alpha) leases some equipment from Beta Limited (Beta) under an agreement that meets the definition of a lease under IFRS 16. Under the terms of the lease, Alpha will make five annual payments of $10,000 commencing on 30 June 20X3. When the lease expires on 30 June 20X8 Alpha has the option to pay $15,000, which would result in legal title to the underlying asset being transferred from Beta to Alpha. As at the commencement date, Alpha does not intend to pay this amount. The interest rate implicit in the lease is 10%. Calculation of lease liability at the commencement date Year

Date

Payment $

PV factor

PV cash flow $

0

30 June 20X3

10,000

1.0000

10,000

1

30 June 20X4

10,000

0.9091

9,091

2

30 June 20X5

10,000

0.8264

8,264

3

30 June 20X6

10,000

0.7513

7,513

4

30 June 20X7

10,000

0.6830

6,830

5

30 June 20X8*

–

Lease liability

41,698

* Note: The $15,000 optional payment is excluded from the lease liability calculation at the commencement date as Alpha is not reasonably certain to exercise the purchase option.

Unit 12 Present value calculations in the FIN module [Available online in myLearning]

Initial measurement of right-of-use asset The initial measurement of the right-of-use asset at the commencement of the lease can be shown as follows: Right-of-use asset – initial measurement at commencement date

Lease liability (amount initially measured)

Prepaid lease payments

Initial direct costs

Estimated costs to dismantle/ remove/ restore (link to Unit 11)

Lease incentives received

Adapted from: Grant Thornton 2016, Major reforms to global lease accounting, accessed 16 April 2018, www.grantthornton.ie/globalassets/1.-member-firms/ireland/insights/publications/grant-thornton---ifrs-16-leasesspecial-edition.pdf.

Unit 12 – Core content

Page 12-11

Financial Accounting & Reporting

Chartered Accountants Program

Example – Prepaid lease payment This example illustrates a prepaid lease payment. Charlie Limited is a lessee that enters into a lease arrangement for a machine from Delta Limited. Charlie signs the lease agreement on 13 March 20X8 and pays $10,000 as a lease payment to Delta. The machine is delivered to Charlie on 13 April 20X8, which is the lease commencement date. The lease liability is measured at $420,000 on 13 April 20X8. Charlie’s right of use asset is $430,000, comprising the $420,000 lease liability measured at the commencement date and the $10,000 prepaid lease payment.

Subsequent measurement Lease liability Calculating the lease liability is very similar to amortised cost calculations for financial instruments (covered in Unit 9): Lease liability – subsequent measurement

Initial measurement of lease liability

Lease payments made

Interest

Any reassessment of the lease liability, lease modifications and revised in-substance fixed lease payments (practical application of this aspect is beyond the scope of the FIN module)

Right-of-use asset The subsequent measurement of the right-of-use asset can be shown as follows: Right-of-use asset – subsequent measurement Three options for measurement 1

2

3

Cost model under IAS 16 Property, Plant and Equipment (IAS 16)

Revaluation model under IAS 16 (application to leases is beyond the scope of the FIN module)

Fair value model under IAS 40 Investment Property (application to leases is beyond the scope of the FIN module)

Recognise any impairment losses under IAS 36 Impairment of Assets

Depreciation Ownership will transfer/ purchase option will be exercised

Other situations

Depreciate from the commencement date to end of useful life of the underlying asset

Depreciate from the commencement date to the earlier of: • the end of the useful life of the right-of-use asset • the end of lease term

Worked example 12.2: Accounting for a lease by a lessee [Available online in myLearning]

Page 12-12

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Other issues for lessees 1. Variable lease payments The treatment of variable lease payments depends on the basis on which the lease payment varies. The treatment can be summarised as follows: Variable lease payments (lessee) Based on an index or rate (IFRS 16 paras 27(b) and 28) • Included in the measurement of the lease liability • The payments are unavoidable as uncertainty relates to the measurement of the liability rather than to its existence Note that remeasurement of the lease liability is beyond the scope of the FIN module

Based on any other variable (IFRS 16 para. 38(b)) • Not included in the measurement of the lease liability • Recognised in profit or loss when the event or condition that triggers that event occurs

For example, variable lease payments that are based on a benchmark market interest rate or market rental rate

For example, variable lease payments that are based on a percentage of sales revenue, output or asset usage

In-substance fixed payments (IFRS 16 para. 27(a) and B 42) • Included in the measurement of the lease liability because in substance they are unavoidable

For example, the lessee has the choice to either exercise a purchase option to acquire the underlying asset or extend the lease term. The lower of the discounted cash outflows is the in-substance fixed payment as one of the two options will be taken

2. Separation of lease and non-lease components A contract may contain a lease that includes an agreement to purchase other goods or services (i.e. non-lease components such as cleaning or maintenance). For these contracts, the non-lease components are identified and accounted for separately from the lease component. However IFRS 16 para. 15 permits a lessee to make an accounting policy election, by class of underlying asset, to account for both components as a single lease component. Lessees that do not make this election are required to allocate the consideration in the contract to the lease and non-lease components on a relative standalone price basis.

3. Implications of an option to extend a lease The definition of ‘lease term’ includes the period of time covered by an option to extend the lease if the lessee is ‘reasonably certain’ to exercise that option. Reasonable certainty is not defined in the accounting standards, therefore the lessee will need to exercise professional judgement when considering their intentions relating to an option to extend the lease term. When there is reasonable certainty, the lease payments for this extension period will be included in the measurement of the lease liability, with a corresponding adjustment to the right-of-use asset.

Unit 12 – Core content

Page 12-13

Financial Accounting & Reporting

Chartered Accountants Program

Example – Determining the impact of an option to extend a lease This example illustrates when an option to extend a lease is included in lease payments. Scenario 1 – Immediate Limited (Immediate) enters into a lease contract for a retail premises for a period of five years. The lease contract contains an option to extend the lease for a further five years. Based on both the costs it incurred to fit out the premises and its business prospects, Immediate is reasonably certain that it will extend the lease when the option arises. In this scenario, the present value of the lease payments for the second period of five years will be included in the calculation of the initial measurement of the lease liability. Scenario 2 – LaterOn Limited (LaterOn) enters into a lease contract for a retail premises for a period of seven years. The lease contract contains an option to extend for a further seven years. At the commencement of the lease, LaterOn is uncertain whether it will extend the lease when the option arises. In this scenario, the present value of the lease payments for the second period of seven years will not be included in the calculation of the initial measurement of the lease liability. [If, after commencing the lease, LaterOn’s intentions change and there is reasonable certainty of exercising the option, the lease liability is remeasured with a corresponding adjustment to the right-of-use asset (IFRS 16 paras 39–43); however these calculations are beyond the scope of the FIN module.]

Recognition exemptions for certain leases IFRS 16 permits two optional recognition exemptions: short-term leases and low-value assets. If the exemption is used, lease payments generally are expensed on a straight-line basis over the lease term. Required reading Read IFRS 16 paras 5–8 before proceeding.

Short-term lease The lease has a term of 12 months or less from the commencement date. A purchase option in the lease agreement excludes the use of this exemption. This exemption is an accounting policy choice which must be applied for each class of underlying asset.

Example – Accounting for a short-term lease This example illustrates how to account for a short-term lease contract. YoghurtDaze Limited enters into a lease contract with PlentyOfShops Limited for the lease of a shop for its yoghurt business. The contract contains an option to extend the lease at the end of the lease period. The shop becomes available after the previous tenant has left the premises. YoghurtDaze will lease the shop for the summer tourist season. YoghurtDaze does not intend to exercise the optional extension clause beyond the summer period as its business drops dramatically once the weather cools down. YoghurtDaze will expense the lease payments over the three-month summer period. If YoghurtDaze leases other retail premises, it must elect to use the short-term lease exemption for all of its retail premises where the lease term is 12 months or less.

Page 12-14

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Low-value assets The assessment of whether an asset is low value applies to when the asset was new. According to the IASB, it was thinking of an asset with a new value of under US$5,000 at the time of reaching its decisions on this exemption (Basis of Conclusions para. 100). Typically this exemption applies to items such as computers, phones and office equipment. This exemption is an accounting policy choice, which can be made on a lease-by-lease basis.

Example – Accounting for a low-value asset This example illustrates how to account for the lease of a low-value asset. CallCentre Limited enters into a lease contract with PCsRUS Limited for the lease of 40 computers for its call centre business. The lease contract contains a purchase option and CallCentre is reasonably certain it will exercise the option at the end of the three-year lease term. The computers have an expected useful life of four years. If purchased outright, the cost of each computer at the lease commencement is $3,000. CallCentre elects to account for the lease as a low-value asset lease. Accordingly, CallCentre will expense the lease payments over the three-year lease term. Subsequently, it will account for the computers under IAS 16 Property, Plant and Equipment if it exercises the purchase option at the end of the three-year lease term.

Complex issues for lessees Lease contracts can be very complicated in practice and IFRS 16 establishes the accounting treatment for various complexities. Accounting for these more complex issues is beyond the scope of the FIN module; however, a brief overview is provided below to raise awareness of these issues. Required reading Read IFRS 16 paras 39–46 before proceeding. Complex issues for lessees

Overview

Reassessing the lease liability

The lease liability may need to be re-calculated if there is a change, including a change to the: •• lease term •• future lease payments (e.g. changes made based on a market rent review) •• intention to exercise a purchase option

Lease modifications

Unit 12 – Core content

The modification may need to be accounted for as a separate lease. For example, when the modification adds the right to use an additional underlying asset along with the use of the asset specified in the original lease contract

Page 12-15

Financial Accounting & Reporting

Chartered Accountants Program

Presentation and disclosure for lessees Required reading Read IFRS 16 paras 47–60 before proceeding. The presentation and disclosure requirements of IFRS 16 for lessees are extensive. Key requirements include: •• Depreciation and interest expense (interest expense can be disclosed within finance costs). •• Expense relating to short-term leases. •• Expense relating to low-value assets. •• Right-of-use assets (disclosed separately from other assets, either in the statement of financial position or notes). •• Lease liabilities (disclosed separately from other liabilities, either in the statement of financial position or notes). •• Statement of cash flows disclosures for the principal component of the lease liability, interest on the lease liability and short-term lease payments, and payments for low-value assets. Further reading IASB 2016, IFRS 16 Leases – Effects Analysis, Appendix C Effects on a company’s financial statements: illustrative examples, accessed 16 April 2018, www.ifrs.org/Current-Projects/IASB-Projects/Leases/ Documents/IFRS_16_effects_analysis.pdf

Lessor accounting Accounting for a contract that is identified as a lease under IFRS 16 is essentially the same as that under the existing IAS 17. Leases are classified as either operating leases or finance leases, in accordance with their substance rather than their legal form. This diagram provides an overview of the key aspects a lessor will consider when accounting for a lease. Classify each lease as a finance or operating lease

Apply appropriate accounting treatment if classified as a finance lease

Prepare appropriate presentation and disclosures

Apply appropriate accounting treatment if classified as a operating lease

Required reading Read the definitions of the following terms from IFRS 16 before proceeding: • Fair value. • Finance lease. • Gross investment in the lease. • Net investment in the lease. • Operating lease. • Lease term. • Lessee’s incremental borrowing rate. Required reading Read IFRS 16 paras 61–87 before proceeding.

Page 12-16

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Classifying a lease as an operating or a finance lease A lease is classified at its inception by the lessor as either a finance lease or an operating lease: •• A finance lease ‘transfers substantially all the risks and rewards incidental to ownership of an underlying asset’ to the lessee (IFRS 16). The legal title of the asset may or may not be transferred to the lessee by the end of the lease term. •• An operating lease is a lease other than a finance lease where the lessor retains ‘substantially all the risks and rewards incidental to ownership of the underlying asset’. The classification of a lease is based on the substance of the transaction rather than the legal form of the contract. The classification determines its accounting treatment (IFRS 16 para. 63). When classifying a lease, ask this question:

Where do the risks and rewards incidental to ownership of the underlying asset substantially reside?

The risks and rewards incidental to ownership of an underlying asset must be considered when establishing the substance of the lease and therefore its classification, as shown in the table. Risks and rewards incidental to ownership of an underlying asset (IFRS 16 Appendix B para. B53) Risks

Rewards

Possibility of losses from idle capacity

Expectation of profitable operation over the economic life of the underlying asset

Possibility of losses from technological obsolescence Variations in returns caused by changing economic conditions

Expectation of gain from an appreciation in value or realisation of a residual value

The following table summarises typical situations and indicators to look for when classifying a lease: Typical situations and indications when classifying a lease (IFRS 16 para. 63) Normally leads to finance lease classification

May lead to finance lease classification

Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease:

Indicators of situations that individually or in combination could lead to a lease being classified as a finance lease:

•• The lease transfers ownership of the asset to the lessee by the end of the lease term

•• If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee

•• The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised (often called a ‘bargain purchase’ option) •• The lease term is for the major part of the asset’s economic life even if title is not transferred

•• Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the lease) •• The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent (IFRS 16 para. 64)

•• At the inception of the lease, the present value of the lease payments amounts to at least substantially all of the fair value of the leased asset •• The leased assets are of such a specialised nature that only the lessee can use them without major modifications

The above situations and indicators are not always conclusive. If it is clear from other features of the lease that it does not transfer substantially all the risks and rewards incidental to ownership, then classify the lease as an operating lease (IFRS 16 para. 65).

Unit 12 – Core content

Page 12-17

Financial Accounting & Reporting

Chartered Accountants Program

The accounting treatment for a lessor under IFRS 16 can be summarised as follows: Lease classification for a lessor Operating lease

Finance lease Statement of financial position of lessor • Underlying asset is not recognised • Lease receivable is recognised Lessor is providing finance to the lessee

Lease payments represent: • Finance income on the lease receivable • Reduction in the lease receivable

Statement of financial position of lessor • Underlying asset is recognised Lessor is effectively renting the asset to the lessee

Recognises: • Operating lease payments as revenue • Depreciates the underlying asset

The classification between operating and finance lease does not apply to the lessee. The lessee will apply the appropriate accounting explained earlier in this unit (e.g. recognise a right-of-use asset and lease liability, short-term lease accounting, or low-value asset accounting)

Page 12-18

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Accounting for a finance lease The following section describes the accounting treatment for a finance lease for a lessor. For the purposes of the FIN module, we will not consider manufacturer or dealer leases. Instead, the focus is on a lessor other than a manufacturer or dealer, for example, a finance company.

Initial recognition The lease receivable recognised by the lessor as an asset at the commencement of the lease is determined by first calculating the gross investment in the lease. The calculation of the asset to be recognised in the statement of financial position can be shown as follows:

Gross investment in the lease

Lease payments receivable by the lessor

Unguaranteed residual value accruing to the lessor

Discounted using the interest rate implicit in the lease

The net investment in the lease

The value of the lease receivable recognised in the statement of financial position at the commencement date The lease receivable can also be calculated as

The fair value of the underlying asset

Any initial direct costs of the lessor Lease payments receivable by the lessor

Fixed payments less any lease incentives receivable

Variable lease payments that are based on an index or rate

Amounts expected to be payable under residual value guarantees

Purchase option exercise price where lessee is reasonably certain to exercise

Penalties for termination of lease (but only where lease term reflects early termination)

Notice how the lease payments receivable by the lessor are equivalent to the lease payments payable by the lessee covered earlier in the unit.

Unit 12 – Core content

Page 12-19

Financial Accounting & Reporting

Chartered Accountants Program

Subsequent measurement A lessor will account for lease payments under a finance lease as follows: Lease payments are split between

Finance income on the lease receivable recognised based on a constant periodic rate of return (using the interest rate implicit in the lease)

Reduction in the lease receivable (reduces the principal of the asset balance)

The calculations are very similar to those for financial assets categorised and measured at amortised cost that were covered in Unit 9

Accounting for operating lease The accounting entries for an operating lease are relatively straightforward. An operating lease is effectively a rental agreement for an underlying asset. Accounting for an operating lease can be summarised as follows: Accounting for an operating lease

• The underlying asset subject to the operating lease is classified by its nature in the statement of financial position • Depreciate the asset consistent with the depreciation applied to similar assets of the entity

• Initial direct costs incurred by a lessor are added to the carrying amount of the underlying asset • These costs are expensed over the lease term on the same basis as the lease income

• Recognise lease payments as income • Recognise on a straight-line basis over the lease term, unless another systematic basis is more appropriate

Example – Accounting for an operating lease This example illustrates the accounting for operating lease payments. Deep Pockets has entered into a lease agreement with Regi-Star Limited for a five-year rental contract for an office building that Deep Pockets owns. The office has a remaining useful life of 15 years. Deep Pockets classifies the lease as an operating lease as the risks and rewards incidental to ownership of the office remain with Deep Pockets. The company receives a $20,000 lease payment for the month of May 20X6 from Regi-Star and records the following journal entry: Date

Account description

31.05.X6

Cash Operating lease income

Dr $

Cr $

20,000 20,000

To record the operating lease payment received from Regi-Star for May 20X6

Note that Regi-Star would recognise a right-of-use asset and lease liability in respect of the lease contract.

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Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Worked example 12.3: Accounting for a lease by a lessor [Available online in myLearning]

Presentation and disclosure for lessors Required reading Read IFRS 16 paras 88–97 before proceeding. The presentation and disclosure requirements of IFRS 16 for lessors are extensive. Key requirements include: •• Finance income on the net investment in a lease. •• A maturity analysis of the lease receivable for finance leases. •• A maturity analysis of future lease payments to be received for operating leases. •• Lease income for operating leases.

Sale and leaseback transactions A sale and leaseback transaction may be used by an entity to unlock cash flow, which an entity can then use to pursue other business strategies. Previously under IAS 17, sale and leaseback transactions were also often entered into as a means of improving a company’s ratios (e.g. the return on assets ratio), particularly when the leaseback part of the transaction for the underlying asset was kept off the balance sheet as an operating lease. The accounting under IFRS 16 is significantly different from that in IAS 17. The IFRS 16 accounting treatment depends on whether the transfer of the asset to the lessor qualifies as a ‘sale’ under IFRS 15. The focus in the FIN module is where the transaction is classified as a sale under IFRS 15, based on fulfilling the performance obligations (as covered in Unit 3). Determining whether the transaction constitutes a sale may require significant professional judgement. In practice, it is anticipated that sale and leaseback transactions will generally not be recognised as a sale under IFRS 15 as control of the asset will usually remain with the lessee. Required reading Read IFRS 16 paras 98–103 before proceeding. A sale and leaseback transaction may be depicted as follows:

Seller-lessee

Sale – transfer of ownership for the underlying asset

Asset Cash

Lease payments

Leaseback – lease contract

Buyer-lessor

Right-of-use for underlying asset

Unit 12 – Core content

Page 12-21

Financial Accounting & Reporting

Chartered Accountants Program

The accounting treatment of sale and leaseback transactions under IFRS 16 can be summarised as follows: Sale and leaseback accounting

Transfer of the asset is a sale under IFRS 15

Seller-lessee 1. The asset is de-recognised 2. A lease liability is recognised 3. A right-of-use asset is recognised in proportion to the asset’s previous carrying amount that relates to the right of use retained 4. A gain or loss is recognised to the extent of the rights transferred to the buyer-lessor

Buyer-lessor 1. Classifies the lease as an operating or finance lease depending on the substance of the transaction 2. Applies the relevant accounting requirements to the lease

Adjustments are required if the sale is not at fair value or where the lease payments are not at market rates (beyond the scope of the FIN module)

Transfer of the asset is not a sale

Seller-lessee 1. The asset is not de-recognised 2. A financial liability equal to the transfer proceeds is recognised

Buyer-lessor 1. A financial asset equal to the transfer proceeds is recognised

IFRS 9 accounting requirements are applied by both parties (application to sale and leaseback transactions is beyond the scope of the FIN module)

A challenging aspect of sale and leaseback accounting is determining the values of the rightof-use asset and the gain or loss to be recognised (items 3 and 4 in the diagram above) for the seller-lessee where the transfer is a sale.

Page 12-22

Core content – Unit 12

Chartered Accountants Program

Financial Accounting & Reporting

Example – Determining the values for the initial accounting for the lessee where the transfer is a sale This example illustrates how to determine the values of the right-of-use asset and the gain or loss to be recognised (items 3 and 4 in the preceding diagram) for the seller-lessee where the transfer is a sale. Facts Carrying amount of asset before sale: $1.5 million Sale consideration (at fair value): $2 million Lease liability: $1.8 million

Measurement of the right-of-use asset

Notional gain on sale

Lease liability Carrying amount of ​ ​ asset    ​        ​​   ​​ × ​______________________ Sale consideration at fair value before sale

Sale consideration ​ ​ at    fair value ​​​ −



$1.5 million

$1.8 million × ​__________ ​  $2 million    ​​

= $1.35 million right-of-use asset



$2 million

−

Carrying amount ​ ​    ​ ​​ of asset before sale $1.5 million

= $500,000

This asset reflects the rights that have been retained by the seller-lessee

Portion of the gain not recognised

Notional gain

Lease liability ______________________

× ​​        ​​ Sale consideration at fair value

$1.8 million __________ $500,000 × ​ ​  $2 million    ​​ = $450,000 This portion of the gain cannot be recognised because it reflects the rights that have been retained by the seller-lessee

Portion of the gain recognised (the balance) Sale consideration ​ at    fair value  ​​ − lease liability Notional gain × ​_____________________________ ​           ​​ Sale consideration at fair value $500,000

×

$2 million − $1.8 million ___________________

   ​​     $2 million ​​

=   $50,000 gain on sale This portion of the gain is recognised because it reflects the rights that have been transferred to the buyer-lessee

Date

Account description

Dr $

xx.xx.xx

Cash

2,000,000

Right-of-use asset

1,350,000

Cr $

Asset

1,500,000

Lease liability

1,800,000

Gain on sale

50,000

(Recording sale of asset, entering into the leaseback transaction and gain recognised in profit or loss)

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Tax effect implications of leases Lease accounting may give rise to tax effect implications under IAS 12 Income Taxes. Based on a practical interpretation of IAS 12, the carrying amount of a lease can be determined by calculating the net lease asset or net lease liability and comparing this with the tax base to establish the value of any temporary difference. This practical interpretation is applied in the FIN module when calculating temporary differences for leases. The temporary difference is multiplied by the applicable tax rate to determine the deferred tax asset (DTA) or deferred tax liability (DTL). Recognition of the DTA or DTL follows the rules covered in Unit 4. [Note that in the FIN module, the taxation treatment of a lease will always be stated to enable any temporary differences to be determined.] Activity 12.1 provides an opportunity to calculate the deferred tax balance relating to a lease. Activity 12.1: Accounting for a lease by a lessee and lessor [Available online in myLearning] Integrated activity 2 The integrated activity is available online in myLearning.

Quiz [Available online in myLearning]

Working paper G You are now ready to complete working paper G of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

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Unit 13: Earnings per share (EPS) Contents Introduction

13-3

Earnings per share Importance of EPS Scope of IAS 33 Basic and diluted EPS

13-3 13-3 13-4 13-4

Calculating EPS Basic EPS Diluted EPS EPS for continuing and discontinued operations Summary – calculating EPS

13-4 13-4 13-11 13-17 13-18

fin31913_csg_01

Disclosures 13-20 EPS presentation and disclosure requirements 13-20 Summary – disclosing EPS 13-21

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Learning outcomes At the end of this unit you will be able to: 1. Explain the requirements for disclosing earnings per share (EPS) information, including which entities need to include EPS information. 2. Calculate basic and diluted EPS for continuing and discontinued operations.

Introduction Earnings per share (EPS) is an indicator that measures an entity’s profitability relative to the number of issued shares of that entity. As a component of the price/earnings ratio, it is used for business valuation and as an indicator of whether shares are expensive or cheap. It allows comparisons of relative profitability between different entities in the same reporting period, and between different reporting periods for the same entity. IAS 33 Earnings per Share prescribes the principles for the determination and presentation of EPS. It recognises that EPS data may have limitations due to the different accounting policies being applied in the calculation of earnings (i.e. the numerator in the EPS calculation); however, it focuses on the number of issued shares (i.e. the denominator in the EPS calculation) on the basis that a consistently determined denominator enhances financial reporting. In your role as a Chartered Accountant, it is likely you will be required to calculate EPS and present EPS information as part of preparing financial statements, and/or apply your understanding of EPS to interpret an entity’s performance. Unit 13 overview video [Available online in myLearning]

Earnings per share Learning outcome 1. Explain the requirements for disclosing earnings per share (EPS) information, including which entities need to include EPS information.

Importance of EPS EPS is considered to be one of the most important indicators of profitability and is widely used in the investment community. One of the reasons for its prominence is that it measures profitability from an investor’s perspective. EPS is also used to calculate the price/earnings ratio, a key indicator of both profitability and share price. While EPS is useful in comparing a company’s profitability between different financial periods, and to other companies in the same reporting period, it does have some limitations. EPS does not take into account the capital contribution of ordinary shareholders; that is, the amount a company receives in issuing the ordinary shares on issue. For example, if Company A and Company B both earn profits of $1.5 million each and both have one million ordinary shares outstanding during the financial period, each company would have the same EPS of $1.50 per share. However, if Company A issued its shares at $1 each and Company B at $0.50

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each, then clearly Company B has produced a better return on the capital from ordinary shareholders.

Scope of IAS 33 IAS 33 applies to the following entities: •• Entities that have their ordinary shares (or potential ordinary shares) traded in a public market. •• Entities that file, or are in the process of filing, financial statements with a securities commission for the purpose of issuing ordinary shares in a public market (IAS 33 para. 2). Where consolidated and separate financial statements are prepared and presented together, EPS is only required to be presented for the consolidated information (IAS 33 para. 4). Any other entities that choose to disclose EPS must apply IAS 33 (IAS 33 para. 3).

Basic and diluted EPS IAS 33 requires the presentation of two EPS figures with equal prominence: •• Basic EPS – calculated using the weighted average number of ordinary shares outstanding. •• Diluted EPS – calculated by including, in addition to the weighted average number of ordinary shares, the future impact of dilutive potential ordinary shares (e.g. from convertible notes, warrants and options) where these would result in a lower EPS than the basic EPS calculated. Required reading IAS 33 (or local equivalent).

Calculating EPS Learning outcome 2. Calculate basic and diluted EPS for continuing and discontinued operations. An ordinary share is defined in IAS 33 para. 5 as ‘an equity instrument that is subordinate to all other classes of equity instruments’. On this basis, it is the substance of an equity instrument, not its description that characterises it as an ordinary share for the purposes of the EPS calculation.

Basic EPS Basic EPS is calculated by dividing profit (or loss) attributable to ordinary equity holders of the parent entity (the numerator) by the weighted average number of ordinary shares outstanding (the denominator) during the period (IAS 33 para. 10), as follows: Profit or loss attributable to ordinary equity holders of the parent entity Weighted average number of ordinary shares outstanding during the period

Earnings The ‘earnings’ used as the numerator in calculating EPS is the profit or loss attributable to the parent entity. As the EPS calculation relates to ordinary shareholders, earnings are adjusted for the effects of any preference shares classified as equity.

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Under IAS 33 para. 12, the numerator is determined after adjusting profit or loss attributable to the parent entity for the following items after tax regarding preference shares classified as equity: •• Preference share dividends. •• Differences arising on the settlement of preference shares. •• Other effects of preference shares.

Example – Calculating basic EPS with preference shares classified as equity This example illustrates adjusting earnings for preference shares classified as equity. Big Limited has a profit after tax of $350,000. It has 1,000,000 ordinary shares and 200,000 non-cumulative preference shares on issue during the financial year. The preference shares are classified as equity. Big paid a preference share dividend of $24,000. Ignore any tax effects. Basic earnings

÷

Weighted average number of ordinary shares

=

Basic EPS

$326,000

÷

1,000,000

=

$0.33

The profit after tax is adjusted for the preference share dividend, as it would be accounted for as a dividend in accordance with IAS 32 para. 35.

Preference shares classified as liabilities In certain circumstances preference shares may be classified as liabilities, as per IAS 32 Financial Instruments: Presentation. Where this is the case, the dividends and income tax expense would be included as expenses (IAS 32 para. 35 and IAS 12 Income Taxes para. 58) when determining the profit for the year, and no adjustment would be necessary.

Example – Calculating basic EPS with preference shares classified as a liability This example illustrates accounting for preference shares that are classified as a liability. Large Limited has a profit after tax of $350,000. It has 1,000,000 ordinary shares and 200,000 non-cumulative preference shares on issue during the financial year. The preference shares are classified as a liability. Large paid a preference share dividend of $24,000. Ignore any tax effects. Basic earnings

÷

Weighted average number of ordinary shares

=

Basic EPS

$350,000

÷

1,000,000

=

$0.35

There is no adjustment to basic earnings for the preference share dividend as it would be accounted for as an expense (i.e. it has already been deducted in calculating profit after tax).

Cumulative versus non-cumulative preference shares Cumulative preference shares are those for which dividends accumulate; that is, if dividends are not paid in the financial year they are due, the obligation to pay the dividends is carried forward to later years. Dividends on cumulative preference shares are deducted from profit used for calculating EPS, whether the dividend has been declared or not. Correspondingly, the profit is not adjusted for dividends on cumulative preference shares paid in the current financial period in respect of previous periods (IAS 33 para. 14(b)).

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Preference shares issued at a discount or premium Where preference shares are issued at a discount or premium, this is considered to be compensation for below or above-market dividend rates. The discount or premium is amortised to retained earnings using the effective interest rate method (defined in IFRS 9 Financial Instruments Appendix A and discussed in the unit on financial instruments), and is treated as a preference dividend for the purposes of calculating earnings per share (IAS 33 para. 15). Repurchase of preference shares Where preference shares are repurchased, the excess of the fair value of the consideration paid over the carrying amount of the preference shares is charged to retained earnings and should be deducted in calculating profit or loss attributable to ordinary equity holders of the parent entity (IAS 33 para. 16). Convertible preference shares Convertible preference shares may not be converted at the fair value of the ordinary shares. This can happen where a company offers an improved conversion rate or cash payment to induce holders to convert their convertible preference shares early (IAS 33 para. 17). Where conversion is not at the fair value of the ordinary shares, the difference is deducted in calculating profit or loss attributable to ordinary equity holders of the parent entity for the purposes of calculating EPS. Fair value of ordinary shares issued at conversion

–

Fair value of ordinary shares issuable under original terms

=

Loss deducted from profit or loss for calculating EPS

Example – Convertible preference shares This example illustrates accounting for convertible preference shares not converted at fair value. Small Limited has 100,000 convertible preference shares on issue, convertible in four years time at two ordinary shares for each convertible preference share held. With the ordinary shares trading at $2.50 each, Small offers to convert the preference shares early at three ordinary shares for each convertible preference share held. If all 100,000 preference shareholders convert their preference shares, the loss will be calculated as follows: Expense on conversion of convertible preference shares Item

$

Fair value of ordinary shares at conversion (100,000 × 3 × $2.50)

750,000

Fair value of ordinary shares issuable under original terms (100,000 × 2 × $2.50)

(500,000

Loss deducted from profit or loss for the purposes of calculating EPS

 250,000

Number of shares Having discussed the numerator for basic EPS, the denominator is now considered. An entity might issue or buy back ordinary shares during a financial period, or holders of convertible instruments may convert those instruments to ordinary shares. For this reason, EPS is calculated using a weighted average of the number of ordinary shares outstanding during the financial period to provide a more accurate measure of the profit earned for each share (IAS 33 para. 19). The weighted average number of ordinary shares outstanding during the period is the number of ordinary shares outstanding at the beginning of the period, adjusted by the number of ordinary shares bought back or issued during the period multiplied by a time-weighting factor (IAS 33 para. 20).

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Time-weighting factor The time-weighting factor is based on the number of days that the shares are outstanding as a proportion of the total number of days in the period (usually 365). Inclusion of new shares Shares are generally included in the calculation of the weighted average number of ordinary shares from the date consideration is receivable (IAS 33 para. 21). Examples of dates for inclusion in the weighted average number of ordinary shares Circumstances of ordinary share issue

Date included for EPS calculation

For cash

Date cash is receivable

On voluntary reinvestment of dividends or preference shares

Date dividends are reinvested

On the conversion of a debt instrument

Date that interest ceases to accrue

In place of interest or principal on other financial instruments

Date that interest ceases to accrue

In exchange for the settlement of a liability

Settlement date

As consideration for the acquisition of a non-cash asset

Date when the acquisition is recognised

For the rendering of services

As the services are rendered

The following is an example of how the time-weighting factor is used to calculate the weighted average ordinary shares outstanding.

Example – Calculating the weighted average number of ordinary shares This example illustrates accounting for changes in the ordinary shares outstanding. Bede Limited (Bede) has a 30 June year end. On 1 July 20X1 Bede had 2,000,000 ordinary shares on issue. On 1 January 20X2 it issued a further 1,000,000 ordinary shares. The weighted average number of ordinary shares at 30 June 20X2 is calculated as: Weighted average number of ordinary shares Details

Period

Days in period

Number of shares

At beginning of period Ordinary share issue

01.07.20X1– 31.12.20X1

184

2,000,000

2,000,000

1,008,2191

01.01.20X2– 30.06.20X2

181

1,000,000

3,000,000

1,487,6711

365

Cumulative Weighted average shares number of ordinary shares

2,495,8901

Note 1. 2,000,000 × 184 ÷ 365

The weighted average number of ordinary shares to be used in the EPS calculation is 2,495,890. Refer to IAS 33 Illustrative examples – Example 2 for another example of calculating the weighted average number of ordinary shares.

Changes in outstanding shares without a corresponding change in resources In the example above, the issue of shares during the financial period was assumed to be in exchange for corresponding resources (i.e. the shares were issued for cash or some other consideration).

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However, certain types of share issues do not result in a corresponding change in resources. For example: •• A capitalisation (dividend reinvestment) or bonus issue. •• A rights issue with a bonus element. •• A share split. •• A reverse share split (share consolidation – IAS 33 para. 27). Impact on the weighted average number of ordinary shares Under IAS 33 para. 26: The weighted average number of ordinary shares outstanding during the period and for all periods presented shall be adjusted for events, other than the conversion of potential ordinary shares, that have changed the number of ordinary shares, outstanding without a corresponding change in resources.

This means that the weighted average number of ordinary shares would be adjusted for the bonus element of a share issue that does not result in a corresponding change in resources, as if those shares had always been on issue. This is done so that EPS is not distorted from period to period for issues that do not result in additional resources. Bonus share issue In a bonus share issue, existing shareholders are issued shares for no consideration in proportion to their existing shareholding (e.g. one ordinary share for every four ordinary shares held). The bonus issue does not change the total equity as no consideration is received. IAS 33 para. 28 requires the number of shares outstanding before the bonus issue to be increased, as though the bonus issue had occurred at the beginning of the earliest period presented. This means that comparatives are also adjusted as if the bonus shares had always been on issue. The adjustment factor is calculated by reference to the proportionate change in the number of ordinary shares outstanding. For example, in a bonus issue where shareholders receive one new share for every four shares held (one-for-four), the adjustment factor is: (4 + 1) = 5 4 4 or 1.25

To adjust EPS for the current period, the weighted average number of ordinary shares before the bonus issue is multiplied by the adjustment factor, thus increasing the weighted average number of shares on issue. This has the effect of decreasing EPS. Conversely, to adjust EPS for the prior periods, the EPS previously calculated should be divided by the adjustment factor. This also has the effect of decreasing EPS.

Example – Bonus issue This example illustrates accounting for a bonus element. At 1 July 20X1 Breght Limited had 4,800,000 ordinary shares on issue. On 1 April 20X2 the company made a bonus issue of one ordinary share for every three ordinary shares held. The weighted average number of shares outstanding for the year ended 30 June 20X2 is calculated as follows: Weighted average number of shares outstanding for the year ended 30 June 20X2 Details

Period

Days in Number of period shares

At beginning of period

01.07.X1–31.03.X2

274

4,800,000

4,800,000

Bonus issue

01.04.X2–30.06.X2

 91 1,600,000**

6,400,000

365

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Cumulative Bonus number of adjustment shares factor

Weighted average number of ordinary shares

4* 3

4,804,384 1,595,616 6,400,000

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(1 + 3) = 4 3 3 1 = ** Bonus issue 4,= 800, 000 # 3 1, 600, 000 * Bonus adjustment factor =

Note: The resulting weighted average number of shares outstanding could be derived by simply adding the original shares on issue to the bonus issue (4,800,000 + 1,600,000), as IAS 33 para. 28 requires the number of ordinary shares before the bonus issue to be adjusted as if the bonus issue had always existed. However, calculating the adjustment factor is important when taking into account other changes in ordinary shares during the period. Refer to IAS 33 Illustrative examples – Example 3 for another example of calculating for bonus issues.

Worked example 13.1: Calculating basic EPS including a bonus share issue [Available online in myLearning] Rights issues In a rights issue, the entity offers existing shareholders additional shares in proportion to their holdings, usually at a discount to the current market value. When offered at a discount to the current market value, a rights issue has a bonus element. The shares outstanding immediately before the rights issue are adjusted to reflect this bonus element as if those shares had always been on issue. This is done as follows: Rights issue adjustment factor Where such a bonus element exists, the adjustment factor as shown in IAS 33 Appendix A para. A2 is applied: Fair value per share immediately before the exercise of rights Theoretical ex-rights fair value per share

Theoretical ex-rights fair value per share The theoretical ex-rights fair value per share (the denominator in the above formula) is determined as follows: Fair value of all oustanding shares before the exercise of rights

+

Proceeds from the exercise of rights

Number of shares outstanding after the exercise of rights

To adjust EPS for the current period, the weighted average number of ordinary shares before the rights issue is multiplied by the adjustment factor, increasing the weighted average number of shares on issue. This has the effect of decreasing EPS. Conversely, to adjust EPS for prior periods, the EPS previously calculated should be divided by the adjustment factor. This also has the effect of decreasing EPS.

Example – Rights issue This example illustrates accounting for a rights issue including a bonus element. At 1 July 20X1, Grimt Limited had 22,000,000 ordinary shares on issue. On 1 December 20X1 Grimt made a rights issue of one share for every five held, at a price of $1.50 per share. The share price on 1 December 20X1 was $2.20 per share. All shareholders took up the rights issue. The formula is used to calculate the theoretical ex-rights fair value per share: Fair value of all outstanding shares + Proceeds from the before the exercise of rights exercise of rights Theoretical ex-rights fair = Number of shares outstanding after the exercise of rights value per share

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(22, 000, 000 # 2.20) + (22, 000, 000 ' 5 # $1.50)

= 22, 000, 000 + (22, 000, 000 ' 5)

= $2.08

The theoretical ex-rights fair value per share is then used to calculate the rights issue adjustment factor: Fair value per share before the exercise of rights

÷

Theoretical ex-rights fair value per share

=

Adjustment factor

$2.20

÷

$2.08

=

1.06

The weighted average number of shares outstanding for the year ended 30 June 20X2 is calculated as follows: Weighted average number of shares outstanding for the year ended 30 June 20X2 Details

Period

Days in period

Number of Cumulative shares number of shares

At beginning of period

01.07.X1–30.11.X1

153

22,000,000

22,000,000

Rights issue

01.12.X1–30.06.X1

212

4,400,000

26,400,000

365

Rights issue adjustment factor

Weighted average number of ordinary shares

1.06

9,775,233 15,333,699 25,108,932

Refer to IAS 33 Illustrative examples – Example 4 for another example of calculating EPS where there has been a rights issue. Worked example 13.2: Calculating basic EPS with a rights issue [Available online in myLearning] Contingently issuable ordinary shares A company may agree to issue ordinary shares in the future for little or no cash or other consideration, on the satisfaction of certain conditions. These shares are known as ‘contingently issuable ordinary shares’ (IAS 33 para. 5). Contingently issuable ordinary shares are often associated with the acquisition of a business, where part of the purchase consideration is only transferred where certain targets or conditions are met. For the purposes of calculating basic EPS, contingently issuable ordinary shares are only included from the date all necessary conditions are met (IAS 33 para. 24). Partly paid ordinary shares Partly paid ordinary shares are treated as a fraction of an ordinary share to the extent that they are entitled to participate in dividends during the period (IAS 33 Appendix A para. A15). Required reading IAS 33 Appendix A paras A1-A2, A15. IAS 32 para. 35. Activity 13.1: Calculating basic EPS [Available online in myLearning]

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Diluted EPS Defining diluted EPS Diluted EPS is a measure of earnings per share taking into account the effects of all dilutive potential ordinary shares (IAS 33 para. 32). However, before discussing how to calculate diluted EPS there are some key terms to consider: Potential ordinary shares IAS 33 para. 5 defines a potential ordinary share as ‘a financial instrument or other contract that may entitle its holder to ordinary shares’. The diluted EPS calculation assumes that an entity’s convertible securities have been converted to ordinary shares. It therefore presents to investors a ‘worst case scenario’ of the dilutive impact on shareholders’ earnings of converting such securities. Common types of convertible securities include: •• Convertible notes/debt. •• Convertible preference shares. •• Share options. •• Warrants. Potential ordinary shares are only used in the diluted EPS calculation if they are ‘dilutive’. This means potential ordinary shares that are ‘anti-dilutive’ are ignored. Dilutive potential ordinary shares Under IAS 33 para. 41: Potential ordinary shares shall be treated as dilutive when, and only when, their conversion to ordinary shares would decrease EPS or increase loss per share from continuing operations.

This means that a potential ordinary share will be dilutive if: Change in earnings due to conversion Basic EPS/ (loss per share) from continuing operations Increase in number of ordinary shares on conversion 1

Calculating diluted EPS To calculate diluted EPS, the numerator and denominator in the basic EPS calculation are adjusted for the impact of converting all dilutive potential ordinary shares: •• Earnings are adjusted to remove income or expenses related to the potential ordinary shares. •• Shares outstanding are adjusted to assume the conversion of dilutive potential ordinary shares. When determining whether particular potential ordinary shares are dilutive, each issue is considered separately. Each type of potential ordinary share is considered in sequence from the most dilutive (i.e. lowest earning per incremental share) to the least dilutive (i.e. highest earning per incremental share), as the sequence may affect whether or not the potential ordinary shares are dilutive. This is considered in more detail below. Earnings for diluted EPS Earnings in the diluted EPS calculation are adjusted to remove any income or expenses in the basic EPS earnings figure that would not exist if the dilutive potential ordinary shares had been converted to ordinary shares.

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Therefore, when calculating diluted EPS (as per IAS 33 para. 33), the earnings is the amount used in the basic EPS, adjusted for the after-tax effect of the following: •• Dividends or other items relating to dilutive potential ordinary shares that have been deducted in arriving at the profit or loss attributable to ordinary equity holders of the parent entity for the purposes of determining basic EPS. •• Any interest recognised in the period relating to dilutive potential ordinary shares. •• Any other changes in income or expenses resulting from the conversion of dilutive potential ordinary shares. Examples of other changes in income or expenses include: •• Transaction costs and discounts accounted for in line with the effective interest method (IAS 33 para. 34). •• Flow-on costs arising from changes in profit (e.g. a reduction in interest paid on convertible debt) will increase profit, which may in turn increase profit-related bonuses (IAS 33 para. 35). Weighted average number of ordinary shares – diluted EPS The weighted average number of ordinary shares for the calculation of diluted EPS reflects the assumed conversion of all convertible instruments that are assessed as dilutive. Thus the denominator in the calculation for diluted EPS is the weighted average number of ordinary shares outstanding during the period (as determined for the basic EPS), plus the weighted average number of dilutive potential ordinary shares that would be issued on the conversion of all the dilutive potential ordinary shares into ordinary shares (IAS 33 para. 36). Rules for adding dilutive potential ordinary shares As the dilutive potential ordinary shares have not actually converted to ordinary shares, the number included in the denominator is based on assumptions about the amounts and timing of conversions. Therefore, there are some specific rules that govern the calculation: •• Conversion is deemed to have happened at the beginning of the period or, if later, at the date of issue of the potential ordinary shares (IAS 33 para. 36). •• The calculation is performed independently for each financial period; that is, the number of dilutive potential ordinary shares is recalculated each period (IAS 33 para. 37). •• Dilutive potential ordinary shares are weighted for the period they are outstanding. They are included in the diluted EPS calculation only for the portion of the period they are outstanding; that is, until they lapse, or are cancelled or converted (IAS 33 para. 38). •• If actual conversion happens during the financial period, the potential ordinary shares are included in the calculation of diluted EPS from the beginning of the period to the conversion date, and from the conversion date the resulting ordinary shares are included in the calculation of both basic and diluted EPS (IAS 33 para. 38). •• Where the terms of the instruments have more than one conversion rate, the most advantageous to the holder is used (IAS 33 para. 39).

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The diluted EPS implications of a number of common types of potential ordinary shares will now be considered: Convertible debt Convertible debt is a financial instrument that may be settled in cash or redeemed for a specified number of ordinary shares. The conversion terms often vary depending on a range of factors, including the timing of conversion and the share price. Impact of convertible debt on diluted EPS calculation (IAS 33 para. 50) Item from basic EPS

Adjustment

Profit or loss attributable to ordinary equity holders

Add back interest charged (net of tax) in respect of the liability component of the convertible debt

Weighted average number of ordinary shares

Increase for effect of conversion Note: This is the maximum number of ordinary shares convertible under the agreement

Example – Diluted EPS with convertible debt This example illustrates calculating the diluted EPS for potentially dilutive convertible debt. A company has an after-tax profit attributable to the parent entity of $1,500,000. Throughout the year the company has the following equity instruments on issue: •• 5,000,000 ordinary shares. •• $1,000,000 of convertible notes, convertible at $1 of debt for two ordinary shares with an effective interest rate of 9%. Assume for the purposes of this example that $90,000 is the annual interest expense on the liability component of the convertible debt. Ignore any tax effects. Calculating basic EPS (rounded to two decimal places) Basic earnings

÷

Weighted average number of ordinary shares

=

Basic EPS

$1,500,000

÷

5,000,000

=

$0.30

Calculating diluted EPS (rounded to two decimal places) Diluted earnings

÷

Weighted average number of shares for calculating diluted EPS

=

Diluted EPS

$1,590,000

÷

7,000,000 (5,000,000 + (1,000,000 × 2))

=

$0.23

Diluted earnings is basic earnings adjusted by adding the interest on the convertible notes. The weighted average number of shares used to calculate the diluted EPS is the weighted average number of ordinary shares adjusted for the impact of the convertible notes. Note: The convertible notes are ‘dilutive’ because their impact reduces the basic EPS.

Convertible preference shares Depending on the terms of the convertible preference shares, they may be classified as equity, a financial liability or have elements of both, in accordance with IAS 32. Therefore, they are treated similarly to convertible debt in calculating diluted EPS.

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Impact of convertible preference shares on diluted EPS calculation (IAS 33 para. 50) Item from basic EPS

Adjustment

Profit or loss attributable to ordinary equity holders

Add back dividends

Weighted average number of ordinary shares

Increase for effect of conversion

Note: If the preference shares are classified as equity, the dividend would have been deducted to calculate basic EPS. If the preference shares are classified as liabilities, the dividend would have been classified as interest and charged in calculating profit or loss. Note: This is the maximum number of ordinary shares convertible under the agreement

Options and warrants Options, warrants and their equivalents are defined as financial instruments that give the holder the right to purchase ordinary shares (IAS 33 para. 5). If the issue price for an option or warrant is less than the market price of the shares the holder is entitled to acquire, then it is likely that the option or warrant will be exercised at some point in time (i.e. the options or warrants are ‘in the money’). Therefore, options and warrants are deemed to be dilutive if the issue price results in ordinary shares being issued at less than the average market price during the period. IAS 33 para. 45 states: For the purpose of calculating diluted earnings per share, an entity shall assume the exercise of dilutive options and warrants of the entity. The assumed proceeds from these instruments shall be regarded as having been received from the issue of ordinary shares at the average market price of ordinary shares during the period. The difference between the number of ordinary shares issued and the number of ordinary shares that would have been issued at the average market price of ordinary shares during the period shall be treated as an issue of ordinary shares for no consideration.

Impact of options/warrants on diluted EPS

Options/warrants exercised

Shares issued at average market price during period

Shares issued at no consideration

No impact on diluted EPS calculation

Dilutive; therefore, include in diluted EPS calculation

Determining average market price Guidance on determining the average market price of ordinary shares is provided in IAS 33 Appendix A paras A4–A5, and an average of weekly or monthly closing price is usually adequate. However, the method used from period to period should be consistent.

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Financial Accounting & Reporting

Example – Diluted EPS with options This example illustrates calculating the impact of options on diluted EPS. A company has a profit attributable to ordinary shareholders of $1,200,000. The weighted average number of ordinary shares outstanding for the year was 2,000,000. The company also has 1,000,000 options outstanding. The options are exercisable at a price of $7.50 per share. The average market price for ordinary shares during the period was $10.00. Ignore any tax effects. Calculating basic EPS (to two decimal places): Basic earnings

÷

Weighted average number of ordinary shares

=

Basic EPS

$1,200,000

÷

2,000,000

=

$0.60

Calculating diluted EPS: Conversion of options Item

Calculation

Number

Weighted average number of ordinary shares under option

1,000,000

Proceeds from conversion of options

1,000,000 × $7.50 = $7,500,000

Weighted average number of ordinary shares that would have been issued at average market price

$7,500,000 ÷ $10

750,000

Ordinary shares deemed to be issued for no consideration

250,000

Diluted earnings

÷

Weighted average number of shares for calculating diluted EPS

=

Diluted EPS

$1,200,000

÷

2,250,000 (2,000,000 + 250,000)

=

$0.53

Note: Options are always dilutive because there is no corresponding impact on the profit.

Share-based payments Share-based payment arrangements relate to the exchange of goods or services for shares or options, including employee share options, and are governed by IFRS 2 Share-Based Payments. This is covered in more detail in Unit 14. An equity-settled share-based payment (e.g. an option), can be a potential ordinary share which would need to be included when calculating diluted EPS. Contingently issuable ordinary shares Examples of contingently issuable ordinary shares include: •• Shares that may be issued as part of a business combination (IAS 33 para. 7(c)). •• Performance-based employee share options (IAS 33 para. 48). As discussed above, contingently issuable ordinary shares are excluded from the calculation of basic EPS until all conditions have been met. They are then included from the date the conditions were met. However, contingently issuable ordinary shares are included in the calculation of diluted EPS from the beginning of the period or, if later, from the date of the contingent share agreement.

Unit 13 – Core content

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Chartered Accountants Program

Where conditions have not been satisfied, the number of contingently issuable shares must be calculated based on the number of shares that would be issuable if the end of the financial period were the end of the contingency period (IAS 33 para. 52). Two examples of circumstances where the issue of shares is dependent on conditions being met in future periods follow: •• If the share issue depends on meeting future profit targets, calculate the number of shares that would be issued if profit at period end has met the required profit (IAS 33 para. 53). •• If the share issue depends on future share prices, calculate the number of shares that would be issued if the share price at period end is the contingency price (IAS 33 para. 54). The examples above assume the contingently issuable ordinary shares are dilutive. The following diagram summarises the treatment of contingently issuable shares: Treatment of contingently issuable shares

Are conditions met at period end?

NO

YES

YES

Would conditions be met assuming period end is the end of the contingency period?

NO

Include in diluted shares from beginning of period (or issue date, if later)

Exclude from diluted shares

Dealing with multiple convertible instruments The objective of calculating diluted EPS is to disclose the most dilutive position. Where a company has several types of potential ordinary shares on issue, careful consideration of the order in which each instrument is considered is necessary to determine whether it is dilutive. Each issue of potential ordinary shares will have a different dilutive effect in dollars/cents per share. Therefore, the order in which these are considered can affect whether they are dilutive, and consequently affect the final diluted EPS figure. To determine the most diluted EPS, the impact of each issue of potential ordinary shares on the overall EPS calculation is considered in turn, with the most dilutive being considered first (IAS 33 para. 44). The term ‘most dilutive’ means the lowest earnings per incremental share, calculated as: Adjustment to profit or loss as result of issue of shares Number of shares that would be issued

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Financial Accounting & Reporting

An example of a calculation dealing with multiple convertible instruments can be found in IAS 33 Illustrative examples – Example 9. Required reading IAS 33 Appendix A paras A3–A9 and A16, Illustrative examples – Example 9. Activity 13.2: Calculating diluted EPS [Available online in myLearning]

EPS for continuing and discontinued operations Where an entity has a discontinued operation, it needs to calculate both the basic and diluted EPS amounts for that discontinued operation. This can be presented in either the statement of profit or loss and other comprehensive income, or in the notes (IAS 33 para. 68). This means the following EPS amounts will be presented: •• Basic EPS. •• Diluted EPS. •• Basic EPS – continuing operations. •• Diluted EPS – continuing operations. •• Basic EPS – discontinued operation. •• Diluted EPS – discontinued operation. When results are segmented between continuing and discontinued operations, there may be a profit in continuing operations and a loss in discontinued operations, or vice versa. In this case, there will be positive and negative EPS amounts presented (IAS 33 para. 69).

Unit 13 – Core content

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Chartered Accountants Program

Summary – calculating EPS Basic EPS (IAS 33 para. 9) Profit or loss attributable to ordinary equity holders of the parent entity (basic earnings) (IAS 33 para. 12)

Use profit or loss attributable to the parent entity for: • Continuing operations • Discontinued operations • Continuing and discontinued operations

Adjust for the impact of preference shares classified as equity. Exclude the after-tax impact of: • Preference share dividends • Differences arising on the settlement of preference shares • Other effects of preference shares

÷

Weighted average number of ordinary shares outstanding during the period (IAS 33 para. 19)

Use the number of shares outstanding at the beginning of the period adjusted by the number of ordinary shares bought back or issued during the period (IAS 33 para. 20)

Calculate the time-weighting factor based on the number of days the shares are outstanding as a proportion of the total number of days in the period (usually 365)

Adjust for changes in outstanding shares without a corresponding change in resources (e.g. a bonus share issue) (IAS 33 para. 27)

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Core content – Unit 13

Chartered Accountants Program

Financial Accounting & Reporting

Diluted EPS (IAS 33 para. 30) Basic earnings adjusted for the effects of all dilutive potential ordinary shares (IAS 33 para. 31)

Use profit or loss attributable to the parent entity used in the basic EPS calculation for: • Continuing operations • Discontinued operations • Continuing and discontinued operations

Adjust for the earnings impact of the dilutive potential ordinary shares For example, exclude the after-tax impact of: • Interest expense on convertible notes • Dividends on convertible preference shares (IAS 33 para. 33)

÷

Weighted average number of ordinary shares adjusted for the effects of all dilutive potential ordinary shares (IAS 33 para. 31)

Identify potential ordinary shares

Determine if potential ordinary shares are dilutive, (i.e. if their conversion would decrease EPS or increase loss per share)

Adjust the number of ordinary shares for any dilutive potential ordinary shares based on assumptions about the amounts and timing of conversions (IAS 33 paras 36−40)

Worked example 13.3: Calculating basic and diluted EPS for continuing and discontinued operations [Available online in myLearning]

Unit 13 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Disclosures EPS presentation and disclosure requirements The key presentation and disclosure requirements for EPS are contained in IAS 33 paras 66–73A, and summarised as follows:

Presentation •• In the statement of profit or loss and other comprehensive income: –– Basic EPS for continuing operations. –– Diluted EPS for continuing operations. –– Basic EPS for profit or loss attributable to the parent entity. –– Diluted EPS for profit or loss attributable to the parent entity. •• Basic and diluted EPS are to be given equal prominence. •• Diluted EPS is to be provided for all periods if it is reported for at least one period, even if it is the same as basic EPS (IAS 33 para. 67). •• The statement of profit or loss and other comprehensive income, or the notes must include: –– Basic EPS for each discontinued operation. –– Diluted EPS for each discontinued operation (IAS 33 para. 68). •• The basic and diluted EPS are to be presented even if the amounts are negative (IAS 33 para. 69).

Disclosures •• Numerators for basic EPS and diluted EPS calculations, together with a reconciliation to profit or loss attributable to the parent entity (IAS 33 para. 70(a)). •• The weighted average number of shares used as the denominator in the basic EPS and diluted EPS calculations, together with a reconciliation to each other (IAS 33 para. 70(b)). •• Instruments that were not included in the EPS calculations because they are presently antidilutive, but which could potentially dilute earnings per share in the future (IAS 33 para. 70(c)). •• A description of ordinary share or potential ordinary share transactions that occurred after the end of the reporting period that would have significantly changed the number of outstanding shares (IAS 33 para. 70(d)).

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Core content – Unit 13

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Financial Accounting & Reporting

Summary – disclosing EPS Basic and diluted EPS Disclosure of basic and diluted EPS is required as follows: In the statement of profit or loss and other comprehensive income (IAS 33 para. 66) Earnings per share (includes both continuing and discontinued operations) Basic EPS

  xx

Diluted EPS

  xx

Earnings per share from continuing operations Basic EPS

  xx

Diluted EPS

  xx

Either in the statement of profit or loss and other comprehensive income or notes to the financial statements for each discontinued operation (IAS 33 para. 68) From discontinued operations Basic EPS

  xx

Diluted EPS

  xx

Quiz [Available online in myLearning]

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Core content – Unit 13

Unit 14: Share-based payments Contents Introduction Share-based payments

fin31914_csg_02

Share-based payment transactions Identifying SBP transactions Accounting for SBP transactions Disclosures for SBP transactions

Unit 14 – Core content

14-3 14-3 14-3 14-3 14-4 14-15

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Worked examples – Unit 14

Chartered Accountants Program

Financial Accounting & Reporting

Learning outcome At the end of this unit you will be able to: 1. Identify and account for share-based payments.

Introduction Share-based payments A share-based payment (SBP) is an arrangement whereby an entity settles a transaction with shares, share options, or a cash figure linked to the value of shares. Share plans and share option schemes often form part of employee remuneration packages, and some entities also use such schemes to pay suppliers for goods and/or services. An example of such an arrangement is one that existed between the social networking utility Facebook and David Choe, the American graffiti artist who decorated the walls of Facebook’s original headquarters in 2005. He was offered a cash payment of US$60,000 for his work but instead opted to take shares in Facebook. It has been reported that these shares were worth between US$200 million and US$500 million when Facebook made its initial public offering (IPO) in May 2012. Difficulties with accounting for such schemes include valuing the SBP and establishing when it should be recognised in an entity’s financial statements. IFRS 2 Share-based Payment provides guidance on the recognition and measurement of SBP transactions. An entity shall apply IFRS 2 in accounting for all SBP transactions. Unit 14 overview video [Available online in myLearning]

Share-based payment transactions Learning outcome 1. Identify and account for share-based payments.

Identifying SBP transactions An SBP arrangement is defined in IFRS 2 Appendix A as an agreement between the entity and another party that entitles the other party to receive: (a) cash or other assets of the entity for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity, or (b) equity instruments (including shares or share options) of the entity or another group entity provided the specified vesting conditions, if any, are met.

An SBP transaction is defined in IFRS 2 Appendix A as a transaction in which the entity: (a) receives goods or services from the supplier of those goods or services (including an employee) in a share-based payment arrangement, or (b) incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity receives those goods or services.

Unit 14 – Core content

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Scope of IFRS 2 IFRS 2 applies in accounting for SBP transactions, including those that are settled by another group entity on behalf of the entity receiving or acquiring the goods or services (IFRS 2 para. 3A). IFRS 2 does not apply to transactions: •• with an employee (or other party) in their capacity as a holder of equity instruments of the entity (IFRS 2 para. 4) •• in which the entity acquires goods as part of the net assets acquired in a business combination, as defined by IFRS 3 Business Combinations, or the contribution of a business on the formation of a joint venture, as defined by IFRS 11 Joint Arrangements (IFRS 2 para. 5) •• in which the entity receives or acquires goods or services under a contract within the scope of IAS 32 Financial Instruments: Presentation or IFRS 9 Financial Instruments (IFRS 2 para. 6).

Other key definitions in IFRS 2 IFRS 2 Appendix A provides other key definitions relevant to SBP transactions of relevance to the coverage in this unit, including: •• Cash-settled share-based payment transaction. •• Equity-settled share-based payment transaction. •• Fair value. •• Grant date. •• Market condition. •• Measurement date. •• Performance condition. •• Service condition. •• Vest. •• Vesting conditions. •• Vesting period. IFRS 2 uses the term ‘fair value’ differently from the way in which it is defined in IFRS 13 Fair Value Measurement, and therefore, when accounting for SBP transactions, the measurement prescribed in IFRS 2 should be used. Required reading IFRS 2 (or local equivalent) and Appendix A – Defined terms. Worked example 14.1: Identifying types of share-based payments [Available online in myLearning]

Accounting for SBP transactions The accounting treatment of an SBP transaction depends on its method of settlement. There are three methods of settlement for SBP transactions: 1. Equity-settled. 2. Cash-settled. 3. Choice of settlement.

Equity-settled SBP transactions For the purposes of this unit, an equity-settled SBP transaction is one in which an entity receives goods or services as consideration for its own equity instruments (IFRS 2 Appendix A).

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Financial Accounting & Reporting

The pro forma journal entry to record an equity-settled SBP transaction is as follows: Date

Account description

Dr $

xx.xx.xx

Expense/asset*

xx

Cr $

Equity*

xx

Record equity-settled SBP transaction * Account descriptions should be adapted to suit each specific equity-settled SBP transaction.

The issues associated with recording this journal in the financial statements are: •• How should the expense or asset be measured? •• When should the expense or asset be recognised? For the remainder of this unit it is assumed that an equity-settled SBP is granted to employees with the debit side of the transaction recognised in profit or loss as an expense. Measuring equity-settled SBP transactions The entity shall measure the goods or services received and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless the fair value cannot be estimated reliably. Where the fair value cannot be estimated reliably, the goods or services received and the corresponding increase in equity shall be measured, indirectly, by reference to the fair value of the equity instruments granted (IFRS 2 para. 10). The fair value of goods or services received from a supplier can usually be measured reliably. For SBP transactions with employees, the fair value of the services received cannot usually be measured reliably, and therefore the transaction is measured by reference to the fair value of the equity instruments measured at the grant date. IFRS 2 paras 16–18 provide further guidance on determining the fair value of equity instruments granted. Recognising equity-settled SBP transactions The period in which an equity-settled SBP transaction is recognised depends on whether or not there are vesting conditions for the equity instruments granted. If the equity instruments vest immediately (i.e. there are no vesting conditions), the expense and corresponding increase in equity are recognised at fair value at the grant date (IFRS 2 para. 14). Where there are vesting conditions in place, the expense and corresponding increase in equity are recognised over the vesting period (IFRS 2 para. 15), as illustrated by the following timeline diagram. Grant date

Vesting date

Vesting period (vesting conditions attached)

Recognise the expense and increase in equity over the vesting period

Unit 14 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Vesting conditions The diagram below shows the different types of vesting conditions: Vesting conditions

Service conditions (required to complete a specified period of service)

Performance conditions (complete a specified period of service and meet specified performance targets)

Market conditions (related to the market price of the entity’s equity instruments)

Non-market conditions (not related to the market price of the entity’s equity instruments)

Reflected in grant-date fair value

Not reflected in grant-date fair value

IFRS 2, Implementation guidance IG Example 1A, scenarios 1 and 2 provide an example of a grant of share options with a service condition. Market conditions relate to the market price of an entity’s equity instruments – for example, achieving an annual increase in share price over a period of years. Market conditions are taken into account when estimating the fair value per equity instrument at measurement date (grant date). The fair value per equity instrument is not revised over the vesting period for a market condition (IFRS 2 para. 21). This is because the probability of achieving or failing to achieve the market condition by the end of the vesting period is reflected in the measurement of the fair value per equity instrument at the grant date. Over the vesting period, the expense recognised is based on this fair value per equity instrument at grant date irrespective of whether or not the market condition is satisfied (e.g. even if the target annual increase in the share price is not achieved); however, if there is a service period it must be satisfied. Accordingly, over the vesting period at each reporting date, the entity performs a ‘true up’ or adjustment to reflect revised estimates of the number of equity instruments expected to vest (e.g. reflecting employee departures).

Example – Grant of share options with a market condition This example illustrates the application of IFRS 2 para. 21 for transactions with a performance condition that relates to the market price of an entity’s equity instruments. On 1 July 20X3 Coco Limited granted 20,000 share options to a senior executive. The share options are conditional on the executive remaining in the company’s employ until at least 30 June 20X6. Coco’s share price on 1 July 20X3 was $17.50. The share options cannot be exercised unless Coco’s share price increases to at least $25 by 30 June 20X6. If this market condition is met, the share options can be exercised at any time between 30 June 20X6 and 30 June 20X9. Using an option pricing model, the fair value of each share option has been estimated at $3 on 1 July 20X3 and reflects the possibility that the share price target might not be achieved.

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Core content – Unit 14

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Financial Accounting & Reporting

Provided the executive satisfies the service condition, the remuneration expense for the three years and the amounts accumulated in equity would be as follows: Year end date

Calculation

Remuneration expense for period $

Equity balance $

30.06.X4

20,000 × $3 × 1/3 years

20,000

20,000

30.06.X5

20,000 × $3 × 2/3 years – $20,000

20,000

40,000

30.06.X6

20,000 × $3 × 3/3 years – $40,000

20,000

60,000

The remuneration expense is recognised regardless of whether the market condition (i.e. the achievement of the share price target) is achieved at 30 June 20X6 (IFRS 2 para. 21). The journal entry to recognise the remuneration expense for the year ended 30 June 20X4 is: Date

Account description

30.06.X4

Remuneration expense

Dr $

Cr $

20,000

Equity1

20,000

To record the remuneration expense relating to issuing 20,000 share options after one year of the three‑year vesting period 1. IFRS 2 is not prescriptive on the accounting for the credit to equity in respect of an equity-settled share-based payment. One common approach in practice is to put the credit to a share-based payment reserve until the award has been settled and then make a transfer to share capital (although this is not permitted in some countries due to local legislation), other reserves or retained earnings.

Adapted from: IFRS 2 Implementation guidance IG Example 5.

Non-market conditions (e.g. target earnings per share (EPS)) are not related to the market price of an entity’s equity instruments. Non-market conditions are not taken into account when estimating the fair value per equity instrument at measurement date (grant date). The fair value per equity instrument at grant date is recognised as an expense over the vesting period based on the best available estimate of the number of equity instruments expected to vest. The number expected to vest is revised at each period end as necessary (IFRS 2 paras 19–20).

Example – Grant of shares with a non-market condition This example illustrates the application of IFRS 2 paras 19–20 for transactions with a performance condition that is not related to the market price of an entity’s equity instruments. On 1 July 20X3 Coco Limited granted 1,000 shares to each of its 100 employees, conditional on the employee remaining in the company’s employ until at least 30 June 20X6. The shares have a fair value of $7.50 at grant date and no dividends are expected to be paid over the threeyear period. The following vesting conditions are attached to the shares: •• The shares will vest on 30 June 20X4 if Coco’s earnings have increased by at least 20%. •• The shares will vest on 30 June 20X5 if Coco’s earnings have increased by at least 16% per year averaged across the two-year period. •• The shares will vest on 30 June 20X6 if Coco’s earnings have increased by at least 12% per year averaged across the three-year period.

20X4 Five employees have left by 30 June 20X4 and Coco’s earnings have increased by 17%. On this date Coco’s management expects that earnings will increase at a similar rate in the next year, and that the shares will vest on 30 June 20X5. Management also expects that an additional three employees will resign during the year ending 30 June 20X5.

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Chartered Accountants Program

The calculation of remuneration expense for the year ended 30 June 20X4 is as follows: Year

30.06.X4

Calculation

Remuneration expense for period $

Equity balance

345,000

345,000

921 employees × 1,000 shares × $7.50 × 1/22 years

$

1. 100 employees – 5 actual departures in 20X4 year – 3 anticipated departures in 20X5 year means that shares are expected to vest in relation to 92 employees. 2. At 30 June 20X4 management expects that the shares will vest at 30 June 20X5.

20X5 At 30 June 20X5 Coco’s earnings had increased by 13% over the previous year. Four employees left during the year. At 30 June 20X5 Coco’s management expects that earnings will increase enough in the next year so that the shares will vest on 30 June 20X6. Management also expects that an additional two employees will resign during the year ending 30 June 20X6. The calculation of remuneration expense for the year ended 30 June 20X5 is as follows: Year

Calculation

Remuneration expense for period $

Equity balance $

30.06.X4

92 employees × 1,000 shares × $7.50 × 1/2 years

345,000

345,000

30.06.X5

891 employees × 1,000 shares × $7.50 × 2/32 years - $345,000

100,000

445,000

1. 100 employees – 5 actual departures in 20X4 year – 4 actual departures in 20X5 year – 2 anticipated departures in 20X6 year means that shares are expected to vest in relation to 89 employees. 2. The average increase in earnings over the 20X4 and 20X5 years is 15% ((17% + 13%)/2). As this is below the required minimum of 16% the shares do not vest on 30 June 20X5. Management now expects that the shares will vest on 30 June 20X6.

20X6 Another three employees left during the year ended 30 June 20X6 and Coco’s earnings increased by 9%. The average increase in earnings over the 20X4–20X6 years is 13% ((17% + 13% + 9%)/3) and therefore achieves the required minimum of 12%. Accordingly, the shares vest at 30 June 20X6. Year

Calculation

Remuneration expense for period $

Equity balance $

30.06.X4

92 employees × 1,000 shares × $7.50 × 1/2 years

345,000

345,000

30.06.X5

89 employees × 1,000 shares × $7.50 × 2/3 years – $345,000

100,000

445,000

30.06.X6

881 employees × 1,000 shares × $7.50 – $445,000

215,000

660,000

1. 100 employees – 5 actual departures in 20X4 year – 4 actual departures in 20X5 year – 3 actual departures in 20X6 year means that shares vest in relation to 88 employees.

Adapted from: IFRS 2, Implementation guidance IG Example 2.

Cancellation/settlement of equity-settled SBP transactions If a grant of equity instruments is cancelled or settled during the vesting period, the amount that would have been recognised in profit or loss over the remaining vesting period is accelerated and recognised as an expense immediately (IFRS 2 para. 28).

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Financial Accounting & Reporting

Required reading IFRS 2 Implementation guidance IG Examples 1A, 2 and 5. Worked example 14.2: Measuring an equity-settled share-based payment transaction with a service condition [Available online in myLearning]

Cash-settled SBP transactions A cash-settled SBP transaction is one ‘in which an entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of those goods or services for amounts that are based on the price (or value) of equity instruments’ (IFRS 2 Appendix A). As cash will actually be transferred on settlement, a liability must be recorded in the financial statements. The pro forma journal entry to record a cash-settled SBP transaction is as follows: Date

Account description

Dr $

xx.xx.xx

Expense/asset*

xx

Liability*

Cr $

xx

Record cash-settled SBP transaction * Account descriptions should be adapted to suit each specific cash-settled SBP transaction.

Again, the issues associated with recording this journal in the financial statements are: •• How should the expense or asset be measured? •• When should the expense or asset be recognised? Measuring cash-settled SBP transactions The goods/services acquired and the liability are measured at the fair value of the liability. The liability is remeasured to fair value at the end of each reporting period and on the date of settlement. Any changes to fair value are reported in profit or loss (IFRS 2 para. 30). Recognising cash-settled SBP transactions If there are conditions attached to the cash-settled SBP – for example, employees must complete a specified period of service – the expense will be recognised over the vesting period (IFRS 2 para. 32), with the liability remeasured at each reporting date. Where the cash-settled SBP vests immediately, it is assumed that the goods/services have already been received, and therefore the expense and liability will be recognised immediately (IFRS 2 para. 32).

Example – Cash-settled SBP transactions This example illustrates how to calculate the amounts to be recognised in a cash-settled SBP transaction. Spitfire Limited set up a cash-settled SBP scheme for its 30 senior employees on 1 July 20X2. Each of the senior employees has been offered a cash bonus based on the value of 2,000 shares. To qualify for the bonus, each of the employees must stay in Spitfire’s employment until 30 June 20X5, when the bonus will be paid. The amount paid will be equal to the value of the 2,000 shares at 30 June 20X5.

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Relevant details at the end of each of the three years of the vesting period are provided in the following table: Spitfire’s cash-settled SBP scheme period end details Year end date

Share price Number of employees who $ have left during the year

Number of employees expected to leave in the future

30.06.X3

6.50

2

4

30.06.X4

7.25

3

1

30.06.X5

7.50

0

–

The liability is remeasured at each period end until it is settled. The liability is calculated as the number of employees expected to remain in employment until the bonus is paid multiplied by the number of shares on which the bonus is based multiplied by the fair value of the shares. This is spread over the three-year vesting period. Recognition of cash-settled SBP scheme Year end date

Liability calculation

Liability $

Expense $

30.06.X3

((30 – 2 – 4) × 2,000 × $6.50) × 1/3

104,000

104,000

30.06.X4

((30 – 2 – 3 – 1) × 2,000 × $7.25) × 2/3

232,000

128,000

30.06.X5

((30 – 2 – 3) × 2,000 × $7.50)

375,000

143,000

IFRS 2 Implementation guidance IG Example 12 provides a further example of a cash-settled SBP transaction. Required reading IFRS 2 Implementation guidance IG Example 12.

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Financial Accounting & Reporting

Summary - SBP transaction measurement - equity-setteled and cash-settled

TRANSACTION

SETTLEMENT TYPE

Share-based payment transaction measurement

Equity-settled

With supplier (IFRS 2 para. 10)

MEASUREMENT

At fair value of goods or services received (measured at date goods or services received)

Cash-settled (IFRS 2 para. 30)

With employee (IFRS 2 para. 11)

At fair value of equity instruments granted* (measured at grant date)

At fair value of liability

If fair value of goods or services received cannot be estimated reliably then use the fair value of equity instruments granted*

REMEASUREMENT

* Fair value takes account of market conditions

Unit 14 – Core content

Remeasured to fair value at end of each reporting period and settlement date with changes in fair value recognised in profit or loss

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Financial Accounting & Reporting

Chartered Accountants Program

Summary - SBP transaction recognition - equity-settled and cash-settled

RECOGNITION

VESTING CONDITIONS

TYPE OF SETTLEMENT

Share-based payment transaction recognition

Equity-settled

Cash-settled

Do vesting conditions exist?

Do vesting conditions exist?

NO

YES

NO

YES

Vest immediately

Vesting conditions apply

Vest immediately

Vesting conditions apply

Recognise immediately (IFRS 2 para. 14)

Market conditions

Non-market conditions

Recognise over the vesting period irrespective of whether market condition is satisfied (IFRS 2 para. 21)

Recognise over the vesting period based on best estimate of the number of equity instruments expected to vest (IFRS 2 para. 19)

Recognise Recognise immediately initially and over (IFRS 2 para. 32) vesting period at fair value to recognise the services received (IFRS 2 paras 32–33)

Activity 14.1: Accounting for a cash-settled share-based payment transaction [Available online in myLearning]

Transactions with a choice of settlement An SBP transaction in which there is a choice of settlement means that the transaction can be settled in cash or by equity instruments issued by an entity, at the choice of either the entity or counterparty (supplier/employee). The accounting treatment for these transactions depends on which party has the choice of settlement. Page 14-12

Core content – Unit 14

Chartered Accountants Program

Financial Accounting & Reporting

Where the entity has a choice of settlement In cases in which the entity has the choice of settlement, the accounting treatment is determined by whether the entity has an obligation to deliver cash. IFRS 2 provides the following guidance: •• Treat as a cash-settled SBP transaction if, and to the extent that, the entity has incurred a liability to settle in cash (IFRS 2 para. 42). •• Treat as an equity-settled SBP transaction if, and to the extent that, no such liability has been incurred (IFRS 2 para. 43). Consideration would be given to factors such as an entity’s stated policy/past practice in determining whether it has an obligation to deliver cash (IFRS 2 para. 41). Where the counterparty has a choice of settlement In substance, in cases in which the counterparty has the choice of settlement, a compound financial instrument has been granted, which includes a debt component and an equity component. The debt component is measured at fair value at the measurement date (grant date). The equity component is the difference between the fair value of the goods and services received and the fair value of the debt component (IFRS 2 para. 35).

Example – SBP transaction with choice of settlement This example illustrates the application of IFRS 2 paras 36–37 for SBP transactions with employees, where the employee has the choice of settlement. On 1 July 20X4, Harboard Limited grants an employee the right to elect to receive on 30 June 20X7 either 20,000 shares or a cash payment equal to 18,000 shares, provided that they are still employed by Harboard at that date. The share price during the vesting period is as follows: Relevant share price Date

Share price $

01.07.X4

3.75

30.06.X5

4.00

30.06.X6

4.10

30.06.X7

4.25

Harboard estimates that the fair value of the share alternative at grant date is $3.60 per share. At grant date, the fair value of the share alternative is $72,000 ($3.60 × 20,000). The fair value of the cash alternative is $67,500 ($3.75 × 18,000). Therefore, the fair value of the equity component of the compound instrument is $4,500 ($72,000 – $67,500). The equity component is recognised through profit or loss over the three-year vesting period ($4,500 ÷ 3 = $1,500 per annum). The liability component based on the 18,000 shares is remeasured to fair value at each period end.

Unit 14 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Summary - SBP with a choice of settlement

Share-based payment with a choice of settlement

Choice of settlement

TREATMENT

WHO HAS THE CHOICE?

Entity has choice

Counterparty has choice

Does the entity have an obligation to deliver cash or other assets? (IFRS 2 para. 41)

YES

NO

Treat as cash-settled (IFRS 2 para. 42)

Treat as equity-settled (IFRS 2 para. 43)

Treat as a compound financial instrument (IFRS 2 para. 35)

Group and treasury share transactions IFRS 2 paras 3A and 43A–43D address how certain types of SBP transactions among group entities should be accounted for – that is, as equity-settled or as cash-settled transactions – and the accounting treatment in a subsidiary’s financial statements for SBP transactions involving the parent’s equity instruments.

Impact of employee share options on earnings per share Options granted under an SBP transaction need to be considered when calculating diluted earnings per share (EPS), which is covered in the unit on earnings per share. For share options and other SBP arrangements that come within the scope of IFRS 2, the issue and exercise price must be increased by the fair value of goods or services to be provided in the future under the share option or SBP arrangement (IAS 33 Earnings per Share para. 47A).

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Core content – Unit 14

Chartered Accountants Program

Financial Accounting & Reporting

The accounting treatment of employee share options depends on the terms of the options, as detailed in the following table: Impact of employee share options on diluted EPS Fixed or determinable terms

Performance-based terms

Treat the same as other options – even though they may be contingent on vesting

Treat the same as contingently issuable shares

Include the employee share options in the weighted average number of ordinary shares outstanding from the date the options were granted

Include the employee share options in the weighted average number of ordinary shares outstanding from the date the options were granted

Include in the calculation of diluted EPS if dilutive

Include in the calculation of diluted EPS if dilutive and if the conditions in the contract would be met if the period end were the contract period end

Adjust the weighted average number of ordinary shares outstanding during the period by the number of actual shares to be issued, less the number of shares that would have been issued for the same proceeds at the average market price for the period

Adjust the weighted average number of ordinary shares outstanding during the period by the number of ordinary shares that would be issued for free, if the period end conditions were the contract end conditions

Required reading IFRS 2 Implementation guidance IG Example 13.

Disclosures for SBP transactions The key disclosure requirements for SBP transactions are detailed in IFRS 2 paras 44–52, and are designed to enable users of financial statements to understand: •• The nature and extent of SBP arrangements that existed during the period. •• How the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined. •• The effect of SBP transactions on an entity’s profit or loss for the period and on its financial position. Quiz [Available online in myLearning]

Unit 14 – Core content

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Worked examples – Unit 14

Introduction to Units 15–17

(Business combinations, accounting for subsidiaries, joint arrangements and investments in associates) Learning outcome At the end of this introduction you will be able to: 1. Identify the appropriate classification for investments as subsidiaries, associates or joint arrangements.

Introduction Investment in another entity can be undertaken for a variety of reasons: to take advantage of synergies, to diversify, for growth, or to eliminate competition. For example, South African retailer Woolworths Holdings Limited acquired 100% of the Australian retailer David Jones Limited in a $2.2 billion takeover. The combined business accelerated the implementation of Woolworths’ strategies, and the resulting synergies have resulted in significant earnings growth. When acquiring 100% of an entity, the position of control is obvious, and the two sets of accounts are consolidated under IFRS 10 Consolidated Financial Statements. However, in many situations, determining control, joint control or significant influence requires considerable professional judgement. These decisions are vital to the financial reports, as decisions about control lead to different accounting and reporting requirements. Units 15–17 aim to help candidates navigate situations where such decisions are required, and account for the various investments. As a Chartered Accountant working in a business environment that is becoming more global, you will need to understand how to account for different levels of power an entity has over another.

Classification of investments We have previously covered accounting for relatively minor investments in ordinary shares in Unit 9. This included ‘Fair value through OCI’ financial assets, which are accounted for under IFRS 9 Financial Instruments. Units 15–17 will cover the accounting treatment where the investment is more significant, giving rise to: •• Control (investment in subsidiaries). •• Joint control (joint ventures or joint operations).

fin31915-17csg_intro_01

•• Significant influence (investment in associates).

Unit 15 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

It helps to have a clear vision of the flow of concepts covered in the upcoming units. The thought process to be applied to determine the appropriate accounting treatment based on the classification of the investment can be represented as follows: Determine the level of power the investor has over the investee

Classify Classify thethe investment I(nvestment based based on on thethe level level of power of power

Accounting Classify thetreatment I(nvestment is determined based on the by the classification level ofofpower the investment

A simple summary of the accounting method associated with various levels of power is shown below.

Investment

po we r

U9

Accounting for a financial asset, IFRS 9

Significant influence

Equity accounting, IAS 28

Inc

rea

sed

U17

U17

Joint control

Joint venture – equity accounting, IAS 28 Joint operation – assets, liabilities, revenue and expenses, IFRS 11

Control

Consolidation – IFRS 10 U16

The following detailed flow chart sets out the process of classifying investments for financial reporting purposes and the accounting method to use for each classification. The relevant CSG units and Accounting Standards are also noted. More detail on each accounting requirement is given in the relevant unit.

Page 15-ii

Introduction to Units 15–17

Financial Accounting & Reporting

combina ess ti in U15

s on

Bu s

Chartered Accountants Program

IFRS 3 Business Combinations

for subs ing id nt U16 Consolidation in accordance with IFRS 10

YES

ies iar

Acc ou

Does the investor gain control in the business combination?

nts and investments in a eme g U17 n sso a r cia ar t te n oi Does the investor have joint control?

s

J

Disclosures per IFRS 12

NO

IFRS 11 Joint Arrangements

Classify the joint arrangement in accordance with IFRS 11 JOINT OPERATION

Account for assets, liabilities, revenue and expenses in accordance with IFRS 11 Disclosures per IFRS 12

Fin

Does the investor have significant influence over the investee? IAS 28 Investments in Associates and Joint Ventures

NO

s nt

NO

YES

instrum cial e an U9 Account for the investment in accordance with IFRS 9 Disclosures per IFRS 7

YES JOINT VENTURE

INVESTMENT IN ASSOCIATE

Equity accounting in accordance with IAS 28 Disclosures per IFRS 12

Notice how the degree of power is mutually exclusive; for example, there cannot be both control and significant influence exerted by an investor over another entity.

Introduction to Units 15–17

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Financial Accounting & Reporting

Chartered Accountants Program

The key terms in the flow chart can be explained as follows: Key terms in the flow chart Term

Explanation

Associate

An entity over which the investor has significant influence

Control

An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee, and has the ability to affect those returns through its power over the investee

Joint arrangement

An arrangement over which two or more parties have joint control

Joint control

The contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control

Joint operation

A joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets and obligations for the liabilities relating to the arrangement

Joint venture

A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement

Significant influence

The power to participate in the financial and operating policy decisions of the investee. It is not, however, control or joint control of those policies

Subsidiary

An entity that is controlled by another entity

As you progress through the last three units of the CSG, please remember to revisit these diagrams to help you determine the correct accounting treatment.

Page 15-iv

Introduction to Units 15–17

Unit 15: Business combinations Contents Introduction Links to other units

15-3 15-3

Identifying a business combination What is a business combination? Parent controls a subsidiary

15-4 15-4 15-5

Determining control and accounting for a business combination in the books of the acquirer 15-5 Acquisition method 15-5 Application of IFRS 10 in determining whether control exists 15-6 Definition of control 15-6 Analyse the facts to determine whether control exists 15-7 Explanation of terms in the flow chart 15-9 Acting as principal or agent 15-10 If control under IFRS 10 cannot be determined 15-11 Tax effect implications of business combination adjustments 15-17 Deferred or contingent consideration 15-18 Gain from a bargain purchase 15-22 Accounting subsequent to the initial accounting Measurement period adjustments Adjustments after the measurement period Other accounting issues subsequent to the business combination Contingent liabilities Contingent consideration

15-22 15-23 15-24 15-24 15-24 15-25

Summary - acquisition method of accounting for business combinations

15-27

fin31915_csg_01

Disclosures 15-28

Unit 15 – Core content

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Core content – Unit 15

Chartered Accountants Program

Financial Accounting & Reporting

Learning outcomes At the end of this unit you will be able to: 1. Identify a business combination. 2. Explain the concept of control. 3. Explain and account for a business combination in the books of the acquirer. 4. Account for subsequent adjustments to the initial accounting for a business combination.

Introduction It is common for an entity to obtain control of another business. This transaction is known as a business combination. IFRS 3 Business Combinations prescribes the accounting and disclosure requirements for business combinations. A business combination can be a complex transaction and it is critical that it is accounted for correctly, as users of a financial report are likely to find this information important. They will be particularly interested to know the value of the purchase consideration and the amount of any goodwill paid for the acquired entity. The focus in this unit is where one entity (the acquirer) obtains control of another entity (the acquiree) by acquiring all or some of its equity, which results in a parent–subsidiary relationship. This unit goes through the accounting requirements for a business combination step by step. Unit 15 overview video [Available online in myLearning]

Links to other units The following diagram identifies the key linkages between this unit and two others in the FIN module, and the accounting standards relevant to the subjects covered in these units. Unit 15 • A business combination requires one entity to control another • The key focus is on calculating the goodwill or gain from a bargain purchase in a business combination (IFRS 3 Business Combinations) (IFRS 10 Consolidated Financial Statements)

Unit 6 Many of the inputs to the business combination accounting under IFRS 3 are required to be measured at fair value (IFRS 13 Fair Value Measurement)

Unit 15 – Core content

Unit 16 The goodwill or gain from a bargain purchase is recognised in the consolidated financial statements (IFRS 10 Consolidated Financial Statements)

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Financial Accounting & Reporting

Chartered Accountants Program

Identifying a business combination Learning outcome 1. Identify a business combination.

What is a business combination? A ‘business’ is defined in IFRS 3 Appendix A as: An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

This definition is dependent on the three elements that make up a business – input, process and output. As explained in IFRS 3 Appendix B, input is the economic resource (e.g. assets) to which a process is applied (e.g. an operational process) to provide output (e.g. a dividend) to benefit stakeholders. A ‘business combination’ arises where an ‘acquirer obtains control of one or more businesses’ (IFRS 3 Appendix A). IFRS 3 is applied when accounting for business combinations. The following are examples of business combinations: •• One entity purchasing another entity by acquiring its equity. •• One entity purchasing a business from another entity by acquiring all or some of the net assets. •• The merger of two previously unrelated entities. •• The establishment of a new entity to control previously unrelated entities. IFRS 3 does not apply to: •• Transactions that involve the formation of a joint arrangement. •• The acquisition of an asset or group of assets that do not constitute a business. •• A combination of entities under common control.

Example – Identifying a business combination This example illustrates how to identify a business combination. Mercury Limited acquired all of Neptune’s inventory when Neptune sold its assets as part of its liquidation. Mercury will make a substantial profit from this inventory, which it will use to acquire new plant and equipment. These new assets will lower Mercury’s operating costs. Despite the flow-on benefits of the inventory purchase to Mercury’s business, the inventory acquisition is not a business combination. This is because acquiring one type of asset does not represent an acquisition of a business.

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Core content – Unit 15

Chartered Accountants Program

Financial Accounting & Reporting

Parent controls a subsidiary A parent–subsidiary relationship arises where one entity (the acquirer) obtains control of another entity (the acquiree) by acquiring all or some of its equity. An example of such acquisition is Permira’s acquisition of I-MED Radiology Network Pty Limited for $1.25 billion. Required reading IFRS 3 paras 2–3, Appendix A Defined terms and Appendix B Application guidance para. B7. Further reading Evans S 2018, ‘I-MED Radiology eyes more acquisitions after 1.25b sale to Permira’, Australian Financial Review, available at www.afr.com/business/banking-and-finance/private-equity/ imed-radiology-eyes-more-acquisitions-after-125b-sale-to-permira-20180128-h0pf5z, accessed 26 April 2018.

Determining control and accounting for a business combination in the books of the acquirer Learning outcomes 2. Explain the concept of control. 3. Explain and account for a business combination in the books of the acquirer.

Acquisition method The acquisition method of accounting for business combinations as prescribed by IFRS 3 is applied to a business combination. This method can be worked through as a series of steps, as outlined below: Step 1 – Identify the acquirer (the entity with control) STEP 1 Identify the acquirer (the entity with control)

Unit 15 – Core content

STEP 2 Determine the acquisition date

STEP 3 Recognise and measure at acquisition date the identifiable assets acquired and the liabilities assumed, as well as any noncontrolling interest (NCI) in the acquiree

STEP 4 Measure the consideration transferred

STEP 5 Recognise and measure the goodwill or gain from a bargain purchase

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Financial Accounting & Reporting

Chartered Accountants Program

To identify the acquirer in a business combination, IFRS 3 requires there to be control, which is determined under IFRS 10 Consolidated Financial Statements (IFRS 10). The linkages between the two Standards in determining control can be shown as follows: A business combination is a transaction or other event in which an acquirer obtains control of one or more businesses IFRS 3 requires that a transaction or event has occurred that relates to a ‘business’

Return to IFRS 3 to account for the business combination once control has been determined

There must be control for there to be a business combination (determined by analysing control in IFRS 10)

IFRS 3 uses the term ‘acquirer’ and ‘acquiree’ (IFRS 10 uses the terms ‘investor’ and ‘investee’)

One of the combining entities in the business combination must be identified as the acquirer

The acquirer is the entity that gains control

Application of IFRS 10 in determining whether control exists Only one investor can control an investee (IFRS 10 para. 16). In many cases, control will be obvious; however, in complex situations, determining whether control exists may require thoroughly analysing the facts and exercising considerable professional judgement. An investor that holds the majority of voting rights, in the absence of any other factors, controls the investee (IFRS 10 Appendix B Application guidance para. B6).

Definition of control IFRS 10 para. 5 states: An investor, regardless of the nature of its involvement with an entity (the investee), shall determine whether it is a parent by assessing whether it controls the investee.

In defining ‘control [of an investee]’ IFRS 10 Appendix A states: An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.

FIN fact An investor that holds ≥ 50% of voting rights, in the absence of any other factors, controls the investee.

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Core content – Unit 15

Chartered Accountants Program

Financial Accounting & Reporting

This definition can be broken down into three key elements (IFRS 10 para. 7), as illustrated in the diagram below:

Elements of control An investor controls an investee if and only if the investor has all the following: Power over the investee (Paras 10–14)

Exposure, or rights, to variable returns from its involvement with the investee (Paras 15 and 16)

The ability to use its power over the investee to affect the amount of the investor’s returns (Paras 17 and 18)

Control

Analyse the facts to determine whether control exists In determining whether there is control, the three elements of control can be broken down into five sub-steps. Step 1(a) – Identify the investee STEP 1(a) Identify the investee

STEP 1(b)

STEP 1(c)

Identify the relevant activities of the investee

Determine whether the investor has power over the investee

STEP 1(d) Determine whether the investor has exposure, or rights, to variable returns from the investee

STEP 1(e) Determine whether the investor has the ability to use its power over the investee to affect its own returns

Typically the investee is a separate entity (and that is our focus in this module). Step 1(b) – Identify the relevant activities of the investee STEP 1(a) Identify the investee

STEP 1(b)

STEP 1(c)

Identify the relevant activities of the investee

Determine whether the investor has power over the investee

STEP 1(d) Determine whether the investor has exposure, or rights, to variable returns from the investee

STEP 1(e) Determine whether the investor has the ability to use its power over the investee to affect its own returns

Where it is not clear whether control of an investee is held through voting rights, a critical step is identifying the relevant activities of the investee. Relevant activities are defined in IFRS 10 Appendix A as ‘activities of the investee that significantly affect the investee’s returns’. Decisions affecting returns include those that relate to key strategic aspects of an investee’s operations, such as operating, financial and capital policies, and appointing or terminating key management personnel and determining their remuneration.

Unit 15 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Step 1(c) – Determine whether the investor has power over the investee STEP 1(a) Identify the investee

STEP 1(b)

STEP 1(c)

Identify the relevant activities of the investee

Determine whether the investor has power over the investee

STEP 1(d) Determine whether the investor has exposure, or rights, to variable returns from the investee

STEP 1(e) Determine whether the investor has the ability to use its power over the investee to affect its own returns

In practice, this is often the most critical sub-step in determining control. This sub-step relates to the first element of control, which analyses the power relationship between an investor and an investee. Power arises from the investor’s existing rights, which gives it the ability to direct the investee’s relevant activities. The conceptual flow chart below illustrates how to determine whether an investor has power over an investee: Flow chart: How to determine whether an investor has power over an investee Does the investor have power over the investee?

Determine whether the investor’s rights provide ability to direct relevant activities Directed by voting rights

Does the investor own >50% of substantive voting rights?

Directed by contracts

YES

YES

NO

Is there de facto control?

Does the investor have power over structured entity? NO

YES

NO

Do substantive potential voting rights give controlling power?

YES

NO

Do other contractual agreements, or some combination of contracts, voting rights and potential voting rights provide controlling power?

Power

Unclear

Consider factors in IFRS 10 paras B18−B20

NO

No power

Adapted from: PwC (2011), p. 5

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Core content – Unit 15

Chartered Accountants Program

Financial Accounting & Reporting

Explanation of terms in the flow chart The table below explains key terms in the flow chart: Key terms in the flow chart Term

Explanation

Investor rights

Different types of rights, either individually or in combination, can give an investor power to direct the relevant activities, including: •• Direction by voting rights – both current and potential (e.g. through options held) •• Direction by other rights (including by contract) – typically arises from contractual arrangements that may involve a structured entity (outside the scope of this module)

Substantive voting rights

When assessing power, only substantive rights are considered To be substantive, rights need to be exercisable when decisions about the direction of activities that significantly affect returns need to be made. The holder of these substantive rights needs to have the practical ability to exercise and benefit from them Protective rights (often known as veto rights) alone do not give control

De facto control

An entity can control another entity with less than a majority of the voting rights. Factors to consider when determining whether an entity has de facto control include: •• Size of the holding relative to the size, dispersion and voting pattern of other vote holders •• Potential voting rights •• Other contractual rights •• Any other facts that may indicate whether the investor has the current ability to direct the investee’s relevant activities

Example – Identifying power over an investee arising from de facto control This example illustrates how de facto control may exist. Jelly Limited holds 47% of the ordinary shares of Trifle Limited. Trifle’s relevant activities are directed by voting rights conferred by ordinary shares. The remaining 53% of the shares are owned by thousands of other unrelated investors, none of whom individually own more than 2% of the investee. There are no arrangements for the other shareholders to consult one another or act collectively. Past experience indicates that few of the other owners actually exercise their voting rights. Jelly has power over Trifle due to its de facto control. This is because Jelly’s voting power is sufficient to provide the practical ability to unilaterally direct Trifle’s relevant activities (IFRS 10 para. B41). A large number of other shareholders would have to act collectively to outvote the investor. There are no mechanisms in place to facilitate any such collective action.

Step 1(d) – Determine whether the investor has exposure, or rights, to variable returns from the investee STEP 1(a) Identify the investee

STEP 1(b)

STEP 1(c)

Identify the relevant activities of the investee

Determine whether the investor has power over the investee

STEP 1(d) Determine whether the investor has exposure, or rights, to variable returns from the investee

STEP 1(e) Determine whether the investor has the ability to use its power over the investee to affect its own returns

This sub-step reflects the second element of control, which analyses the variability of returns. A return may still be considered variable even if it is fixed under a contract – for example, fixed

Unit 15 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

performance fees for managing an investee’s assets are still considered variable as the investor is exposed to the investee’s risk of non-performance (IFRS 10 para. B56). Returns may be positive, negative, or both positive and negative. Examples include dividends or other distributions, tax benefits, residual interests in the investee’s assets and liabilities, and an investor’s ability to use the investee’s assets in combination with its own to achieve economies of scale. Step 1(e) – Determine whether the investor has the ability to use its power over the investee to affect its own returns STEP 1(a) Identify the investee

STEP 1(b)

STEP 1(c)

Identify the relevant activities of the investee

Determine whether the investor has power over the investee

STEP 1(d) Determine whether the investor has exposure, or rights, to variable returns from the investee

STEP 1(e) Determine whether the investor has the ability to use its power over the investee to affect its own returns

The link between power over an investee and exposure to variable returns from involvement with the investee is essential to having control. An investor that has power over an investee, but cannot benefit from that power, does not control that investee. Returns are often an indicator of control: the greater an investor’s exposure to the variability of returns from its involvement with an investee, the greater the incentive for the investor to obtain rights that give the investor power.

Acting as principal or agent Step 1(e) centres on whether the investor with decision-making rights is acting as a principal or an agent (IFRS 10 para. 18). The principal-agent relationship is an arrangement in which one entity appoints another to act on its behalf, for example, when an agent acts on behalf of the principal. Accordingly, power resides with the principal and not with its agent, as shown in the diagram below: Use of the power to generate returns for itself Principal (can control)

Use of the delegated power for the benefit of others Agent (cannot control)

Decision-maker The investor (decision-maker) has the ability to use its power to affect the amount of its returns

To determine whether a decision-maker is acting as principal or agent, the following factors should be considered: •• The scope of decision-making authority. •• Any rights held by other parties (e.g. removal/kick-out rights).

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Core content – Unit 15

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Financial Accounting & Reporting

•• The remuneration to which the decision-maker is entitled. •• The exposure of the decision-maker to the variability of returns from other interests it holds in the investee. If a single party holds kick-out rights that can remove a decision-maker without cause, then the decision-maker is acting as an agent and not a principal (IFRS 10 para. B65).

Example – Determining whether the investor acts as principal or agent This example illustrates how an investor uses its power as an agent. Sable Fund Managers (Sable) establishes, markets and provides ongoing management to the Azure Investment Fund (Azure). The fund provides investment opportunities to many investors. Sable has a 3% ownership interest in Azure. Azure’s governing agreement requires Sable to make decisions that are in the best interests of the investors; however, it has broad decision-making discretion. Sable receives a market-based fee equal to 2% of the fund’s assets under management plus 10% of the fund’s profits if a specified profit is achieved. The investors can remove Sable by a simple majority vote if Sable breaches its contract. Sable acts as agent and therefore does not control Azure because: •• Its remuneration is at market rates. •• Although its minor investment holding does create an exposure to variability of returns, it is insufficient to indicate that Sable is acting as principal. The kick-out rights held by the other investors are protective rights which cannot provide them with control over Azure. Adapted from: IFRS 10 Application example 14A.

If control under IFRS 10 cannot be determined In the unlikely event that IFRS 10 does not clearly indicate which of the combining entities in a business combination is the acquirer, the guidance in IFRS 3 Appendix B paras B14–B18 should be applied, as it considers other factors, such as the relative size of the combining entities (which usually indicates that the acquirer is the larger entity). Required reading IFRS 10 paras 5–18, Appendix A Defined terms, Appendix B Application guidance paras B5–B28, B34–B50, B55–B61 and B64–B67. IFRS 3 paras 4–7; Appendix B Application guidance paras B13–B18.

Unit 15 – Core content

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Example – Identifying the acquirer in a business combination This example illustrates how to identify the acquirer in a business combination.

JUPITER

100%

ordinary shares PLUTO

100%

preference shares

SATURN

Jupiter Limited (Jupiter) purchased 100% of the ordinary share capital of Saturn Limited (Saturn) from Pluto Limited (Pluto) and replaced Pluto’s directors with its own. Saturn operates a profitable transport business that complements Jupiter’s medical equipment business, achieving cost savings for Jupiter. Pluto retains its preference shares in Saturn. These preference shares, which are all owned by Pluto, give it the right to a fixed dividend each year before any dividends can be declared on Jupiter’s ordinary shares. The preference shares do not have voting rights except on matters that directly affect their rights. Applying the five sub-steps to determine whether there is control: 1. Saturn is the investee. 2. The relevant activities are those involved in Saturn’s transport business. 3. Jupiter has power over Saturn because it controls all of the substantive voting rights in the investee. The voting rights on the preference shares held by Pluto are not substantive as their voting rights cannot direct the relevant activities of Saturn. 4. Jupiter is exposed to variable returns from Saturn, such as dividends on the ordinary shares. 5. Jupiter, acting as the principal, can use its power to direct Saturn, which will affect its own returns. Therefore, Jupiter is the acquirer in the business combination because it controls Saturn.

Worked example 15.1: Determining whether an investor has control [Available online in myLearning] Having determined that an acquirer has gained control in a business combination, the remainder of the acquisition method under IFRS 3 is applied.

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Financial Accounting & Reporting

Step 2 – Determine the acquisition date STEP 1 Identify the acquirer (the entity with control)

STEP 2 Determine the acquisition date

STEP 3 Recognise and measure at acquisition date the identifiable assets acquired and the liabilities assumed, as well as any noncontrolling interest (NCI) in the acquiree

STEP 4 Measure the consideration transferred

STEP 5 Recognise and measure the goodwill or gain from a bargain purchase

The determination of the acquisition date is important as it impacts the amount of goodwill or gain from a bargain purchase. To correctly calculate the amount of goodwill or gain from a bargain purchase, the items listed below must be recognised and measured at the acquisition date: •• Consideration transferred. •• Identifiable assets acquired and liabilities assumed. •• Any NCI. •• Any previously held equity interest owned by the acquirer in the acquiree (for a business combination that is achieved in stages). The acquisition date is the date the acquirer gains control of the acquiree. This is generally when the consideration is legally transferred in return for acquiring the assets and assuming any liabilities of the acquiree.

Example – Determining the acquisition date This example illustrates how to identify the acquisition date in a business combination. On 15 February 20X5, Bombe Limited signed an agreement to purchase 100% of Alaska Limited. The consideration consists of a cash payment of $5 million to Alaska and the issue of 100,000 Bombe shares to former shareholders of Alaska. The purchase agreement specifies that the acquisition date is 1 May 20X5. However, with effect from 15 February 20X5, Bombe can remove any of Alaska’s directors and appoint directors of its choice. On 1 April 20X5 Bombe removes all of the existing directors of Alaska and appoints directors of its choice. On 1 May 20X5 Bombe receives ownership of all of the shares in Alaska, pays the cash consideration and issues the shares. The fair value of Bombe’s shares at the various dates are as follows: Fair value of Bombe’s shares Date

Fair value per share

15 February 20X5

$5.20

1 April 20X5

$5.25

1 May 20X5

$5.30

The acquisition date is 15 February 20X5 – the date on which Bombe first obtained the power to govern Alaska’s financial and operating policies through its ability to remove and appoint all of the members of Alaska’s board. Accordingly, Bombe’s journal entry to record the 100,000 share issue on 1 May 20X5 will value the shares at the acquisition date fair value of $5.20 per share. Adapted from: IFRS Foundation: Training Material for the IFRS® for SMEs (version 2013-05)

Required reading IFRS 3 paras 8–10 and 18.

Unit 15 – Core content

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Step 3 – Recognise and measure at acquisition date the identifiable assets acquired and the liabilities assumed, as well as any NCI in the acquiree STEP 1 Identify the acquirer (the entity with control)

STEP 2 Determine the acquisition date

STEP 3 Recognise and measure at acquisition date the identifiable assets acquired and the liabilities assumed, as well as any noncontrolling interest (NCI) in the acquiree

STEP 4 Measure the consideration transferred

STEP 5 Recognise and measure the goodwill or gain from a bargain purchase

IFRS 3 sets out the recognition and measurement principles relating to the acquiree’s identifiable assets acquired, liabilities assumed and any NCI in a business combination. Keep in mind that the acquisition method results in recognising a value for goodwill. It is only when there is a business combination that goodwill can be recognised as an asset, as IAS 38 Intangible Assets prohibits the recognition of internally generated goodwill (covered in Unit 8). Goodwill is defined in IFRS 3 Appendix A as: An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.

Therefore, a business combination is a rare opportunity for an entity to recognise goodwill as an asset. Goodwill is effectively a ‘residual asset’ once all other individually identified and separately recognised assets are recorded. Consequently, IFRS 3 is getting the acquirer to ‘freshen up’ the values of the acquiree’s net assets before any goodwill can be calculated and recognised for the business combination. The IFRS 3 recognition and measurement principles include a number of exemptions and variations to the general recognition and measurement principles contained in The Conceptual Framework for Financial Reporting (the Framework) and other IFRSs. FIN fact There may be assets such as brand names that are recognised when calculating the amount of goodwill acquired in a business combination. This is even though a particular Accounting Standard may prohibit the acquiree from recognising the asset in its own financial statements.

When an acquirer does not obtain ownership of all of the equity of the acquiree, the equity that was not acquired is an NCI. For example, when 80% of a subsidiary is acquired, the 20% not acquired by the parent is recognised as the NCI. IFRS 3 requires an acquisition-date value to be placed on the NCI in order to calculate the goodwill acquired.

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Financial Accounting & Reporting

The following diagram summarises these recognition and measurement rules. At the acquisition date the acquirer recognises separately from goodwill, these items of the acquiree (IFRS 3 paras 10–14) Identifiable assets acquired (tangible and intangible)

Liabilities assumed

Assets acquired and liabilities assumed must meet the definitions of ‘assets’ and ‘liabilities’ in the Conceptual Framework E.g. expected future costs such as restructuring costs cannot be included in the calculation of liabilities assumed General measurement rule Identifiable assets acquired and liabilities assumed are measured at fair value at the acquisition date (IFRS 3 para. 18) Specific recognition rule for intangible assets Recognise identifiable intangible assets acquired intangible assets at fair value (IFRS 3 para. 13 and IAS 38 paras 33–34) Examples of intangible assets recognised in a business combination (even if acquiree had previously expensed these costs) Brand names, trademarks, customer lists, royalty agreements, patented technology and computer software (IFRS 3 Appendix B paras B31–B34)

Specific recognition rule for contingent liabilities Even though the acquiree would never recognise a contingent liability in its own financial statements under IAS 37, the accounting for a business combination is different Where a contingent liability of the acquiree is a present obligation arising from a past event that can be reliably measured, its fair value is recognised, e.g. in relation to a law suit against the acquiree (IFRS 3 paras 22–23) The fair value reflects market participant expectations about all possible cash flows, rather than simply the likely or expected maximum or minimum cash flows

NCI in the acquiree For each business combination, an acquirer can choose to value any NCI (IFRS 3 para. 19 and Appendix B paras B44–B45) at: • fair value (used in the full goodwill method) OR • the NCI’s share of the acquiree’s fair value of identifiable net assets (used in the partial goodwill method)

Exception for employee benefit liabilities The IFRS 3 fair value rule doesn’t apply − the normal IAS 19 Employee Benefits rules apply (IFRS 3 para. 26) Specific recognition and measurement rules for income taxes Where the book value of assets acquired and liabilities assumed in a business combination is different from their fair value, a tax effect adjustment is required (IFRS 3 paras 24–25) IAS 12 Income Taxes (IAS 12) requires corresponding deferred tax assets and deferred tax liabilities to be recognised on the fair value adjustments of assets and liabilities (IAS 12 para. 19)

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Example – General measurement rule This example illustrates the general measurement rule in IFRS 3 para. 18. Mercury Limited gained control of Neptune Limited by acquiring all of its equity. At the acquisition date, Neptune owns the following two assets, which have a fair value that differs from the carrying amount in its financial statements: Item

Carrying amount at acquisition date $

Fair value at acquisition date

300,000

400,000

2,700,000

2,900,000

Inventory Plant and equipment

$

When applying IFRS 3 to calculate goodwill, the consolidated financial statements will recognise: •• Inventory of $400,000. •• Plant and equipment of $2,900,000.

Explanation IAS 2 Inventories requires inventory to be measured at the lower of cost and net realisable value; however, IFRS 3 overrules this when accounting for a business combination. [Unit 16 will explain that a consolidation journal entry will be recorded to recognise these fair value adjustments in the consolidated financial statements. Later in this unit an acquisition analysis will illustrate how these fair value adjustments are treated when goodwill is calculated.]

Example – Specific recognition rule for intangible assets This example illustrates how an unrecognised intangible asset is recognised in a business combination. Mercury gained control of Neptune by acquiring all of its equity. At the acquisition date, Neptune’s business had successful products that traded under the ‘Out of This World’ brand name. IAS 38 para. 63 prohibits Neptune from recognising an internally generated brand name in its financial statements. A fair value of $800,000 was measured for this brand name at the acquisition date. When applying the acquisition method of accounting for the business combination under IFRS 3, a fair value of $800,000 will be attributed to Neptune’s brand name. [In Unit 16, a consolidation journal entry will recognise the brand name asset in the consolidated financial statements. Note that IAS 38 para. 63 still prohibits Neptune from recognising the brand name in its own financial statements.]

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Financial Accounting & Reporting

Example – Recognition of a contingent liability This example illustrates how a contingent liability is recognised in a business combination. Mercury gained control of Neptune by acquiring all of its equity. At the acquisition date Neptune was defending a lawsuit involving an employee who slipped in the factory while wearing inappropriate footwear. Neptune had not recognised the liability on its statement of financial position because its lawyers advised that they were highly likely to successfully defend the claim. Neptune determined that there was a present obligation, but payment of a claim was not considered probable. It had correctly disclosed the matter in its notes to its financial statements as a contingent liability under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. A fair value of $300,000 was measured for this contingent liability at the acquisition date. Although IAS 37 only permits note disclosure for a contingent liability, IFRS 3 overrules this when specified requirements are met. Therefore, Mercury will recognise a fair value of $300,000 for this contingent liability at the acquisition date when accounting for the business combination under IFRS 3. IFRS 3 still considers the item to be a contingent liability but the Standard is effectively taking a practical view of the situation because Mercury would have factored in this law suit when determining how much it was willing to pay to gain control of Neptune. [In Unit 16, a consolidation journal entry will recognise the contingent liability in the consolidated financial statements. IAS 37 still prohibits Neptune from recognising the contingent liability in its own financial statements.]

Tax effect implications of business combination adjustments As mentioned in the previous diagram, there may be tax effect implications if fair value adjustments are made when accounting for a business combination. Unless stated to the contrary, the FIN module assumes that a temporary difference will arise under IAS 12 Income Taxes where there is a fair value adjustment in determining the fair value of the identifiable net assets when accounting for a business combination. The temporary difference is multiplied by the applicable tax rate to determine the deferred tax asset (DTA) or deferred tax liability (DTL). Recognition of the DTA or DTL follows the rules covered in Unit 4. Required reading IFRS 3 paras 10–14, 18–19, 21–26, 51–52, Appendix B ‘Application guidance’ paras B31–B34, B44–B45. IAS 12 para. 19. IAS 38 paras 33–34.

Unit 15 – Core content

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Chartered Accountants Program

Step 4 – Measure the consideration transferred STEP 1 Identify the acquirer (the entity with control)

STEP 2 Determine the acquisition date

STEP 3 Recognise and measure at acquisition date the identifiable assets acquired and the liabilities assumed, as well as any noncontrolling interest (NCI) in the acquiree

STEP 4 Measure the consideration transferred

STEP 5 Recognise and measure the goodwill or gain from a bargain purchase

The consideration transferred to gain control of the acquiree is not limited to cash paid. IFRS 3 identifies that there can be three different components to the consideration transferred as shown below: Consideration transferred Measured under IFRS 3 para. 37 as the aggregate of the fair values of:

Assets the acquirer transferred

Liabilities the acquirer incurred to the former owners of the acquiree

Equity interests the acquirer issued to the former owners of the acquiree

FIN fact Acquisition related costs are not included within the consideration transferred. They are expensed (IFRS 3 para. 53).

Deferred or contingent consideration The consideration transferred may not always be settled at the acquisition date. However, the fair value of the deferred and/or contingent consideration at the acquisition date must be included in the consideration transferred calculation.

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Financial Accounting & Reporting

For the purposes of the FIN module, deferred and/or contingent consideration is confined to situations that give rise to a liability. In order to measure the appropriate fair value, the following rules are applied: Deferred consideration For example, a cash payment due 12 months after the acquisition date

Contingent consideration For example, a payment due based on the acquiree meeting an earnings target or reaching a specified share price

Apply IFRS 13 to measure the fair value

Discount the future payment back to the acquisition date

Discount the expected future payment back to the acquisition date

Typically the acquirer’s incremental borrowing rate is used as the discount factor

As this can be complex, the fair value of contingent consideration will be provided in the FIN module

Required reading IFRS 3 paras 37–40, 53. IAS 32 para. 35. IFRS 9 Appendix A (definition of transaction costs). Step 5 – Recognise and measure the goodwill or gain from a bargain purchase STEP 1 Identify the acquirer (the entity with control)

STEP 2 Determine the acquisition date

STEP 3 Recognise and measure at acquisition date the identifiable assets acquired and the liabilities assumed, as well as any noncontrolling interest (NCI) in the acquiree

STEP 4 Measure the consideration transferred

STEP 5 Recognise and measure the goodwill or gain from a bargain purchase

This is the final step in applying the acquisition method. The diagram below summarises some of the key concepts covered so far: Apply the IFRS 3 acquisition method to the business combination (determines goodwill or gain from a bargain purchase)

The parent will prepare consolidated financial statements for the group in accordance with IFRS 10 (covered in Unit 16)

Unit 15 – Core content

The acquisition method views the business combination from the perspective of the acquirer (parent)

The goodwill or gain from a bargain purchase is recognised in the consolidated financial statements (covered in Unit 16)

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Goodwill may relate to: •• The ability of the acquiree to earn a higher rate of return on an assembled collection of net assets than it would expect to earn from those net assets if they were operating separately. •• Anticipated synergies between the acquirer and the acquiree. Goodwill is recognised at the acquisition date and is measured as follows:

Goodwill

=

Fair value of the consideration transferred

+

Value of any NCI

+

Fair value of the acquirer’s previously held equity interest in the acquiree at acquisition date (only if the business combination is achieved in stages)

Acquisition date identifiable assets

Acquisition date liabilities

Both measured in accordance with IFRS 3 Referred to as fair value of identifiable net assets (FVINA)

Full versus partial goodwill method for valuing the NCI When not all of the equity interests in the acquiree are acquired (i.e. where a partly owned subsidiary is acquired), the goodwill formula requires a value to be placed on the NCI at the acquisition date. IFRS 3 permits the full or partial goodwill method to be applied for each business combination where there is a partly owned subsidiary as explained in the following diagram: Valuing the NCI under the full or partial goodwill method

There is a choice of measurement of the NCI in the acquiree at the acquisition date when accounting for the business combination

Full goodwill method Measure the NCI at fair value at the acquisition date (For the purposes of the FIN module this value will always be provided)

Partial goodwill method Measure the NCI at its proportionate share of the FVINA at the acquisition date

Both of these methods are demonstrated in Worked example 15.2

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Core content – Unit 15

Chartered Accountants Program

Financial Accounting & Reporting

Example – Calculating goodwill This example illustrates how to calculate goodwill and draws on fair value adjustments covered in earlier examples. On 30 June 20X5, Mercury Limited gained control of Neptune Limited by acquiring all of its equity for a cash consideration of $2,500,000. At the acquisition date the recorded net assets of Neptune were: Net assets at 30 June 20X5 Item

Neptune $

Issued capital (1,000,000 shares)

1,000,000

Retained earnings

  500,000

Total equity/net assets

1,500,000

Neptune’s identifiable assets acquired and liabilities assumed were recorded at fair value except for the following items: Item

Carrying amount at acquisition date $

Fair value at acquisition date $

300,000

400,000

2,700,000

2,900,000

Brand name

0

800,000

Contingent liability

0

300,000

Inventory Plant and equipment

The tax rate is 30%. Goodwill is calculated as follows: Acquisition analysis – calculation of goodwill Goodwill acquired in Neptune at 30 June 20X5 Item

$

Consideration transferred

$ 2,500,000

Net assets acquired Book value of net assets

1,500,000

Fair value adjustments (net of tax): Inventory (($100,000) × (1 – 30%))

70,000

Plant and equipment (($200,000) × (1 – 30%))

140,000

Brand name (($800,000) × (1 – 30%))

560,000

Contingent liability (($300,000) × (1 – 30%))

(210,000)

Fair value of identifiable net assets (FVINA)

2,060,000

Goodwill acquired

  440,000

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FIN fact Always include a value for the NCI at the acquisition date as part of the goodwill calculation when a partly owned subsidiary is acquired. ••

If the NCI is measured at fair value, the full goodwill method is being used.

••

If the NCI is calculated as its share of the FVINA, the partial goodwill method is being used.

Worked example 15.2: Calculate goodwill when a partly owned subsidiary is acquired in a business combination [Available online in myLearning]

Gain from a bargain purchase Occasionally, an acquirer will make a gain from a bargain purchase which is akin to negative goodwill. This is the reverse of the situation depicted in the preceding diagram, where the gain is equal to the FVINA minus the sum of the three items in the first box. The treatment required before the gain can be recognised for the business combination is as follows:

Calculate the gain from a bargain purchase

Reassess the amounts recognised and measured in Steps 3-5 of the acquisition method (IFRS 3 para. 34)

Any gain remaining after this reassessment is immediately recognised in profit or loss and attributed to the acquirer (that is, no amount is allocated to any NCI) (IFRS 3 para. 36)

This process of re-examining the calculation could possibly identify an asset impairment when reassessing asset fair values. Assuming this re-examination identified that an asset of the acquiree needed to be written down, this will revise the initial calculation of the gain from a bargain purchase

Required reading IFRS 3 paras 32–36. Worked example 15.3: Calculate a gain from a bargain purchase [Available online in myLearning]

Accounting subsequent to the initial accounting Learning outcome 4. Account for subsequent adjustments to the initial accounting for a business combination. IFRS 3 sets out rules for the accounting of certain issues after the acquisition date. Several of the important matters are covered in this section. The emphasis is on how the goodwill calculation may be impacted; however, the discussion could equally apply to a gain from a bargain purchase.

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Financial Accounting & Reporting

Measurement period adjustments Generally, the goodwill calculated at the acquisition date remains unchanged after that time and is recognised as an asset in the consolidated financial statements. However, IFRS 3 recognises that the initial accounting for a business combination may be performed on a provisional basis at the end of a reporting period; for example, when a business combination occurs just before a reporting date. Adjustments that alter the provisional goodwill value are called measurement period adjustments. The measurement period is the time from the acquisition date that ends at the earlier of either: •• the date the acquirer receives the information it was seeking •• the date the acquirer learns that the information it was seeking cannot be obtained, or •• twelve months from the acquisition date. The diagram below explains the accounting treatment of measurement period adjustments:

Measurement period adjustments Goodwill is calculated at the acquisition date as per Step 5 (known as the provisional calculation when considering measurement period adjustments) No, new facts/circumstances during the measurement period

Make measurement period adjustments by retrospectively adjusting goodwill at the acquisition date for the new information (IFRS 3 para. 45)

YES

Is there new information obtained during the measurement period AND the facts/circumstances existed at the acquisition date?

Examples of measurement period adjustments: • Changes to the consideration transferred (including contingent consideration) • Assets or liabilities in existence at the date of acquisition that were not recognised • Assets or liabilities in existence at the date of acquisition that were recognised at values other than the measurement basis specified in IFRS 3 • A contingent liability in existence at the date of acquisition is re-measured for new information obtained

NO

Not a measurement period adjustment. No change to the business combination accounting, therefore, goodwill is not changed. E.g. an asset acquired in the business combination is impaired post-acquisition – the accounting under the relevant accounting standard is applied (in this case IAS 36 Impairment of Assets)

Implications of retrospective adjustment: • Adjust comparative financial statements to reflect the revised values including goodwill • Changes to fair values may also require tax effect adjustments • Depreciation or amortisation may need to be adjusted if fair values are altered (covered in Unit 16)

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Example – Measurement period adjustment This example illustrates how a measurement period adjustment alters the provisional goodwill value measured for a business combination. Tartan Limited gained control of Spots Limited by acquiring all of its equity in a business combination that occurred on 31 May 20X5. Goodwill of $800,000 was recognised in the consolidated financial statements at 30 June 20X5 in respect of this business combination. The $800,000 goodwill calculation included an estimated fair value for one of Spots’ intangible assets. Due to new information obtained in September 20X5 that was not available at the acquisition date, it was determined that the asset’s fair value should have been measured at a value $500,000 higher than in the original calculation. The after-tax impact of this measurement period adjustment is a $350,000 ($500,000 × (1 – 30%)) increase to the fair value of the identifiable net assets acquired in Spots. Correspondingly, the goodwill recognised for the business combination is reduced by $350,000 to $450,000 ($800,000 provisional goodwill – $350,000 after tax measurement period adjustment).

FIN fact The amount of goodwill calculated at the acquisition date might change in the 12 months after the acquisition date … if there is a measurement period adjustment.

Adjustments after the measurement period After the end of the measurement period, the acquirer can only adjust the business combination accounting (including the goodwill) if there has been an error. Any error is accounted for retrospectively under IAS 8 Accounting Policies, Changes in Accounting estimates and Errors as covered in Unit 2. Required reading IFRS 3 paras 45–50.

Other accounting issues subsequent to the business combination IFRS 3 prescribes the accounting treatment for the following: •• Contingent liabilities. •• Contingent consideration. The treatment of these matters are discussed below.

Contingent liabilities For the purposes of the FIN module, a contingent liability recognised in a business combination is remeasured at each reporting date to the best estimate of the expenditure required to settle the present obligation under IAS 37 para. 36. •• Where the reporting date falls within the measurement period, this will result in the goodwill being adjusted (as explained in the diagram on measurement period adjustments). •• Where the reporting date falls after the measurement period ends, this will result in the subsequent adjustment being recognised in profit or loss.

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Financial Accounting & Reporting

Contingent consideration If additional information is obtained about facts and circumstances relating to contingent consideration that existed at acquisition date, these are accounted for as measurement period adjustments where they fall within the measurement period (as explained in the diagram on measurement period adjustments). However, events that occur after the acquisition date – for example, meeting an earnings target or reaching a specified share price – are not measurement period adjustments. Changes in the fair value of contingent consideration that are not measurement period adjustments are accounted for as follows: Changes in contingent consideration that are not measurement period adjustments Classification of contingent consideration

Contingent consideration remeasured?

Recognition of change in fair value

IFRS 3 para. reference

Equity

No

Not required as not remeasured 58(a)

A financial asset or liability

Yes

Recognised in profit or loss

58(b)(i)

A non-financial asset or liability

Yes

Recognised in profit or loss

58(b)(ii)

Example – Change in contingent consideration This example illustrates the accounting for changes in contingent consideration relating to an event occurring after the acquisition date. Major Limited gained control of PeeWee Limited by acquiring all of its equity on 1 July 20X5. The purchase consideration payable by Major to PeeWee’s shareholders was as follows: •• $1,000,000 payable in cash at the acquisition date. •• $500,000 payable in cash on 1 January 20X6 if PeeWee’s profit for the first six months following the acquisition achieved a targeted amount. At the acquisition date, the fair value of the contingent consideration was measured at $400,000 and was recognised as a liability in Major’s general ledger.

Business combination accounting The consideration transferred that is used in the calculation of goodwill on the business combination will be measured at $1,400,000. It does not change whether the profit target is achieved or not as this is an event that occurs after the acquisition, which is not a measurement period adjustment.

Major’s general ledger Entry at acquisition date Date

Account description

01.07.X5

Investment in PeeWee

Dr $

Cr $

1,400,000

Cash Payable (contingent consideration)

1,000,000 400,000

To record the investment in PeeWee upon gaining control of the subsidiary

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Entry six months later when the profit is determined (i) Profit target is achieved An amount of $500,000 will be paid to PeeWee’s former shareholders and the following journal entry will be recorded: Date

Account description

Dr $

01.01.X6

Payable (contingent consideration)

400,000

Fair value movement on contingent consideration1

100,000

Cash

Cr $

500,000

To record the payment of the additional consideration due to PeeWee achieving the profit target, with the $100,000 expense recognised in profit or loss 1. IFRS 3 para. 58(b)(i) does not specify the account within profit or loss to use for this debit entry; however, this account description is used in practice.

(ii) Profit target is not achieved No additional amount will be paid to PeeWee’s former shareholders and the following journal entry will be recorded: Date

Account description

01.01.X6

Payable (contingent consideration) Gain on contingent consideration

Dr $

Cr $

400,000 400,000

To derecognise the liability for the contingent consideration as the profit target was not achieved, with the gain recognised in profit or loss

Required reading IFRS 3 paras 54, 56 and 58.

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Summary - acquisition method of accounting for business combinations Step 1 Identify the acquirer

Step 2 Determine the acquisition date

Step 3 Recognise and measure, at acquisition date, the identifiable assets acquired and the liabilities assumed, as well as any non-controlling interest (NCI) in the acquiree

Control determined under IFRS 10 Consolidated Financial Statements

The date the acquirer gains control of the acquiree

Assets and liabilities of the acquiree are generally measured at fair value NCI measured for each business combination at fair value (full goodwill method) or proportionate share of fair value of identifiable net assets (partial goodwill method) Special rules set by IFRS 3 Business Combinations: Recognition rule Contingent liabilities Both recognition and measurement rules Income taxes Employee benefits

Step 4 Measure the consideration transferred

Step 5 Recognise and measure the goodwill or gain from a bargain purchase

Subsequent measurement and accounting

Aggregate of the fair value of: • Assets transferred by the acquirer • Liabilities incurred by the acquirer to the former owners of the acquiree • Equity interests issued by the acquirer to the former owners of the acquiree The consideration may include contingent and/or deferred consideration

Goodwill – allocation and impairment prescribed by IAS 36 Impairment of Assets Gain from a bargain purchase – recognise in profit or loss in year of acquisition Goodwill (gain from a bargain purchase)

=

Fair value of the consideration transferred

+

Value of any NCI

+

Fair value of the acquirer’s previously held equity interest in the acquiree at acquisition date (only if the business combination is achieved in stages)

Acquisition date identifiable assets

Acquisition date liabilities

Both measured in accordance with IFRS 3 Referred to as fair value of identifiable net assets (FVINA)

• The measurement period ends as soon as the acquirer receives the information it was seeking or obtains more information that was previously not obtainable. The measurement period cannot exceed one year from the acquisition date • Measurement period adjustments alter goodwill/gain from a bargain purchase when it subsequently becomes known that: the cost of acquisition needs adjusting; assets or liabilities in existence at the date of acquisition were not recognised; and assets or liabilities in existence at the date of acquisition were recognised at values other than the measurement basis specified in IFRS 3 • Special rules for the subsequent accounting, which do not alter goodwill/gain from a bargain purchase, are: contingent liabilities and contingent consideration

Activity 15.1: Accounting for a business combination [Available online in myLearning]

Unit 15 – Core content

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Disclosures Due to the significance of a business combination to the economic entity, both at acquisition and because of the anticipated long-term benefits, disclosures are extensive. The information disclosed enables users of the financial statements to: ... evaluate the nature and financial effect of a business combination that occurs either: (a) during the current reporting period; or (b) after the end of the reporting period but before the financial statements are authorised for issue (IFRS 3 para. 59).

IFRS 3 paras B64–B67 detail these disclosures. Information is also disclosed that enables users of the financial statements to evaluate the financial effects of adjustments recognised in the current reporting period that relate to business combinations that occurred in the period or previous reporting periods (IFRS 3 para. 61). IFRS 3 para. B67 details these disclosures. Required reading IFRS 3 paras 59–63 and Appendix B Application guidance paras B64–B67. Quiz [Available online in myLearning]

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Unit 16: Accounting for subsidiaries Contents Introduction

16-3

Extra support with this unit 1. Integrated activity 2. Adaptive learning lesson

16-4 16-4 16-4

Tax effect implications of consolidated accounting

16-4

What is consolidation?

16-5

Consolidation process Step 1 – Determine whether control exists

16-8 16-8

Preparing consolidated financial statements Step 2 – Determine whether consolidated financial statements need to be presented Step 3 – Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s Step 4 – Prepare all necessary consolidation eliminations and adjustments Step 4(a) – Perform an acquisition analysis Step 4(b) – Prepare any business combination valuation reserve entries Step 4(c) – Eliminate the investment asset Step 4(d) – Eliminate intragroup transactions and balances Step 4(e) – Prepare the NCI allocations Step 4(e)(i) – Calculate the NCI percentage Step 4(e)(ii) – Calculate the NCI allocation Step 4(e)(iii) – Record the NCI allocation Step 5 – Prepare the consolidated financial statements Separate financial statements Assessing goodwill for impairment for partly owned subsidiaries Consolidating a foreign subsidiary

16-8 16-8 16-9 16-10 16-11 16-12 16-17 16-18 16-23 16-24 16-24 16-26 16-26 16-27 16-27 16-30

Accounting for movements in investments Acquisition of additional investment (step acquisition) New issue of shares by a subsidiary

16-32 16-32 16-32

Disclosures 16-33

Unit 16 – Core content

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Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Learning outcomes At the end of this unit you will be able to: 1. Explain how a business combination is accounted for in the books of the acquiree. 2. Explain and account for a consolidation for a wholly-owned subsidiary. 3. Explain and account for a consolidation for a partly-owned subsidiary. 4. Account for movements in the parent’s interest in a subsidiary

Introduction When a parent entity has control over another entity, that entity is a subsidiary. The consolidated financial statements of the parent and its subsidiaries (the group) are presented as those of a single economic entity. Whether a Chartered Accountant is the preparer, auditor or interpreter of consolidated financial statements, knowledge of accounting for subsidiaries is critical to understanding and explaining the financial results and position of a group. This unit explains the ongoing accounting requirements when a parent controls one or more subsidiaries. It outlines the necessary steps to account for subsidiaries and prepare consolidated financial statements. It follows on from the unit on business combinations; therefore, it is recommended that you complete that unit first. Unit 16 overview video [Available online in myLearning] The five relevant Standards covered in this unit are as follows: Standards relevant to accounting for subsidiaries Standard

Deals with

IFRS 10 Consolidated Financial Statements

The principles related to the presentation and preparation of consolidated financial statements when an entity controls one or more other entities

IFRS 3 Business Combinations

The accounting for a business combination (in the context of this unit, the acquisition of a subsidiary)

IFRS 12 Disclosure of Interests in Other Entities

The disclosure requirements applying to subsidiaries (in the context of this unit)

IAS 12 Income Taxes

The tax effect of consolidation adjustments. (The worked examples and activities in this unit assume that the entities are not part of a tax-consolidation group)

IAS 21 The Effects of Changes in Foreign Exchange Rates

The translation of a foreign subsidiary (covered in Unit 5) before applying the procedures for the preparation of consolidated financial statements

Unit 16 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Extra support with this unit Accounting for subsidiaries can be a challenging area. Revisiting the flowcharts and tables in Unit 15 will help candidates as they work through this unit. Also, to assist candidates in developing their skills, there are two additional resources to support this unit, as follows:

1. Integrated activity Integrated activity 3 is based on a relatively straightforward scenario and provides an opportunity for candidates to ‘dip in and dip out’ with their learning as they proceed through the consolidation process outlined in this unit. It is not necessary to wait until the end of this unit to attempt this integrated activity and, for some people, it might be a refresher from university studies. Integrated activity 3 The integrated activity is available online in myLearning.

2. Adaptive learning lesson This unit includes an adaptive learning lesson, which is designed to develop candidates’ knowledge and understanding of accounting for subsidiaries and accounting for business combinations (covered in the previous unit). It allows the learner to explore the consolidation entries when either the full goodwill or partial goodwill method is applied. The adaptive learning tool offers a number of benefits. For example, if the learner is unable to successfully complete part of the task, guidance is provided to help the learner to proceed with the task at hand. When completed, the lesson can be attempted again but with a new fact pattern, enabling knowledge to be re-applied in a different scenario. The adaptive learning lesson is available on myLearning and is launched with one click from the Unit 16 page.

Tax effect implications of consolidated accounting Unless stated to the contrary, the FIN module assumes that a temporary difference will arise under IAS 12 where the carrying amount of an asset or liability is adjusted on consolidation (including consequential consolidation adjustments that reverse such an adjustment). The temporary difference is multiplied by the applicable tax rate to determine the deferred tax asset (DTA) or deferred tax liability (DTL). Recognition of the DTA or DTL follows the rules covered in Unit 4.

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Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

What is consolidation? Learning outcomes 1. Explain how a business combination is accounted for in the books of the acquiree. 2. Explain and account for a consolidation for a wholly-owned subsidiary. 3. Explain and account for a consolidation for a partly-owned subsidiary. Consolidation is the process of presenting the financial statements of all entities within a group as those of a single economic entity. A summary of the key principles of consolidation is tabled below. It would be helpful for candidates to have a basic understanding of the principles before proceeding with their study of the consolidation process. Key principles of consolidation

Points to note

Owner is called ‘the parent’

The parent is the entity that has gained control in the business combination

Acquired entity is called ‘the subsidiary’

The subsidiary may be wholly owned or partly owned by the parent

The parent's and the subsidiary's trial balances at the current reporting date are added across in a consolidation worksheet

Consolidation is a line-by-line aggregation process

If the subsidiary is partly owned, a non-controlling interest (NCI) will need to be recognised in the consolidated financial statements Even if a subsidiary is only partly owned by the parent, 100% of the subsidiary’s trial balance values are used Think of the consolidation worksheet as sitting outside an entity’s normal accounting system. For example, a parent and its subsidiary may use XEROTM accounting software to operate their general ledgers When the consolidation is prepared, the trial balances of each entity are downloaded to a spreadsheet. This spreadsheet is the consolidation worksheet where the consolidation journal entries are recorded. Therefore, the consolidation journal entries never alter the general ledger of either the parent or the subsidiary A consolidation worksheet may look like this: Consolidation worksheet for the year ended 30 June 20X6 Parent

Subsidiary

Consolidation journal entries

$

$

Journal ref.

Dr $

4,000,000

2,900,000

3

1,000,000

Cr $

Journal ref.

Consolidated trial balance $

Statement of profit or loss Sales revenue

Unit 16 – Core content

5,900,000

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Financial Accounting & Reporting

Chartered Accountants Program

Key principles of consolidation

Points to note

Consolidation entries are made to many different accounts

Consolidation journal entries are recorded on the consolidation worksheet and may be made to accounts within the statement of financial position and the statement of profit or loss and other comprehensive income Consolidation journal entries do not alter the general ledger of the parent or the subsidiary. Rather, they must be posted into the consolidation worksheet at each reporting period. This means that consolidation journal entries do not carry forward to the next accounting period (unlike asset and liability balances within the general ledger that do). As such, a current year consolidation journal entry may need to reflect a transaction or an event that happened in an earlier year For example, three years of amortisation for an asset recognised in a business combination where the business combination occurred several years ago. The consolidation journal entry would record the prior two years’ amortisation expense against the opening retained earnings account while the current year’s charge would be recorded to amortisation expense within the statement of profit or loss and other comprehensive income

Goodwill of the subsidiary acquired in the business combination is recognised as an asset

Goodwill is calculated by performing an acquisition analysis (which is covered in the unit on business combinations)

The parent’s investment asset in the subsidiary is eliminated

As the consolidated financial statements show the economic entity as one entity, the parent’s investment asset in the subsidiary would be an internal investment, so it must be eliminated



Video resource

The goodwill is not separately shown in the general ledger of the parent. It is only through a consolidation entry that the goodwill asset is recognised in the consolidated financial statements

This is achieved through a consolidation journal entry, using the values from the acquisition analysis that calculated the goodwill from the business combination The consolidation journal entry also has the effect of removing the parent’s share of the subsidiary’s pre-acquisition earnings and reserves, as the net assets of the subsidiary are included in the consolidated financial statements Refer to the Unit 16 page on myLearning for a video demonstration of why eliminating the investment asset avoids double counting

An NCI is recognised if the parent does not own 100% of the subsidiary

The NCI is part of the economic entity and is considered to be a contributor of equity. It is shown in the equity section of the statement of financial position within the consolidated financial statements It may help to think that the economic entity (group) can include 100% of the subsidiary’s net assets in the consolidated financial statements, despite only partly owning the subsidiary, because it recognises an NCI within equity Subsidiary’s equity in consolidated financial statements Parent’s share 75%

NCI

25%

Intragroup transactions are eliminated

If transactions occur within the economic entity, they must be eliminated through consolidation journal entries to avoid double-counting

FIN fact Consolidation journal entries do not alter the general ledger of the parent or the subsidiary. Therefore, consolidation journal entries do not carry forward to the next accounting period. As such, a current year consolidation journal entry may need to reflect a transaction or an event that happened in an earlier year.

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Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

One of the key effects of the consolidation journal entries is that the parent’s share of postacquisition earnings and reserves remain in the consolidated financial statements. Remember that the shareholders of the parent will be particularly interested to know how a subsidiary has performed since the parent gained control of it. The diagram below is an example of a group structure which we will use to briefly apply some of the key principles tabled above. NO

MIC ENT IM

RO

Y

E

P

IT

S

PR

O EC

60%

Acquisition date 1 July 20X5 S

C

NCI 40% A

RL

ET

Other shareholders 40% NCI

Applying the principles of consolidation to the diagram above, we can determine that: •• Primrose is the parent. •• Scarlet is the subsidiary. •• There is a 40% NCI in Scarlet. We do not need to know detailed information about the NCI. It could be one shareholder owning 40% of Scarlet, or multiple shareholders whose ownership interests total 40%. •• The economic entity/group comprises Primrose, Scarlet and the 40% NCI. •• Therefore, the consolidated financial statements will: –– show 100% of post-acquisition earnings and reserves that Primrose has earned from Scarlet since it gained control of the subsidiary on 1 July 20X5 and allocate 40% of them to the NCI –– recognise within equity that there is a 40% NCI in Scarlet. Required reading IFRS 10 Appendix A ‘Defined terms’ and Appendix B para. B86.

Unit 16 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Consolidation process The consolidation process can be worked through as a series of steps, as outlined below: STEP 1

Step 1 – Determine whether control exists STEP 1

STEP 2

STEP 3

STEP 4

Determine whether control exists

Determine whether consolidated financial statements need to be presented

Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s

Prepare all necessary consolidation eliminations and adjustments

STEP 5 Prepare the consolidated financial statements

The process of determining whether control exists (Step 1) was covered in Unit 15 on business combinations, where it was established that a business combination required the parent entity to have gained control of the subsidiary in an acquisition. IFRS 10 defines ‘control’ and specifies the three elements that must be present for control to exist (IFRS 10 para. 7). Required reading IFRS 10 paras 7–8. Consolidated financial statements are prepared when there is control. Therefore, control is not only required when the business combination occurs but also needs to be assessed on an ongoing basis. It must also be reassessed if there is any indication of a change to any of the three key elements of control (IFRS 10 para. 8).

Preparing consolidated financial statements Paragraph 4 of IFRS 10 requires a parent entity to present consolidated financial statements. However, in certain circumstances a parent can be exempted from this obligation if specific requirements are met – for example, an intermediate parent (that is also a reporting entity) may not be required to prepare consolidated financial statements. (These exceptions are beyond the scope of the FIN module and will not be further discussed.) STEP 2

Step 2 – Determine whether consolidated financial statements need to be presented STEP 1

STEP 2

STEP 3

STEP 4

Determine whether control exists

Determine whether consolidated financial statements need to be presented

Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s

Prepare all necessary consolidation eliminations and adjustments

Page 16-8

STEP 5 Prepare the consolidated financial statements

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Once it has been established that the investor has control (and is therefore a parent), it must be determined whether consolidated financial statements should be presented or if an exemption applies.

STEP 2

Australia-specific According to AASB 10 Consolidated Financial Statements para. Aus4.2, there is no exemption available for the ultimate Australian parent company if either the parent or the group (or both) are reporting entities.

Required reading IFRS 10 para. 4.

Step 3 – Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s STEP 1

STEP 2

STEP 3

STEP 4

Determine whether control exists

Determine whether consolidated financial statements need to be presented

Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s

Prepare all necessary consolidation eliminations and adjustments

STEP 3

STEP 5 Prepare the consolidated financial statements

A parent that is required to prepare consolidated financial statements may need to make certain adjustments as part of the consolidation process to ensure the subsidiary’s accounting policies and presentation currency are consistent with its own financial statements. It may also need to adjust the subsidiary’s reporting date to align it with that of its own.

Accounting policies Consolidated financial statements should be prepared using uniform accounting policies for like transactions and other events with similar circumstances (e.g. where an overseas subsidiary adopts a different inventory valuation method that is not permitted under IFRS), requiring consolidation adjustments to achieve uniformity among the entities in the group.

Example – Achieving uniform accounting policies This example illustrates how uniform accounting policies can be achieved by recording a consolidation journal entry. On 1 July 20X4, an entity acquires a subsidiary that is not a reporting entity. The subsidiary recognises revenue from the provision of services in its management accounts when cash is received. This type of revenue only started to be earned by the subsidiary after the business combination. The consolidated financial statements comply with the revenue recognition requirements specified by IFRS 15 Revenue from Contracts with Customers. The accounting policy for revenue recognition should be consistent throughout the consolidated financial statements.

Unit 16 – Core content

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Financial Accounting & Reporting

STEP 3

Chartered Accountants Program

An analysis of the subsidiary’s revenue recognition under both methods reveals: Subsidiary’s revenue recognition Date

Recognition when cash is received $

IFRS 15 recognition method $

Difference

30.06.X5

100,000

90,000

10,000

30.06.X6

80,000

60,000

20,000

$

Ignoring tax, the consolidation entry required to achieve uniform accounting policies is: Date

Account description

Dr $

30.06.X6

Opening retained earnings1

10,000

Revenue - services2

20,000

Deferred revenue

Cr $

30,000

3

To achieve a uniform accounting policy by applying the IAS 18 revenue recognition basis to the subsidiary Notes 1. Last year’s revenue is reduced by $10,000 on consolidation, lowering that year’s consolidated profit. 2. By debiting revenue, the current year profit is reduced by $20,000 as required. 3. Deferred revenue of $30,000 should be recognised as a liability at 30 June 20X6, as the cash received to date of $180,000 exceeds the $150,000 revenue recognised to date under IFRS 15 by $30,000.

Presentation currency If an entity’s functional currency differs from the group’s presentation currency, the entity’s financial statements need to be translated into the group’s presentation currency to enable consolidation. Translation of financial statements from the functional currency to the presentation currency is discussed in the unit on foreign exchange.

Reporting date The reporting dates of subsidiaries should generally be aligned with those of the parent. In the event that the reporting date of a subsidiary is different from that of its parent, the subsidiary must make adjustments to its reporting cycle to enable consolidation. Required reading IFRS 10 paras 19–20, Appendix B Application guidance paras B87 and B92–B93. STEP 4

Step 4 – Prepare all necessary consolidation eliminations and adjustments STEP 1

STEP 2

STEP 3

STEP 4

Determine whether control exists

Determine whether consolidated financial statements need to be presented

Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s

Prepare all necessary consolidation eliminations and adjustments

Page 16-10

STEP 5 Prepare the consolidated financial statements

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Step 4 includes the identification, calculation and preparation of the consolidation entries. This step is usually the most complicated step in the preparation of consolidated financial statements; however, identifying the issues that consolidation journal entries need to address should make this step easier. To achieve this, Step 4 can be broken down into five sub-steps.

STEP 4a

Step 4(a) – Perform an acquisition analysis STEP 4(a) Perform an acquisition analysis

STEP 4

STEP 4(b)

STEP 4(c)

STEP 4(d)

STEP 4(e)

Prepare any business combination valuation reserve entries

Eliminate the investment asset

Eliminate intragroup transactions and balances

Prepare the NCI allocations

Accounting for a business combination, including how to perform an acquisition analysis to calculate goodwill or a gain from a bargain purchase under IFRS 3 is discussed in Unit 15. The table below identifies the acquisition analysis information (from sub-step 4(a)) that flows into the other sub-steps of Step 4, with each explained in detail in the discussion of relevant sub‑step: Information from the acquisition analysis

Consolidation journal entries affected

Goodwill calculation

Wholly owned subsidiary •• Elimination of the investment asset

Step 4 sub-step

Step 4(c)

Partly owned subsidiary •• Full goodwill method

Business combination valuation reserve (BCVR) entry

Step 4(b)



Allocation of a portion of the goodwill to the NCI

Step 4(e)

•• Partial goodwill method Acquisition date fair value adjustments

Elimination of the investment asset

Step 4(c)

BCVR entry to recognise the acquisition date fair value adjustments

Step 4(b)

Depreciation or amortisation entries after the acquisition date relating to these fair value adjustments

Step 4(b)

Consideration transferred

Elimination of the investment asset entry as the consideration transferred is recognised within this asset

Step 4(c)

Gain from a bargain purchase

Elimination of the investment asset entry to enable the gain to be recognised

Step 4(c)

Unit 16 – Core content

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Financial Accounting & Reporting

STEP 4b

Chartered Accountants Program

Step 4(b) – Prepare any business combination valuation reserve entries STEP 4(a) Perform an acquisition analysis

STEP 4(b)

STEP 4(c)

STEP 4(d)

STEP 4(e)

Prepare any business combination valuation reserve entries

Eliminate the investment asset

Eliminate intragroup transactions and balances

Prepare the NCI allocations

IFRS 3 generally requires identifiable assets acquired and liabilities assumed to be recorded at fair value at the acquisition date. Depending on the circumstances, these adjustments will be recognised in the subsidiary’s general ledger or as a consolidation entry. In the FIN module, the approach taken to recording these fair value adjustments via a consolidation entry is to use a BCVR account. Candidates may have been taught a different approach in their university studies, but provided the same end result is achieved, various methods are accepted in the exam. Think of the BCVR account as a consolidation suspense account that is used to process certain fair value adjustments arising prior to the acquisition date. After processing all consolidation entries, the balance in the BCVR should always be $0 because this account can never contain post-acquisition movements. FIN fact Acquisition-date fair value adjustments to assets that are depreciated or amortised will also require consolidation entries (including tax effect entries) for depreciation/amortisation. A timeline will help you to calculate the depreciation/amortisation expense.

FIN fact Think of the BCVR account as a consolidation suspense account that is used to process certain fair value adjustments arising prior to the acquisition date.

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Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

The following diagram explains how acquisition-date fair value adjustments are recorded. STEP 4b

Acquisition-date fair value adjustments

Recognise in the subsidiary’s general ledger

For example, subsidiary uses the fair value method to account for plant and equipment and an item of plant requires a fair value adjustment

Use the revaluation surplus account Recognise the fair value adjustment in the subsidiary’s revaluation surplus account (net of tax) For example, Dr Plant and equipment, Cr Deferred tax liability, Cr Revaluation surplus

Ongoing adjustments post-acquisition

Recognise in consolidation entries For example, the item cannot be recognised in the subsidiary’s records due to the application of another Accounting Standard such as inventory revaluation, a contingent liability or an internally generated intangible asset

Use the business combination valuation reserve (BCVR) account – Recognise the fair value adjustment in a consolidation entry to the BCVR (net of tax) – For example, Dr Brand name, Cr Deferred tax liability, Cr BCVR

Ongoing adjustments post-acquisition

If the subsidiary has recognised the fair value adjustment in its own general ledger, ongoing accounting such as depreciation will also be recorded by the subsidiary (no consolidation entries are required)

If the fair value adjustment was recognised in a consolidation entry, ongoing accounting such as depreciation or amortisation will also be recorded as a consolidation entry (and related tax effect)

For example, Depreciation adjustment – Dr Depreciation expense, Cr Accumulated depreciation Related tax effect – Dr Deferred tax liability, Cr Income tax expense

For example, Amortisation adjustment – Dr Amortisation expense, Dr Opening retained earnings, Cr Accumulated amortisation Related tax effect – Dr Deferred tax liability, Cr Opening retained earnings, Cr Income tax expense

When the item is sold/realised/settled Year of sale – If the subsidiary has recognised the fair value adjustment in its own general ledger, the subsidiary will record the appropriate entries for example, when the asset is sold (no consolidation entries are required) Subsequent years – no entries are required as the sale was correctly accounted for in the prior year in the subsidiary’s general ledger

When the item is sold/realised/settled Year of sale – If the fair value adjustment was recognised in a consolidation entry, in the year when the item is sold/realised/settled, the impact of the acquisition date fair value is taken to the relevant account in profit or loss (and related tax effect). For example, Sale of brand name – Dr Profit on sale, Dr Opening retained earnings (for prior year amortisation), Cr BCVR Related tax effect – Dr BCVR, Cr Opening retained earnings (for prior year tax effect on amortisation adjustments), Cr Income tax expense Subsequent years – the acquisition date fair value adjustment is adjusted in a consolidation entry to opening retained earnings (net of the tax effect) For example, Prior year sale of brand name – Dr Opening retained earnings, Cr BCVR

Acquisition-date fair value adjustments always form part of the pre-acquisition reserves of the subsidiary and must be eliminated even when the item is no longer recognised on the statement of financial position, for example after asset is sold As the fair value adjustment is part of the acquisition analysis it must be eliminated so that the correct goodwill/gain from a bargain purchase is recognised

Pre-acquisition revaluation surplus must be eliminated every year – Elimination of the investment asset Step 4(c) – eliminate the parent’s share of the revaluation surplus – Allocate to the NCI Step 4(e) – allocate the NCI’s share of the revaluation surplus

Unit 16 – Core content

Pre-acquisition BCVR must be eliminated every year – Elimination of the investment asset Step 4(c) – eliminate the parent’s share of the BCVR – Allocate to the NCI Step 4(e) – allocate the NCI’s share of the BCVR

Page 16-13

Financial Accounting & Reporting

STEP 4b

Chartered Accountants Program

Recognition of goodwill/gain from a bargain purchase Goodwill/gain from a bargain purchase is calculated in the acquisition analysis. Goodwill The table below summarises how goodwill is recognised in the consolidated financial statements: Recognition of goodwill in the consolidated financial statements Degree of ownership

Measurement of the NCI in the goodwill calculation

Goodwill calculation

In which consolidation entry is the goodwill asset recognised?

Impact on Impact on NCI elimination of allocations the investment (Step 4(e)) asset (Step 4(c))

Wholly owned subsidiary

Not applicable as the subsidiary is wholly owned

Goodwill = Consideration transferred less FVINA

The goodwill asset is recognised within the elimination of the investment entry

Goodwill is one line within the elimination of the investment entry

No impact as there is no NCI

The NCI is measured at fair value

Goodwill = (Consideration transferred + fair value of NCI)

The goodwill asset is recognised in a separate entry

less

DR Goodwill

FVINA

CR BCVR

The parent’s share of the BCVR is debited in the elimination of the investment entry

(The goodwill asset recognised is higher than that under the partial method as it includes an amount that relates to the NCI)

(The goodwill asset includes an amount relating to the parent and an amount relating to the NCI)

The NCI’s share of the BCVR is debited in the NCI entry (effectively allocates to the NCI its share of the goodwill)

Goodwill = (Consideration transferred + NCI’s % share of FVINA)

The goodwill asset is recognised within the elimination of the investment entry

Goodwill is one line within the elimination of the investment entry

No impact as no goodwill is allocated to the NCI

Partly owned subsidiary (i) Full goodwill method

(ii) Partial goodwill method

The NCI is measured at its proportionate share of the subsidiary’s fair value of identifiable net assets (FVINA)

less FVINA (The goodwill asset recognised is the proportion attributable to the parent only)

(The goodwill asset is all attributable to the parent)

FIN fact Any goodwill acquired in a business combination will be recognised in the statement of financial position every time consolidated financial statements are prepared.

Page 16-14

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Summary - full versus partial goodwill method An entity that acquires less than 100% of another entity can choose whether to apply either the full or partial goodwill methods when accounting for the business combination.

STEP 4b

The key differences between the full and partial goodwill methods when consolidating a partly‑owned subsidiary are shown below:

Full goodwill

Partial goodwill

Goodwill is recognised via the BCVR account

Goodwill is not recognised via the BCVR Goodwill is recognised as the balancing item within the elimination of investment asset entry

Consideration transferred + Fair value of NCI – FVINA = Goodwill

Consideration transferred + NCI's % share of FVINA – FVINA = Goodwill

The goodwill value is apportioned so a share can be allocated to the NCI within the NCI allocation entry. NCI's share of goodwill = fair value of NCI – (NCI's % share × FVINA)

The goodwill value is not apportioned as all of it is attributable to the parent

Goodwill asset in the consolidated financial statements is higher under the full goodwill method as a portion of the asset recognised is attributable to the NCI

Gain from a bargain purchase As explained in Unit 15, IFRS 3 para. 34 requires that: •• A gain from a bargain purchase is immediately recognised in profit or loss. •• In the case of a partly owned subsidiary, any amount of gain from a bargain purchase is attributed to the parent (i.e. no amount of the gain is allocated to the NCI regardless of whether the full or partial goodwill method is used to measure the NCI at the acquisition date).

Unit 16 – Core content

Page 16-15

Financial Accounting & Reporting

STEP 4b

Chartered Accountants Program

A gain from a bargain purchase is recognised as a credit within the elimination of the investment asset entry (see Step 4(c)). In future reporting periods the gain is credited to opening retained earnings as part of the elimination of investment asset entry.

Example – Recognising a gain from a bargain purchase This example illustrates how to recognise a gain from a bargain purchase that has been calculated in an acquisition analysis. On 1 July 20X4, Jupiter Limited purchased 100% of the ordinary issued shares of Pluto Limited for a cash consideration of $580,000. Pluto’s business was in a declining market and its shareholders were willing to accept Jupiter’s offer at a $20,000 discount to its net asset value. Any impairment losses have been recognised in Pluto’s financial statements. At the acquisition date the fair value of the recorded net assets of Pluto were: Net assets at 1 July 20X4 Item

$

Issued capital (400,000 shares)

400,000

Retained earnings

200,000

Total equity/net assets

600,000

Acquisition analysis – gain from a bargain purchase in Pluto at 1 July 20X4 Item

$

Consideration transferred

580,000

Fair value of identifiable net assets (FVINA)

600,000

Gain from a bargain purchase

(20,000)

When Jupiter’s consolidated financial statements are prepared at 30 June 20X5, the elimination of investment asset entry will recognise this gain in profit or loss as the acquisition occurred during the current year. Date

Account description

30.06.X5

Share capital

400,000

Opening retained earnings

200,000

Gain from a bargain purchase* Investment in Pluto

Dr $

Cr $

20,000 580,000

To eliminate Jupiter’s share of the pre-acquisition equities of Pluto, which are reflected in the cost of the investment * Credited to opening retained earnings in future reporting periods.

Note that there is no deferred tax liability to be recognised on the gain from a bargain purchase (IAS 12 para. 39)

FIN fact A gain from a bargain purchase is recognised in the consolidated profit in the year of acquisition. The gain will be recognised as a credit to opening retained earnings when future years’ consolidated financial statements are prepared.

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Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Step 4(c) – Eliminate the investment asset STEP 4(a) Perform an acquisition analysis

STEP 4c

STEP 4(b)

STEP 4(c)

STEP 4(d)

STEP 4(e)

Prepare any business combination valuation reserve entries

Eliminate the investment asset

Eliminate intragroup transactions and balances

Prepare the NCI allocations

The parent’s statement of financial position will include an asset, being the investment in the subsidiary. Appendix B para. B86 of IFRS 10 requires both the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary, to be eliminated. Elimination of the investment asset through a consolidation journal entry is required because: •• The consolidated financial figures represent the group, comprising a parent and its subsidiaries. As it is not possible for an entity to show an investment in itself, the investment asset in the parent’s records must be eliminated on consolidation. •• When a parent acquires shares in a subsidiary, it is effectively gaining access to its relevant share of the identifiable net assets of that subsidiary – hence the line-by-line inclusion of all assets and liabilities of the subsidiary in the consolidation worksheet. The pre-acquisition equity balances in the subsidiary’s records represent the other side of the net assets equation and thus must be removed to avoid double counting. •• Eliminating the parent’s share of pre-acquisition equities means that the parent’s share of post-acquisition earnings and reserves remains in the consolidated financial statements. •• Depending on the goodwill method applied, this consolidation entry recognises the goodwill from the business combination as an asset. FIN fact The balance in the investment in subsidiary account should always be $0 after processing all consolidation entries.

FIN fact The acquisition analysis is reflected in the elimination of investment asset entry. This entry is prepared every time consolidated financial statements are prepared.

Required reading IFRS 10 Appendix B Application guidance paras B86 and B88. Worked example 16.1: Recording entries to the BCVR account to recognise a fair value adjustment for an asset [Available online in myLearning] Worked example 16.2: Eliminating the investment asset at the acquisition date [Available online in myLearning] Worked example 16.3: Preparing consolidation journal entries after the acquisition date [Available online in myLearning]

Unit 16 – Core content

Page 16-17

Financial Accounting & Reporting

STEP 4d

Chartered Accountants Program

Step 4(d) – Eliminate intragroup transactions and balances STEP 4(a) Perform an acquisition analysis

STEP 4(b)

STEP 4(c)

STEP 4(d)

STEP 4(e)

Prepare any business combination valuation reserve entries

Eliminate the investment asset

Eliminate intragroup transactions and balances

Prepare the NCI allocations

All intragroup assets, liabilities, equity, income, expenses and cash flows must be eliminated in full in the consolidated financial statements. Profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, must also be eliminated in full. IFRS 10 requires the elimination of intragroup transactions to be made in full as the NCI is recognised in the consolidated financial statements as being part of the economic entity. The NCI is adjusted to reflect its share of unrealised profits or losses on eliminated intragroup transactions (this is covered in Step 4(e)). Where there is an elimination adjustment required on a profit or loss arising from an intragroup transaction, IAS 12 is applied to recognise any temporary difference. FIN fact When you alter profit on consolidation, a tax effect consolidation entry is generally required.

Common intragroup transactions or balances requiring elimination are: •• Receivables/payables and associated interest. •• Sales and purchases. •• Unrealised profit/loss on inventory transfer. •• Unrealised profit/loss on transfer of property, plant and equipment. •• Dividends. A visual representation of the relevant consolidation issues for each of these intragroup transactions is presented in the five diagrams following. For the purpose of these illustrations: •• P is the parent. •• S is the subsidiary. •• P holds a 60% interest in S. •• The year end is 30 June. •• Any tax and NCI impacts are not considered.

Intragroup receivables/payables and associated interest Often, transactions are not settled in cash but rather are charged to a current or loan account (receivable or payable) recorded in the general ledger of each of the entities. If an entity is recording the transactions accurately and in the same financial reporting period, then the receivables and payables should be equal and must be eliminated in the consolidated financial statements. Similarly, any related interest expense and interest revenue must also be eliminated. For example, consider a scenario in which P makes a loan of $100,000 at 10% interest per annum to S on 1 January 20X3. This transaction will give rise to a $100,000 receivable in P’s accounting records and a corresponding $100,000 payable in S’s accounting records. The loan will also result in interest income of $5,000 being recorded by P during the six months to 30 June 20X3, and interest expense of the same amount being recorded by S during that period.

Page 16-18

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

These transactions are illustrated in the diagram below, including the consolidation journal entries (shown to the right): Group

Consolidation journal entries Loan of $100,000 at 10% interest per annum advanced on 01.01.X3

P $5,000 interest

STEP 4d

60% ownership

$100,000 loan

Date

Account description

30.06.X3

Loan payable

$5,000 interest due on 30.06.X3

Dr $

Cr $

100,000

Loan receivable

100,000

Being elimination of intragroup loan

S

Date

Account description

30.06.X3

Interest revenue

Dr $

Cr $

5,000

Interest expense

5,000

Being elimination of intragroup interest on loan

As the loan and resultant interest are transactions that take place between entities within a group, they are required to be eliminated when preparing consolidated financial statements. FIN fact The balance in the intragroup receivables and payables should always be $0 after processing all consolidation entries.

Intragroup sales and purchases Intragroup sales and purchases must be eliminated because they are not transactions with external parties. For example, consider a scenario where P makes sales of $50,000 to S during the year ended 30 June 20X3. S, in turn, makes sales of $250,000 to P during that period. These transactions are illustrated in the diagram below, including the consolidation journal entry (shown to the right): Group

Consolidation journal entry Intragroup sales during the year ended 30.06.X3

P

Date

Account description

30.06.X3

Sales revenue Cost of sales

$250,000 sales

60% ownership

$50,000 sales

Dr $

Cr $

300,000 300,000

Being elimination of intragroup sales during the year

S

As the sales and resultant purchases are transactions that take place between entities within a group, they are required to be eliminated when preparing consolidated financial statements. Note here that the direction of sale does not matter as the elimination entry simply totals the sales and eliminates the whole of the intragroup transaction from the consolidated financial statements. This consolidation journal entry is recorded on the assumption that the inventory that was transferred internally via the intragroup sales, has all been sold outside the group by year end. If some of this inventory is still on hand at year end, an additional consolidation journal entry will be required to eliminate any unrealised profit. Unit 16 – Core content

Page 16-19

Financial Accounting & Reporting

STEP 4d

Chartered Accountants Program

Unrealised profit/loss on inventory transfer From a consolidation perspective, profits and losses are not realised until there has been a transaction (i.e. sale) to an entity outside the group, or the asset is consumed within the group. For example, consider a scenario in which S purchases inventory from an external supplier for $50 on 1 May 20X2. S then sells that inventory to P on 15 June 20X2 for $80, generating a profit of $30 (i.e. $80 – $50). P subsequently sells the inventory to an external party on 1 August 20X2 for $140, generating a profit of $60 (i.e. $140 – $80). These transactions are illustrated in the diagram below: Group

P 3

Group unrealised profit is $30 at 30.06.X2

2

S sold inventory to P for $80 in 20X2 and it is still on hand at 30.06.X2

1

Inventory cost $50 in 20X2

$80 inventory

60% ownership

4

Inventory sold to external party for $140 during 20X3

5

Group realises a $90 profit ($140 − $50) in 20X3

S

This transaction will have an impact on the consolidation process in both the 20X2 and 20X3 years. First, consider its impact on the 20X2 consolidation process. At 30 June 20X2, the inventory is still held by the group. As a result of this intragroup sale, the carrying amount of inventory and profit are both overstated by $30 from the group’s perspective. The inventory is currently recorded by P at $80, but the cost of the inventory to the group was $50. The profit of $30 generated by S on the sale to P is considered unrealised profit from the group’s perspective at 30 June 20X2. A consolidation adjustment is required at 30 June 20X2 to eliminate the unrealised profit and reduce the carrying amount of the inventory. The consolidation journal entry for the unrealised profit is as follows: Consolidation journal entry Date

Account description

Dr $

30.06.X2

Cost of sales

30

Inventory

Cr $

30

Being elimination of unrealised profit in closing inventory

Now consider the impact of the transaction on the 20X3 consolidation process. The inventory is sold to an external party during the 20X3 financial year, and as a result the profit that was considered to be unrealised in 20X2 from the group’s perspective has now been realised. The total profit from the group’s perspective in relation to this sale is $90 (being $140 – $50). As the amount of profit recognised by P on the sale to the external party is $60, a consolidation adjustment is required in 20X3 to increase profit by $30. There will be a corresponding adjustment required to opening retained earnings to reflect the fact that the profit was unrealised at 30 June 20X2. The consolidation journal entry to recognise that the unrealised profit has now been realised is as follows:

Page 16-20

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Consolidation journal entry

STEP 4d

Date

Account description

Dr $

30.06.X3

Opening retained earnings

30

Cost of sales

Cr $

30

Being elimination of unrealised profit in opening inventory that was sold during the year

Unrealised profit/loss on transfer of property, plant and equipment Elimination adjustments are also required when other assets, such as property, plant and equipment, are transferred between entities within the group, as unrealised profits and losses may arise on the transfer. In these situations, it is necessary to eliminate any unrealised profit or loss. Intragroup losses may indicate an impairment that requires separate recognition in the consolidated financial statements (IFRS 10 para. B86(c)). Where the asset is depreciable, it may also be necessary to make ongoing depreciation adjustments, which will reflect the different depreciable values of the asset by both the transferee and the transferor. As the asset is being consumed through its use within the group, the depreciation consolidation adjustment processed each year of the asset’s remaining useful life represents a realisation of part of the unrealised profit. For example, consider a scenario in which S purchases a depreciable asset from an external supplier for $120 on 1 July 20X1. The useful life of the asset at that time is assessed to be six years. S then sells that depreciable asset to P on 1 July 20X2 for $160. As the carrying amount of the asset at that time was $100 ($120 cost – $20 accumulated depreciation), S generated a profit of $60 (i.e. $160 – $100). P holds the asset until the end of its useful life and depreciates the asset over its remaining useful life of five years. These transactions are illustrated in the diagram below: Group

4

2

1

Group unrealised profit is $60 at 30.06.X3 ($160 − $100) S sold depreciable asset to P for $160 at 01.07.X2 when the carrying amount was $100 (12 months after S acquired the asset) Original cost of asset is $120 on 01.07.X1

P $160 asset

60% ownership

3

Useful life of the asset has five years remaining No change to this assessment when acquired by P

S

Useful life assessed at six years

This transaction will have an effect on the consolidation process over a number of years, commencing in 20X3 and continuing over the remaining useful life of the asset. First, consider the impact on the 20X3 consolidation process. As a result of the intragroup sale, the carrying amount of the depreciable asset and profit are both overstated from the group’s perspective. The depreciable asset was initially recorded by P at $160, but the carrying amount from the group’s perspective at the date of sale was $100. The profit of $60 generated by S on the sale to P is considered unrealised profit from the group’s perspective at 30 June 20X3.

Unit 16 – Core content

Page 16-21

Financial Accounting & Reporting

STEP 4d

Chartered Accountants Program

A consolidation adjustment is required at 30 June 20X3 to eliminate the unrealised profit and reduce the carrying amount of the depreciable asset, as follows: Consolidation journal entry Date

Account description

Dr $

30.06.X3

Profit on sale of asset

60

Cr $

Asset

40

Accumulated depreciation - asset

20

Being elimination of unrealised profit on depreciable asset sale and reinstate the original accumulated depreciation

A further consolidation adjustment will be required at 30 June 20X3 to adjust the depreciation expense that P has recognised. P will record a depreciation expense of $32 ($160 ÷ 5) for the 20X3 year. From the group’s perspective, the depreciation expense should be $20 ($120 ÷ 6) based on the initial cost and useful life of the asset to the group. Therefore, a consolidation adjustment is required at 30 June 20X3 to reduce the depreciation expense by $12, as follows: Consolidation journal entry Date

Account description

Dr $

30.06.X3

Accumulated depreciation - asset

12

Depreciation expense

Cr $

12

Being adjustment to the depreciation recognised by the group

For the remaining useful life of the asset, consolidation adjustments will be required to carry forward the entry, to eliminate the original unrealised profit and adjust for the cumulative effect of depreciation.

Intragroup dividends Parent entities often receive dividends from subsidiaries, which must be eliminated on consolidation. The amount eliminated is calculated by reference to the ownership interest of the immediate parent of the subsidiary paying the dividend. For example, consider a scenario in which S declared and paid a dividend of $10,000 during the year ended 30 June 20X3. Of this dividend, $6,000 was paid to P.

Page 16-22

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

This transaction is illustrated in the diagram below:

STEP 4d

Group

P Subsidiary declared and paid a $10,000 dividend

$6,000 dividend paid

60% ownership

S

A consolidation adjustment will be required at 30 June 20X3 to eliminate the $6,000 dividend revenue in P’s accounting records and the corresponding $6,000 dividend paid in S’s accounting records, as follows: Consolidation journal entry Date

Account description

30.06.X3

Dividend revenue

Dr $

Cr $

6,000

Dividend paid

6,000

Being elimination of the dividend paid by S that P has recognised as revenue

If a dividend has not been paid by the reporting date, the intragroup receivable and payable relating to the dividend will also require elimination. It is assumed that there is no tax effect resulting from the elimination of dividends due to intragroup dividends being exempt from assessability under the prevailing tax laws. Required reading IFRS 10 Appendix B Application guidance para. B86(c). Worked example 16.4: Eliminating intragroup transactions [Available online in myLearning]

Step 4(e) – Prepare the NCI allocations STEP 4(a) Perform an acquisition analysis

Unit 16 – Core content

STEP 4e

STEP 4(b)

STEP 4(c)

STEP 4(d)

STEP 4(e)

Prepare any business combination valuation reserve entries

Eliminate the investment asset

Eliminate intragroup transactions and balances

Prepare the NCI allocations

Page 16-23

Financial Accounting & Reporting

STEP 4e

Chartered Accountants Program

NCI is the equity in a subsidiary that is not attributable, directly or indirectly, to the parent. As 100% of a subsidiary’s assets, liabilities, income and expenses are included in the consolidated financial statements under the line-by-line consolidation process, in instances where the group does not wholly own a subsidiary, the NCI is recognised within equity to reflect the economic substance of the subsidiary’s ownership. The NCI can be shown diagrammatically as follows: Company A 80%

Company B

20%

NCI

Required reading IFRS 10 para. 22 and Appendix B Application guidance paras B94–B95. The preparation of the NCI allocations can be broken down into three sub-steps, as illustrated below:

Step 4(e)(i) – Calculate the NCI percentage STEP 4(e)(i) Calculate the NCI percentage

STEP 4(e)(ii) Calculate the NCI allocation

STEP 4(e)(iii) Record the NCI allocation

The NCI is considered to be a contributor of capital to the economic entity. To the extent that the equity of a subsidiary is not attributable to the parent, this will represent the NCI’s ownership interest. Referring to the previous example of Companies A and B, there is a 20% NCI percentage.

Step 4(e)(ii) – Calculate the NCI allocation STEP 4(e)(i) Calculate the NCI percentage

STEP 4(e)(ii) Calculate the NCI allocation

STEP 4(e)(iii) Record the NCI allocation

The NCI’s allocation of equity can be calculated as shown in the table below: Component

NCI

Current year profits or losses



Current year dividends



Share capital, opening retained earnings and reserves



Under IFRS 10, 100% of a subsidiary’s equity (comprising both pre-acquisition and postacquisition balances) is initially included in the consolidation worksheet on a line-by-line basis. Through a combination of the pre-acquisition investment asset elimination entry and the NCI allocation, the remaining equity balances reflect the parent’s entitlement to each subsidiary’s post-acquisition retained earnings and reserves. This method will therefore show what the subsidiary has contributed to the group since control was obtained. Page 16-24

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

NCI allocation of current year profits, post-acquisition opening retained earnings and reserves

STEP 4e

In calculating the NCI allocation of current year profits, post-acquisition opening retained earnings and reserves, IFRS 10 does not provide explicit guidance on its determination. The approach taken in this unit when calculating adjustments when allocating to the NCI is: E

N CO

OMIC ENT

IT

Y

P 60% Parent NCI

DO

Adjust NCI (and tax effect) for. . .

Don’t adjust NCI for. . .

• Depreciation and amortisation re fair value adjustment at acquisition of subsidiary

• Intragroup revenue/expenses eliminated on consolidation with no unrealised profit impact (e.g. interest) • Impairment of goodwill (partial goodwill method)

• The group sold an asset or settled a liability of a subsidiary that was the subject of a fair value adjustment on acquisition

DON’T

• Impairment of goodwill (full goodwill method) UPSTREAM SALES

DOWNSTREAM SALES

• Unrealised profits in subsidiary’s general ledger on inventory (consider opening and closing inventory)

• Unrealised profits recognised in parent’s general ledger, eliminated on consolidation (e.g. inventory or non-current asset sales)

• Unrealised profits in subsidiary’s general ledger for non-current assets sales (consider prior year and current year as well as consequential depreciation impact)

Video resource See the video on unrealised profits on inventory sales on myLearning.

Unit 16 – Core content

Page 16-25

Financial Accounting & Reporting

STEP 4e

Chartered Accountants Program

Step 4(e)(iii) – Record the NCI allocation STEP 4(e)(i) Calculate the NCI percentage

STEP 4(e)(ii)

STEP 4(e)(iii)

Calculate the NCI allocation

Record the NCI allocation

The NCI is shown as a single line item in the equity section of the consolidated statement of financial position. FIN fact The balance in the BCVR should always be $0 after processing all consolidation entries because this account can never contain post-acquisition movements.

FIN fact The balance in the share capital account should only be the parent’s own share capital after processing all consolidation entries. The parent’s share of the subsidiary’s share capital must be eliminated and the amount, if any, that belongs to an NCI is allocated to the NCI.

Worked example 16.5: Calculating the non-controlling interest [Available online in myLearning]

STEP 5

Step 5 – Prepare the consolidated financial statements STEP 1

STEP 2

STEP 3

STEP 4

Determine whether control exists

Determine whether consolidated financial statements need to be presented

Ensure that the subsidiary’s accounting policies, reporting date and presentation currency are consistent with the parent’s

Prepare all necessary consolidation eliminations and adjustments

STEP 5 Prepare the consolidated financial statements

The consolidated financial statements consist of the following: •• Consolidated statement of profit or loss and other comprehensive income. •• Consolidated statement of financial position. •• Consolidated statement of changes in equity. •• Consolidated statement of cash flows. •• Notes to the consolidated financial statements. The consolidated statement of profit or loss and other comprehensive income, statement of financial position and statement of changes in equity are prepared based on the output from the consolidation worksheet. Key statements from the Harvey Norman Holdings Limited’s 2016 Annual report were displayed in Unit 2. Refer to these now to identify that they are consolidated financial statements. For example, you will notice that there is a non-controlling interest in the equity section of the statement of financial position.

Page 16-26

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Further reading KPMG 2017, ‘KPMG Example Public Company Limited: Guide to annual reports – Illustrative disclosures 2016–17’. Review the layout of the key consolidated statements in this example report.

Australia-specific Where a parent of a consolidated group that prepares consolidated financial statements does not prepare separate financial statements for the parent entity, reg. 2M.3.01 of the Corporations Regulations 2001 requires consolidated financial statements to include certain disclosures about the parent, including: •• Profit or loss. •• Total comprehensive income. •• Equity separated between issued capital and individual reserve balances. •• Current assets, total assets, current liabilities and total liabilities. •• Guarantees provided in support of a subsidiary’s debts. •• Contingent liabilities. •• Contractual commitments for the acquisition of property, plant and equipment. •• Comparative information for the previous period.

Separate financial statements If the parent of the group presents separate financial statements in addition to the consolidated financial statements, then the requirements (including disclosure requirements) under IAS 27 Separate Financial Statements are followed for the preparation of the separate financial statements. In these separate financial statements, investments in subsidiaries, associates and jointly controlled entities are accounted for at cost or in accordance with IFRS 9.

Assessing goodwill for impairment for partly owned subsidiaries It is not possible to determine the recoverable amount of goodwill on its own as goodwill does not produce cash flows independently of other assets. Therefore, goodwill is always tested for impairment at a cash generating unit (CGU) level, as explained in Unit 10. Recognising an impairment loss on goodwill for a partly owned subsidiary differs depending on whether the full or partial goodwill method is applied. Where the partial goodwill method is used to measure goodwill, the amount of goodwill needs to be grossed up to include a notional amount of goodwill that is attributable to the NCI when testing the goodwill for impairment (in accordance with IAS 36 Appendix C para. C4).

Unit 16 – Core content

Page 16-27

Financial Accounting & Reporting

Chartered Accountants Program

The issue can be illustrated by considering an example.

Example – Recognising a CGU impairment loss for a partly owned subsidiary This example illustrates how to calculate and recognise a CGU impairment loss where there are partly owned subsidiaries. Peacock is the parent of numerous subsidiaries. Subsidiaries Alzir and Beid are separate CGUs for the purposes of IAS 36, and there are indications of impairment at 30 June 20X8. Acquisition details Subsidiary/CGU

Ownership interest

Goodwill method applied to the business combination

Goodwill arising on acquisition $

Alzir

80%

Full goodwill method

500,000

Beid

70%

Partial goodwill method

420,000

The goodwill that arises from each business combinations relates only to that particular subsidiary, rather than benefiting other entities in the Peacock group. Assume that the only identifiable assets of each subsidiary are plant and equipment with carrying amounts as follows: Carrying amount of identifiable assets at 30 June 20X8 CGU

Plant and equipment $

Alzir

700,000

Beid

800,000

For the purposes of the annual impairment testing of goodwill, the value in use for each CGU has been determined as follows: Value in use at 30 June 20X8 CGU

$

Alzir

300,000

Beid

1,300,000

A fair value less costs of disposal cannot be measured for each CGU. Accordingly, the recoverable amount for each CGU is its value in use. To determine the carrying amount of each CGU, the carrying amount of the goodwill is added to the carrying amount of identifiable assets for each subsidiary. The impairment loss can then be determined as follows: Carrying amount of each CGU at 30 June 20X8 CGU

Goodwill Goodwill gross arising on up required for acquisition (a) impairment testing (b) $ $

Carrying CGU carrying Recoverable Impairment amount of amount amount (value loss identifiable (a) + (b) + (c) = (d) in use)(e) (d) – (e) assets (c) $ $ $ $

Alzir

500,000

0

700,000

1,200,000

300,000

900,000

Beid

420,000

180,000

800,000

1,400,000

1,300,000

100,000

1

Note 1 – As the partial goodwill method had been used for the business combination accounting for Beid, the carrying amount of goodwill in Beid must be grossed up to reflect 100% of goodwill: $420,000 ÷ 70% = $600,000. This adds $180,000 to the goodwill arising on the acquisition, effectively attributing a value for goodwill to the 30% NCI. This grossing up is a notional calculation, so that there is matching of like for like. The plant and equipment value is a 100% amount; however, the goodwill value under the partial goodwill method is calculated as belonging only to the parent and is therefore a 70% value.

Page 16-28

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

It may seem there would be no impairment loss for the Beid CGU if the calculation were performed without grossing up the goodwill. The carrying amount of the Beid CGU would be $1,220,000 (i.e. $420,000 goodwill and $800,000 plant and equipment). With a recoverable amount of $1,300,000 being higher than this carrying amount, this would suggest there is no impairment loss. However, this approach is not in accordance with IAS 36 as it is not comparing the grossed up value with the recoverable amount. The impairment loss for each CGU, as correctly calculated in the table above, is first allocated to that CGU’s goodwill and then, if there is a remaining impairment loss, it is allocated to the other assets in the CGU (in this case plant and equipment) on a pro rata basis in accordance with IAS 36 para. 104. The impairment loss allocation for the Alzir CGU is as follows: Alzir – allocation of impairment loss Asset

Carrying amount

Goodwill (full goodwill method) Plant and equipment

$

Allocation of impairment loss $

Revised carrying amount $

500,000

(500,000)

0

     700,000

(400,000)

300,000

1,200,000

(900,000)

300,000

The $100,000 impairment loss allocation for the Beid CGU is performed differently. Only $70,000 of this impairment loss for goodwill is actually recognised because the $100,000 impairment loss calculated was based on 100% values using a notional grossed up value for goodwill. The $30,000 difference ($100,000 – $70,000) is not allocated to Beid’s plant and equipment as it results only from this notional calculation required by IAS 36. The CGU impairment losses are recognised through consolidation journal entries as the goodwill is only recognised as a separate asset when the consolidated financial statements are being prepared (as explained in Step 4 of the consolidation process). Date

Description

30.06.X8

Impairment loss

Dr $

Cr $

900,000

Accumulated impairment losses – goodwill

500,000

Accumulated depreciation and impairment losses – plant and equipment

400,000

To recognise the impairment loss for the Alzir CGU to reduce the goodwill to a revised carrying amount of $0 and the plant and equipment to a carrying amount of $300,000 Date

Description

30.06.X8

Impairment loss Accumulated impairment losses – goodwill

Dr $

Cr $

70,000 70,000

To recognise the impairment loss for the Beid CGU to reduce the goodwill to a revised carrying amount of $350,000

Unit 16 – Core content

Page 16-29

Financial Accounting & Reporting

Chartered Accountants Program

Consolidating a foreign subsidiary The unit on foreign exchange covers the translation of foreign operations financial statements and should be attempted before working through this section. That unit contains a table of applicable exchange rates to apply when translating functional currency to presentation currency. When a parent holds an interest in a foreign subsidiary, the normal consolidation procedures apply. However, when calculating amounts to be recorded in consolidation journals, consideration must be given to foreign currency translation and related measurement issues. In the FIN module only the consolidation of a wholly owned foreign subsidiary will be considered. An investment in a foreign subsidiary has an impact on the application of Step 4 of the consolidation process, as discussed below. FIN fact The goodwill acquired from a business combination involving the acquisition of a foreign subsidiary is treated as an asset of the foreign subsidiary. The goodwill must be translated at the spot rate at reporting date whenever consolidated financial statements are prepared.

Perform an acquisition analysis, prepare any BCVR entries and eliminate the investment asset (Steps 4(a)–(c)) One fundamental issue when accounting for a foreign subsidiary is the treatment of goodwill and fair value adjustments arising on acquisition. IAS 21 para. 47 requires any goodwill arising on the acquisition of a foreign operation, and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation, to be treated as assets and liabilities of the foreign operation. Such balances are therefore expressed in the functional currency of the foreign operation and are subject to translation into the group’s presentation currency each period. Assuming that exchange rates move from what they were at the acquisition date, when preparing a later consolidation this will mean: •• There will be a foreign currency translation reserve (FCTR) balance within a fair value adjustment entry because the BCVR is translated at the historical rate, while the asset, accumulated depreciation and deferred tax balances are translated at the spot rate at the reporting date. •• Subsequent depreciation or amortisation adjustments arising from fair value adjustments also have an FCTR balance because the depreciation or amortisation, being an expense, is translated at the average exchange rate for the period, while the accumulated depreciation or amortisation is translated at the closing rate at the reporting date. •• There will be an FCTR balance within the elimination of investment entry, because parts of the entry are translated at the historical rate while any goodwill, being considered an asset of the subsidiary, is translated at the spot rate at the reporting date. Required reading IAS 21 para. 47.

Eliminate intragroup transactions and balances (Step 4(d)) Neither IAS 21 nor IFRS 10 provide specific guidance on the appropriate exchange rate to be used when eliminating intragroup transactions between the parent and the foreign subsidiaries. The approach adopted in this unit and commonly used in practice is as follows: •• Intragroup sales and purchases and other intragroup revenue and expenses are eliminated using the exchange rate applicable at the transaction date (or, if applicable, the average exchange rate).

Page 16-30

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

•• Unrealised profits or losses on inventory and other asset transfers are eliminated using the exchange rate applicable at the transaction date. There is no further requirement to re‑translate any asset or liability components of this consolidation journal entry to the period end rate. •• Dividends declared are eliminated using the exchange rate applicable at the declaration date. •• Intragroup payables and receivables are eliminated using the closing rate. Tax-effect entries are calculated using the tax rate of the country holding the asset, rather than the rate applicable to the entity that recognised the unrealised profit. This is because IAS 12 requires the recognition of a temporary difference since the tax base of the asset is different from its carrying amount. Further reading Consolidating a foreign subsidiary

Unit 16 – Core content

Page 16-31

Financial Accounting & Reporting

Chartered Accountants Program

Accounting for movements in investments Learning outcome 4. Account for movements in the parent’s interest in a subsidiary. This section covers two types of movements in a parent’s interest in a controlled entity: •• The acquisition of an additional investment whereby an associate becomes a subsidiary (a step acquisition). •• The new issue of shares by a subsidiary. Accounting for movements in a parent’s interest in a controlled entity can be a complicated process with many possible scenarios. This section establishes the key principles for identifying the issues that may arise in accounting for the types of movements listed above.

Acquisition of additional investment (step acquisition) Acquisitions of additional interests that result in a change in the classification of an investment from an associate to a subsidiary are not addressed in either IFRS 10 or IAS 28 Investments in Associates and Joint Ventures. IFRS 3 paras 41 and 42 specify the accounting treatment for a business combination achieved in stages, which is commonly referred to as a step acquisition. IFRS 3 requires the acquirer to remeasure its previously held interest in the acquiree at fair value at acquisition date, being the date control was achieved. Any difference between the carrying amount and the fair value of the previously held interest must be recognised in profit or loss. Any amount that was previously recognised in other comprehensive income, and that would be reclassified to profit or loss in the event of a disposal, is reclassified to profit or loss. Once the parent has gained control of the acquiree, it will need to include the acquiree in its consolidated financial statements, or commence preparing consolidated financial statements if it has no other subsidiaries. Required reading IFRS 3 paras 41–42. Further reading Accounting for movements in investments – step acquisitions

New issue of shares by a subsidiary A subsidiary may issue additional shares to new or existing shareholders to raise further equity. Any change in the parent’s ownership interest of a subsidiary after control has been obtained is accounted for as transactions with equity holders in their capacity as equity holders. Accordingly, there is no adjustment to profit or loss as a consequence of any changes in the parent’s ownership interest where control is maintained. A share issue transaction will result in an increase in the net assets of the subsidiary, with a corresponding increase in its contributed equity. There is no change to the retained earnings and reserves of the subsidiary. After the share issue, the retained earnings and reserves attributed to the parent entity and the NCI must reflect the parent’s ownership interest after the issue of the shares. Required reading IFRS 10 para. 23 and Appendix B Application guidance para. B96.

Page 16-32

Core content – Unit 16

Chartered Accountants Program

Financial Accounting & Reporting

Disclosures The disclosures concerning a consolidated group are found in IFRS 12. This Standard also applies to disclosures for interests in joint arrangements and associates, which are covered in Unit 17. While IFRS 12 also applies to interests in unconsolidated structured entities, these disclosures are beyond the scope of this unit. There are two main types of disclosures for interests in subsidiaries, as outlined in the table below: Disclosures for interests in subsidiaries Type of disclosures

Disclosures include

Significant judgements and assumptions

An explanation of the significant judgements and assumptions made in determining whether the entity controls another entity

Interests in subsidiaries

Information about: •• Group composition •• Nature of risks associated with an entity’s interest in consolidated structured entities, including restrictions on use of assets or ability to settle liabilities •• Non-controlling interests •• Change in ownership of a subsidiary during the reporting period that does not result in loss of control •• Details of subsidiaries for which loss of control occurred during the reporting period

Required reading IFRS 12 paras 7–9, 10–13, 18–19. Adaptive learning lesson: The consolidation process [Available online in myLearning] Quiz [Available online in myLearning] Remember to attempt Integrated activity 3 The integrated activity is available online in myLearning.

Integrated activity 3 – how a consolidation worksheet works [Available online in myLearning]

Unit 16 – Core content

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Core content – Unit 16

Unit 17: Equity Accounting Contents

fin31917_csg_03

Introduction Differences between the equity method and the consolidation method Applying the equity method

17-3 17-4 17-5

Complexities with equity accounting Changes in ownership interests Consolidating a foreign associate or joint venture Recognising the tax effect of the equity carrying amount of the investment Impairment of the investment in associate or joint venture Discontinuing equity accounting

17-14 17-14 17-14 17-14 17-14 17-14

Significant influence and joint control Identifying associates: significant influence Establishing when joint control exists

17-16 17-16 17-17

Disclosures – interests in joint arrangements and investments in associates

17-18

Unit 17 – Core content

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Core content – Unit 17

Chartered Accountants Program

Financial Accounting & Reporting

Learning outcomes At the end of this unit you will be able to: 1. Explain and account for an investment using the equity method. 2. Explain the concepts of significant influence and joint control.

Introduction

combina ess ti in U15

s on

Bu s

The diagram below is from the Introduction to Units 15-17. Now that you have covered business combinations, it is worth reviewing the connections between the different units and different Accounting Standards.

IFRS 3 Business Combinations

for subs ing id nt U16 Consolidation in accordance with IFRS 10

YES

ies iar

Acc ou

Does the investor gain control in the business combination?

nts and investments in a eme g U17 sso an r r cia a t te n oi Does the investor have joint control?

s

J

Disclosures per IFRS 12

NO

IFRS 11 Joint Arrangements

Classify the joint arrangement in accordance with IFRS 11 JOINT OPERATION

Account for assets, liabilities, revenue and expenses in accordance with IFRS 11 Disclosures per IFRS 12

Fin

Does the investor have significant influence over the investee? IAS 28 Investments in Associates and Joint Ventures

NO

s nt

NO

YES

instrum cial e an U9 Account for the investment in accordance with IFRS 9 Disclosures per IFRS 7

YES JOINT VENTURE

INVESTMENT IN ASSOCIATE

Equity accounting in accordance with IAS 28 Disclosures per IFRS 12

Unit 9 discussed investments that fell under IFRS 9 Financial Instruments. Units 15 and 16 looked at situations where control was established under IFRS 3 Business combinations, and consolidated financial statements were prepared in accordance with IFRS 10 Consolidated Financial Statements. This unit examines equity accounting. Equity accounting is applied in two different situations: 1. Investments in associates, where significant influence is established under IAS 28 Investments in associates and Joint Ventures. 2. Joint ventures, where joint control is established under IFRS 11 Joint Arrangements.

Unit 17 – Core content

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Chartered Accountants Program

Financial asset IFRS 9

Associate: Significant influence IAS 28 Joint Venture: joint control IFRS 11

Subsidiary: control IFRS 3 and consolidation IFRS 10

The unit will start by examining how to apply the equity method of accounting, first by introducing the differences between equity accounting and consolidations, and then by walking through the equity method step-by-step. Later sections discuss why you need to apply the equity method, and analyse the factors that need to be considered when establishing significant influence under IAS 28 and joint control under IFRS 11. Unit 17 overview video [Available online in myLearning]

Differences between the equity method and the consolidation method The reasons why we use the equity method are similar to why we consolidate: to present the post-acquisition movements in retained earnings and reserves of the acquired entity. The appearance of the two methods in the financial statements is quite different. The consolidation method is covered in Unit 16. Key differences between the equity method and the consolidation method Considerations

Equity method Equity method used for associates (with significant influence) and joint ventures (with joint control IAS 28)

Consolidation method Consolidation method used for subsidiaries (with control) IFRS 3 and 10

Accounting method applied

Single-line (investment in associate)

Line-by-line aggregation (each asset, liability, equity item, revenue and expense is consolidated)

Adjustments

Most equity accounting adjustments are recorded against:

Consolidation adjustments can be made against most accounts, leading to a line-by-line aggregation

•• investment in associate/investment in joint venture (statement of financial position) •• ‘share of associate’s profit after tax’ or ‘share of joint venture’s profit after tax’ (SPLOCI) Proportion of investee’s balances recognised

Page 17-4

The investor’s share of the associate or joint venture’s post-acquisition earnings and reserves are recognised and generally the investor’s share of interentity transactions are eliminated

100% of a subsidiary’s balances are included in the consolidated financial statements and 100% of inter-entity transactions are eliminated, with appropriate adjustments to reflect any noncontrolling interest

Core content – Unit 17

Chartered Accountants Program

Financial Accounting & Reporting

View the video on myLearning for a more detailed explanation of the similarities and differences between the equity method of accounting and consolidations. Unit 17 Equity accounting – the basics [Available online in myLearning]

Applying the equity method The equity method of accounting is generally based on the investor’s ownership interest in an associate or joint venture. Ownership interest is the percentage of equity held in an associate or joint venture, directly or indirectly, by the investor. The step-by-step process detailed below can be used when applying the equity method. Required reading IAS 28 paras 10–11, 16 and 27. IFRS 11 paras 24–25.

Step 1 – Ensure consistent accounting policies and reporting dates STEP 1 Ensure consistent accounting policies and reporting dates

STEP 2 Determine where to apply the equity method

STEP 3 Prepare all necessary equity accounting journals and adjustments required by IAS 28

IAS 28 para. 35 requires the investor’s financial statements to be prepared using uniform accounting policies for like transactions and other events in similar circumstances. If an associate or joint venture uses accounting policies other than those adopted by the investor, appropriate adjustments must be made when using that entity’s financial statements (IAS 28 para. 36). In the event that the reporting date of the associate or joint venture is different to that of the investor, adjustment for significant transactions or events to align the financial statements with those of the investor should be made. If this is impractical, a maximum difference of three months between the end of reporting periods is permissible (IAS 28 para. 34). Required reading IAS 28 paras 33–36.

Unit 17 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Step 2 – Determine where to apply the equity method STEP 1 Ensure consistent accounting policies and reporting dates

STEP 2 Determine where to apply the equity method

STEP 3 Prepare all necessary equity accounting journals and adjustments required by IAS 28

It is important to determine where to record the equity method journal entries and to identify whether there are further accounting requirements in respect of the investment in the associate or joint venture under IAS 27 Separate Financial Statements. Application of the equity method Accounts prepared by the investor

Where is the equity method applied?

Nature of the equity journal entries

Does IAS 27 also apply?

The investor prepares consolidated financial statements as it is a parent entity in a group

In the consolidated financial statements

Equity journal entries are notional (i.e. recorded in the consolidation worksheet only)

If the parent entity itself holds the investment in the associate or joint venture, then it applies IAS 27 in its separate financial statements. In the parent’s separate financial statements, the investment can be accounted for: •• at cost, or •• in accordance with IFRS 9 Financial Instruments, or •• by applying the equity accounting method in accordance with IAS 28

The investor does not prepare consolidated financial statements as it is not a parent entity in a group

In the investor’s own separate financial statements

Equity journal entries are permanent (i.e. recorded in the general ledger)

No

The activity for this unit assumes that the investor is a parent entity; that is, it prepares consolidated financial statements. Therefore, the equity journal entries are recorded through the consolidation worksheet as notional entries. The journal entries will need to reflect current year movements in retained earnings and reserves as well as post-acquisition movements of prior years, given that these notional entries do not carry forward from previous years. Required reading IAS 28 paras 2, 4 and 44. IAS 27 para. 10.

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Core content – Unit 17

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Financial Accounting & Reporting

Step 3 – Prepare all necessary equity accounting journals and adjustments required by IAS 28 STEP 1

STEP 2

Ensure consistent accounting policies and reporting dates

Determine where to apply the equity method

STEP 3 Prepare all necessary equity accounting journals and adjustments required by IAS 28

Similar to a business combination, an investor is required to determine the amount of any goodwill or negative goodwill at the acquisition date (IAS 28 para. 32). Its treatment is summarised in the following table: Amount

How is the amount calculated?

Is an equity accounting entry required to remove the amount from the investment cost?

Equity accounting treatment

Goodwill

Investment cost

No

Any goodwill is not separately recognised and remains in the carrying amount of the investment. The goodwill amount is not tested separately for impairment, nor is it amortised

Yes

The negative goodwill is recognised as income in the determination of the entity’s share of the associate’s or joint venture’s profit or loss in the year of acquisition. A corresponding adjustment is made to the equity carrying amount

less Investor’s share of the net fair value of the investee’s identifiable assets and liabilities Negative goodwill

Investor’s share of the net fair value of the investee’s identifiable assets and liabilities less Investment cost

Therefore, goodwill/negative goodwill must be calculated at acquisition date because if there is negative goodwill, an equity accounting entry must be recorded to recognise the amount as income.

Example – Calculation of goodwill and negative goodwill This example illustrates how to calculate goodwill and negative goodwill when an investor gains significant influence over an investee. In the case of negative goodwill, an equity accounting entry will need to be recorded. On 1 July 20X4, Brave purchased 40% of the ordinary issued shares of Timid Limited and gained significant influence over the investee. Brave must equity-account the investment in this associate under IAS 28. At the acquisition date the recorded net assets of Timid were: Net assets of Timid at 1 July 20X4 Item

$

Issued capital (400,000 shares)

400,000

Retained earnings

 40,000

Total equity/net assets

440,000

Unit 17 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Timid’s identifiable assets acquired and liabilities assumed were recorded at fair value except for an unrecorded brand name which had a fair value of $100,000 and an estimated remaining useful life of five years. (i) If Brave paid $250,000 for the investment

Calculation of goodwill Goodwill acquired in Timid at 1 July 20X4 Item

$

$

Cost of investment

250,000

Assets acquired



Book value of net assets

440,000

Fair value adjustment re brand name net of tax (($100,000) × (1 – 30%))

 70,000

Fair value of identifiable net assets (FVINA)

510,000

Share of FVINA acquired (40%)

204,000

Goodwill acquired that is included in the investment cost

 46,000

The $46,000 in goodwill is included in the cost of the investment in Timid and does not require an equity accounting journal entry to be recorded.

(ii) If Brave paid $150,000 for the investment

Calculation of negative goodwill Negative goodwill on the acquisition of Timid at 1 July 20X4 Item

$

$

Cost of investment

150,000

Assets acquired



Book value of net assets

440,000

Fair value adjustment re brand name net of tax (($100,000) × (1 – 30%))

 70,000

Fair value of identifiable net assets (FVINA)

510,000

Share of FVINA acquired (40%)

204,000

Negative goodwill that is included in the investment cost

 (54,000)

The ($54,000) in negative goodwill is included in the cost of the investment in Timid. When the equity accounting entries are recorded for the first reporting period, the ($54,000) will be recognised as income in the determination of the entity’s share of the associate’s profit or loss (IAS 28 para. 32(b)). Date

Account description

30.06.X5

Investment in Timid Share of associate’s profit after tax

Dr $

Cr $

54,000 54,000

To recognise the negative goodwill as income in the year that Brave acquired its interest in Timid

Required reading IAS 28 para. 32

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Core content – Unit 17

Chartered Accountants Program

Financial Accounting & Reporting

Equity accounting journal entries The equity method involves the subsequent measurement of the carrying amount of the investment at an amount that includes the post-acquisition movements of the associate or joint venture. The investor’s share of post-acquisition movements in the retained earnings and reserve balances is recorded by raising equity accounting journal entries. This procedure within the equity accounting process is the most time-consuming. It can be broken down into four sub-steps: Sub-step 3a – Record the investor’s share of current year profits or losses of the associate or joint venture The investor recognises its share of the investee’s profit/(loss) for the financial period. IAS 1 Presentation of Financial Statements para. 82(c) requires the share of the profit or loss of associates and joint ventures accounted for using the equity method to be disclosed as a separate line item in the statement of profit or loss and other comprehensive income. To facilitate ease of disclosure, the equity journal entry to record this share of profit or loss may be made to an account called ‘share of associate’s/joint venture’s profit after tax’. Required reading IAS 1 para. 82(c). Sub-step 3b – Record the investor’s share of post-acquisition movements in reserves and opening retained earnings in the associate or joint venture If there has been a post-acquisition movement in the associate’s opening retained earnings and/or reserves, the investor’s share of these movements must also be recognised (IAS 28 para. 10). A common example of a post-acquisition reserve movement is a credit to a revaluation surplus following the upward revaluation of an asset to fair value under IAS 16 Property, Plant and Equipment. Current year reserve movements require disclosure. IAS 1 para. 82A requires that the current year share of other comprehensive income of associates and joint ventures, accounted for using the equity method, be disclosed as a separate line item in other comprehensive income. To facilitate ease of disclosure, the equity journal entry to record the current year share of a revaluation surplus may be made to an account called ‘share of associate’s/joint venture’s revaluation surplus’. FIN fact The equity carrying amount of the investment is increased or decreased to recognise the investor’s share of post-acquisition profits and post-acquisition reserve movements.

Required reading IAS 1 para. 82A. IAS 28 para.10.

Unit 17 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Sub-step 3c – Eliminate the effect of current year dividends paid or declared by the associate or joint venture Dividends distributed by an investee and recognised as income by the investor in the current period must be eliminated to avoid double-counting, as the dividend amount has effectively been included through the equity journal entries recorded in sub-steps 3a and/or 3b above. FIN fact The equity accounting method includes the investor’s share of post-acquisition closing retained earnings in the equity carrying amount of the investment. As dividends are paid from profits included within closing retained earnings, they must be subtracted – otherwise we would be double-counting these profits.

Sub-step 3d – Record adjustments to the share of associate’s or joint venture’s profits or losses as required In recognising the investor’s share of the associate’s current year results and post-acquisition movements in opening retained earnings, it may be necessary to make the following adjustments: 1. Negative goodwill on acquisition.

If, on acquisition of the associate or joint venture there is negative goodwill, the amount is recognised as income in the year the investment was acquired in determining the share of the investee’s profit or loss with a corresponding adjustment to the investment carrying amount (refer to earlier example).

2. Fair value and depreciation adjustments.

A depreciation or amortisation adjustment is required if a fair value adjustment to depreciable or intangible assets forms part of the acquisition analysis in the associate or joint venture.



If the carrying amount of an asset is less than its fair value at acquisition date, a notional adjustment to the asset must be made as part of the acquisition analysis. In addition, if the carrying amount has not subsequently been revalued or recognised in the books of the associate or joint venture, any depreciation or amortisation on the asset is understated from the point of view of the investor. In this case, an adjustment is needed to recognise additional depreciation or amortisation, which will result in a reduction in the investor’s share of the associate’s or joint venture’s profits.



If the carrying amount of an asset is more than its fair value at acquisition date, a notional adjustment to the asset will be required in the acquisition analysis. If an impairment has not been recognised in the books of the associate or joint venture, an adjustment will be required to reduce the depreciation or amortisation, which will result in an increase in the investor’s share of the associate’s or joint venture’s profits.

3. Elimination of unrealised profits and losses on transactions between the investor and the associate or joint venture.

IAS 28 para. 28 requires that adjustments must be made to eliminate unrealised profits and losses on transactions between the associate or joint venture and the investor.



Where a transaction results in a profit Irrespective of whether the transaction is ‘upstream’ or ‘downstream’, an adjustment is made to eliminate the investor’s share in the investee’s profits resulting from these transactions, so the entity’s financial statements include the transaction only to the extent of the unrelated investor’s interest. Such adjustments may be required on the sale of inventory or non-current assets, which may be depreciable. Where depreciable non-current assets are transferred between entities, consequential depreciation adjustments will also be required.

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Core content – Unit 17

Chartered Accountants Program

Financial Accounting & Reporting

Example – Upstream versus downstream transaction This example illustrates the equity accounting entries for upstream and downstream transactions. Bossy Boots owns 45% of Agreeable and exerts significant influence over the investee. The ownership structure is as follows:

Bossy Boots

45% ownership

Significant influence

Agreeable

Both companies manufacture footwear. Profit after tax for the year ended 30 June 20X8: •• Agreeable: $800,000. •• Bossy Boots: $2,000,000. The tax rate is 30%.

Scenario 1: Associate sells to investor – upstream sale

Bossy Boots

45% ownership

Upstream sale

Agreeable

During the year, Agreeable sold running shoes to Bossy Boots. This is an upstream sale. The cost to Agreeable was $200,000 and the selling price was $280,000, resulting in $80,000 profit. Bossy Boots has not sold any of this inventory by 30 June 20X8. Under the equity accounting method of accounting, this profit is unrealised and cannot be recognised by Bossy Boots until the shoes are sold to an unrelated party. The simplest way to eliminate the unrealised profit existing at 30 June 20X8 is when calculating the investor’s share of the associate’s profit for the year. Item

Calculation

Current year profit after tax

800,000

Less unrealised profit in closing inventory ($80,000 × (1 – 30%))

 (56,000)

Adjusted current year profit

744,000

Bossy Boots’ 45% interest

334,800

Unit 17 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

If Bossy Boots had sold all of the running shoes, it would recognise $360,000 ($800,000 × 45%) as its share of the associate’s profit for the year. However, as the running shoes are still owned by Bossy Boots, only $334,800 can be recognised, which would be recorded in this equity accounting journal entry: Date

Account description

30.06.X8

Investment in associate

Dr $

Cr $

334,800

Share of associate’s profit after tax

334,800

To record Bossy Boots’ share of Agreeable’s profit for the year ended 30 June 20X8

Scenario 2: Investor sells to associate – downstream sale

Bossy Boots

45% ownership

Downstream sale

Agreeable

During the year, Bossy Boots sold boots to Agreeable. This is a downstream sale. The cost to Bossy Boots was $400,000 and the selling price was $520,000, resulting in a $120,000 profit. Agreeable has not sold any of this inventory by 30 June 20X8. In this situation, it is Bossy Boots’ profit, not Agreeable’s profit, which needs to be adjusted. This is because Bossy Boots has recognised 100% of the profit on the sale of boots in its general ledger. IAS 28 only permits the profit to be recognised to the extent of the unrelated interest, which in this case is 55% (1 – 45%). Therefore, 45% of the $120,000 profit must be eliminated and can only be recognised when the boots are sold by Agreeable to an unrelated party. Included in Bossy Boots’ $2,000,000 profit after tax is a profit after tax of $84,000 (($120,000 × (1 – 30%)) on the sale of the boots to Agreeable. Because the sale was made by the investor to the associate, $37,800 (45% of the $84,000 profit) is unrealised and needs to be eliminated as an equity accounting adjustment. Under the equity method of accounting the downstream profit is eliminated by adjusting the relevant accounts of the investor line by line, as follows: Date

Account description

30.06.X8

Revenue1

Dr $

Cr $

234,000

Cost of sales2

180,000

Income tax expense

16,200

Investment in associate4

37,800

3

To record the adjustment for the transfer of inventory from Bossy Boots to Agreeable, being the current year downstream unrealised profit

This journal entry will be reversed in the next reporting period, assuming Agreeable sells the boots in that period.

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Core content – Unit 17

Chartered Accountants Program

Financial Accounting & Reporting

Notes 1. $520,000 × 45% = $234,000. Bossy Boots’ revenue is overstated, as 45% of the $520,000 transfer made to Agreeable is considered unrealised (as it is still unsold) and therefore needs to be eliminated. 2. $400,000 × 45% = $180,000. Bossy Boots’ cost of sales is also overstated and requires an equivalent adjustment. 3. ($234,000 – $180,000) × 30% = $16,200. As the profit before tax has been reduced by $54,000, a corresponding reduction in income tax expense is required. 4. ($234,000 – $180,000) × (1 – 30%) = $37,800. The net effect of these adjustments reduces the carrying amount of Bossy Boots’ investment in Agreeable.

FIN fact When there is an unrealised profit, draw a diagram to determine who made the sale. The unrealised profit is captured in the seller’s profit. Then apply the appropriate equity accounting treatment depending on whether it is an upstream or a downstream unrealised profit.

Where a transaction results in a loss If the transaction results in a loss, it may indicate evidence of a decline in the net realisable value of the asset or the impairment of the asset subject to the transaction. If so, para. 29 requires the loss on downstream transactions to be recognised in full and a loss on upstream transactions to be recognised to the extent of the investor’s share. Tax effect implications of certain equity accounting adjustments Step 3 of applying the equity accounting method outlines four sub-steps requiring equity accounting journal entries. The view taken for the purposes of the FIN module, reflecting common practice, is that certain equity accounting adjustments should be recorded on an after‑tax basis. IAS 28 does not specify that income tax consequences under IAS 12 Income Taxes are required when applying the equity method; however, IAS 28 para. 26 states that: Many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10. Furthermore, the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint venture.

As covered in the unit on accounting for subsidiaries, IFRS 10 Appendix B Application guidance para. B86(c) provides guidance on tax effect adjustments. It requires IAS 12 to be applied to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions when preparing consolidated financial statements. Similarly, as covered in the unit on business combinations, IFRS 3 requires deferred tax assets or liabilities to be recognised on the restatement of assets and liabilities to fair value when performing the acquisition accounting for a business combination. Accordingly, when applying the equity method, adjustments specified in sub-step 3d points 2 and 3 should be recorded on an after-tax basis. Required reading IAS 28 paras 26 and 28–31. Activity 17.1: Accounting for an investment in an associate under the equity method of accounting [Available online in myLearning]

Unit 17 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Complexities with equity accounting This section outlines a number of complexities that can arise with equity accounting, however practical application of these issues is beyond the scope of the FIN module.

Changes in ownership interests In this unit we only consider the accounting treatment applicable if an entity’s ownership interest in an associate or a joint venture is reduced but the entity continues to apply the equity method. The entity must reclassify to profit or loss the proportion of the gain or loss that had previously been recognised in other comprehensive income relating to the reduction in ownership interest if that gain or loss would be required to be reclassified to profit or loss on the disposal of the related assets or liabilities (IAS 28 para. 25).

Consolidating a foreign associate or joint venture When an entity holds an interest in a foreign associate or joint venture, the normal equity accounting procedures outlined apply. However, when calculating the amounts to be recorded in the equity accounting journals, consideration must be given to foreign currency translation issues as covered in the unit on foreign exchange.

Recognising the tax effect of the equity carrying amount of the investment On application of the equity method, there will be a difference between the original cost of the investment and the equity-accounted carrying amount of the investment. This can give rise to a temporary difference which is accounted for under IAS 12 Income Taxes.

Impairment of the investment in associate or joint venture After the application of the equity method, including recognising the associate’s or joint venture’s losses, the entity needs to determine whether it is necessary to recognise any additional impairment loss on its investment. IAS 28 provides specific guidance on assessing objective evidence of impairment of the investment in the associate or joint venture. IAS 36 Impairment of Assets is applied to account for an impairment loss.

Discontinuing equity accounting Under IAS 28, the equity method of accounting must be discontinued in either of the following situations: 1. The investor no longer significantly influences the investee.

In this situation, the investor must measure at fair value any investment retained in the former associate or joint venture. The investment is then accounted for in accordance with IFRS 9. Any difference between the fair value of the remaining investment, along with any proceeds from disposing of part of the investment and the equity carrying amount at the date when significant influence was lost, is recognised in profit or loss (IAS 28 para. 22(b)).

2. The investor’s share of the investee’s losses reduces the carrying amount of the investment to below $0.

In this situation, the equity method must be discontinued and the investment recorded as $0 (IAS 28 para. 38). A liability for additional losses is recognised by the investor only in limited circumstances. When the investor resumes the application of equity accounting, it must not recognise its share of profits until these offset its share of losses not recognised (IAS 28 para. 39).

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Financial Accounting & Reporting

Required reading IAS 28 paras 22, 25 and 38–43.

Determining the guidance to follow when accounting for joint arrangements and investments where the investor has significant influence

NO

Accounting treatment is applied under IFRS 9 Financial Instruments

Does the investor have significant influence over the investee?

YES

Equity method of accounting is applied under IAS 28 unless there is scope exclusion

NO

START HERE

Does a joint arrangement exist?

YES

Does the party to the joint arrangement have joint control?

NO

Accounting treatment for the party that participates in but does not share in joint control is specified in IFRS 11 paras 23 and 27

YES JOINT OPERATION

Accounting for underlying assets and liabilities applied by joint operator under (IFRS 11 para. 20)

JOINT VENTURE

Equity method of accounting is applied under IAS 28 unless there is scope exclusion (IFRS 11 para. 24)

Is the arrangement a joint operation or a joint venture?

Note: If an investor has control over an entity, then IFRS 10 Consolidated Financial Statements is applied.

Unit 17 – Core content

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Financial Accounting & Reporting

Chartered Accountants Program

Significant influence and joint control Learning outcome 2. Explain the concepts of significant influence and joint control. This section will explore: •• the concepts of significant influence, under IAS 28, and •• classification as a joint venture (with joint control) under IFRS 11. The principles around the requirements of joint control or significant influence within each standard must be satisfied, prior to applying equity accounting.

Identifying associates: significant influence IAS 28 para. 3 defines an associate as ‘an entity over which the investor has significant influence’. Understanding and applying the definition of significant influence is therefore the key factor in determining application of equity accounting under IAS 28. Key paragraphs of the standard in determining significant influence are outlined in the diagram below:

IAS 28 para. 3 ASSOCIATE: ‘an entity over which the investor has significant influence’

IAS 28 para. 5 20% or more voting power of investee = presume significant influence IAS 28 para. 6 notes indicators of significant influence

IAS 28 para. 7 potential voting rights must be considered in deciding if there is significant influence

Required reading IAS 28 paras 3 and 5–9.

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Financial Accounting & Reporting

Example: Establishing significant influence Bam-bam Limited (Bam-bam) acquired 18% of Teeny Tiny Limited (Teeny Tiny) on 1 April 20X7, with commensurate voting rights. Bam-bam is guaranteed one of the six seats on the board of directors, where key operational and strategic decisions for Teeny Tiny are made. Bam-bam’s wholly owned subsidiary, Slamdunk Limited, holds a further 5% of the shares in Teeny Tiny. You have been asked to determine if Bam-bam has significant influence over Teeny-Tiny at 30 June 20X7. Applying the requirements of IAS 28 para.5, Bam-bam’s direct shareholding would not be presumed to result in significant influence as it is under 20%. However, this paragraph requires Bam-bam to also consider indirect shareholdings. By including the voting rights held by Slamdunk, this results in Bam-bam achieving more than 20% of the voting rights, which is presumed to be significant influence, unless evidence can be shown to the contrary. The seat Bam-bam holds on the board of directors further demonstrates Bam-bam’s influence, as it is one of the indicators noted in IAS 28 para.6. As such, we would conclude Bam-bam has significant influence over Teeny Tiny, and apply equity accounting as required by IAS 28 para.16.

Establishing when joint control exists Two kinds of joint arrangements are covered by IFRS 11: joint operations, and joint ventures. Joint venture is defined by IFRS 11 Appendix A as ‘a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement’. IFRS 11 distinguishes joint ventures from joint operations, as each of these arrangements is accounted for differently. Once an arrangement is classified as a joint venture by IFRS 11, it is accounted for using the equity method in IAS 28. Joint control is a common feature of both joint ventures and joint operations. Joint control is defined as ‘the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing joint control’. IFRS 11 Appendix B para. B10 provides the following flow chart to assess whether there is joint control:

Assessing whether there is joint control Does the contractual arrangement give all the parties, or a group of parties, control of the arrangement collectively?

YES

Do decisions about the relevant activities* require the unanimous consent of all the parties, or a group of parties, that collectively control the arrangement?

NO

Outside the scope of IFRS 11

NO

YES

The arrangement is jointly controlled and is therefore a joint arrangement

* Relevant activities are described in IFRS 10, Appendix A as activities that significantly affect the returns of the entity (for IFRS 11 purposes this means the arrangement). Unit 17 – Core content

Page 17-17

Financial Accounting & Reporting

Chartered Accountants Program

In practice, once joint control is established, the arrangement is then classified as a joint operation, or joint venture, using the flow chart in IFRS 11 para. B33. Accounting for joint operations, and distinguishing between joint ventures and joint operations, is beyond the scope of the FIN module. Required reading IFRS 11 paras 4–5, Appendix A Defined terms and Appendix B, Application guidance paras B2–B4. Further reading IFRS 11 Illustrative examples 1 and 2 for situations that distinguish a joint venture from a joint operation. FIN fact The investment in the associate/JV is initially measured at cost.

Disclosures – interests in joint arrangements and investments in associates The key disclosure requirements concerning interests in joint arrangements and investments in associates are found in IFRS 12 Disclosure of Interests in Other Entities paras 20–23, with the detail specified in Appendix B Application guidance paras B12–B20. These disclosures include: •• Paragraph 7(b) – significant judgements and assumptions made in determining whether there is joint control of an arrangement or significant influence over another entity. •• Paragraphs 21(a)(i) and (a)(ii) – the name, ownership interest and nature of the relationship between the entity and the joint arrangement or associate. •• Paragraphs 21(b)(ii) and B12–B13 – summarised financial information for each joint venture or associate that is material to the entity. •• Paragraph 22(c) – the unrecognised share of losses of the associate or joint venture. In addition, IAS 1 requires disclosure of the following: •• Share of the profit or loss of associates and joint ventures accounted for using the equity method. •• Share of the other comprehensive income of associates and joint ventures accounted for using the equity method. Required reading IFRS 12 paras 7, 20–23 and Appendix B Application guidance paras B12–B20. IAS 1 paras 82(c) and 82A. Quiz [Available online in myLearning]

Working paper H You are now ready to complete working paper H of integrated activity 4, to understand how this topic relates to the financial reports. You can complete this activity progressively as you do each topic, or as a comprehensive exam preparation activity.

Page 17-18

Core content – Unit 17

1%

1.0100

1.0201

1.0303

1.0406

1.0510

1.0615

1.0721

1.0829

1.0937

1.1046

1.1157

1.1268

1.1381

1.1495

1.1610

1.1726

1.1843

1.1961

1.2081

1.2202

Periods

1

2

Financial tables

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

1.4859

1.4568

1.4282

1.4002

1.3728

1.3459

1.3195

1.2936

1.2682

1.2434

1.2190

1.1951

1.1717

1.1487

1.1262

1.1041

1.0824

1.0612

1.0404

1.0200

2%

1.8061

1.7535

1.7024

1.6528

1.6047

1.5580

1.5126

1.4685

1.4258

1.3842

1.3439

1.3048

1.2668

1.2299

1.1941

1.1593

1.1255

1.0927

1.0609

1.0300

3%

2.1911

2.1068

2.0258

1.9479

1.8730

1.8009

1.7317

1.6651

1.6010

1.5395

1.4802

1.4233

1.3686

1.3159

1.2653

1.2167

1.1699

1.1249

1.0816

1.0400

4%

2.6533

2.5270

2.4066

2.2920

2.1829

2.0789

1.9799

1.8856

1.7959

1.7103

1.6289

1.5513

1.4775

1.4071

1.3401

1.2763

1.2155

1.1576

1.1025

1.0500

5%

3.2071

3.0256

2.8543

2.6928

2.5404

2.3966

2.2609

2.1329

2.0122

1.8983

1.7908

1.6895

1.5938

1.5036

1.4185

1.3382

1.2625

1.1910

1.1236

1.0600

6%

7%

3.8697

3.6165

3.3799

3.1588

2.9522

2.7590

2.5785

2.4098

2.2522

2.1049

1.9672

1.8385

1.7182

1.6058

1.5007

1.4026

1.3108

1.2250

1.1449

1.0700

Table 1: Compound amount of $1 (the future value of $1)

4.6610

4.3157

3.9960

3.7000

3.4259

3.1722

2.9372

2.7196

2.5182

2.3316

2.1589

1.9990

1.8509

1.7138

1.5869

1.4693

1.3605

1.2597

1.1664

1.0800

8%

5.6044

5.1417

4.7171

4.3276

3.9703

3.6425

3.3417

3.0658

2.8127

2.5804

2.3674

2.1719

1.9926

1.8280

1.6771

1.5386

1.4116

1.2950

1.1881

1.0900

9%

6.7275

6.1159

5.5599

5.0545

4.5950

4.1772

3.7975

3.4523

3.1384

2.8531

2.5937

2.3579

2.1436

1.9487

1.7716

1.6105

1.4641

1.3310

1.2100

1.1000

10%

8.0623

7.2633

6.5436

5.8951

5.3109

4.7846

4.3104

3.8833

3.4985

3.1518

2.8394

2.5580

2.3045

2.0762

1.8704

1.6851

1.5181

1.3676

1.2321

1.1100

11%

9.6463

8.6128

7.6900

6.8660

6.1304

5.4736

4.8871

4.3635

3.8960

3.4785

3.1058

2.7731

2.4760

2.2107

1.9738

1.7623

1.5735

1.4049

1.2544

1.1200

12%

11.523

10.197

9.0243

7.9861

7.0673

6.2543

5.5348

4.8980

4.3345

3.8359

3.3946

3.0040

2.6584

2.3526

2.0820

1.8424

1.6305

1.4429

1.2769

1.1300

13%

13.743

12.056

10.575

9.2765

8.1372

7.1379

6.2613

5.4924

4.8179

4.2262

3.7072

3.2519

2.8526

2.5023

2.1950

1.9254

1.6890

1.4815

1.2996

1.1400

14%

16.367

14.232

12.375

10.761

9.3576

8.1371

7.0757

6.1528

5.3503

4.6524

4.0456

3.5179

3.0590

2.6600

2.3131

2.0114

1.7490

1.5209

1.3225

1.1500

15%

19.461

16.777

14.463

12.468

10.748

9.2655

7.9875

6.8858

5.9360

5.1173

4.4114

3.8030

3.2784

2.8262

2.4364

2.1003

1.8106

1.5609

1.3456

1.1600

16%

38.338

31.948

26.623

22.186

18.488

15.407

12.839

10.699

8.9161

7.4301

6.1917

5.1598

4.2998

3.5832

2.9860

2.4883

2.0736

1.7280

1.4400

1.2000

20%

20

19

18

17

16

15

14

13

12

11

10

9

8

7

6

5

4

3

2

1

Periods

Chartered Accountants Program Financial Accounting & Reporting

Present and future value tables

Page FT-1

1%

0.9901

0.9803

0.9706

0.9610

0.9515

0.9420

0.9327

0.9235

0.9143

0.9053

0.8963

0.8874

0.8787

0.8700

0.8613

0.8528

0.8444

0.8360

0.8277

0.8195

Periods

1

2

Page FT-2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

0.6730

0.6864

0.7002

0.7142

0.7284

0.7430

0.7579

0.7730

0.7885

0.8043

0.8203

0.8368

0.8535

0.8706

0.8880

0.9057

0.9238

0.9423

0.9612

0.9804

2%

3%

0.5537

0.5703

0.5874

0.6050

0.6232

0.6419

0.6611

0.6810

0.7014

0.7224

0.7441

0.7664

0.7894

0.8131

0.8375

0.8626

0.8885

0.9151

0.9426

0.9709

Table 2: Present value of $1

0.4564

0.4746

0.4936

0.5134

0.5339

0.5553

0.5775

0.6006

0.6246

0.6496

0.6756

0.7026

0.7307

0.7599

0.7903

0.8219

0.8548

0.8890

0.9246

0.9615

4%

0.3769

0.3957

0.4155

0.4363

0.4581

0.4810

0.5051

0.5303

0.5568

0.5847

0.6139

0.6446

0.6768

0.7107

0.7462

0.7835

0.8227

0.8638

0.9070

0.9524

5%

0.3118

0.3305

0.3503

0.3714

0.3936

0.4173

0.4423

0.4688

0.4970

0.5268

0.5584

0.5919

0.6274

0.6651

0.7050

0.7473

0.7921

0.8396

0.8900

0.9434

6%

0.2584

0.2765

0.2959

0.3166

0.3387

0.3624

0.3878

0.4150

0.4440

0.4751

0.5083

0.5439

0.5820

0.6227

0.6663

0.7130

0.7629

0.8163

0.8734

0.9346

7%

0.2145

0.2317

0.2502

0.2703

0.2919

0.3152

0.3405

0.3677

0.3971

0.4289

0.4632

0.5002

0.5403

0.5835

0.6302

0.6806

0.7350

0.7938

0.8573

0.9259

8%

0.1784

0.1945

0.2120

0.2311

0.2519

0.2745

0.2992

0.3262

0.3555

0.3875

0.4224

0.4604

0.5019

0.5470

0.5963

0.6499

0.7084

0.7722

0.8417

0.9174

9%

0.1486

0.1635

0.1799

0.1978

0.2176

0.2394

0.2633

0.2897

0.3186

0.3505

0.3855

0.4241

0.4665

0.5132

0.5645

0.6209

0.6830

0.7513

0.8264

0.9091

10%

0.1240

0.1377

0.1528

0.1696

0.1883

0.2090

0.2320

0.2575

0.2858

0.3173

0.3522

0.3909

0.4339

0.4817

0.5346

0.5935

0.6587

0.7312

0.8116

0.9009

11%

0.1037

0.1161

0.1300

0.1456

0.1631

0.1827

0.2046

0.2292

0.2567

0.2875

0.3220

0.3606

0.4039

0.4523

0.5066

0.5674

0.6355

0.7118

0.7972

0.8929

12%

0.0868

0.0981

0.1108

0.1252

0.1415

0.1599

0.1807

0.2042

0.2307

0.2607

0.2946

0.3329

0.3762

0.4251

0.4803

0.5428

0.6133

0.6931

0.7831

0.8850

13%

0.0728

0.0829

0.0946

0.1078

0.1229

0.1401

0.1597

0.1821

0.2076

0.2366

0.2697

0.3075

0.3506

0.3996

0.4556

0.5194

0.5921

0.6750

0.7695

0.8772

14%

0.0611

0.0703

0.0808

0.0929

0.1069

0.1229

0.1413

0.1625

0.1869

0.2149

0.2472

0.2843

0.3269

0.3759

0.4323

0.4972

0.5718

0.6575

0.7561

0.8696

15%

0.0514

0.0596

0.0691

0.0802

0.0930

0.1079

0.1252

0.1452

0.1685

0.1954

0.2267

0.2630

0.3050

0.3538

0.4104

0.4761

0.5523

0.6407

0.7432

0.8621

16%

0.0261

0.0313

0.0376

0.0451

0.0541

0.0649

0.0779

0.0935

0.1122

0.1346

0.1615

0.1938

0.2326

0.2791

0.3349

0.4019

0.4823

0.5787

0.6944

0.8333

20%

20

19

18

17

16

15

14

13

12

11

10

9

8

7

6

5

4

3

2

1

Periods

Financial Accounting & Reporting Chartered Accountants Program

Financial tables

1%

1.0000

2.0100

3.0301

4.0604

5.1010

6.1520

7.2135

8.2857

9.3685

10.462

11.567

12.683

13.809

14.947

16.097

17.258

18.430

19.615

20.811

22.019

Periods

1

2

Financial tables

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

24.297

22.841

21.412

20.012

18.639

17.293

15.974

14.680

13.412

12.169

10.950

9.7546

8.5830

7.4343

6.3081

5.2040

4.1216

3.0604

2.0200

1.0200

2%

26.870

25.117

23.414

21.762

20.157

18.599

17.086

15.618

14.192

12.808

11.464

10.159

8.8923

7.6625

6.4684

5.3091

4.1836

3.0909

2.0300

1.0300

3%

29.778

27.671

25.645

23.698

21.825

20.024

18.292

16.627

15.026

13.486

12.006

10.583

9.2142

7.8983

6.6330

5.4163

4.2465

3.1216

2.0400

1.0400

4%

33.066

30.539

28.132

25.840

23.657

21.579

19.599

17.713

15.917

14.207

12.578

11.027

9.5491

8.1420

6.8019

5.5256

4.3101

3.1525

2.0500

1.0500

5%

Table 3: Compound amount of annuity of $1

36.786

33.760

30.906

28.213

25.673

23.276

21.015

18.882

16.870

14.972

13.181

11.491

9.8975

8.3938

6.9753

5.6371

4.3746

3.1836

2.0600

1.0600

6%

40.995

37.379

33.999

30.840

27.888

25.129

22.550

20.141

17.888

15.784

13.816

11.978

10.260

8.6540

7.1533

5.7507

4.4399

3.2149

2.0700

1.0700

7%

45.762

41.446

37.450

33.750

30.324

27.152

24.215

21.495

18.977

16.645

14.487

12.488

10.637

8.9228

7.3359

5.8666

4.5061

3.2464

2.0800

1.0800

8%

51.160

46.018

41.301

36.974

33.003

29.361

26.019

22.953

20.141

17.560

15.193

13.021

11.028

9.2004

7.5233

5.9847

4.5731

3.2781

2.0900

1.0900

9%

57.275

51.159

45.599

40.545

35.950

31.772

27.975

24.523

21.384

18.531

15.937

13.579

11.436

9.4872

7.7156

6.1051

4.6410

3.3100

2.1000

1.1000

10%

64.203

56.939

50.396

44.501

39.190

34.405

30.095

26.212

22.713

19.561

16.722

14.164

11.859

9.7833

7.9129

6.2278

4.7097

3.3421

2.1100

1.1100

11%

72.052

63.440

55.750

48.884

42.753

37.280

32.393

28.029

24.133

20.655

17.549

14.776

12.300

10.089

8.1152

6.3528

4.7793

3.3744

2.1200

1.1200

12%

80.947

70.749

61.725

53.739

46.672

40.417

34.883

29.985

25.650

21.814

18.420

15.416

12.757

10.405

8.3227

6.4803

4.8498

3.4069

2.1300

1.1300

13%

91.025

78.969

68.394

59.118

50.980

43.842

37.581

32.089

27.271

23.045

19.337

16.085

13.233

10.730

8.5355

6.6101

4.9211

3.4396

2.1400

1.1400

14%

102.444

88.212

75.836

65.075

55.717

47.580

40.505

34.352

29.002

24.349

20.304

16.786

13.727

11.067

8.7537

6.7424

4.9934

3.4725

2.1500

1.1500

15%

115.380

98.603

84.141

71.673

60.925

51.660

43.672

36.786

30.850

25.733

21.321

17.519

14.240

11.414

8.9775

6.8771

5.0665

3.5056

2.1600

1.1600

16%

186.688

154.740

128.117

105.931

87.442

72.035

59.196

48.497

39.581

32.150

25.959

20.799

16.499

12.916

9.9299

7.4416

5.3680

3.6400

2.2000

1.2000

20%

20

19

18

17

16

15

14

13

12

11

10

9

8

7

6

5

4

3

2

1

Periods

Chartered Accountants Program Financial Accounting & Reporting

Page FT-3

Page FT-4

5.7955

6.7282

7.6517

8.5660

9.4713

10.368

11.255

12.134

13.004

13.865

14.718

15.562

6

7

8

9

10

11

12

13

14

15

16

17

18.046

4.8534

5

20

3.9020

4

17.226

2.9410

3

19

1.9704

2

16.398

0.9901

1

18

1%

Periods

16.351

15.678

14.992

14.292

13.578

12.849

12.106

11.348

10.575

9.7868

8.9826

8.1622

7.3255

6.4720

5.6014

4.7135

3.8077

2.8839

1.9416

0.9804

2%

14.877

14.324

13.754

13.166

12.561

11.938

11.296

10.635

9.9540

9.2526

8.5302

7.7861

7.0197

6.2303

5.4172

4.5797

3.7171

2.8286

1.9135

0.9709

3%

4%

13.590

13.134

12.659

12.166

11.652

11.118

10.563

9.9856

9.3851

8.7605

8.1109

7.4353

6.7327

6.0021

5.2421

4.4518

3.6299

2.7751

1.8861

0.9615

Table 4: Present value of annuity $1

12.462

12.085

11.690

11.274

10.838

10.380

9.8986

9.3936

8.8633

8.3064

7.7217

7.1078

6.4632

5.7864

5.0757

4.3295

3.5460

2.7232

1.8594

0.9524

5%

11.470

11.158

10.828

10.477

10.106

9.7122

9.2950

8.8527

8.3838

7.8869

7.3601

6.8017

6.2098

5.5824

4.9173

4.2124

3.4651

2.6730

1.8334

0.9434

6%

10.594

10.336

10.059

9.7632

9.4466

9.1079

8.7455

8.3577

7.9427

7.4987

7.0236

6.5152

5.9713

5.3893

4.7665

4.1002

3.3872

2.6243

1.8080

0.9346

7%

9.8181

9.6036

9.3719

9.1216

8.8514

8.5595

8.2442

7.9038

7.5361

7.1390

6.7101

6.2469

5.7466

5.2064

4.6229

3.9927

3.3121

2.5771

1.7833

0.9259

8%

9.1285

8.9501

8.7556

8.5436

8.3126

8.0607

7.7862

7.4869

7.1607

6.8052

6.4177

5.9952

5.5348

5.0330

4.4859

3.8897

3.2397

2.5313

1.7591

0.9174

9%

8.5136

8.3649

8.2014

8.0216

7.8237

7.6061

7.3667

7.1034

6.8137

6.4951

6.1446

5.7590

5.3349

4.8684

4.3553

3.7908

3.1699

2.4869

1.7355

0.9091

10%

7.9633

7.8393

7.7016

7.5488

7.3792

7.1909

6.9819

6.7499

6.4924

6.2065

5.8892

5.5370

5.1461

4.7122

4.2305

3.6959

3.1024

2.4437

1.7125

0.9009

11%

7.4694

7.3658

7.2497

7.1196

6.9740

6.8109

6.6282

6.4235

6.1944

5.9377

5.6502

5.3282

4.9676

4.5638

4.1114

3.6048

3.0373

2.4018

1.6901

0.8929

12%

7.0248

6.9380

6.8399

6.7291

6.6039

6.4624

6.3025

6.1218

5.9176

5.6869

5.4262

5.1317

4.7988

4.4226

3.9975

3.5172

2.9745

2.3612

1.6681

0.8850

13%

6.6231

6.5504

6.4674

6.3729

6.2651

6.1422

6.0021

5.8424

5.6603

5.4527

5.2161

4.9464

4.6389

4.2883

3.8887

3.4331

2.9137

2.3216

1.6467

0.8772

14%

6.2593

6.1982

6.1280

6.0472

5.9542

5.8474

5.7245

5.5831

5.4206

5.2337

5.0188

4.7716

4.4873

4.1604

3.7845

3.3522

2.8550

2.2832

1.6257

0.8696

15%

5.9288

5.8775

5.8178

5.7487

5.6685

5.5755

5.4675

5.3423

5.1971

5.0286

4.8332

4.6065

4.3436

4.0386

3.6847

3.2743

2.7982

2.2459

1.6052

0.8621

16%

4.8696

4.8435

4.8122

4.7746

4.7296

4.6755

4.6106

4.5327

4.4392

4.3271

4.1925

4.0310

3.8372

3.6046

3.3255

2.9906

2.5887

2.1065

1.5278

0.8333

20%

20

19

18

17

16

15

14

13

12

11

10

9

8

7

6

5

4

3

2

1

Periods

Financial Accounting & Reporting Chartered Accountants Program

Financial tables