ACCA Advanced Corporate Reporting 2005
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ATe INTERNATIONAL
ACCA
PAPER 3.6 ADVANCED CORPORATE REPORTING (INTERNATIONAL)
STUDY SYSTEM
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, editor or publisher. This training material has been published and prepared by Accountancy Tuition Centre Limited 16 Elmtree Road Teddington TWl18ST United Kingdom. Editorial material Copyright © Accountancy Tuition Centre (International Holdings) Limited, 2005.
All rights reserved. No part of this training material may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including photocopying and recording, or in any information storage and retrieval system, without permission in writing from the Accountancy Tuition Centre Limited.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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INTRODUCTION
INTRODUCTION
This Study System has been specifically written for The Chartered Association of Certified Accountants Part 3 examination, Paper 3.6 Advanced Corporate Reporting (International). It provides comprehensive coverage of the core syllabus areas and is designed to be used interactively with the ATC system of tuition providing you with the knowledge, skill and confidence to succeed in your ACCA studies. SYLLABUS Aim
To ensure that candidates can exercise judgement and technique in corporate reporting matters encountered by accountants and can react to current developments or new practice. Objectives
On completion of this paper candidates should be able to: •
explain and evaluate the implications of an accounting standard or proposed accounting standard for the content of published financial information
•
explain and evaluate the impact on the financial statements of business decisions
•
explain the legitimacy and acceptability of an accounting practice proposed by a company
•
prepare financial statements for complex business situations
•
analyse fmancial statements and prepare a report suitable for presentation to a variety of users
•
evaluate current practice in the context needs of users and the objectives of financial reporting
•
evaluate current developments in corporate reporting in the context of their practical application, implications for corporate reporting, and the underlying conceptual issues and
•
demonstrate the skills expected in Part 3.
POSITION OF THE PAPER IN THE OVERALL SYLLABUS
This paper is the final assessment of the candidates' skills in the area of corporate reporting. The paper builds on the technical skills studied in Paper 1.1 Preparing Financial Statements and Paper 2.5 Financial Reporting by requiring candidates to demonstrate the high level technical and evaluatory skills expected of an accountant. The paper complements the skills acquired in studying the other core papers in Part 3 of the ACCA examination structure.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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INTRODUCTION
Syllabus content 1 The International Accounting Standard Board's (IASB) regulatory framework
a
International Accounting Standards, Exposure Drafts, Discussion Papers, Standard Interpretation Committee pronouncements including accounting for equity and liabilities, assets, provisions and contingencies, segments, related parties, fmancial instruments, taxes, leases, retirement benefit costs. Also International Financial Reporting Standards.
b
The content of the IASC's regulatory framework in a given range of practical situations
c
The problems with the current and proposed changes to the IASC's regulatory framework including measurement and recognition issues.
d
The impact of current and proposed regulations on the financial statements of the entity.
e
The effect of business decisions and proposed changes in accounting practice by the entity on the financial statements.
f
The legitimacy of current accounting practice and its relevance to users of corporate financial statements.
2 Preparation ofthe financial statements ofcomplex business entities
a
The financial statements of complex groups including vertical and mixed groups.
b
Group cash flow statements.
c
Accounting for group reorganisations and restructuring including demergers, take-overs and group schemes.
d
Accounting for foreign currency transactions and entities.
3 Preparation ofreports for external and internal users
a
Appraisal of financial and related information, the purchase of a business entity, the valuation of shares and the reorganisation of an entity.
b
Appraisal of the impact of changes in accounting policies and the regulatory framework on shareholder value.
c
Appraisal of the business performance of the entity including quantitative and qualitative measures of performance and the potential for corporate failure.
d
The assessment of the impact of price level changes and available methods of valuation on business decisions and performance.
e
The effectiveness of corporate governance within an entity.
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INTRODUCTION
4 Current issues and developments
a
The accounting impact of environmental, cultural and social factors on the entity.
b
The impact of the content offmancial statements on users including changes in design and content of interim and year-end fmancial statements and alternate ways of communicating results to users.
c
Proposed changes in the structure of national and international regulation and the impact on global harmonisation and standardisation.
d
The applicability of the lASC's regulatory framework to small and medium sized entities.
e
Current developments in corporate reporting.
5 Ethical considerations
a
Ethics and business conduct.
Excluded topics
The following topic is specifically excluded from the syllabus: •
lAS 30 Disclosure in Financial Statements ofBanks and Similar Financial Institutions.
Key areas of the syllabus
Key topic areas are as follows: •
group accounting, group cash flow statements and foreign currency translation
•
discussion papers, exposure drafts and recent International Accounting Standards
•
problems with current International Accounting Standards and the impact of changes therein on the entity
•
preparation of reports in an advisory capacity including share valuation, and purchase of a business
•
changes in organisational structure, reconstructions, demergers, etc.
•
the potential for business failure and problems with the business including financial analysis, corporate failure prediction and measurement of corporate performance
•
environmental and social accounting and the impact of culture
•
corporate governance and the dissemination of information to users
•
current issues.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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INTRODUCTION
The main thrust of the syllabus will be the preparation of a set of group fmancial statements, advising clients on current standards and changes therein, reporting business performance including environmental and social reporting and corporate governance, and appraising current issues. It is important to realise that other areas of the syllabus will be also examined but they are not considered as important.
Approach to examining the syllabus The examination is a three hour paper divided into two sections. Section A will normally comprise one compulsory question on group financial statements including group cash flows and foreign currency translation. This question will be technically demanding and could have a discursive element in it. Section B will comprise four questions out of which candidates should select three questions. These questions will involve advising, discussing and reporting on issues and topics in corporate fmancial reporting. The questions will view the subject matter from the perspective of the preparer of financial statements and from the perspective of the accountant as an advisor. Invariably a technical understanding of the subject matter will be required and candidates will have to apply their knowledge to given cases and scenarios. Advice as to current and future reporting requirements and their impact on reported corporate performance will be an important element of these questions. Additionally current issues and developments in fmancial reporting will be examined on a discursive basis. Number of marks Section A: One compulsory question Section B: Choice of3 from 4 questions (25 marks each)
25 75 100
Additional information Candidates need to be aware that questions involving knowledge of new examinable regulations will not be set until at least six months after the last day of the month in which the regulation was issued. The Study Guide provides more detailed guidance on the syllabus. Examinable documents are listed in the Exam Notes section of the Student Accountant.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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EXAMINATION TECHNIQUE
EXAMINATION TECHNIQUE Time allocation •
Divide your time in proportion to the marks on offer. To allocate your time multiply the marks for each question by 1.7 minutes. If you allocate 1.8 minutes per mark you will find that at the end of the exam you need a couple more minutes! e.g. 25 mark question should take you 25 x 1.7 = 43 minutes
•
Stick to this time allocation.
•
The first marks are the easiest to gain in each question, so don't be tempted to overstep the time allocation on one question to tidy up a complicated answer, start the next question instead.
Numerical questions •
Before starting a computation, picture your route. Do this by jotting down the steps you are going to take and imagining the layout of your answer.
•
Set up a pro-forma structure to your answer before working the numbers.
•
Use a columnar layout if appropriate. This helps to avoid mistakes and is easier for the marker to follow.
•
Include all your workings and cross-reference them to the face of your answer.
•
A clear approach and workings will help earn marks even if you make an arithmetic mistake.
•
If you do spot a mistake in your answer, it is not worthwhile spending time amending the consequent effects of it. The marker of your script will not punish you for errors caused by an earlier mistake.
•
Don't ignore marks for written recommendations or comments based upon your computation. These are easy marks to gain.
•
If you could not complete the calculations required for comment then assume an answer to the calculations. As long as your comments are consistent with your assumed answer you can still pick up all the marks for the comments.
Case Study/Scenario based questions •
Read the requirements carefully to identify Instruction e.g. "outline, discuss ....." Content eg "the factors, the advantages VehiclelFormat eg "report, memo, letter Addressee eg "the board, the accountant
•
" " "
Read the scenario quickly to identify Company name, dates, nature of business, performance.
•
Recall the technical knowledge you have learned relating to the content from the requirements and your quick read of the scenario.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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EXAMINATION TECHNIQUE
•
•
Read the scenario again slowly and actively
o
highlighting key points, or
o
noting implications in the margin, and
o
noting points on a plan of your answer.
Draw together your technical knowledge and the points from the scenario. Do this by thinking and rearranging your plan, before you write up your answer.
Written questions Planning •
Read the requirements carefully at least twice to identify exactly how many points you are being asked to address.
•
Jot down relevant thoughts on your plan
•
Give your plan a structure which you will follow when you write up the answer.
Presentation •
Use headings, indentation and bullet points to give your answer structure and to make it more digestible for the marker.
•
Use short paragraphs for each point that you are making.
•
Use "bullet points" where this seems appropriate.
•
Separate paragraphs by leaving at least one line of space between each one.
Style •
Long philosophical debate does not impress markers. Concise, easily understood language scores marks.
•
Lots of points briefly explained tends to score higher marks than one or two points elaborately explained.
•
Imagine that you are a marker, you would like to see a short, concise answer which clearly addresses the requirement.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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CONTENTS
Session
Page
1
GAAP and the IASB
0101
2
International issues
0201
3
Framework for the preparation and presentation of financial statements
0301
4
Substance over form
0401
5
lAS 1 Presentation of fmancial statements
0501
6
lAS 8 Accounting policies, changes in accounting estimates and errors
0601
7
lAS 18 Revenue
0701
8
lAS 11 Construction contracts
0801
9
lAS 16 Property, plant and equipment
0901
10
lAS 23 Borrowing costs
1001
11
lAS 20 Accounting for government grants & disclosure of government assistance
1101
12
lAS 17 Leases
1201
13
lAS 38 Intangible assets
1301
14
lAS 40 Investment properties
1401
15
lAS 41 Agriculture
1501
16
lAS 36 Impairment of assets
1601
17
lAS 37 Provisions, contingent liabilities and contingent assets
1701
18
lAS 12 Income taxes
1801
19
lAS 32 and lAS 39 Financial instruments
1901
20
lAS 19 Employee benefits
2001
21
IFRS 2 Share-based payments
2101
22
Regulatory framework
2201
23
Group accounts - Revision of basics
2301
24
lAS 22 Goodwill
2401
25
Group accounts - More complex groups
2501
26
Group accounts - Disposals
2601
27
Group accounts - Piecemeal acquisition
2701
28
lAS 28 Investments in associates
2801
29
lAS 31 Interests in joint ventures
2901
30
lAS 21 The effects of changes in foreign exchange rates
3001
31
Changes in organizational structure
3101
32
Share valuation
3201
33
Analysis and interpretation
3301
34
lAS 7 Cash flow statements
3401
35
The effects of changing prices
3501
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CONTENTS
Session
Page
36
lAS 33 Earning per share
3601
37
lAS 14 Segment reporting
3701
38
IFRS 5 Non-current assets held for sale and discontinued operations
3801
39
lAS 10 Events after the balance sheet date
3901
40
lAS 24 Related parties
4001
41
lAS 34 Interim financial reporting
4101
42
Corporate reporting issues
4201
43
IFRS 1 First-time adoption ofIntemational Financial Reporting Standards
4301
Index
4401
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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CONTENTS
SESSION 00 iii iii iii iii iii iv
Introduction Syllabus Aim Objectives Position of the paper in the overall syllabus Syllabus content Excluded topics Key areas of the syllabus Approach to examining the syllabus Additional information Examination technique Time allocation Numerical questions Case Study/Scenario based questions Written questions
v v
vi vi vii vii vii vii viii
SESSION 01 GAAP and the IASB 1
2
3
4
5
6
GAAP 1.1 What is GAAP? 1.2 Sources of GAAP 1.3 Role of statute and standards International Federation of Accountants (IFAC) 2.1 What is it? 2.2 Membership 2.3 Technical committees 2.4 Accounting v auditing ThelASB 3.1 What is it? 3.2 Objectives 3.3 Structure International fmancial reporting standards (IFRSs) 4.1 Importance 4.2 Development of lASs 4.3 Interpretation of lASs 4.4 Benchmark and allowed alternative treatments 4.5 Scope and application 4.6 Authority The big GAAP/little GAAP debate 5.1 The debate 5.2 Difficulties 5.3 Arguments for 5.4 Arguments against International fmancial reporting interpretations committee (SIC). 6.1 Background 6.2 Approach 6.3 Changes 6.4 SICs/IFRICs in issue (as examinable documents)
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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0102 0102 0102 0102 0103 0103 0103 0103 0104 0104 0104 0104 0104 0106 0106 0106 0106 0107 0107 0107 0108 0108 0108 0109 0109 0110 0110 0110 0110 0111
CONTENTS
7
8
Relationship ofIASC with other bodies 7.1 Intergovernmental bodies 7.2 National standard setting bodies (NSSBs) G4+ 1 GROUP
0112 0112 0112 0113
SESSION 02 International issues 1
2
3 4
5
6
International harmonisation 1.1 Introduction 1.2 Environmental factors 1.3 General comment Advantages of harmonisation 2.1 Multinational enterprises (MNEs) 2.2 Multinational accounting firms 2.3 Investors 2.4 Others Barriers to harmonisation Progress on harmonisation 4.1 IASB 4.2 The IOSCO project 4.3 Growth of importance of lASs 4.4 Problems associated with the further adoption of lASs The role of other organisations in harmonisation 5.1 European Union directives 5.2 Others lAS vs national alternatives
0202 0202 0202 0203 0204 0204 0204 0204 0205 0205 0206 0206 0206 0207 0207 0208 0208 0208 0209
SESSION 03 Framework for the preparation and presentation of fmancial statements 1
2 3
4
5
Purpose and Status 1.1 Purpose 1.2 Scope 1.3 Financial statements 1.4 Application 1.5 Users and their information needs The Objective of Financial statements 2.1 Financial position, performance and changes in fmancial position Underlying Assumptions 3.1 Accrual basis 3.2 Going concern Qualitative Characteristics of Financial statements 4.1 Principal qualitative characteristics 4.2 Understandability 4.3 Relevance 4.4 Reliability 4.5 Comparability Elements of fmancial statements 5.1 Defmitions 5.2 Recognition 5.3 Measurement bases
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0302 0302 0302 0302 0303 0303 0304 0304 0305 0305 0305 0305 0305 0305 0306 0306 0307 0307 0307 0308 0309
CONTENTS
6
Concepts of capital and capital maintenance 6.1 Concepts of capital 6.2 Concepts of capital maintenance and the determination of profit
0309 0309 0309
SESSION 04 Substance over form 1
2
3
Why substance matters 1.1 Introduction 1.2 Recognition of assets and liabilities Reporting the substance of transactions 2.1 Objective 2.2 Recognition and derecognition Examples 3.1 Consignment inventory 3.2 Sale and repurchase agreements 3.3 Quasi subsidiaries 3.4 Factoring of debts
0402 0402 0402 0402 0402 0402 0403 0403 0405 0407 0408
SESSION 05 lAS 1 Presentation of financial statements 1
2
3
4
5
Introduction 1.1 Objective 1.2 General purpose financial statements 1.3 Application Financial Statements 2.1 Representation 2.2 Objectives of financial statements (see the Framework) 2.3 Components 2.4 Supplementary statements Overall considerations 3.1 Fair presentation and compliance with lASs 3.2 Emphasis 3.3 Departure from lAS 3.4 Going Concern 3.5 Accrual basis of accounting 3.6 Consistency of presentation 3.7 Materiality and aggregation 3.8 Offsetting 3.9 Comparative information Structure and Content 4.1 "Disclosure" 4.2 Identification of fmancial statements 4.3 Reporting date and period 4.4 Terms used Balance Sheet 5.1 The current/non-current distinction 5.2 Current assets 5.3 Current liabilities 5.4 Overall structure 5.5 Presentation of balance sheet items
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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0503 0503 0503 0503 0503 0503 0504 0504 0504 0505 0505 0505 0505 0506 0506 0507 0507 0508 0508 0508 0508 0509 0509 0509 0510 0510 0510 0511 0511 0513
CONTENTS
Income Statement 6.1 Presentation of income statement items 6.2 Structure of the income statement Statement of Changes in Equity 7 7.1 A separate statement 7.2 Function 7.3 Structure of notes 7.4 Items which are taken directly to equity The G4+1 Position Paper on reporting fmancia1 performance 8 8.1 What is Performance Reporting? 8.2 Scattered Information about Performance 8.3 Recycling 8.4 Why have 2 statements? 8.5 The G4+1 Position Paper Proposals 8.6 IASB position 9 Notes to the financial statements 9.1 Structure 9.2 Disclosure of accounting policies 9.3 Key sources of estimation uncertainty 9.4 Other disclosures 10 IASC discussion paper - business reporting on the internet 6
0514 0514 0515 0517 0517 0517 0518 0520 0521 0521 0521 0522 0522 0522 0523 0523 0523 0524 0524 0524 0524
SESSION 06 lAS 8 Accounting policies, changes in accounting estimates and errors 1
2
3
4
5
Background 1.1 Performance 1.2 Disaggregation 1.3 Reporting aspects of performance Introduction 2.1 Scope 2.2 Defmitions Accounting policies 3.1 Selection and application 3.2 Consistency of accounting policies 3.3 Changes in accounting policy 3.4 Disclosure Changes in accounting estimate 4.1 Introduction 4.2 Accounting treatment 4.3 Disclosure Prior period errors 5.1 Introduction 5.2 Accounting treatment 5.3 Disclosures
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0602 0602 0602 0603 0604 0604 0604 0605 0605 0606 0606 0607 0610 0610 0610 0610 0611 0611 0611 0611
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CONTENTS
SESSION 07 lAS 18 Revenue 1
2 3 4 5
Introduction 1.1 Scope 1.2 Defmitions 1.3 Measurement of revenue 1.4 Disclosure Sale of goods Rendering of services Interest, royalties and dividends specific examples 5.1 Sale of Goods 5.2 Specific examples - Rendering of Services 5.3 Specific examples - Interest, Royalties and Dividends
0702 0702 0702 0702 0703 0703 0704 0706 0706 0706 0709 0711
SESSION 08 lAS 11 Construction contracts 1
2
3
Introduction 1.1 Scope 1.2 Defmitions 1.3 Key issues 1.4 Revenue 1.5 Contract costs 1.6 Exam comments Recognition and measurement 2.1 The rules 2.2 Calculations 2.3 Recognition Presentation and disclosure
0802 0802 0802 0802 0803 0803 0804 0804 0804 0806 0808 0809
SESSION 09 lAS 16 Property, plant and equipment 1
2 3
4
5
0902 0902 0902 0902 0903 0903 0903 0903 0904 0904 0904 0904 0904 0905 0905 0905 0905
Introduction 1.1 Scope 1.2 Exclusions 1.3 Defmitions Recognition 2.1 Criteria Initial Measurement at cost 3.1 Components of cost 3.2 Exchange of assets Subsequent Costs 4.1 Running costs 4.2 Part replacement 4.3 Major inspection or overhaul costs Measurement after Recognition 5.1 Accounting policy 5.2 Cost Model 5.3 Revaluation Model
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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CONTENTS
6
Revaluations 6.1 Fair value 6.2 Frequency 6.3 Accumulated Depreciation 6.4 Increase/decrease 7 Depreciation 7.1 Accounting standards 7.2 Depreciable amount 8 Recovery of Carrying Amount 8.1 Impairment 8.2 Compensation 9 Derecognition 9.1 Accounting treatment 9.2 Derecognition date 10 IFRS 5 disposal of non-current assets and presentation of discontinued operations 10.1 Reasons for issuing the standard 10.2 Main features of the standard 11 Disclosure 11.1 For each class 11.2 Others 11.3 Items stated at revalued amounts 11.4 Encouraged 12 Non - depreciation 12.1 Background 12.2 Arguments employed 12.3 lAS 16
0905 0905 0906 0906 0906 0908 0908 0908 0909 0909 0909 0909 0909 0910 0910 0910 0911 0912 0912 0912 0913 0913 0913 0913 0914 0914
SESSION 10 lAS 23 Borrowing costs 1
2
3
4
Introduction 1.1 Recognition 1.2 Arguments 1.3 Scope 1.4 Defmitions Benchmark treatment 2.1 Recognition 2.2 Disclosure Allowed alternative treatment 3.1 Recognition 3.2 Borrowing costs eligible for capitalisation 3.3 Commencement of Capitalisation 3.4 Suspension of Capitalisation 3.5 Cessation of Capitalisation 3.6 Disclosure Consistency of treatment
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1002 1002 1002 1002 1003 1003 1003 1003 1003 1003 1004 1006 1007 1007 1007 1007
CONTENTS
SESSION 11 lAS 20 Accounting for government grants & disclosure of government assistance 1
2
3
4 5
Introduction 1.1 Scope 1.2 Defmitions Government grants 2.1 Criteria 2.2 Forgivable loans 2.3 Broad approaches to accounting treatment 2.4 lAS 20 treatment 2.5 Non-monetary government grants 2.6 Presentation of grants related to assets 2.7 Presentation of grants related to income 2.8 Repayment of government grants Government Assistance 3.1 Defmition 3.2 Excluded from government grants but are included as government assistance 3.3 Issue 3.3 Loans at nil or low interest rates Disclosure 4.1 Matters SIC - 10: Government assistance - No specific relation to operating activities
1102 1102 1102 1103 1103 1103 1103 1104 1104 1104 1105 1105 1105 1105 1106 1106 1106 1106 1106 1106
SESSION 12 lAS 17 Leases 1
2
3
4
Introduction 1.1 Traditional accounting for leases (pre lAS 17) 1.2 Problem 1.3 Overview 1.4 Scope 1.5 Defmitions Type of arrangement 2.1 Lease classification; 2 types 2.2 Risks and rewards of ownership 2.3 Indicators 2.4 Terms of the lease 2.5 Comment on classification 2.6 Land and buildings 2.7 SIC-27: Evaluating the Substance of Transactions Involving the Legal Form of a Lease Lessee accounting for a finance lease 3.1 Principles 3.2 Rentals in arrears 3.3 Rentals in advance 3.4 Disclosures - finance leases Lessee accounting for an operating lease 4.1 Lessee accounting for an operating lease 4.2 SIC-15: Operating Leases - Incentives 4.3 Disclosures
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1202 1202 1202 1202 1202 1203 1205 1205 1205 1205 1206 1206 1206 1207 1210 1210 1211 1213 1216 1218 1218 1218 1219
CONTENTS
5
6 7
8
Lessor accounting for a finance lease 5.1 Background 5.2 Recognition 5.3 Allocation of finance income 5.4 Disclosure in respect of fmance leases Lessor accounting for an operating lease Sale and leaseback transactions 7.1 Background 7.2 Sale and leaseback as finance lease 7.3 Sale and leaseback as an operating lease G4+1 discussion Paper on Leases
1220 1220 1220 1220 1220 1221 1222 1222 1222 1224 1226
SESSION 13
lAS 38 Intangible assets 1
2
3
4
5
6
7
Introduction to lAS 38 1.1 Scope 1.2 Defmitions 1.3 Defmition criteria Recognition and initial measurement 2.1 General criteria 2.2 Initial measurement - cost 2.3 Subsequent expenditure Internally generated intangible assets 3.1 Internally generated goodwill 3.2 Other internally generated assets 3.3 Specific recognition criteria for internally generated intangible assets 3.4 Recognition of expenses and costs Measurement after recognition 4.1 Cost model 4.2 Revaluation model 4.3 Active markets 4.4 Accounting entries on revaluation Usefullife 5.1 Factors 5.2 Finite useful lives 5.3 Indefinite useful lives Impairment and derecognition 6.1 Impairment losses 6.2 Retirements and disposals Disclosure 7.1 Intangible assets 7.2 Revaluations 7.3 Research and development expenditure
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CONTENTS
SESSION 14
lAS 40 Investment properties 1
2
3
4
1402 1402 1402 1402 1403 1403 1403 1403 1404 1404 1404 1406 1406 1406 1406 1407 1409
Introduction 1.1 Objective 1.2 Scope 1.3 Defmitions Recognition and measurement 2.1 Rule 2.2 Initial Measurement 2.3 Meaning of cost 2.4 Expenditure after initial recognition Measurement after recognition 3.1 Fair value model 3.2 Exceptional circumstances 3.3 The cost model 3.4 Transfers 3.5 Disposals 3.6 Change in method Disclosure
SESSION 15
lAS 41 Agriculture 1
2
3 4
Introduction 1.1 Objective 1.2 Scope 1.3 Defmitions 1.4 Commentary Recognition and measurement 2.1 Recognition 2.2 Measurement 2.3 Commentary 2.3 Gains and losses 2.4 If fair value cannot be determined Government grants Presentation and disclosure 4.1 Presentation 4.2 Disclosure
1502 1502 1502 1502 1503 1503 1503 1503 1504 1505 1505 1506 1507 1507 1507
SESSION 16
lAS 36 Impairment of assets 1
2
1602 1602 1602 1603 1603 1603 1603
Introduction 1.1 Objective of the standard 1.2 Defmitions Basic rules 2.1 All assets 2.2 Intangible assets 2.3 Indications of potential impairment loss
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CONTENTS
3
4
5
6
7
Measurement of recoverable amount 3.1 General principles 3.2 Fair value less costs to sell 3.3 Value in use Cash-generating units 4.1 Basic concept 4.2 Allocating shared assets Accounting for impairment loss 5.1 Basics 5.2 Allocation within a cash-generating unit Subsequent review 6.1 Basic provisions 6.2 Reversals of impairment losses Disclosure 7.1 For each class of assets 7.2 Segment reporting 7.3 Material impairment losses recognised or reversed
1607 1607 1608 1610 1613 1613 1615 1618 1618 1619 1621 1621 1622 1623 1623 1624 1624
SESSION 17
lAS 37 Provisions, contingent liabilities and contingent assets 1
2
3
4 5
6
7
8
Introduction 1.1 Objective 1.2 Scope 1.3 Defmitions 1.4 The relationship between provisions and contingent liabilities Recognition 2.1 Recognition of provisions 2.2 Recognition issues 2.3 Contingent assets and liabilities Measurement 3.1 General rules 3.2 Specific points Changes in provisions IFRIC 1 5.1 Scope 5.2 Issue 5.3 Consensus 5.4 Transition Application of the rules to specific circumstances 6.1 Future operating losses 6.2 Onerous contracts 6.3 Specific application - Restructuring Provisions for repairs and maintenance 7.1 Refurbishment Costs - No Legislative Requirement 7.2 Refurbishment Costs - Legislative Requirement Disclosures
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1702 1702 1702 1702 1704 1704 1704 1705 1708 1708 1708 1709 1709 1709 1709 1710 1710 1711 1712 1712 1712 1713 1715 1715 1716 1717
CONTENTS
SESSION 18
lAS 12 Income taxes 1
2 3
4
5
6
7
8
9
Introduction 1.1 Overview 1.2 Scope 1.3 Defmitions 1.4 Recognition of current tax liabilities and current tax assets 1.5 Accounting for withholding tax Deferred taxation - introduction 2.1 Underlying problem Deferred taxation - The concept illustrated 3.1 Scenario 3.2 Analysis - balance sheet approach 3.3 After the company has accounted for deferred tax the financial statements will be as follows Accounting for deferred taxation - basics 4.1 Introduction 4.2 Calculation of the balance sheet amounts 4.3 Jargon Accounting for deferred tax - detailed rules 5.1 Recognition of deferred tax liabilities 5.2 Recognition of deferred tax assets 5.3 Accounting for the movement on the deferred tax balance Complications 6.1 Rates 6.2 Change in rates 6.3 SIC 21 - Income Taxes - Recovery of Revalued Non-Depreciable Assets 6.4 SIC 25 - Income Taxes - Changes in the Tax Status of an Entity or its Shareholders Business Combinations 7.1 Introduction 7.2 Temporary differences arising on the calculation of goodwill 7.3 Temporary differences arising due to the carrying amount of the investment and the tax base 7.4 Inter company transactions Presentation and disclosure 8.1 Presentation 8.2 Disclosure Appendix
1802 1802 1802 1802 1803 1803 1804 1804 1805 1805 1806 1807 1808 1808 1808 1809 1813 1813 1815 1817 1818 1818 1819 1820 1821 1822 1822 1823 1824 1826 1827 1827 1827 1829
SESSION 19
lAS 32 and lAS 39 Financial instruments 1
2
Background 1.1 Traditional accounting 1.2 Financial instruments 1.3 History Application and scope 2.1 lAS 32 2.2 lAS 39
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CONTENTS
Definitions 3.1 From lAS 32 3.2 From lAS 39 4 Presentation (lAS 32) 4.1 Liabilities and equity 4.2 Settlement in own equity instruments 4.3 Offset 4.4 Interest, dividends, losses and gains 4.5 Compound instruments 4.6 Contingent settlement provisions 4.7 Treasury shares 5 Disclosure (lAS 32) 5.1 Rules 5.2 Illustrative notes - Nokia 5.3 ED7 Financial Instruments: Disclosures 6 Recognition (lAS 39) 6.1 Initial recognition 6.2 Examples 6.3 Embedded derivatives Derecognition 7 7.1 Derecognition of a fmancia1 asset 7.2 Derecognition of a fmancia1liability 8 Measurement (lAS 39) 8.1 Initial measurement of fmancia1 assets and fmancial1iabi1ities 8.2 Fair value considerations 8.3 Subsequent measurement of financia11iabilities 8.4 Subsequent measurement of financial assets 9 Hedging 9.1 lAS 39 defmitions 9.2 Hedging instruments 9.3 Hedged items 10 Hedge accounting 10.1 Background 10.2 Fair value hedges 10.3 Cash flow hedges 3
1905 1905 1906 1908 1908 1909 1910 1911 1911 1912 1913 1913 1913 1918 1922 1922 1922 1923 1923 1924 1924 1926 1926 1926 1927 1927 1927 1928 1928 1929 1929 1929 1929 1930 1932
SESSION 20 lAS 19 Employee benefits 1
2
3 4
Introduction 1.1 Key problem 1.2 Objective 1.3 Scope 1.4 Defmitions Short term employee benefits 2.1 Types 2.2 Accounting for short-term employee benefits Post retirement benefits Defined contribution schemes 4.1 Introduction 4.2 Accounting for defined contribution schemes 4.3 Recognition and Measurement 4.4 Disclosure
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2002 2002 2002 2002 2002 2004 2004 2004 2004 2005 2005 2005 2005 2005
CONTENTS
5
6
7 8
Accounting for defined benefit schemes 5.1 Introduction 5.2 Accounting for defined benefit schemes 5.3 Amendment to lAS 19 Sundry guidance 6.1 Actuarial Valuation Method 6.2 Discount Rate 6.3 Regularity Past Service Cost Disclosure
2006 2006 2007 2015 2016 2016 2016 2016 2017 2018
SESSION 21 IFRS 2 Share-based payments 1
2
3 4
5
Share-based payments 1.1 Need for a standard 1.2 Key issues 1.3 Objective of IFRS 2 1.4 Scope 1.5 Effective date Definitions 2.1 Share-based payment transaction arrangement 2.2 Types of transactions Recognition 3.1 On receipt or acquisition Measurement 4.1 Fair value 4.2 Equity-settled transactions 4.3 Granting of equity instruments 4.4 Indirect measurement 4.5 Valuation technique 4.6 Cash-settled transactions Disclosures 5.1 Purpose 5.2 Nature and extent of schemes in place 5.3 How fair value was determined 5.4 Effect of expenses arising
2102 2102 2102 2102 2103 2103 2103 2103 2104 2105 2105 2105 2105 2105 2106 2111 2111 2112 2112 2112 2112 2113 2114
SESSION 22 Regulatory framework 1
2
Introduction 1.1 Defmitions 1.2 Accounting for subsidiaries in separate financial statements 1.3 Truth and fairness Inclusions 2.1 Parent and control 2.2 SIC-12: Consolidation - Special Purpose Entities 2.3 Potential voting rights 2.4 Purchase method
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2202 2202 2202 2202 2203 2203 2204 2204 2206
CONTENTS
3
4
5
6
Sundry provisions ofIAS 27 3.1 Results of intra-group trading 3.2 Accounting year ends 3.3 Accounting policies 3.4 Date of acquisition or disposal Exemption from preparing group accounts 4.1 Rule 4.2 Rationale Disclosure 5.1 lAS 27 disclosures 5.2 IFRS 3 disclosures Transitional provisions 6.1 Previously recognised goodwill 6.2 Previously recognised negative goodwill 6.3 Previously recognised intangible assets
2206 2206 2206 2206 2207 2207 2207 2208 2208 2208 2209 2212 2212 2212 2212
SESSION 23 Group accounts - Revision of basics I
2 3 4 5
6
The issue 1.1 Background 1.2 Defmitions 1.3 Rule 1.4 Types of consolidation Conceptual background The technique - consolidated balance sheets Question approach 4.1 Specific steps Unrealised profit 5.1 Background 5.2 The group suffers the whole charge 5.3 The group shares the charge with the minority interest where appropriate. 5.4 Exception 5.5 Deferred tax Consolidated income statements 6.1 Control and ownership 6.2 Unrealised profits on trading 6.3 Non current asset transfers 6.4 Mid-year acquisitions
2302 2302 2302 2302 2302 2303 2303 2304 2304 2306 2306 2306 2306 2307 2309 2310 2310 2310 2310 2311
SESSION 24 lAS 22 Goodwill I
2 3
Goodwill 1.1 Purchase method 1.2 Defmition 1.3 Features of goodwill Fair value of purchase consideration Solution I Identifiable assets and liabilities 3.1 Introduction 3.2 Provisions 3.3 Contingent liabilities
© Accountancy Tuition Centre (International Holdings) Ltd 2005
2402 2402 2402 2402 2403 2404 2405 2405 2405 2405 (xxiv)
CONTENTS
4
5
6
7
Fair value of the identifiable assets and liabilities 4.1 General guidelines 4.2 Provisional accounting 4.3 Subsequent adjustments Accounting for the revaluation in the accounts of subsidiary entitys 5.1 Exam complication 5.2 How is the revaluation accounted for? Accounting for goodwill 6.1 Positive goodwill 6.2 Excess ofacquirer's interest over cost Discussion topics 7.1 Should an asset be recognised at all? 7.2 Impairment review vs amortisation
2406 2406 2407 2408 2410 2410 2410 2413 2413 2413 2414 2414 2416
SESSION 25 Group accounts - More complex groups 1 2
3
Types of structure Status of the investment 2.1 Status is always based on control 2.2 In the above illustration P effectively owns Technique 3.1 There are 2 possible approaches to consolidations involving sub subsidiaries. 3.2 Direct technique 3.3 Sub subsidiary 3.4 Sub associate 3.5 Timing of acquisitions 3.6 D shaped groups 3.7 Income statement consolidations
2502 2503 2503 2503 2503 2503 2504 2505 2507 2508 2508 2509
SESSION 26 Group accounts - Disposals 1 2 3 4
5
6
7
Introduction 1.1 Accounting issues Disposal possibilities Treatment in parent's own accounts Treatment in group accounts 4.1 Summary 4.2 Consolidated income statement - "pattern of ownership" 4.3 Consolidated income statement - Profit / loss on disposal Deemed disposals 5.1 Background 5.2 Accounting treatment - Income statement 5.3 Accounting treatment - Balance sheet Demergers 6.1 Accounting issues 6.2 Treatment by P Inc 6.3 Treatment by R Inc Summary
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2602 2602 2602 2603 2603 2603 2604 2605 2612 2612 2612 2613 2618 2618 2619 2619 2619
CONTENTS
SESSION 27 Group accounts - Piecemeal acquisition 1 2 3 4 5
2702 2702 2703 2703 2704 2707 2707 2707 2707
Piecemeal acquisitions 1.1 Introduction Trade investment becoming a subsidiary Trade investment becoming an associate Increase in stake in subsidiary Associate becoming a subsidiary 5.1 Introduction 5.2 Consolidated balance sheet 5.3 Consolidated income statement
SESSION 28 lAS 28 Investments in associates 1
2
3
4
Equity accounting 1.1 Background 1.2 Scope 1.3 Defmitions 1.4 Significant influence 1.5 Separate fmancia1 statements Accounting treatment 2.1 Relationship to a group 2.2 Basic rule 2.3 Equity accounting 2.4 Treatment in a consolidated balance sheet 2.5 Treatment in a consolidated income statement 2.6 Recognition of losses 2.7 Accounting policies and year ends 2.8 Impairment 2.9 Exemptions to equity accounting Inter-company items with an associate 3.1 Inter-company trading 3.2 Dividends 3.3 Unrea1isedprofit Disclosure 4.1 Investments in associates 4.2 Using the equity method
2802 2802 2802 2803 2803 2804 2804 2804 2804 2804 2805 2810 2812 2813 2813 2814 2815 2815 2815 2816 2817 2817 2817
SESSION 29 lAS 31 Interests in joint ventures 1 2
3
lAS 31 1.1 Scope Joint ventures 2.1 Defmitions 2.2 Forms ofjoint venture 2.3 Characteristics Jointly controlled operations 3.1 Description 3.2 Presentation and accounting
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CONTENTS
4
5
6
7
Jointly controlled assets 4.1 Description 4.2 Presentation and accounting Jointly controlled entities 5.1 Description 5.2 Presentation and accounting 5.3 Transactions between venturer and a joint venture 5.4 SIC-13: Jointly Controlled Entities - Non-Monetary Contributions by Venturers 5.5 Exemptions to proportionate consolidation and equity methods 5.6 Separate fmancial statements of a venturer 5.7 Reporting the interests of an investor 5.8 Ceasing to be a venturer in a joint venture Disclosure 6.1 Contingencies 6.2 Interests Consolidation methods - Summary
2908 2908 2908 2909 2909 2910 2913
2914 2915 2916 2916 2916 2916 2916 2917 2918
SESSION 30 lAS 21 The effects of changes in foreign exchange rates
1
2 3 4
5
6 7
8 9
Accounting issues 1.1 Introduction 1.2 Key issues 1.3 Scope 1.4 Defmitions Individual company stage 2.1 Accounting treatment - basic transactions Exceptions to the basic rules 3.1 Net investment in a foreign operation Consolidated financial statements 4.1 Nature of exchange difference 4.2 Identifying the functional currency Foreign operation - (closing rate method) 5.1 Presentation currency 5.2 Supplementary information 5.3 lAS 21 Foreign currency translation 5.4 Calculation of exchange difference 5.5 Goodwill Foreign associates Disposal of foreign operation Disclosure SIC - 7; Introduction of the Euro
3002 3002 3002 3002 3002 3003 3003 3006 3006 3007 3007 3008 3009 3009 3009 3009 3010 3011 3014 3014 3015 3015
SESSION 31 Changes in organizational structure
1
Corporate reconstruction 1.1 Background 1.2 Protection of the stakeholders 1.3 Questions 1.4 Appraisal of the scheme 1.5 Order in which interested parties are ranked on a winding up
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3102 3102 3102 3103 3106 3106
CONTENTS
2
3
Purchase of own shares 2.1 Legal background 2.2 Creditors buffer 2.3 Accounting rules Distributable profit 3.1 What is a distribution? 3.2 Meaning of realised 3.3 Revaluations can have a number of impacts on distributable profits.
3108 3108 3108 3109 3110 3110 3110 3111
SESSION 32 Share valuation I 2
3
Reasons Methods 2.1 Introduction 2.2 Asset based methods 2.3 Earnings based methods 2.4 Dividends based Regulatory environment (using the uk as an example) 3.1 City code on takeovers and mergers 3.2 Monopolies & Mergers Commission
3202 3202 3202 3202 3203 3203 3204 3204 3204
SESSION 33 Analysis and interpretation I 2
3
4 5
6
3302 3302 3302 3303 3304 3305 3305 3306 3306 3306 3306 3306 3306 3307 3308 3308 3309 3309 3310 3310 3310 3312 3312 3312 3312 3313
Accounting issues Users and user focus 2.1 Introduction 2.2 Investors 2.3 Employees 2.4 Lenders 2.5 Suppliers and other creditors 2.6 Customers 2.7 Government and their agencies 2.8 Public Interpretation of financial statements 3.1 Use of ratios 3.2 Limitations of ratios 3.3 Influences on ratios 3.4 Accounting policies 3.5 Business factors 3.6 Other indicators Accounting ratios Performance 5.1 Significance 5.2 Key ratios 5.3 Commentary Short term liquidity 6.1 Significance 6.2 Key ratios 6.3 Commentary
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CONTENTS
7
8
9
10 11
12
13
Long term solvency 7.1 Significance 7.2 Key ratios 7.3 Commentary Efficiency 8.1 Significance 8.2 Key ratios 8.3 Commentary Investors' ratios 9.1 Significance 9.2 Key ratios 9.3 Commentary Creative accounting 10.1 Introduction Corporate failure prediction models 11.1 Altman 11.2 Argenti 11.3 Problems associated with using the models Trend analysis 12.1 Introduction 12.2 Specific cost and price indices 12.3 General price indices Interpretation technique
3314 3314 3314 3315 3317 3317 3317 3318 3319 3319 3319 3320 3321 3321 3322 3322 3323 3323 3324 3324 3324 3324 3325
SESSION 34 lAS 7 Cash flow statements 1
2 3
4
5 6
7
Scope 1.1 Applies to all entities 1.2 Importance of cash flow 1.3 Benefits of cash flow information 1.4 Defmitions Presentation of a Cash Flow Statement 2.1 Classification Reporting Cash Flows from Operating Activities 3.1 Direct method 3.2 Indirect method 3.3 Techniques Reporting Cash Flows from Investing and Financing Activities 4.1 Separate reporting 4.2 Investing activities 4.3 Financing Components of Cash and Cash Equivalents 5.1 Reconciliation Proforma 6.1 Direct method 6.2 Indirect method 6.3 Notes to the cash flow statement Group cash flow statements 7.1 Introduction 7.2 Minority interests 7.3 Associated undertakings 7.4 Acquisition and disposal of subsidiaries
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3402 3402 3402 3402 3402 3403 3403 3404 3404 3404 3404 3405 3405 3405 3407 3407 3407 3408 3408 3409 3409 3410 3410 3410 3411 3413
CONTENTS
8
9
Additional disclosures 8.1 Analysis of cash and cash equivalents 8.2 Major non cash transactions 8.3 Cash and cash equivalents not held by the group 8.4 Reporting futures, options and swaps 8.5 Voluntary disclosures Further considerations - interpretation of cash flow statements 9.1 Introduction 9.2 Illustration 9.3 Comments
3417 3417 3417 3418 3418 3418 3419 3419 3420 3421
SESSION 35 The effects of changing prices 1
2
3
4
6
Introduction 1.1 Limitation of historical cost accounting 1.2 Holding gains 1.3 Conclusions 1.4 Effects oflower inflation Design of systems of accounts 2.1 Purpose 2.2 Defmition 2.3 3 decisions 2.4 Combinations 2.5 Double entries Current purchasing power 3.1 Background 3.2 Specific adjustments Current cost accounts - ocm version 4.1 Background 4.2 Specific adjustments lAS 29 - Financial Reporting in Hyperinflationary Economies 6.1 The problem 6.2 Solution 6.3 Historical Cost Financial Statements - balance sheets 6.4 Historical Cost Financial Statements - Income Statement 6.5 Gain or Loss on Net Monetary Position 6.6 Current Cost Financial Statements 6.7 Taxes 6.8 Cash Flow Statement 6.9 Corresponding Figures 6.10 Consolidated Financial Statements 6.11 Economies Ceasing to be Hyperinflationary 6.12 Disclosures
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3502 3502 3502 3503 3503 3504 3504 3504 3504 3506 3507 3508 3508 3508 3509 3509 3509 3511 3511 3511 3511 3512 3512 3512 3513 3513 3513 3513 3513 3513
CONTENTS
SESSION 36 lAS 33 Earning per share I
2 3 4
5 6
7
8
Introduction 1.1 Earnings performance 1.2 Scope 1.3 Defmitions Basic earnings per share (EPS) Basic EARNINGS 3.1 Which earnings? Basic weighted average number of ordinary shares 4.1 Partly paid shares 4.2 Issues for consideration 4.3 Issues of shares where no consideration is received Multiple capital changes Diluted eps 6.1 Purpose 6.2 Method 6.3 Options Order of dilution 7.1 Background 7.2 Method 7.3 Contracts that may be settled in sharesChyba! Zalozka neni definovana, Disclosure
3602 3602 3602 3602 3603 3603 3603 3603 3603 3604 3604 3608 3609 3609 3609 3613 3615 3615 3615 3617 3617
SESSION 37 lAS 14 Segment reporting I
2
3
Introduction 1.1 Purpose 1.2 Scope 1.3 Defmitions Reporting 2.1 Primary versus secondary 2.2 Business segments 2.3 Geographical segments 2.4 Usual basis 2.5 Reportable segments 2.6 Disclosures 2.7 Analysis of revenue 2.8 Analysis of assets 2.9 Sundry disclosures Illustration
© Accountancy Tuition Centre (International Holdings) Ltd 2005
3702 3702 3702 3702 3705 3705 3705 3705 3706 3706 3707 3707 3707 3707 3708
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CONTENTS
SESSION 38 IFRS 5 Non-current assets held for sale and discontinued operations 1 2
3
4
Introduction 1.1 Reasons for issuing IFRS 5 Definitions 2.1 Component of an entity 2.2 Disposal group 2.3 Discontinued operation Held for sale classification 3.1 Defmitions 3.2 Held for sale non-current assets 3.3 Abandoned non-current assets 3.4 ~easurement 3.5 Changes to a plan of sale Presentation and disclosure 4.1 Purpose 4.2 Discontinued operations 4.3 Continuing operations 4.4 Held for sale non-current assets
3802 3802 3802 3802 3802 3803 3804 3804 3804 3806 3806 3807 3807 3807 3807 3808 3809
SESSION 39 lAS 10 Events after the balance sheet date 1
2
3
Introduction 1.1 Objective 1.2 Scope 1.3 Defmitions Recognition and Measurement 2.1 Adjusting events 2.2 Non adjusting events 2.3 Dividends 2.4 Going Concern Disclosure
3902 3902 3902 3902 3902 3902 3903 3903 3903 3904
SESSION 40
lAS 24 Related parties 1
2
3
Introduction 1.1 Scope 1.2 Defmitions 1.3 Parties deemed not to be related The Related Party Issue 2.1 Affect on reporting enterprise 2.2 Methods for pricing related party transactions Disclosure 3.1 Situations where related party transactions may lead to disclosures 3.2 Disclosure required 3.3 Aggregation
© Accountancy Tuition Centre (International Holdings) Ltd 2005
(xxxii)
4002 4002 4002 4003 4003 4003 4004 4004 4004 4004 4007
CONTENTS
SESSION 41 lAS 34 Interim fmancial reporting 1 2
3
Scope Content of an interim Financial Report 2.1 Minimum Components 2.2 Condensed Balance Sheet 2.3 Condensed Income Statement 2.4 Condensed Cash Flow Statement 2.5 Changes in Equity 2.6 Selected Note Disclosures Recognition and Measurement 3.1 General comment 3.2 Tax charge 3.3 Use of Estimates
4102 4102 4102 4102 4102 4102 4103 4103 4104 4104 4104 4104
SESSION 42 Corporate reporting issues 1
2
3
Operating and financial review (OFR) 1.1 Background 1.2 OFR in the UK Corporate governance 2.1 Defmition 2.2 Corporate governance in other countries 2.3 Cadbury Report 2.4 Hampel Report 2.5 The way ahead Sarbanes - oxley 3.1 Background 3.2 Main requirements
4202 4202 4202 4204 4204 4204 4204 4205 4206 4207 4207 4207
SESSION 43 IFRS 1 First-time adoption of International Financial Reporting Standards 1
Introduction 1.1 Background 1.2 Objective 1.3 Scope 1.4 Defmitions 1.5 Stages in transition to IFRSs 1.6 Transition overview
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CONTENTS
2
3
4
Opening IFRS balance sheet 2.1 Recognition and measurement principles 2.2 Exemptions from other IFRSs 2.3 Property, plant and equipment 2.4 Business combinations 2.5 Employee benefits 2.6 Cumulative translation differences 2.7 Compound fmancial instruments 2.8 Assets and liabilities of subsidiaries 2.9 Designation of previously recognised fmancial instruments 2.10 Share-based payment transactions 2.11 Insurance contracts 2.12 Decommissioning liabilities 2.13 Mandatory exceptions to retrospective application Presentation and disclosure 3.1 Explanation of transition 3.2 Reconciliations 3.3 Other disclosures Practical matters 4.1 Overview 4.2 Making the transition
INDEX
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4306 4306 4306 4307 4307 4310 4311 4311 4311 4311 4312 4312 4313 4315 4316 4316 4316 4316 4320 4320 4321
GAAP AND THE IASB
OVERVIEW Objectives
•
To describe the concept ofGAAP.
•
To describe the objectives ofthe International Accounting Standards Board (IASB) and its relationship with other bodies and the development, scope and use of International Accounting Standards (lASs).
GAAP L...------r--------'
INTERNATIONAL FEDERATION OF ACCOUNTANTS
• • •
What is GAAP? Sources ofGAAP Role ofstatute and standards
• • • •
What is it? Membership Technical committees Accounting v auditing
• • L...------r--------' •
THEIASB
INTERNATIONAL FINANCIAL REPORTING STANDARDS
BIG GAAP VS LITTLEGAAP DEBATE • • • •
• • • •
The debate Difficulties Arguments for Arguments against
• •
Background Approach Changes SICs in issue
© Accountancy Tuition Centre (International Holdings) Ltd 2005
RELATIONSHIP OFIASCWITH OTHER BODIES
Importance Development Interpretation Benchmark and allowed alternative treatments Scope and application Authority
INTERNATIONAL FINANCIAL REPORTING INTERPRETATIONS COMMITEE • • • •
What is it? Objectives Structure
0I0 I
• •
Intergovernmental bodies National standard setting bodies
G4+ I GROUP
GAAP AND THE IASB
1
GAAP
1.1
What is GAAP?
•
GAAP (Generally Accepted Accounting Principles) is a term used to describe how financial statements are prepared in a given environment.
•
GAAP is a general term.
o
UK GAAP, US GAAP, lAS GAAP are more specific statements.
•
The term mayor may not have legal authority in a given country.
•
It is a dynamic concept. It changes with time in accordance with changes in the business environment.
1.2
Sources of GAAP
•
Regulatory Framework The body of rules and regulations, from whatever source, which an entity must follow when preparing accounts in a particular country for a particular purpose. eg:
o
Statute
o
Accounting standards - Statements issued by professional accounting bodies which lay down rules on accounting for different issues. e.g.: International Accounting Standards/lnternational Financial Reporting Standards Financial Reporting Standards (U.K.) Financial Accounting Standards (U.S.A.).
•
Other sources
o
lASs - In countries where these have not been adopted they have an influence on local standards because the provisions of the lAS will be considered by the local standard setting body
o
Best practice - Methods of accounting developed by companies (industry groups) in the absence of rules in a specific area.(e.g. oil exploration costs).
1.3
Role of statute and standards
•
Varies from country to country
o
Some countries have a very legalistic approach to drafting financial statements. The legal rules are detailed and specific and the system is often geared to the production of a profit figure for taxation purposes.
o
Some countries adopt an approach where statute provides a framework of regulation and standards then fill in the blanks. e.g. in the UK. Statute Companies Acts 1985 and 1989 Standards SSAPs and FRSs
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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GAAP AND THE IASB
Note: The legislation ofEU member states is based on EU directives
o
Some countries have little in the way of statute and rely largely on standards e.g. the USA
Note: Although there is no accounting statute as such in the USA there is a body of the federal government called the Securities and Exchange Commission (SEC) which oversees the accounting regulations issued by the profession. The SEC can veto accounting treatments and demand regulation to be enacted in new areas. Companies in the USA probably face the most highly regulated environment in the world. 2
INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)
2.1
What is it?
•
IFAC is a non-profit, non-governmental, non-political organisation of accountancy bodies that represents the worldwide accountancy profession.
•
Its' mission is to develop and enhance the profession to provide services of consistently high quality in the public interest.
2.2
Membership
•
Accountancy bodies recognised by law or consensus within their countries.
•
Membership in IFAC automatically includes membership in the International Accounting Standards Board (IASB).
2.3
Technical committees
•
International Auditing Practices Committee (IAPC) - issues International Standards on Auditing (ISAs).
•
Forum on Ethics - publishes a Code of Ethics for Professional Accountants.
•
Others
o
Education
o
Financial and Management Accounting
o
Public Sector
o
Information Technology
o
Membership.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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GAAP AND THE IASB
2.4
Accounting v auditing Accounting
• •
Auditing
•
The classification and recording of actual transactions in monetary terms. The presentation and interpretation of the results of transactions.
Objective is to express an opinion whether the financial statements are prepared, in all material respects, in accordance with a financial reporting framework.
3
THEIASB
3.1
What is it?
•
The IASB was called the International Accounting Standards Committee (lASe) until April 2001.
•
The IASC was an independent private sector body and was set up in 1973. It is the sole body having responsibility and authority to issue pronouncements on international accounting standards.
•
It has a very wide membership. As at March 2001 it had 153 member associations from 112 countries representing over 2,000,000 accountants.
3.2
Objectives
•
To develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other fmancial reporting to help participants in the worlds capital markets and other users make economic decisions
•
To promote the use and rigorous application of those standards, and
•
To bring about convergence of national accounting standards and lASs to provide high quality solutions.
3.3
Structure
3.3.1
lJvervie1V TRUSTEES
I STANDARDS ADVISORY COUNCIL
© Accountancy Tuition Centre (International Holdings) Ltd 2005
I I
BOARD
0104
I INTERNATIONAL FINANCIAL REPORTING INTERPRETATIONS COMMITTEE
GAAP AND THE IASB
3.3.2
Trustees
•
19 individuals from diverse geographical and functional backgrounds.
•
The trustees will:
o
appoint the members of the: Board Standing advisory council Standing interpretations committee
o
monitor the IASB's effectiveness
o
secure funding
o
approve the IASB's budgets
o
have responsibility for constitutional change.
3.3.3
Board
•
14 members appointed by the trustees.
•
The board has complete responsibilities for all technical matters including:
o
preparation and issue ofIASs
o
preparation and issue of exposure drafts
o
setting up procedures for reviewing comments received on documents published for comment
o
issue bases for conclusions.
3.3.4
Standards advisory council
•
About 45 members all appointed by the trustees.
•
The council provides a forum for participation by organisations and individuals with an interest in international financial reporting.
•
Will meet at least 3 times a year.
•
The council will
o
advise the board on agenda decisions and priorities
o
pass on views of the council members on the major standard setting projects
o
give other advice to the trustees and the board.
3.3.5
International Financial Reporting Interpretations Committee
•
Covered in a later section - see paragraph 6.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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GAAP AND THE IASB
4
INTERNATIONAL FINANCIAL REPORTING STANDARDS (lFRSs)
4.1
Importance
•
Ultimately, IASs will form the basis of international financial reporting.
•
The IASC concentrated on essentials. It endeavoured not to make lASs so complex that they cannot be applied effectively on a worldwide basis.
4.2
Development of lASs Draft statement of principles or discussion document L-
----,-
• --'.
--------.-----_1: Exposure draft
International Accounting Standard
•
Only for major projects Issued by a simple majority of the board Published for all standards Issued on approval by 8 out of 14 board members Issued on approval by 8 out of 14 board members
•
Since the IASB took over the role of the IASC in 2001, all new standards are issued as International Financial Reporting Standards (lFRSs). Standards issued by the IASC were International Accounting Standards (lASs). Both terms are acceptable to mean accounting standards in general.
4.3
Interpretation of lASs
•
Steps taken by the IASC to achieve consistent interpretation include
o
comparability and improvements project - resulted in the revision of 13 IASs. "Alternative accounting treatments" (see below) were reduced or eliminated and disclosure requirements reviewed in the context of the Framework -see later session 3
o
publication of draft statement of principles - to make IASB intentions clear
o
issue of a newsletter "Insight" - provides regular updates and explains technical decisions
o
issue of interpretations by the Standing Interpretations Committee (SIC), renamed International Financial Reporting Interpretations Committee (lFRlC).
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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GAAP AND THE IASB
4.4
Benchmark and allowed alternative treatments
•
Where IASs permit two accounting treatments for like transactions and events
o
one is often designated the benchmark treatment
o
the other is the allowed alternative treatment.
•
The advantage of allowing two treatments (in cases where there is an allowed alternative) is that it increases the acceptability of the standard.
•
The disadvantage is that it reduces the comparability of fmancial statements.
•
Dilly IAS 23 Borrowing Costs now has a benchmark and allowed alternative treatment, all other standards have been revised to eliminate the benchmark and allowed alternative.
•
However, some standards still have options available, ie IAS 16 Property, Plant and Equipment allows assets to be valued either using a cost or revaluation model.
4.5
Scope and application
•
lASs apply to the published financial statements of any commercial, industrial or business reporting entity (whether public or private sector).
•
lASs apply to both separate and consolidated financial statements.
•
Any limitation on the applicability of specific IASs is made clear in the lAS.
•
lASs are not intended to apply to immaterial items.
•
An IAS applies from a date specified in the standard and is not retroactive unless indicated to the contrary. (Note: this is often the case!)
Exclusions •
Non-business aspects of public sector entities.
•
Private sector not-for-profit (NFP) entities.
4.6
Authority
•
lASs do not override local regulations governing the issue of financial statements in a particular country.
•
Neither the IASB nor the accountancy profession has the power to enforce international agreement or to require compliance.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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GAAP AND THE IASB
5
THE BIG GAAPILITTLE GAAP DEBATE
5.1
The debate
•
There has been a consensus for a long time that reporting requirements are biased towards larger companies, and ignore the needs of small companies.
•
Compliance places a burden on small companies. This burden includes:
o
the cost of considering whether a particular standard is applicable to the entity,
o
the cost of assembling the information,
o
the cost of auditing the information, and
o
the loss of commercial advantage arising from increased disclosure.
•
The issue of the application of accounting standards to small companies has been the subject of numerous studies in the UK and around the world. The debate has revolved around whether accounting standards should apply equally to all financial statements that purport to present a true and fair view, or whether small companies should be exempted from the need to comply with certain standards.
5.2
Difficulties
•
Difficulties include:
•
•
o
the choice of a method of determining which companies should be allowed exemption from the general GAAP, and
o
the choice of which accounting rules such companies should be exempt from.
In considering how to distinguish between categories of companies a number of factors could be used including:
o
the extent to which there is public interest in an entity,
o
its complexity, the separation of ownership and control, and
o
its size. (It has been recognised that while size is not the most important factor, it is the easiest to apply).
The Accounting Standards Board in the UK has introduced a modified GAAP for certain companies based on size. They have chosen size as the easiest to apply. This has met with an amount of criticism, most commentators feeling that the separation of ownership would be a more useful criterion.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0108
GAAP AND THE IASB
5.3
Arguments for
•
The purpose of a set of accounts is to communicate with these users. However, for a simple concern, some of the complex rules that are in force today may serve to hinder communication and not aid it.
•
The complex calculations, the quantity of disclosure and the technical terminology called for by accounting standards may serve to make the accounts of small companies incomprehensible to their users.
•
The owners of public companies are not generally involved in managing the business. For this reason, a relationship of accountability exists between owners and managers. This is not the case for owner managed entity's.
•
In short standards fail to take adequate account of the needs of the users.
o
The users of public companies' financial statements include: existing and potential shareholders, loan creditors, fmancial analysts and advisers, the financial press, employees.
o
The users of small companies' fmancial statements include: owner-managers, bankers, and tax authorities.
•
The recent developments in international standard setting have been driven by the desire to achieve endorsement by IOSCO. The requirements of the newer standards are not necessarily appropriate to smaller entities.
5.4
Arguments against
•
Empirical research has not found that small companies find complying with accounting standards a matter for concern.
•
Small entities normally have very few major accounting issues that need to be addressed, simply because of their size. In practice, this means that many of the lASs have negligible impact on the small company.
•
For companies already in existence, accounts formats with full disclosure will already be in place.
•
In 2004 the IASB issued a discussion paper entitled Preliminary Views on Accounting Standards for Small and Medium-sized Entities. The aim of the paper was to gather views of interested parties on whether there should be some form of reduced GAAP and if so what form should it take. It is expected that an IASB working party will be looking into this issue during 2005/2006.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0109
GAAP AND THE IASB
6
INTERNATIONAL FINANCIAL REPORTING INTERPRETATIONS COMMITTEE (SIC).
6.1
Background
•
This committee was reconstituted in December 2001 to take over the role of the Standing Interpretations Committee (SIC). The SIC was founded in April 1997 with the objective of developing conceptually sound and practicable interpretations of lASs to be applied on a global basis where the standards are silent or unclear.
•
It is made up of a team of accounting experts from 13 countries appointed by the IASC.
6.2
Approach
•
The SIC uses the approach described in lAS 8 i.e.:
o
making analogies with the requirements and guidance in International Accounting Standards dealing with similar and related issues,
o
applying the defmitions, recognition and measurement criteria for assets, liabilities, income and expenses set out in the IASC Framework, and
o
taking into consideration the pronouncements of other standard setting bodies and accepted industry practices to the extent, but only to the extent, that these are consistent with international GAAP.
•
The interpretations were originally issued as SIC 1, SIC 2 etc
•
After approval by the board the interpretations become part of the IASC's authoritative literature. The pronouncements have the same status as an lAS.
6.3
Changes
•
The IASB has renamed this committee and the interpretations that they produce. The committee is now known as the International Financial Reporting Interpretations Committee (IFRIC) and they will now be issuing IFRIC's. All SIC's currently in existence will still be known as SIC's but any new interpretation will be known as IFRIC 1, IFRIC 2 etc.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0110
GAAP AND THE IASB
6.4
SICslIFRICs in issue (as examinable documents)
•
The following interpretations are in issue as at November 2004
SIC
(Relating to)
SIC-7
IAS21
SIC -10
IAS20
SIC -12
IFRS 3 &lAS 27
SIC -13
IAS 31
SIC - 15
IAS 17
SIC -21
IAS 12
SIC -25
IAS 12
SIC -27
IAS 17
SIC -29
IAS 1
SIC - 31
IAS 18
SIC - 32 IFRlC-l
IAS 38 IAS 37
Title
Introduction of the Euro Government assistance - No specific relation to operating activities Consolidation - Special purpose entities Jointly controlled entities - Non-monetary contributions by venturers Operating leases - incentives Income taxes - Recovery of revalued non depreciable assets Income taxes - Changes in the tax: status of an entity or its shareholders Evaluating the Substance of Transactions in the Legal Form ofa lease Disclosure - Service Concession Arrangements Revenue - Barter Transactions Involving Advertising Services Intangible Assets - Website Costs Changes in Existing Decommissioning, Restoration and Similar Liabilities
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0111
Examinable and contained in session 30 11
23 29 12 18 18 12 5 7 13 17
GAAP AND THE IASB
7
RELATIONSIDP OF rxsc WITH OTHER BODIES
7.1
Intergovernmental bodies
•
Those concerned with improvement and harmonisation of financial statements include:
o
the European Commission,
o
the Working Group on Accounting Standards of the Organisation for Economic Co-operation and Development (OECD working group),
o
the United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (UN ISAR group).
7.2
National standard setting bodies (NSSBs)
•
The European Commission and the United States Financial Accounting Standards Board (FASB).
o
participate in IASC consultative groups, and
o
attend board meetings.
•
IASC, FASB and the Federation des Experts Compatables Europeens (FEE) organise an international conference of standard setting bodies.
•
Representatives ofNSSBs are invited to discuss EDs and develop papers.
•
IASC representatives have visited more than 45 NSSBs to discuss matters of common interest.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0112
GAAP AND THE IASB
8
G4+1GROUP
•
This is a group of standard setters made up of the standard setting bodies from Australia, Canada, New Zealand, UK and USA with observers from the lASC. The objective of the group was to promote International harmonisation by the identification and discussion of major issues in international reporting. Together the six standard setting bodies have significant influence on international accounting.
•
The members share the following objectives:
•
•
o
To provide quality accounting standards for the primary purpose of providing information useful to capital market participants,
o
To seek common solutions to financial reporting issues, and
o
To seek a common conceptual framework.
The members further their common objectives by:
o
Analysis and discussion of fmancial reporting issues,
o
Exchanging ideas and approaches, and
o
Pursuing projects that have the potential to align financial reporting standards across member jurisdictions.
They have released discussion papers on the following areas (amongst others);
o
Business combinations (See session 29)
Recommends doing away with pooling ofinterests
o
Leasing (See session 12)
Recommends the capitalisation ofall non cancellable leases
o
Reporting financial performance (See session 5)
Recommends the replacing income statement and the statement of changes in equity with a "A statement ofcomprehensive income".
o
Joint ventures and similar arrangements (See session 28)
Recommends the use ofequity accounting (not proportionate consolidation) for reporting interests in joint ventures.
o
Share based payments (see session 21)
Proposes rules for the recognition and measurement oftransactions paid for by the issue ofshares •
The role of this body has now been taken over by the lASB, as have the consultation papers that were issued by G4+ 1.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0113
GAAP AND THE IASB
FOCUS
You should now be able to: •
discuss the nature of the changing role of the IASB;
•
describe the applicability of lAS's, IFRS's for small companies;
•
discuss the solutions to differential financial reporting both nationally and internationally.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0114
INTERNATIONAL ISSUES
OVERVIEW Objectives •
To discuss the advantages and disadvantages of harmonisation.
•
To explain the reconciliation of profits obtained under different GAAPs.
INTERNATIONAL HARMONISATION
ADVANTAGES OF HARMONISATION
• • •
Introduction Environmentalfactors General comment
• • • •
Multinational enterprises (MNEs) Multinationalaccountingjlrms Investors Others
• • • •
lASE The IOSeO project Growth ofimportance oflASs Problems associated with the further adoption oflASs
• •
European Union directives Others
BARRIERS TO HARMONISATION
PROGRESS ON HARMONISATION
THE ROLE OF OTHER ORGANISATIONS IN HARMONISATION
lAS vs. NATIONAL ALTERNATIVES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0201
INTERNATIONAL ISSUES
1
INTERNATIONAL HARMONISATION
1.1
Introduction
•
There has been a strong tendency to globalisation in recent years resulting in the formation of increased numbers of larger multinational companies.
•
Operating divisions of such companies are subject to different reporting rules in each country.
1.2
Environmental factors
•
The form of financial statements is influenced by the environment in the jurisdiction.
•
Environmental factors which influence accounting (and auditing) practices include:
o
Economic development,
o
Language,
o
Global perspective,
o
Interdependence on other economies,
o
Global capital markets,
o
Growth in multinational enterprises,
o
Government involvement,
o
Needs of users and preparers of financial statements,
o
Importance of the accounting profession,
o
Local orientation of accounting practice and profusion of accounting standards,
o
Inflation,
o
Culture,
o
Legal and political system,
o
Education system and academic influence,
o
Historical events, and
o
Foreign investment in the country.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0202
INTERNATIONAL ISSUES
•
In particular the needs of users are an important influence on the accounting rules in each jurisdiction.
Jurisdiction
Comment
USA and UK
Information is produced for owners and potential owners with the stock market having an important influence.
Germany
There is often heavy institutional investment reducing the need for information to individual shareholders as the institutions may have board representation.
France
Financial statements are used for macro economic purposes with the government determining the information that it needs to be included in the accounts.
Italy
The large number of family businesses reduces the need for published information.
South American countries
The accounts are often used for tax purposes.
1.3
General comment
•
Harmonisation of accounting would result in all companies anywhere in the world reporting:
o
Position;
o
Performance;
o
Changes in financial position;
in the same way. •
This would lead to greater market efficiency through the quality of the information and should make raising fmance cheaper and easier.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0203
INTERNATIONAL ISSUES
2
ADVANTAGES OF HARMONISATION
2.1
Multinational enterprises (MNEs)
•
Harmonisation would benefit the multinationals as follows:
o
Leads to improved management control.
o
Leads to improved access to funds. (The provider of capital would find it easier to appraise the companies/divisions).
o
The multinational itself would find it easier to appraise investments.
o
The preparation of group accounts would be easier.
o
Accounting expertise within the multinational would become transferable between countries.
o
Cost of complying with a single framework would be cheaper than a large number of local regulatory frameworks.
o
Similarly, the costs of monitoring such compliance would be reduced.
Note that multinational enterprises are a drivingforce in the move towards international harmonisation.
2.2
Multinational accounting firms
•
The fact that the firm taken, as a whole would provide services in a standardised environment should lead to improved quality control.
•
It would be easier to train staff to deal with multinational accounting issues.
•
Harmonisation should lead to reduced costs of:
o
training
o
compliance
o
transferring expertise
Note that the "big 4" accountingfirms have an important role to play in the move towards international harmonisation because oftheir influence in accounting matters in individualjurisdictions.
2.3
Investors
•
Investor confidence should increase with the ability to compare and understand the investment opportunities presented by multinationals.
•
Improved confidence should lead to a reduction in cost of capital.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0204
INTERNATIONAL ISSUES
2.4
Others
•
Harmonisation would make it easier for developing countries and emerging free market economies to adopt acceptable systems of fmancial reporting.
•
Harmonisation reduces market friction and will therefore enhance cross border trade.
3
BARRIERS TO HARMONISATION
•
Language is a significant barrier. Harmonisation requires adoption of a universally accepted business language.
English is the international language ofbusiness due to the importance ofthe US economy but even for native speakers there is the possibility ofconfusion. For example, the term "stock" has a different use in the UK and Australia than it does in the USA. •
Countries with strong accounting traditions and professions may feel that the standards that they have developed are more appropriate.
•
Different governments lay different emphasis on accounts.
•
o
In some countries the accounts are primarily used as the basis of tax computations whilst,
o
In others they report performance to other parties.
Different countries traditionally draft standards to serve different uses.
o
UK
owners
o
Russia
taxation
o
Germany-
creditors
Often companies prepare sets offinancial statements in different GAAP for different purposes •
True harmonisation would require the existence of a strong accounting profession in each country together with a government with the will to adopt a standardised system. These factors are not always prevalent.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0205
INTERNATIONAL ISSUES
4
PROGRESS ON HARMONISATION
4.1
IASB
•
It has a very wide membership. As at March 2001 it had 153 member associations from 112 countries representing over 2,000,000 accountants.
•
The objectives of the IASB are:
o
To develop, in the public interest, a single set of high quality, understandable and enforceable global standards that require high quality, transparent and comparable information in fmancial statements and other financial reporting to help participants in the worlds capital markets and users make economic decisions,
o
To promote the use and rigorous application of those standards, and
o
To bring about convergence of national accounting standards and IASs to high quality solutions.
4.2
The IOSCO project
•
IOSCO is the international organisation of stock exchange regulators. In 1995 the IASC agreed to produce a set of core standards covering all of the main and general issues in accounting. The 2 bodies have liased in determining the IASC's programme for revising standards.
•
The aim was that on completion of these core standards IOSCO would endorse them as satisfactory for use in the preparation of financial statements that could be used in world wide cross border listings.
•
This endorsement was given in May 2000.
•
Approval for use in individual stock exchanges is not automatic following endorsement. This will only happen when individual regulatory authorities take action at a national level. However the endorsement is seen as a major step towards international harmonisation.
•
The US body, the SEC, is represented on IOSCO and has backed the IASC's efforts. The support of the SEC was essential as endorsement could only proceed with a unanimous approval by a working party set up for the purpose. The support of the SEC is also widely seen as crucial to the future success ofIASs. Companies need and want access to US capital markets.
•
Endorsement was given as IOSCO were satisfied that:
o
The core standards constitute a comprehensive generally accepted basis of accounting,
o
The standards are of high quality resulting in: comparability, transparency, and full disclosure.
o
The standards can be rigorously interpreted and applied.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0206
INTERNATIONAL ISSUES
4.3
Growth of importance of lASs
In recent years; •
Many countries have based their standards closely or exactly on IAS (e.g. Singapore, Nigeria, and Kenya).
•
They are being widely adopted by emerging economies.
•
More and more large multinational companies are adopting them to satisfy investor needs in the various markets from which they raise finance (e.g. Adidas, Deutsche Bank).
•
The European Commission has recently stated that the majority of standards are compatible with European directives.
•
The governments of France and Germany are drafting legislation to enable their multinationals to adopt IASs in their group accounts.
•
Many stock exchanges already accept IAS based accounts (e.g. London, Frankfurt, and Hong Kong).
•
Australia has adopted a policy of ensuring that its accounting standards are harmonised with IASs. Compliance with Australian standards automatically ensures compliance with lASs.
The adoption oflAS is still in its infancy but these will become more and more important in future years (sooner rather than later).
4.4
Problems associated with the further adoption of lASs
•
Companies must apply all IASs before they can describe their accounts as compliant. In some countries it is felt this will cause the loss of necessary flexibility.
•
Choices allowed in the IASs may lead to lack of comparability.
•
Different interpretation of the same rule may result in like items being accounted for in different ways.
•
Entity's may feel that the disclosures will result in the loss of competitive advantage.
•
Enforcement of the standards is a big problem. The IASC have no power to ensure compliance. This will be up to the local regulatory authorities and the "big 4 " have an important part to play in this respect.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0207
INTERNATIONAL ISSUES
5
THE ROLE OF OTHER ORGANISATIONS IN HARMONISATION
5.1
European Union directives
•
The ED guides legislation of member states through the issue of directives.
•
Examples: Directive
Area covered
4th directive
Form and content of financial statements
7th directive
Group accounts
8th directive
Regulation of auditors
•
The adoption of these directives by member states has resulted in the ED moving towards harmonisation.
•
There are two further barriers to harmonisation within the ED. Problem
Progress
Lack of a single currency
The ED has introduced the Euro
Different countries still use different standards
The ED has recently said that all entity's quoted on a stock exchange in the community must comply with lAS by 2005.
•
As stated above, all ED listed companies must adopt lASs by 2005. This means entity's with a 31 December year end must prepare and lAS opening balance sheet as at 1 January 2004. Problems associated with first time adoption of lASs are dealt with in session 44.
•
In July 2003 the UK has stated that any non-listed UK company may choose to prepare their accounts in accordance with lAS's.
•
Emergent economies in Eastern Europe are incorporating the ED directives into their accounting acts (to further their ambitions to join the ED) and often adopt lASs.
5.2
Others
•
Other important international bodies have committees which advise on accounting matters e.g.
o
UN
o
OEeD
o
WTO
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0208
INTERNATIONAL ISSUES
6
lAS VS NATIONAL ALTERNATIVES IAS
CONTENTS BS P&L/Income statement Note on accounting policies Segment reporting Cash Flow statement
GERMANY
FRANCE
USA
UK
JAPAN
KOREA
1 ~
J
------------------------------------------ ALL -----------------------------------y
y
y
y
y
y
Y
Optional
Optional
Y
Y
Y
N Y
CONCEPTS Accruals/Going concern Substance over form
---------------------------------------------- ALL --------------------------------y varies N Y Y Varies Y
ASSET ACCOUNTING Historical cost Revaluation Capitalisation of interest
--------------------------------------------- ALL ---------------------------------Y N Y N Y N Y Allowed y Y Y Y Y N
FIXED ASSETS AnyoverUEL Specified Declining balance Straight line sum of digits unit of production Finance lease capitalised INTANGffiLES Goodwill; Write off to reserves May be carried as a permanent item capitalised and amortise period of amortisation specified Capitalized and tested for impairment R&D Deferred Income Statement STOCK VALUATION Lower of cost + NRV Lower of cost + MY GROUPS Acquisition accounting Uniting of interests Equity accounting
•
Y
Y
Y
Y
y
y
y
Y
Y
Y
y y
y y
y
y
varies
N
Y
Y
N
Y
N
Y
N
N
N
N
N
N N
N Y
N Y
N N
Y Y
N Y
N Y
N
N
20
5
5
Y Y
Y Y
Y Y
Y
Y Y
Y
N Y
Y
Y Y
Y Y
Y Y
Y Y
Y Y
--------------------------------------------- ALL ---------------------------------N Y N N N Y Y --------------------------------------------- ALL ----------------------------------
Some regulatory authorities allow foreign entity's to use their own GAAP for the purposes of satisfying local listing requirements but ask them to submit a reconciliation of the different profit figures. An example of such a reconciliation (together with explanatory notes) is given on the next page.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0209
INTERNATIONAL ISSUES
December 31 1t 1004
Sm Profit under UK GAAP
1,000
Bull of coDloUdation
i·The·story ·Th€;group· acqiiired:Ii-i ooo/~ iioidiilg·iii·a-SUbsidiarY- fui $8i)0Di·on· --...: : 30th September 2004. This hadbeen accounted for as a uniting ofinteresl IAS : i does not allow the use of Uniting of Interest so the treatment has to be changed : :.~-~-q~~~~~~~_ _-----_. _ _-----_._ _-----_._.: Remove profit for the year Add post acquisition profit (3/12 x 120) Less goodwill impairment for period
Leue classification
I" • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •
• •
• •
• •
• •
• •
• • • • •
(120) 30 (5)
• • • • • • • • • • • • • • • • • • • • • • • • • • • • • •
• • • • • • • • • • • • • • • • •
:. Tk~~-h;;ld~ -a-l~· ~hi-~h·i~ ~i~~ifi~f~-~ -~-i~~~-tiK---- ---: : GAAP. The IAS criteria are stricter resulting in the lease being reclassified as a :
i. ~~J~~~
._
.: 20
Remove rental from. profit by adding it back. Deduct depreciation Deduct finance charge
(15) (10)
Valuation of flnandal assets
;"The group hoids-&mciaiassets·whlcii"ii-cairieiiai-cost:uruh "i~s- 3-9 thes~; -""-:
i. ~ ~J~~~(i~4.~~. ~~~~~ ~!~. f~ ~g_ ~4_~~.~t.1'.~ .~~~~ ~5_~ _'-'~~~ UK. GAAP - cost IAS 39 - fair value
_.i
2003 100 130
2004 100 150
30
50
20
Only the movement on the fair value need be recognised as the 30 relates to prior period Deferred. taxation
:-UK· aMPrecognises iiefeiTed -tU ·lliliniIi-fuii pro~Sion -approach- b~t ;"jib -----.:
i. ~~1?'!c:: _~j~ ~~~~_~ .~~. ~~ ~~t.~ Deferred tax liability b1f Charge to the income statement Deferred tax liability elf
Profit under lAS
@
AccmmIBDlly Tuition Centre (lntmnatiODll1 HoldingB) Ltd 2005
.i UKGAAP 100 20
IAsn
120
500
400 100
(80)
840
0210
INTERNATIONAL ISSUES
FOCUS
You should now be able to: •
Evaluate the developments and the impact on global harmonisation and standardisation;
•
Assess proposed changes to international regulation;
•
Identify the reasons for major differences in accounting practices;
•
Restate overseas financial statements in line with lASs and IFRS's.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0211
INTERNATIONAL ISSUES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0212
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
OVERVIEW Objective •
To set out the concepts that underlie the preparation and presentation of financial statements for external users.
PURPOSE AND STATUS
THE OBJECTIVE OF FINANCIAL STATEMENTS
• • • • •
Purpose Scope Financial statements Application Users and their iriformation needs
•
Financial position, performance and changes in financial position
CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE
UNDERLYING ASSUMPTIONS
• •
• •
Accrual basis Going concern
QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS
• • • • •
ELEMENTS OF FINANCIAL STATEMENTS
Principal qualitative characteristics Understandability Relevance Reliability Comparability
© Accountancy Tuition Centre (International Holdings) Ltd 2005
Concepts ofcapital Concepts ofcapital maintenance and the determination ofprofit
• • •
0301
Definitions Recognition Measurement bases
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
1
PURPOSE AND STATUS
1.1
Purpose
•
To assist the Board ofIASB in
o
developing future IFRSs and reviewing existing IASs
o
promoting harmonisation of regulations etc by providing a basis for reducing the number of alternative accounting treatments permitted by IASs.
•
To assist national standard setting bodies in developing national standards.
•
To assist preparers of financial statements in applying lASs and in dealing with topics that have yet to form the subject of an lAS.
•
To assist auditors in forming an opinion as to whether fmancial statements conform with IASs.
•
To assist users offmancial statements in interpreting information contained in financial statements prepared in conformity with IASs.
•
To provide those who are interested in the work ofIASB with information about its approach to the formulation ofIASs.
•
In short to provide a conceptual framework as a foundation for the preparation and appraisal of accounting standards.
1.2
Scope
•
Objective of fmancial statements.
•
Underlying assumptions.
•
Qualitative characteristics that determine the usefulness of information in financial statements.
•
Defmition, recognition and measurement of elements.
•
Concepts of capital and capital maintenance.
1.3
Financial statements
•
Included
o
Balance sheet
o
Income statement
o
Statement of changes in fmancial position (e.g. a statement of cash flows)
o
Integral notes, other statements and explanatory material.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0302
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
•
Not included
o
reports by directors
o
statements by chairman
o
discussion and analysis by management and similar items included in a financial or annual report.
1.4
Application
•
Financial statements of all commercial, industrial and business reporting entities, whether public or private.
1.5
Users and their information needs Users
Information needs
•
•
Investors and their advisers
Risk and return of investment. Need information for decision-making (buy, hold or sell?) to assess ability to pay dividends.
•
Employees and their representatives
• •
• •
Lenders
• •
Whether loans and interest will be paid when due.
•
Customers
•
Continuance - important for long-term involvement with, or dependence on, the entity.
•
Governments and their agencies
• •
Allocation of resources and, therefore, activities of entities.
•
Suppliers and other trade creditors
Public
• •
Stability and profitability of employers. Ability to provide remuneration, retirement benefits and employment opportunities.
Whether amounts owing will be paid when due.
Information to regulate activities, determine taxation policies and as the basis for national income and similar statistics. Contribution to local economy including number of employees and patronage of local suppliers. Trends and recent developments in prosperity and range of activities.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0303
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
2
THE OBJECTIVE OF FINANCIAL STATEMENTS
•
To provide information about
o
the financial position,
o
the financial performance, and
o
changes in financial position of an entity
that is useful to a wide range of users in making economic decisions. •
Also, to show the results of management's stewardship (i.e. accountability for resources entrusted to it).
2.1
Financial position, performance and changes in financial position
•
Information that enables users to evaluate
o
ability of entity to generate cash and cash equivalents
o
timing and certainty of their generation.
FINANCIAL POSITION
•
Affected by economic resources controlled
FINANCIAL PERFORMANCE
• •
financial structure liquidity and solvency capacity to adapt to changes.
=> BALANCE SHEET
•
In particular profitability. To predict capacity to generate cash flows from existing resource base. To form judgements about effectiveness with which additional resources might be employed.
=> INCOME STATEMENT
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0304
CHANGES IN FINANCIAL POSITION
•
To assess investing, fmancing and operating activities.
•
To assess ability to generate cash and cash equivalents and needs to utilise those cash flows.
=> SEPARATE STATEMENT
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
3
UNDERLYING ASSUMPTIONS
3.1
Accrual basis
•
Effects of transactions and other events are
o
recognised when they occur, and
o
recorded in the accounting records and reported in the financial statements of the periods to which they relate.
3.2
Going concern
•
Assumption that an entity will continue in operation for the foreseeable future.
•
Therefore there is neither the intention nor need to liquidate or curtail materially the scale of operations.
4
QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS
Attributes that make information provided in fmancial statements useful to users.
4.1
Principal qualitative characteristics
•
Relateto
~
Presentation
I
I---c-o-n-te-n-t--
o
Understandability
0
Relevance
o
Comparability
0
Reliability
4.2
Understandability
•
Users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study information with reasonable diligence.
•
Information about complex matters should not be excluded on the grounds that it may be too difficult for certain users to understand.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0305
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
4.3
Relevance
•
Quality helps users
•
o
evaluate past, present or future events.
o
confirm or correct their past evaluations.
Relevance of information is affected by
~
---n-s-n-a-tur-e---I
•
Nature alone may be sufficient to determine relevance.
I---M-a-te-n-'a-li-ty---
•
Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
•
Depends on size of item or error judged in the particular circumstances of its omission or misstatement.
•
=> a threshold or cut-off point rather than being a primary qualitative characteristic.
4.4
Reliability
•
Free from material error and bias.
•
Can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.
•
Reliability encompasses:
o
faithful representation - e.g. meeting recognition criteria
o
substance over form - substance and economic reality, not merely legal form - see session 4
o
neutrality - free from bias
o
prudence - including a degree of caution in making estimates under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated
o
completeness (within bounds of materiality and cost) - an omission can cause information to be false or misleading and thus unreliable.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0306
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
4.5
Comparability
•
Users need to be able to compare
o
fmancial statements of an entity through time - to identify trends in fmancial position and performance
o
fmancial statements of different entities - to evaluate relative fmancial position, performance and changes in fmancial position.
•
Therefore we need consistent measurement and display of financial effect of like transactions and other events.
•
Users must be informed of accounting policies employed, any changes in those policies and the effects of such changes.
•
Financial statements must show corresponding information for preceding periods.
5
ELEMENTS OF FINANCIAL STATEMENTS
5.1
Definitions
•
"Elements" are broad classes of the financial effects of transactions grouped according to their economic characteristics.
•
An asset is
•
•
o
a resource controlled by the entity
o
as a result ofpast events
o
from whichfuture economic benefits are expected to flow.
A liability is
o
a present obligation of the entity
o
arising from past events
o
settlement of which is expected to result in an outflow of resources embodying economic benefits.
Equity is
o
the residual interest
o
in the assets of the entity
o
after deducting all its liabilities.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
•
•
Income is
o
increases in economic benefits during the accounting period
o
in the form of inflows (or enhancements) of assets or decreases of liabilities
o
that result in increases in equity
o
other than those relating to contributions from equity participants.
Expenses are
o
decreases in economic benefits during the accounting period
o
in the form of outflows (or depletions) of assets or incurrences of liabilities
o
that result in decreases in equity
o
other than those relating to distributions to equity participants
•
The Framework defines assets, liabilities and equity, and the definitions for income and expenses follow on from those. Therefore it is said that the Framework takes a balance sheet approach.
5.2
Recognition
5.2.1
Meaning
•
The process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition - noted below.
•
It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheets or income statement totals.
•
Items that satisfy the recognition criteria shall be recognised.
•
The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material.
5.2.2
Recognition criteria
•
It is probable that any future economic benefit associated with the item will flow to or from the entity and
•
The item has a cost or value that can be measured with reliability.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0308
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
5.3
Measurement bases
Assets
Liabilities
Historical cost
•
The amount paid (or the fair value of the consideration given) to acquire them at the time of their acquisition.
•
The amount received in exchange for the obligation.
Current cost
•
The amount that would have to be paid if the same or an equivalent asset was acquired currently.
•
The undiscounted amount that would be required to settle the obligation currently.
Realisable (settlement) value
•
The amount that could currently be obtained by selling the asset in an orderly disposal.
•
At settlement values (i.e. the undiscounted amounts expected to be paid to satisfy the liabilities in the normal course of business).
Present value
•
Present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business.
•
Present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.
6
CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE
6.1
Concepts of capital
6.1.1
Financial concept
•
Capital is synonymous with the net assets or equity of the entity.
6.1.2
Physical concept
•
Capital is regarded as the productive capacity of the entity based on, e.g. units of output per day.
6.2
Concepts of capital maintenance and the determination of profit
6.2.1
Financial capital maintenance
•
Profit is earned only if the fmancial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period (after excluding any distributions to/contributions from owners during the period).
6.2.2
Physical capital maintenance
•
Profit is earned only if the physical productive capacity (or operating capability) of the entity at the end of the period exceeds the physical productive capacity at the beginning of the period (after excluding any distributions to/contributions from, owners during the period).
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0309
FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS
FOCUS
You should now be able to: •
discuss what is meant by a conceptual framework;
•
describe the objectives offmancia1 statements and the qualitative characteristics of fmancia1 information;
•
define the elements of financial statements;
•
apply the above definitions to practical situations.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0310
SUBSTANCE OVER FORM
OVERVIEW Objective •
To explain the need for substance over form accounting.
•
To describe the issues to be addressed in assessing the commercial form of a transaction.
•
To cover the analysis of certain common substance over form examples.
WHY SUBSTANCE MATTERS
REPORTING THE SUBSTANCE OF TRANSACTIONS
EXAMPLES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
• •
Introduction Recognition ofassets and liabilities
• •
Objective Recognition and derecognition
• • • •
Consignment inventory Sale and repurchase agreements Quasi subsidiaries Factoring ofdebts
0401
SUBSTANCE OVER FORM
1
WHY SUBSTANCE MATTERS
1.1
Introduction
•
Financial statements must reflect the true substance of transactions if they are to show a true and fair view.
•
Ultimately fmancial statements must follow the Framework which states that if information reflects substance it has the characteristic of reliability.
•
Usually substance (ie commercial effect) = legal form. For more complex transactions this may not be the case.
1.2
Recognition of assets and liabilities
•
The key issue underlying the treatment of a transaction is whether an asset or liability should be shown in the balance sheet.
•
In recent years some companies have devised increasingly sophisticated "off balance sheet financing" schemes whereby it was possible for them to hold assets and liabilities which did not actually appear on the balance sheet according to the local GAAP. This is one of the most important issues in financial reporting. Some countries have issued accounting standards to address this point specifically.
•
The concept of substance over form has existed as a concept in lAS for many years. If companies had been following lAS some of the reporting problems which have occurred would not have arisen.
•
The release ofIAS 39 Financial Instruments: Recognition and Measurement will greatly improve accounting for financial instruments and complex hedging arrangements.
2
REPORTING THE SUBSTANCE OF TRANSACTIONS
2.1
Objective
•
To ensure that financial statements reflect the substance of transactions.
2.2
Recognition and derecognition
•
Recognise item only if
•
o
it meets definition of asset/liability, and
o
monetary amount can be measured with sufficient reliability.
Cease to recognise an asset only if
o
all significant access to benefits, and
o
all significant exposure to risks inherent in those benefits have been transferred to others.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0402
SUBSTANCE OVER FORM
3
E~PLES
3.1
Consignment inventory
•
This is very common in the car industry. Consignment inventory is held by the dealer but legally owned by the manufacturer.
•
The issue is who should record the inventory as an asset?
•
This will depend on whether it is the dealer or the manufacturer who bears the risks and benefits from the rewards of ownership.
•
Treatment - Is the inventory an asset of the dealer at delivery?
o
If yes - the dealer recognises the inventory on the balance sheet with the corresponding liability to the manufacturer
o
If no - do not recognise inventory on balance sheet until transfer of title has crystallised (manufacturer recognises inventory until then).
Illustration 1 David Wickes, a car dealer buys cars from FMC (a large multi-national car manufacturer) on the following terms. •
Legal title passes on sale to the public or when the car is used for demonstration.
•
The car is paid for when legal title passes. The price to David is determined at the date of delivery.
•
David must pay interest at 10% on cost for the period from delivery to payment.
•
David has the right to return the cars to FMC. This right has never been exercised in 10 years of trading.
David's year end is 31 December 2004.
Required: Using as an example a car delivered to David on 30 September 2004 and still held at the year end explain how David should account for the transaction.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0403
SUBSTANCE OVER FORM
Solution 1 (1)
Have the risks and rewards of ownership passed to David on delivery?
Risk/reward passed?
Factors Right to return inventory
No (but it has never been exercised so for all intents and purposes the risk/reward actually does pass on delivery)
Price reflects an interest charge varying with time (:. slow movement risk)
Yes
Conclusion On balance the risks and rewards of ownership pass to David on delivery. The transaction should be treated as a purchase of inventory on credit.
(2)
Journal entries On receipt of car
Dr
Purchases Cr Payables
Up to date of earlier sale to third party or use as a demonstator Dr
Interest payable Cr Payables (accrued interest)
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0404
SUBSTANCE OVER FORM
3.2
Sale and repurchase agreements
•
Here, an asset is sold by A to B on terms such that A repurchases the asset in certain circumstances.
•
The issue is to decide whether the substance of the transaction is
•
o
a sale, or
o
raising of fmance on an asset still held.
Treatment in A's accounts
Was there in substance a sale?
A
On "sale"
Recognise sale and any profit
On "repurchase"
Recognise purchase, including any interest payable, as cost of sales
Leave asset in alance sheet. Record proceeds as a liability. Accrue for any interest payable Settle liability and accrued payable
Effect
Effect
•
Finance cost recognised on repurchase (as part of cost of sales)
•
Finance cost recognised on "sale" (as interest payable)
•
Finance is offbalance sheet
•
Finance is on balance sheet
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0405
SUBSTANCE OVER FORM
Illustration 2 Christov is a vodka manufacturer. The company manufactures vodka out of the finest wheat grain. The manufacturing process involves a maturing period of 3 years. The vodka is sold at cost + 200%. On the first day of its accounting period Christov sold 100,000 litres of 1 year old vodka to Watnest plc, a bank, on the following terms. •
Sale price $500,000 (cost).
•
Christov has the option to repurchase the vodka at any time over the next 2 years at cost + a mark up.
•
The mark up is based on an annual rate of interest of 12% and will be prorated.
•
Watnest has the option to sell the vodka to Christov in 2 years time at a price based on a similar formula.
Required: Explain how Christov should account for this transaction at inception and at the year end.
Solution 2 (1)
Has there in substance been a sale? Is the repurchase likely to happen? If so it is not a real sale and the legal form should be set aside. Factors Sale is unusual - sale at cost/to a bank - indicates that it is not a real sale. A mirror image put and call option means that the repurchase is bound to occur. Christov is paying a borrowers return. Therefore the sale is not a real sale but a financing arrangement.
(2)
Journal entries On "sale"
Dr Cash CrPayables
At year end
Dr Income statement CrPayables On "repurchase" Dr Payables CrCash (assumes repurchase is at the end of the 2 year period)
$ 500,000
$ 500,000
60,000 60,000 620,000 620,000
Tutorial note - If in substance there had been a sale On "sale" On "repurchase"
Dr Cash Cr Revenue Dr Cost ofsales CrCash
The example presumes simple interest © Accountancy Tuition Centre (International Holdings) Ltd 2005
0406
$ 500,000
$ 500,000
620,000 620,000
SUBSTANCE OVER FORM
3.3
Quasi subsidiaries A controlled undertaking but not a legal subsidiary
,r Benefit and risk source equivalent to a subsidiary
,
IConsolidate as a subsidiary I Illustration 3
A hotel company, Company H, sells some of its hotels to Company B, the subsidiary of a bank. B is financed by loans from the bank at normal interest rates. H and B enter into a management contract whereby H undertakes the complete management of the hotels. It is remunerated for this service by a management charge which is set at a level which absorbs all the profits ofB after paying the interest on its loan finance. There are also arrangements which give H control over the sale of any of the hotels by B, and any gain or loss on such sales also reverts to it through adjustment of the management charge.
Required: Giving reasons, show how H should record the above.
Solution 3 In these circumstances, it is clear that the bank's legal ownership ofB is oflitt1e relevance. All the profits ofB go to H, and the bank's return is limited to that ofa secured lender. In substance, H holds the equity interest in both B and the hotels that it owns. B will therefore be regarded as a quasi subsidiary ofH and will be consolidated by it. As a result, all transactions between the two companies will be eliminated from the group accounts of H, and the group balance sheet will show the hotels as an asset and the bank loans as a liability. The group profit and loss account will show the full trading results of the hotels and the interest charged by the bank on its loans, while the inter-company management charge will be eliminated on consolidation.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0407
SUBSTANCE OVER FORM
3.4
Factoring of debts
•
The "seller" transfers debts to a "factor" for an agreed % of the value of the debts. Again, the key issue is the extent to which the risks and rewards of ownership have been transferred.
•
Possible treatments.
o
debts no longer an asset of the seller ~ derecognition.
o
debts remain an asset of the seller ~ separate presentation
FOCUS You should now be able to: •
explain the nature of the off balance sheet problem and the principle of substance over form;
•
discuss common forms of off balance sheet finance and current regulations in this area;
•
discuss the perceived problems of current regulatory requirements including recognition and measurement issues.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0408
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
OVERVIEW Objective
•
To prescribe the basis for presentation of general purpose financial statements by setting out:
o
overall considerations;
o
guidelines for structure;
o
minimum requirements for content.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
050 I
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
SCOPE • • •
Objective General purposefinancial statements Application
FINANCIAL STATEMENTS • • • •
OVERALL CONSIDERATIONS
STRUCTURE AND CONTENT • • • •
Fair presentation and compliance with lASs Emphasis Departure from lAS Going Concern Accrual basis ofaccounting Consistency ofpresentation Materiality and aggregation Offietting Comparative information
• • • • • • • • •
Representation Objectives offinancial statements Components Supplementary statements
BUSINESS REPORTING ON THEINTERNET
"Disclosure" Identification offinancial statements Reporting date and period Termsused
BALANCE SHEETS • • • • •
The current/non-current distinction Current assets Current liabilities Overall structure Presentation ofbalance sheet items
INCOME STATEMENT • •
Presentation ofincome statement items Structure ofthe income statement
-
• • • • • •
STATEMENT OF CHANGES IN EQUITY • • • •
A separate statement Function Structure ofnotes Items which are taken • NOTES TO FINANCIAL • STATEMENTS • L-
---'.
G4+1 POSITION PAPERON REPORTING FINANCIAL PERFORMANCE What is Performance Reporting? Scattered Information about Performance Recycling Why have 2 statements? The G4+ 1 Position Paper Proposals lASH position
directly to equity Structure Disclosure ofaccounting policies Key sources ofestimation uncertainty Other disclosures
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0502
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
1
INTRODUCTION
1.1
Objective
•
To prescribe the content of general purpose financial statements in order to ensure comparability with:
•
o
the entity's own financial statements, and
o
fmancial statements of other entity's.
o
overall considerations for the presentation,
To achieve this the standard sets out:
o
guidelines for the structure, and
o
minimum requirements for content of fmancial statements.
1.2
General purpose financial statements
1.2.1
Meaning
•
Financial statements intended to meet the needs of users who are not in a position to demand reports tailored to specific information needs.
•
May be presented separately or within another public document (eg annual report or prospectus).
1.3
Application
•
To financial statements of individual entity's and consolidated financial statements of groups.
•
To all types of entity's including banks, insurance and other financial institutions.
•
To entity's with a profit objective (including public sector business entity's).
2
FINANCIAL STATEMENTS
2.1
Representation
•
Financial statements are a structured fmancial representation of
o
fmancial position of, and
o
transactions undertaken by an entity.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0503
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
2.2
Objectives of financial statements (see the Framework)
•
To provide information useful to a wide range of users in making economic decisions about:
o
fmancial position
o
performance
o
cash flows.
•
To show the results of management's stewardship.
•
To meet this objective financial statements provide information about an entity's:
o
assets
o
liabilities
o
equity
o
income and expenses including gains and losses
o
cash flows.
2.3
Components
•
A complete set of fmancial statements includes
o
Balance sheet
o
Income statement
o
A statement of changes in equity
o
Cash flow statement
o
Accounting policies and explanatory notes.
2.4
Supplementary statements
•
Entities may also present additional information on a voluntary basis, eg
•
o
A fmancial review by management
o
Environmental reports
o
Value added statements.
Any additional statements presented are outside the scope ofIFRSs.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0504
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
3
OVERALL CONSIDERATIONS
3.1
Fair presentation and compliance with lASs
•
Financial statements shall "present fairly"
o
fmancial position
o
fmancial performance
o
cash flows.
•
Achieved by appropriate application ofIASs (and any necessary additional disclosures).
•
Inappropriate accounting treatments are NOT rectified by
o
disclosure of accounting polices used
o
notes or explanatory material.
3.2
Emphasis
•
In virtually all circumstances fair presentation is achieved by compliance in all material respects with applicable lASs. Compliance with lASs shall be disclosed.
•
Fair presentation requires
o
selection and application of appropriate accounting policies
o
presentation of information (including accounting policies) in a manner which provides relevant, reliable, comparable and understandable information.
•
Additional disclosures when the requirements of lASs are insufficient to enable users to understand the impact of particular transactions on the financial position and performance of the entity.
3.3
Departure from lAS
•
In extremely rare circumstances, if compliance would be misleading, and therefore departure from a standard is necessary to achieve a fair presentation, the entity must disclose
o
that management has concluded that the financial statements fairly present the entity's fmancial position, performance and cash flows
o
that it has complied in all material respects with applicable lASs except that it has departed from a standard in order to achieve a fair presentation
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0505
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
o
the standard from which the entity has departed, the nature of departure, including the treatment that the standard would require together with the reason why that treatment would be misleading in the circumstances and the treatment adopted
o
the financial impact of the departure on the entity's net profit or loss, assets, liabilities, equity and cash flows for each period presented.
•
Where an lAS is applied before its effective date, that fact shall be disclosed.
3.4
Going Concern
•
Management shall
o
assess the entity's ability to continue as a going concern (considering all information available for the foreseeable future)
o
prepare fmancial statements on a going concern basis (unless management consider that it is probable that the entity will be liquidated/cease trading)
o
disclose material uncertainties which may affect the going concern concept.
•
The degree of consideration depends on the facts in each case. If the entity has a history of profitable operation and ready access to financial resources detailed analysis may not be required before a conclusion is reached.
•
In other cases management may need to consider a wide range of factors, eg
o
current and expected future profitability
o
debt repayment schedules
o
sources of finance.
•
Foreseeable future is at least, but not limited to, 12 months from the balance sheet date.
•
When financial statements are not prepared on a going concern basis, that fact shall be disclosed, together with the basis on which the fmancial statements are prepared and the reason for departing from the going concern concept.
3.5
Accrual basis of accounting
An entity shall prepare its financial statements (except the cash flow statement) under the accrual basis of accounting.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0506
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
3.5.1
Concept
•
Assets, liabilities, equity, income and expenses are
o
recognised when they occur (not as cash or its equivalent is received or paid) and
o
recorded in the accounting records and reported in the fmancial statements of the periods to which they relate.
3.5.2
"Matching" concept
•
Expenses are recognised on the basis of a direct association between
3.6
o
costs incurred and
o
earning of specific items of income.
Consistency of presentation
Presentation and classification of items in financial statements shall be retained from one period to the next.
3.6.1
Exceptions
•
The change will result in a more appropriate presentation (eg if there is a significant change in the nature of the entity's operations).
•
A change is required by an accounting standard or an interpretation.
3.7
Materiality and aggregation
•
lAS I defmes materiality as 'omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor'. Material items
Immaterial amounts
•
•
Present separately in financial statements.
• •
Aggregate with amounts of similar nature or function (on face of fmancial statements or in notes) Need not be presented separately.
Materiality provides that the specific disclosure requirements ofIASs need not be met if a transaction is not material.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0507
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
3.8
Offsetting
•
Assets and liabilities, and income and expenses, shall not be offset unless another standard or interpretation requires or allows the use of offsetting.
•
Offsetting, except when the offset reflects the substance of a transaction, would detract the ability of users to understand the events that occurred and would inhibit the assessment of the entity's future cash flows.
•
A provision of bad or doubtful debts against receivables is not seen as offsetting as this provision is an adjustment on an asset valuation.
•
The standard does allow some netting off of items within the income statement, eg
3.9
•
o
gains/losses on sale of non-current assets are reported after deducting the carrying value from the proceeds
o
expenditure related to a recognised provision, where reimbursement occurs from a third party, may be netted off against the reimbursement
o
gainllosses relating to a group of similar transactions will be reported on a net basis, eg foreign exchange gains and losses. Any material gain or loss shall be reported separately.
Comparative information Numerical information in the previous period
Narrative and descriptive information in the previous period
•
•
DISCLOSE unless an lAS permits/requires otherwise.
INCLUDE when relevant to understanding current period's financial statements, eg re legal disputes
When the presentation/classification of items in the financial statements is amended
o
if practicable, reclassify comparatives and disclose nature, amount and reason for reclassification;
o
if impracticable, disclose reason for not reclassifying and the nature of the changes that would otherwise have been made.
4
STRUCTURE AND CONTENT
4.1
"Disclosure"
•
lAS 1 uses the term in a broad sense, encompassing items presented on the face of each fmancial statement as well as in the notes to the fmancial statements.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0508
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
4.2
Identification of financial statements
Financial statements shall be clearly identified and distinguished from other information in the same published document (eg annual report or prospectus).
4.2.1
Importance
•
lASs apply only to the financial statements and not to other information so users must be able to distinguish information prepared using lASs from other information not subject to accounting requirements.
4.2.2
Information to be prominently displayed (and repeated where necessary)
•
Component of the fmancial statements presented (eg balance sheet).
•
Name of reporting entity.
•
Whether fmancial statements cover an individual entity or a group.
•
Balance sheet date or the period covered by the financial statements (as appropriate).
•
Presentation currency.
•
Level of precision used (eg 000, millions, etc).
4.3
Reporting date and period
•
Financial statements shall be presented at least annually.
•
In exceptional circumstances where an entity's balance sheet date changes and the statements are presented for a period longer or shorter than a year the entity shall disclose
o
reason for a period other than one year being used
o
fact that comparative amounts for the income statement, changes in equity, cash flow statement and related notes are not comparable.
4.4
Terms used
•
The standard applies a terminology that is consistent with all other standards but it does not prohibit the use of other terms as long as the meaning is clear (eg non-current assets = fixed assets).
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0509
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
5
BALANCE SHEET
5.1
The current/non-current distinction
•
An entity shall present current and non-current assets and current and noncurrent liabilities as separate classifications on the face of the balance sheet, unless when presentation based on liquidity order provides more relevant and reliable information. This may be the case for financial institutions.
•
Whichever method is adopted, where a classification includes amounts that will be recovered in less than 12 months and more than 12 months, an entity shall disclose the amount to be settled or recovered after more than 12 months.
•
A separate classification:
•
o
distinguishes net assets that are continuously circulating as working capital from those used in long-term operations,
o
highlights assets expected to be realised within the current operating cycle, and liabilities due for settlement in the same period.
Other useful information
o
maturity dates of trade and other receivables and payables
o
inventories expected to be recovered more than one year from the balance sheet date.
5.2
Current assets
•
An asset shall be classified as "current" when it satisfies one of the following criteria:
o
is expected to be realised, or is intended for sale or consumption, in the normal course of the operating cycle, or
o
is held primarily for trading purposes
o
is expected to be realised within 12 months of the balance sheet date, or
o
is cash or cash equivalent which is not restricted in use.
Note there are two conceptual views of the term current
Liquidity approach Classification of assets and liabilities into current and non-current is intended to give an approximate measure of an entity's liquidity (i.e. it's ability to carry on it's activities on a day to day basis without encountering financial stringencies). (Criterion: - Will items be realised / liquidated in the near future?)
Operating cycle approach Classification is intended to identify those resources and obligations of the entity that are continuously circulating. (Criterion: - Will items be consumed or settled within the normal operating cycle ofthe entity?) © Accountancy Tuition Centre (International Holdings) Ltd 2005
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IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
•
All other assets shall be classified as "non-current".
5.3
Current liabilities
•
A liability shall be classified as "current" when
o
expected to be settled in the normal course of the operating cycle
o
held primarily for the use of being traded
o
due to be settled within 12 months of the balance sheet date
o
the entity does not have an unconditional right to defer settlement for at least 12 months after the balance sheet date.
•
All other liabilities shall be classified as "non-current".
•
Refinancing of a long-term loan, falling due within 12 months, after the balance sheet date will still require the loan to be classed as a current liability.
•
Any refinancing or restructuring of loan payments after the balance sheet date will qualify for disclosure as a non-adjusting event in accordance with IAS 10 Events after the Balance Sheet Date.
5.4
Overall structure
•
There is no prescribed format though IAS 1 presents a format as an illustration.
•
There are 2 main types of format found in practice. They differ in respect of which form of the accounting equation that they are an expansion of.
o
Net assets (assets - liabilities) = Capital
o
Assets
=
Capital + Liabilities
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0511
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
Illustrations lAS 1 suggested format
UK format
ASSETS
$
$
Non current assets
50
Non current assets
Current assets
40
Current assets Current liabilities Net current assets
50 40 ~ 10
Total assets less current liabilities Non current liabilities Total assets
90
BALANCES TO;
BALANCES TO;
EQUITY AND LIABILITIES Capital and reserves
50
Non current liabilities
10
Current liabilities
30
Capital and reserves
90
•
50
Each of the above would be consistent with IAS practice.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
50
0512
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
5.5
Presentation of balance sheet items
•
Certain items must be shown on the face of the balance sheet. The minimum requirements for these line items are as follows (note that the order in which they appear is not specified).
o
Property, plant and equipment
o
Investment property
o
Intangible assets
o
Financial assets
o
Assets and assets included in disposal groups classed as held for sale
o
Investments accounted for under the equity method
o
Biological assets
o
Inventories
o
Trade and other receivables
o
Cash and cash equivalents
o
Trade and other payables
o
Liabilities included in disposal groups classed as held for sale
o
Current tax assets or liabilities
o
Deferred tax assets or liabilities
o
Provisions
o
Financial liabilities
o
Minority interest, to be presented as part of equity
o
Issued equity capital and reserves.
•
An entity shall disclose either on the face of the balance sheet or in the notes to the balance sheet further sub classifications of the line items presented classified in a manner appropriate to the entity's operations.
•
The detail provided in sub classifications depends on specific requirements of other lASs and the size, nature and amounts involved. The disclosures will vary for each item.
•
Typically companies will present the main headings on the face of the balance sheet and the detail in the notes to the accounts.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0513
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
6
INCOME STATEMENT
6.1
Presentation of income statement items
•
Certain items must be shown on the face of the income statement. The minimum requirements for these line items are as follows
o
Revenue
o
Finance costs
o
Share of profits and losses of associates and joint ventures accounted for under the equity method
o
Tax expense
o
Total of (i) post tax profit or loss of discontinued operations and (ii) post tax gain or loss recognised on the measurement to fair value less costs to sell on the disposal of assets or disposal groups of a discontinued operation
o
Profit or loss for the period.
•
The profit or loss for the period shall be allocated between equity holders of the parent and minority interest. This disclosure shall be made on the face of the income statement.
•
Classification of items as extraordinary is not permitted.
•
An entity shall provide an analysis of expenses using a classification based on either nature or function.
•
This shall be performed either on the face of the income statement or in the notes though presentation on the face is encouraged.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0514
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
6.2
Structure of the income statement
•
This is determined by the way in which the entity chooses to comply with the above requirements to analyse expense items as discussed above.
Nature of expenditure method
•
Function of expenditure method
Expenses are aggregated by nature eg -
-
•
Classifies expenses as -
depreciation purchases of materials transport costs wages and salaries
-
cost of sales distribution administrative activities.
Advantages - nature
Advantage - function
• •
Simple to apply in many small entities
•
No arbitrary allocations :.
Disadvantage - function
More objective
•
• •
Less judgement required
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0515
Provides more relevant info to users
Cost allocation can be arbitrary and involves considerable judgement.
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
Illustration Classification by nature
$
Classification by function
Revenue
X
Revenue
Other operating income
X
Cost of sales
Changes in inventories of fmished goods & WIP Work performed by entity and capitalised
$ X (X)
Gross profit'(loss)
X
Distribution costs
(X)
Administrative expenses
(X)
X/(X) X
Raw materials and consumables used
(X)
Staff costs
(X)
Depreciation and amortisation expense
(X)
Other operating expenses
(X)
Other operating expenses
(X)
Finance cost
(X)
Finance cost
(X)
Income from associates
X
Income from associates
X
Profit before tax
X
Profit before tax
X
Income tax expense
X
Income tax expense
X
Profit after tax
X
Profit after tax
X
Attributable to:
Attributable to:
Equity holders of the parent
X
Equity holders of the parent
X
Minority Interest
X
Minority Interest
X
•
Entity's classifying expenses by function shall disclose additional information on the nature of expenses, including depreciation and amortisation expense and staff costs.
•
An entity shall disclose either on the face of the income statement, or in the statement of changes in equity or in the notes, the amount of dividends in total and per share, recognised as distributions to equity holders, for the period covered by the financial statements.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0516
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
7
STATEMENT OF CHANGES IN EQUITY
7.1
A separate statement
•
An entity shall present as a separate component of its financial statements, a statement showing
•
o
profit or loss for the period
o
each item of income and expense, gain or loss recognised directly in equity, and total thereof
o
sum of the above two amounts split between equity holders of the parent and minority interest
o
cumulative effect of changes in accounting policy and the correction of errors (per lAS 8 - see session 6).
In addition an entity shall present either within this statement or in the notes:
o
capital transactions with/distributions to owners
o
accumulated profit or loss balance at beginning of period balance at the balance sheet date movements for period
o
a reconciliation between carrying amount of the following at the beginning and end of the period each class of equity share premium each reserve.
7.2
Function
•
Change in equity in the period reflects the change in the net assets in the period (ie the change in wealth) under the particular measurement basis used.
•
This change represents the total gains and losses generated by the entity in the period together with changes resulting from transactions with shareholders.
•
lAS 1 requires all items of income and expense to be included in the determination of the profit for the period unless an lAS permits or requires otherwise. Therefore there maybe significant gains and losses which do not appear in the income statement. These disclosures ensure that such items are highlighted for the users of the accounts so that they are in possession of all information necessary to judge the performance of the entity.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0517
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
7.3
Structure of notes
• •
The requirements may be satisfied in a number of ways. In many jurisdictions a columnar format is adopted with a separate column for each element within equity (this is known as a movement on reserves note).
Attributable to equity holders ofthe parent
Balance blf
Share capital $
Share premium $
Revaluation reserve $
Retained earnings $
Total
X
X
X
X
X
X
X
(X)
(X)
(X)
(X)
X
X
(X)
X
X
X
X
X
(X)
(X)
(X)
(X)
X
X
X
X
X
X
X
X
(X)
(X) X
X
X
Change in accounting policy Restated balance
X
X
X
Surplus on revaluation of property Deficit on revaluation of investments Net gains and losses not recognised in the income statement Net profit for the period Dividends Issue of share capital
X
X
Balance elf
X
X
•
Minority interest
X
$
An alternative approach would be to present a separate component of the financial statements which shows the gains and losses arising in the period. If this approach is adopted the entity will need to support it with notes showing the movements and reconciliation of each separate element of equity in order to comply with the standard.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0518
Total
(X) X X
X
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
$ Surplus on revaluation of properties
x
Deficit on revaluation of investments
(X)
Net gains and losses not recognised in the income statement
X
Net profit in the period
X
Total recognised gains and losses
X
Attributable to: Equity holders ofthe parent
X
Minority interest
X
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0519
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
7.4
Items which are taken directly to equity
•
The following transactions which are taken directly to equity (it is not an exhaustive list)
o
IAS 8 - Prior period adjustments to correct an error or on the introduction of a new accounting policy.
o
IAS 16 - Revaluation surpluses recognised when adopting the revaluation model for the subsequent measurement of non current assets.
o
IAS 36 - Impairment losses on assets carried at a previously recognised surplus.
o
IAS 36 - Reversals of impairment losses previously taken to equity.
o
IAS 21 - Foreign exchange differences arising on a monetary item that is, in substance, part of a net investment in a foreign entity.
o
IAS 21 - Foreign exchange differences arising on consolidation of foreign entities.
o
IAS 39 - Fair valuation adjustments on the year end revaluation of "available for sale fmancial assets".
o
IAS 12 - Deferred tax insofar as it relates to a transaction which has gone directly to equity.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0520
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
8
THE G4+1 POSITION PAPER ON REPORTING FINANCIAL PERFORMANCE
•
Reporting fmancia1 performance is an area in which there are significant differences between the existing standards in the jurisdictions of the G4+ 1 organisations.
8.1
What is Performance Reporting?
•
Reporting information about an entity's performance is an important objective offmancia1 statements. Traditionally, the income statement has been viewed as the performance statement, with components of the income statement used to record different aspects of performance.
•
Some aspects of performance have been reported outside the traditional income statement, directly in equity. This is particularly true for reporting changes in fair values of assets and liabilities.
•
Under IAS 1, Presentation ofFinancialStatements, an entity shall present, as a separate component of its financial statements, a statement showing:
o
the net profit or loss for the period,
o
each item of income and expense, gain or loss which, as required by other Standards, is recognised directly in equity, and the total of these items, and
o
the cumulative effect of changes in accounting policy and the correction of errors under lAS 8.
8.2
Scattered Information about Performance
•
Reporting income, expenses, gains, losses, and recognised value changes elsewhere than in the income statement results in a scattering of information about various aspects of an entity's fmancia1 performance. A key conclusion in the G4+ 1 Position Paper is that performance information shall be reported in a single financial statement.
o
Currently some value changes are reflected in profit or loss for the period - (eg reductions of assets for impairments)
o
Some value changes are taken directly to equity - (eg revaluation surpluses)
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0521
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
8.3
Recycling
•
This is where a transaction reported directly in equity is later reported again in the net profit or loss usually when realised). lASs may require or prohibit this.
o
foreign exchange differences arising on translation of a net investment in a foreign entity under lAS 21, The Effects of Changes in Foreign Exchange Rates (recycling to net profit or loss is required when the investment is disposed of); and
o
recycling to profit or loss is prohibited for surpluses on the revaluation of property, plant and equipment (lAS 16, Property, Plant and Equipment). If the asset is sold the surplus is taken to accumulated profits directly.
•
The IASC decisions on whether to report changes in values to income or equity, and if reported initially in equity whether they should be recycled, have been made on an ad hoc basis.
8.4
Why have 2 statements?
•
The traditional answer to this question has been that it is to allow the income statement to do its job: ie:
o
To show realised items
o
To show the result of exchange transactions
o
To show the results of management actions
•
The G4+ 1 group has concluded that this is no longer justifiable.
8.5
The G4+1 Position Paper Proposals
•
The main proposals in the G4+ 1 Position Paper are:
o
fmancial performance should be presented in one statement rather than two or more statements,
o
the single statement of fmancial performance should be divided into three components: the results of operating (or trading) activities, the results of financing and other treasury activities, and other gains and losses.
o
recycling should not be generally permitted,
o
the category of extraordinary items should be abolished, and abnormal or exceptional items should not be reported as a separate category of revenue or expenses,
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0522
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
o
results of continuing and discontinued operations should be segregated, and
o
changes in accounting policy should be reported by retrospectively applying the new policy with restatement of prior periods.
These final three points have been adopted by revisions to existing standards and issue ofnew standards
8.6
IASB position
•
IASB has a working party working with FASB on the way forward on reporting financial performance. They had previously been working with the UK ASB on this area but were unable to reach a consensus on how to take the project forward.
9
NOTES TO THE FINANCIAL STATEMENTS
9.1
Structure
•
Objectives of notes to the financial statements
o
to present information about the basis of preparation of the fmancial statements specific accounting policies selected and applied for significant transactions and events.
•
•
o
to disclose information required by lASs that is not presented elsewhere
o
to provide additional information which is not presented on the face of the fmancial statements but is necessary for a fair presentation.
Presentation
o
notes shall be presented in a systematic manner.
o
each item on the face of the balance sheet, income statement and cash flow statement shall be cross-referenced to notes.
Normal order of presentation is as follows:
o
statement of compliance with lASs,
o
statement of measurement basis and accounting policies applied,
o
supporting information for items presented on the face of each fmancial statement in the order in which each line item and each fmancial statement is presented,
o
other disclosures, including contingencies, commitments and other financial disclosures non-fmancial disclosures.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0523
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
9.2
Disclosure of accounting policies
•
Matters to be disclosed in respect of significant accounting policies
o
measurement basis (or bases) used
o
each specific accounting policy that is significant to a fair presentation.
•
Disclosure is required ofjudgements management has made in the process of applying an entity's accounting policies that have the most significant effect on amounts recognised.
9.3
Key sources of estimation uncertainty
•
Disclosure shall be made about key assumptions concerning the future, and key sources of estimation uncertainty at the balance sheet date, that have a significant risk of causing a material adjustment to the carrying value of assets and liabilities within the next fmancial year.
•
The disclosure shall include information of:
o
their nature; and
o
their carrying amount at the balance sheet date.
9.4
Other disclosures
•
Amount of dividends declared but not recognised as a distribution during the period
•
Amount of cumulative preference dividends not recognised
•
Domicile and legal form of the entity, to include country of incorporation
•
Description of the nature of the entity's operations and its principal activities
•
Name of the parent and ultimate parent of the group
10
lAse DISCUSSION PAPER - BUSINESS REPORTING ON THE INTERNET
•
The IASC paper states that "the growing significance of electronic performance reporting and eCommerce brings opportunities, challenges and implications for the accounting profession and ultimately the applicable regulatory organisations".
•
A growing number of companies have web sites and more and more of them are placing business reporting information including financial data on these sites.
•
This causes a potential problem. Financial statements are subject to an audit but information posted to the web is not. Information extracted or presented out of context maybe misleading. Furthermore the accounting profession should move with the times and recognise the importance of the web as a means of disseminating information.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0524
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
•
The lASe discussion proposes that the lASe should draft a code of conduct for reporting on the internet. The recommendations for the content of the code include the following:
o
the same data as that published should be included on line. Thus if the financial statements are presented in more than I GAAP each should be available on the internet and these should be clearly identified so that a user knows when he is moving out of lAS fmancial statements. A reconciliation of each GAAP to lAS should be posted too.
o
information on the web should not be contradictory to the information published in other formats (this includes press releases).
o
fmancial or other information that is not derived from the lAS fmancial statements may also be posted on the web. Such information should not be presented in such a way to suggest that it conforms to an lAS standard.
o
if only excerpts of fmancial statements are published on the web then they should be clearly identified as such and reference should be made as to where the full fmancial statements can be found or obtained.
o
supplementary information that has been released by the entity but is not widely available (eg briefmgs to investment analysts) should be provided online to the benefit of all stakeholders.
o
if the financial statements are translated and the translated fmancial statements have not been audited then this should be clearly stated.
o
information should be provided in the language of an entity's key stakeholders. This may mean that the information has to be translated from the primary reporting language.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0525
IAS 1 PRESENTATION OF FlNANCIAL STATEMENTS
FOCUS You should now be able to: •
describe the structure and content of general purpose financial statements;
•
explain the overall considerations which underlie their presentation;
•
explain the relevance of the current/non-current distinction;
•
present fmancial information, as appropriate: on the face of the balance sheet; on the face of the income statement; in the notes;
•
describe the structure and content of notes;
•
understand the current discussion about the structure of reports on fmancial performance;
•
explain the issues facing the profession in respect of business reporting on the internet.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0526
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
OVERVIEW Objective •
To explain the need for guidance on reporting performance.
•
To prescribe the classification, disclosure and accounting treatment of certain items in the income statement.
BACKGROUND
• • •
Performance Disaggregation Reporting aspects ofperformance
INTRODUCTION
• •
Scope Definitions
• • • •
Selection and Application Consistency ofaccounting policies Changes in accounting policy Disclosure
CHANGES IN ACCOUNTING ESTIMATE
• • •
Introduction Accounting treatment Disclosure
PRIOR PERIOD ERRORS
• • •
Introduction Accounting treatment Disclosures
ACCOUNTING POLICIES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0601
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
1
BACKGROUND
1.1
Performance
•
The objective offmancial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
•
The economic decisions that are taken by users of financial statements require an evaluation of the ability ofan entity to generate cash and cash equivalents and of the timing and certainty of their generation.
•
Users are better able to evaluate this ability to generate cash and cash equivalents if they are provided with information that focuses on the fmancial position, performance and changes in fmancial position of an entity.
•
Information about the performance of an entity, in particular its profitability, is required in order to:
o
assess potential changes in the economic resources that it is likely to control in the future,
o
predict the capacity of the entity to generate cash flows from its existing resource base, and
o
form judgements about the effectiveness with which the entity might employ additional resources.
•
Information about variability of performance is important in this respect.
1.2
Disaggregation
•
In order to make economic decisions users of the accounts need to understand the composition of figures in as much detail as possible. There is a trend in reporting to provide more detailed information about the composition of key elements of the fmancial statements. In short the information may be analysed, either on the face of the statements or in notes to the accounts, into component parts to better aid understanding.
•
•
For example:
o
Disclosure of material and unusual items which are part of ordinary activities,
o
Information on discontinued operations, and
o
Segmental reporting.
Users can use such information to make better quality forecasts in respect of the entity.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0602
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
1.3
Reporting aspects of performance
Relevant standards are: •
lAS 8 - Accounting Policies, Changes in Accounting Estimates and Errors
•
lAS 1 - Presentation ofFinancial Statements
•
lAS 14 - Segmental Reporting
•
lAS 7 - Cash flow Statements
•
IFRS 5 - Non-current Assets Held for Sale and Discontinued Operations
In considering the reporting of fmancial performance the following areas need to be covered: •
•
•
The form and content of the income statement
o
Structure (lAS 1)
o
Which items must be taken through the income statement (lAS 1)
o
Classification of material items (lAS 1)
o
Disclosure in respect of discontinued operations (IFRS 5)
Other statements of performance
o
Segmental reports (lAS 14)
o
Cash flow statements (lAS 7)
o
Statements showing changes in equity (lAS 1)
Other non mandatory disclosures
o •
Operating and financial reviews
Corporate governance
Note that many of these areas are covered elsewhere in this system. All ofthese areas need to be incorporated into an understanding of how international GAAP provides information to enable users to understand performance.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0603
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
2
INTRODUCTION
2.1
Scope
•
lAS 8 shall be applied in selecting and applying accounting policies and accounting for changes in accounting policies, changes in accounting estimates and corrections of prior period errors.
2.2
Definitions
•
Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting fmancial statements.
•
Changes in accounting estimate are adjustments to the carrying value of an asset or liability, or the amount of annual consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. These changes arise due to new information or developments and therefore are not to be classed as correction of errors. Examples of changes in accounting estimate are:
•
•
o
A receivable balance that is subsequently not recovered.
o
Changes to the usefu1life of a depreciable non-current asset
International Financial Reporting Standards are Standards and Interpretations adopted by the lASH. They comprise:
o
International Financial Reporting Standards;
o
International Accounting Standards;
o
International Financial Reporting Interpretations Committee pronouncements; and
o
Standing Interpretations Committee pronouncements
Prior period errors are omissions and misstatements, relating to the fmancial statements of previous periods arising from a failure to use, or misuse, information that:
o
Was available when those fmancial statements were authorised for issue
o
Could reasonably be expected to have been obtained and taken into account in the preparation and presentation of the financial statements.
Errors may include the effects of mathematical mistakes, mistakes in application of accounting policies, oversights and fraud.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0604
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
3
ACCOUNTING POLICIES
3.1
Selection and application
•
When a standard or interpretation applies to a transaction, the accounting policy or policies applied to that transaction shall be determined by applying the relevant standard or interpretation along with any relevant implementation guidance issued by the lASH.
•
If there is no applicable standard or interpretation relating to a transaction, management shall use its judgement in developing and applying an accounting policy resulting in information that:
•
o
is relevant to the economic decision making needs of users
o
is reliable
o
represents faithfully
o
reflects the economic substance of the transaction
o
is neutral
o
is prudent
o
is complete in all material aspects.
Management when making judgement may well consider requirements of accounting standards dealing with similar transactions, the definitions and recognition criteria in the Framework, recent pronouncements of other standard-setting bodies that use a similar conceptual framework, and any other accounting literature denoting best practice within a particular industry.
Illustration 1 Kitty has recently purchased a Van Gogh painting to display in their client reception area, with the hope it will lead to more contracts and that the painting will appreciate in value. There is no specific accounting standard that deals with these types of asset, but lAS 40 Investment Property does deal with a particular type of asset that is being held for capital appreciation. It would therefore seem appropriate to use lAS 40 as justification to value the painting at fair value year on year.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0605
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
3.2
Consistency of accounting policies
•
An entity shall be consistent in selection and application of accounting policies to transactions of a similar nature.
•
lAS 2 Inventories requires inventory to be valued at lower of cost and net realisable values. In identifying cost it allows a number of possible formulas, such as FIFO or weighted average. The same cost formula must be applied to similar items of inventory, but a different cost formula can be applied to a different classification of inventory.
•
lAS 23 Borrowing Costs allows certain borrowing costs to be included in the cost of a qualifying asset. If the capitalisation policy is selected then borrowing costs relating to ALL qualifying assets must be capitalised.
3.3
Changes in accounting policy
3.3.1
When
•
An entity shall only change its accounting policy if:
o
it is required to do so by a standard or interpretation; or
o
it would result in the financial statements providing more relevant and reliable information.
•
As users of financial statements will wish to see trends in an entity's financial statements it would not be appropriate for an entity to change its accounting policy whenever it wishes.
•
If an entity decides to adopt the revaluation model of lAS 16 Property, Plant and Equipment this would be classed as a change in accounting policy.
3.3.2
How
•
If a new accounting standard is issued the transitional provisions of that standard will be applied to any change of accounting policy. When lAS 39 Financial Instruments, Recognition and Measurement was fITSt issued it required entity's to value and recognise all derivative instruments in an entity's balance sheet with effect from 1 January 2001.
•
If the new standard does not have any transitional provisions, or it is a voluntary change in policy, then the entity shall apply the change in policy retrospectively.
•
When a change is applied retrospectively, an entity shall adjust the opening balance of each affected part of equity for the earliest period presented and the comparative amounts disclosed for each prior period as if the new policy had always been applied.
•
If it is not practicable to apply the effects of a change in policy to prior periods then the standard allows the change of policy to be made from the earliest period for which retrospective application is practicable.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0606
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
3.4
Disclosure
3.4.1
Change due to new standard or interpretation
•
Title of new standard or interpretation and the nature of the change in policy.
•
When applicable, that the change is made in accordance with the standard's transitional provisions, a description of those provisions and the effect that the provisions might have on future periods.
•
For the current period and each prior period presented the amount ofthe adjustment for each line item affected within the financial statements.
•
The amount of the adjustment relating to periods before those presented.
•
If retrospective restatement is not practicable, the circumstances that led to the existence of the condition and a description of how and from when the change has been applied.
3.4.2
Voluntary change in policy
•
Nature of the change in policy
•
Reasons why the new policy provides more reliable and relevant information.
•
For the current period and each prior period presented the amount of the adjustment for each line item affected within the financial statements.
•
The amount of the adjustment relating to periods before those presented.
•
If retrospective restatement is not practicable, the circumstances that led to the existence of the condition and a description of how and from when the change has been applied.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0607
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
Illustration 2 Alpha, an incorporated entity has previously followed a policy of capitalisation of development expenditure. It has recently decided to adopt the provisions ofIAS 38 Intangible Assets, for the year ending 31 st December 2004. Alpha has been advised by their auditors that the expenditure previously capitalised does not qualify for capitalisation under the recognition criteria set out in the standard. The notes to the accounts for the year ended 31st December 2003 in respect of the deferred development expenditure was as follows; Balance at 1st January 2003 Additions
$ 1,000 500
Amortisation
(400)
Balance at 31 st December 2003
1,100
During the year ended 31 st December 2004 the company has expensed all expenditure in the period on projects, in respect of which, expenditure had previously been capitalised, and no amortisation has been charged in the income statement in 2004. The following are extracts from the draft accounts for the year ended 31 st December 2004.
Income statements
2004
2003 (as previously published)
$
$
Revenue
1,200
1,100
Expenses
(800)
(680)
400
420
Profit for the year
Statement of changes in equity (extract) Balance as at 1st January Profit for the year Balance as at 31 st December
$
$
3,000
2,580
400
420
3,400
3,000
Required: Show how the income statement and statement of changes in equity would appear in the financial statements for the year ended 31 st December 2004 processing the necessary adjustments in respect of the change in accounting policy by applying the new policy retros ectivel .
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0608
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
Solution Income statements
2004
2003 (as restated) $ 1,100
Revenue
$ 1,200
Expenses
(800)
(780)
400
320
$
$
3,000
2,580
(1,100)
(1,000)
1,900
1,580
400
320
2,300
1,900
Profit for the year Statement of changes in equity (extract) Balance as at I st January 2004 As previously stated Prior period adjustment
Profit for the year Balance as at 31st December 2004 Notes I
The entity amortised $400 in 2003 but spent $500. The policy would have been to write off the amount of expenditure directly to the income statement, therefore the entity needs to adjust last year's figures by an extra $100 expense. The adjustment against last year's income statement ($100) has the effect of restating it to what it would have been if the company had been following the same policy last year. This is important because the income statements as presented shall be prepared on a comparable basis.
2
The balance left on the deferred expenditure account at the end of the previous year (1,100) is written off against the accumulated profit that existed at that time. This 1,100 is made up of an amount that arose last year (the difference between the amount spent ($500) and the amount amortised ($400), and the balance that existed at the beginning of the previous year ($1,000». These amounts are written off against last year's profit and the opening balance on the accumulated profit last year, respectively.
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0609
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
4
CHANGES IN ACCOUNTING ESTIMATE
4.1
Introduction
•
Many items recognised in the financial statements must be measured with an element of estimation attached to them.
o
Receivables may be measured after allowing for a general bad debt provision
o
Inventory is measured at lower of cost or net realisable value but must provide for obsolescence
o
A provision under lAS 37 by its very nature may be an estimation of future economic benefits to be paid out
o
Non-current assets are depreciated, the charge takes into account the expected pattern of consumption of the asset and its expected useful life. The consumption pattern and expected life are estimates.
4.2
Accounting treatment
•
As soon as a change in circumstances occur which affect the estimates previously made, the effect of that change shall be recognised prospectively by including in the current and future (where relevant) periods profit and loss. A change in estimate is not an error or a change in accounting policy and therefore does not impact upon prior period statements.
•
If the change in estimate affects the measurement of assets or liabilities then the change shall be recognised by adjusting the carrying amount of the asset or liability.
4.3
Disclosure
•
The nature and amount of a change in estimate that has an effect in the current period or is expected to have an effect in future periods.
•
If it is not possible to estimate the effects on future periods then that fact must be disclosed.
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0610
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
5
PRIOR PERIOD ERRORS
5.1
Introduction
•
These are defined as 'omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from the failure to use or, misuse of, reliable information that was available and could reasonably be expected to have been obtained when those prior period financial statements were authorised for issue'.
5.2
Accounting treatment
•
The amount of the correction of an error that relates to prior periods shall be reported by adjusting the opening balance of retained earnings and restating comparative information.
•
The financial statements ofthe current period are presented as if the error had been corrected in the period in which the error was originally made. However, an entity does not reissue the financial statements of prior periods.
•
If it is not practicable to determine the period specific effects of an error on comparative information for prior periods presented, the entity shall restate the opening balances for the earliest period practicable.
5.3
Disclosures
•
Nature of the error
•
For each prior period presented the amount of the correction for each line item affected within the financial statements
•
The amount of the correction at the beginning of the earliest period presented.
•
If retrospective restatement is not practicable, the circumstances that led to the existence of the condition and a description of how and from when the error has been corrected.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0611
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS
FOCUS You should now be able to: •
explain the need for an accounting standard in this area;
•
prepare an income statement in accordance with the requirements of lAS 8;
•
describe the circumstances where a change in accounting policy is justified;
•
account for the correction of prior period errors and changes in accounting policies.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0612
IAS 18 REVENUE
OVERVIEW Objective
•
To describe the principles of revenue recognition
INTRODUCTION
I
• • • •
Scope Definitions Measurement ofrevenue Disclosure
• • •
Sale ofGoods Rendering ofServices Interest, Royalties and Dividends
SALE OF GOODS
I RENDERING OF SERVICES
I INTEREST, ROYALTIES AND DIVIDENDS
I SPECIFIC EXAMPLES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
070 I
IAS 18 REVENUE
1
INTRODUCTION
1.1
Scope
•
Revenue arising from
Sale of goods
•
Including goods produced/purchased for resale egs merchandise purchased by a retailer
Rendering of services
•
Use of entity assets yielding interest, royalties and dividends
Typically involves performance of a contractually agreed task over an agreed period of time.
land and property held for resale.
•
• •
Interest - charges for use of cash/cash equivalents or amounts due Royalties - charges for use of long-term assets e.g. patents, trademarks, copyrights and computer software Dividends - distributions of profits to equity holders.
1.2
Definitions
•
Revenue is the gross inflow of economic benefits during the period arising in the course of ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.
•
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.
1.3
Measurement of revenue
•
At fair value of the consideration received or receivable.
•
Taking into account trade discounts and volume rebates allowed.
Illustration 1 Accounting policies (extract) Valuation methods and definitions Sales to customers Sales to customers represent sales of products and services rendered to third parties, net of general price reductions and sales taxes.
Nestle Consolidated accounts 2002
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IAS 18 REVENUE
Illustration 2 1. Accounting policies Revenue recognition Turnover, which excludes intergroup sales, represents invoiced sales and is stated net of value added taxes. Much of the Group's activity is conducted under Production Sharing Agreements ("PSAs") which involve the delivery of a share of the production to the host government and as such represents a form of taxation. Turnover excludes royalties paid in oil and the share of oil attributable to host governments under PSAs.
Energy Africa 2002
1.4
Disclosure
•
Accounting policies adopted for revenue recognition
•
Amount of each significant category of revenue recognised during the period.
2
SALE OF GOODS
•
Revenue recognition criteria
•
D
Significant risks and rewards of ownership are transferred to the buyer
D
Neither continuing managerial involvement nor effective control over goods sold are retained
D
The amount of revenue can be measured reliably
D
It is probable that economic benefits associated with the transaction will flow to entity
D
Costs (to be) incurred in respect of the transaction can be measured reliably.
The passing of risks and rewards is critical to revenue recognition. D
If legal title passes but risk and rewards are retained, no sale shall be recognised. eg: where the entity retains obligation for unsatisfactory performance not covered by normal warranty provisions, or where the receipt of revenue is contingent on the buyer selling the goods on, or goods are to be installed and the installation is a significant part of the contract and remains uncompleted, or the buyer has the right to rescind and the seller is uncertain about the outcome.
D
If legal title does not pass but the risks and rewards do then the transaction shall be recognised as a sale.
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IAS 18 REVENUE
•
Cost recognition D
Usually revenue and expenses are to be recognised simultaneously.
D
Expenses can normally be measured reliably when other conditions for revenue recognition have been satisfied.
D
Revenue cannot be measured when the related expenses cannot be measured reliably. In such cases proceeds shall be recognised as a liability not a sale.
3
RENDERING OF SERVICES
•
Revenue recognition criteria D
Recognise revenue by reference to the stage of completion of the transaction at the balance sheet date (but only if the outcome can be estimated reliably). this is known as the percentage completion method it is applied in lAS 11 Construction contracts it provides useful information on service activity in the period.
•
•
Stage of completion shall be estimated using the method that measures reliably the services performed. May include: D
surveys of work completed (known as work certified).
D
services performed as a percentage of total services.
D
proportion of costs to date to total estimated costs.
Reliable estimate of outcome is subject to the following conditions (all must be satisfied). D
The amount of revenue can be measured reliably,
D
It is probable that the economic benefits associated with the transaction will flow to the entity,
D
The stage of completion of the transaction can be measured reliably,
D
Costs to complete can be measured reliably.
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lAS 18 REVENUE
•
Ability to make reliable estimate depends on D
Agreement with the customer about enforceable rights of each party consideration to be exchanged manner and the terms of settlement Existence of an effective internal financial reporting and budgeting system.
D
•
If outcome cannot be measured reliably recognise the revenue only to the extent of the expenses recognised that are recoverable.
Illustration 3
Notes to the consolidated financial statements (extract) Revenue recognition Sales from the majority of the Group are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable and collectibility is probable. Sales and cost of sales from contracts involving solutions achieved through modification of telecommunications equipment are recognized on the percentage of completion method when the outcome of the contract can be estimated reliably. Completion is generally measured by reference to cost incurred to date as a percentage of estimated total project costs.
NOKIA ANN U A LAC C 0 U N T S 2 0 0 2 Illustration 4 NOTES TO THE STATEMENTS OF INCOME (extract) [1] Net sales Sales are recognized upon delivery of goods or rendering of services to third parties and are reported net of sales taxes and rebates. Revenues from contracts that contain customer acceptance provisions are deferred until customer acceptance occurs or the contractual acceptance period has lapsed. Allocations to provisions for rebates to customers are recognized in the period in which the related sales are recorded based on the contract terms. Payments relating to the sale or outlicensing of technologies or technological expertise - once the respective agreements have become effective - are immediately recognized in income if all rights to the technologies and all obligations resulting from them have been relinquished under the contract terms. However, if rights to the technologies continue to exist or obligations resulting from them have yet to be fulfilled, the payments received are recorded in line with the actual circumstances.
Notes to Consolidated Financial Statements of the Bayer Group
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IAS 18 REVENUE
4
INTEREST, ROYALTIES AND DIVIDENDS
•
Revenue recognition criteria
•
D
It is probable that economic benefits will flow to the entity and
D
The amount of the revenue can be measured reliably.
Recognition bases D
Interest - a time proportion basis
D
Royalties - an accrual basis in accordance with the substance of the agreement
D
Dividends - when the shareholder's right to receive payment is established.
5
SPECIFIC EXAMPLES
5.1
Sale of Goods
•
The law in different countries may determine the point in time at which the entity transfers the significant risks and rewards of ownership. The examples in this section need to be read in the context of the laws relating to the sale of goods in the country in which the transaction takes place.
5.1.1
Bill and hold sales
•
Delivery is delayed at the buyer's request but the buyer takes title and accepts billing
•
Revenue is recognised when the buyer takes title, provided:
•
D
it is probable that delivery will be made;
D
the item is on hand, identified and ready for delivery to the buyer at the time the sale is recognised;
D
the buyer specifically acknowledges the deferred delivery instructions; and
D
the usual payment terms apply.
Revenue is not recognised when there is simply an intention to acquire or manufacture the goods in time for delivery.
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IAS 18 REVENUE
5.1.2
Goods shipped subject to conditions
5.1.2.1
Condition - installation and inspection
•
Revenue is normally recognised when the buyer accepts delivery, and installation and inspection are complete. However, revenue is recognised immediately upon the buyer's acceptance of delivery when:
o
The installation process is simple in nature, (e.g. the installation of a piece of equipment which only requires unpacking and connection of power) or
o
The inspection is performed only for purposes of final determination of contract prices, (e.g. shipments of commodities e.g. iron ore).
5.1.2.2
Condition - on approval when the buyer has negotiated a limited right of return
•
If there is uncertainty about the possibility of return, revenue is recognised when the shipment has been formally accepted by the buyer or the goods have been delivered and the time period for rejection has elapsed.
5.1.2.3
Consignment sales - Under these contracts the buyer undertakes to sell the goods on behalfofthe seller
•
Revenue is recognised by the shipper when the goods are sold by the recipient to a third party.
5.1.2.4
Cash on delivery sales
•
Revenue is recognised when delivery is made and cash is received by the seller or its agent.
5.1.3
Layaway sales
•
Goods are delivered only when the buyer makes the fmal payment in a series of instalments.
•
Revenue from such sales is recognised when the goods are delivered.
•
However, revenue may be recognised earlier, i.e. when a significant deposit is received, provided the goods are on hand, identified and ready for delivery to the buyer, when experience indicates that most such sales will actually proceed to completion.
5.1.4
Orders when payment (or partial payment) is received in advance ofdelivery for goods not presently held in inventory
•
Revenue is recognised when the goods are delivered to the buyer.
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IAS 18 REVENUE
5.1.5
Sale and repurchase agreements
•
Under these agreements the two parties enter into an agreement where the seller may repurchase the goods at some later date. For example:
•
D
As the result of an explicit agreement;
D
The seller has a call option to repurchase;
D
The buyer has a put option to require the repurchase, by the seller, ofthe goods.
Revenue is recognised according to the substance of the transaction. D
If the substance of the arrangement is that the seller has transferred the risks and rewards of ownership to the buyer revenue shall be recognised.
D
If the substance of the arrangement is that the seller retains the risks and rewards of ownership (even if legal title is transferred) the transaction is a financing arrangement and does not give rise to revenue.
5.1.6
Sales to intermediate parties, such as distributors, dealers or others for resale
•
Revenue from such sales is generally recognised when the risks and rewards of ownership have passed.
•
However, when the buyer is acting, in substance, as an agent, the sale is treated as a consignment sale.
5.1.7
Subscriptions to publications and similar items
•
When the items involved are of similar value in each time period, revenue is recognised on a straight-line basis over the period in which the items are despatched.
•
When the items vary in value from period to period, revenue is recognised on the basis of the sales value of the item despatched in relation to the total estimated sales value of all items covered by the subscription.
5.1.8
Installment sales
•
Contracts where the consideration is receivable in instalments.
•
Revenue attributable to the sales price, exclusive of interest, is recognised at the date of sale.
•
Note that the sale price is the present value of the consideration, determined by discounting the instalments receivable at the imputed rate of interest.
•
The excess of cash receipts over the initial sale price recognised is interest and shall be recognised as revenue as it is earned, on a time proportion basis that takes into account the imputed rate of interest.
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IAS 18 REVENUE
5.1.9
Real estate sales
•
Revenue is normally recognised when legal title passes to the buyer.
•
However the basic transaction might be subject to complication e.g. D
In some jurisdictions the equitable interest in a property may pass at a date which is different to that at which legal title passes
D
Real estate may be sold with a degree of continuing involvement by the seller such that the risks and rewards of ownership have not been transferred.
•
In such cases revenue shall be recognised to reflect the substance of the transaction.
5.2
SPECIFIC EXAMPLES - Rendering of Services
5.2.1
Installation fees
•
Recognise as revenue by reference to the stage of completion of the installation, unless they are incidental to the sale of a product in which case they are recognised when the goods are sold.
5.2.2
Servicingfees included in the price ofthe product
•
Recognised as revenue over the period during which the service is performed.
•
The amount to be deferred is enough to cover the expected costs of the services under the agreement, plus a reasonable profit on those services.
5.2.3
Advertising commissions
•
Media commissions - recognise when the related advertisement or commercial appears before the public.
•
Production commissions - recognise by reference to the stage of completion of the project.
5.2.4
Admissionfees
•
Recognise when the event takes place.
•
When a subscription to a number of events is sold, the fee is allocated to each event on a basis which reflects the extent to which services are performed at each event.
5.2.5
Tuitionfees
•
Revenue is recognised over the period of instruction.
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IAS 18 REVENUE
5.2.6
Initiation, entrance and membership fees
•
Recognise as revenue when no significant uncertainty as to its collectability exists as long as it is a membership fee only and any other service is paid for separately.
•
If the fee entitles the member to other benefits it is recognised on a basis that reflects the timing, nature and value of the benefits provided.
5.2.7
Franchise fees
•
Franchise fees may cover the supply of initial and subsequent services, equipment and other tangible assets, and know-how.
•
Franchise fees are recognised as revenue on a basis that reflects the purpose for which the fees were charged.
5.2.7.1
Supplies ofequipment and other tangible assets
•
The amount, based on the fair value of the assets sold, is recognised as revenue when the items are delivered or title passes.
5.2.7.2
Supplies ofinitial and subsequent services
•
The initial fee is recognised as the initial service is completed
•
Fees for the provision of continuing services are recognised as revenue as the services are rendered.
•
Sufficient fee must be deferred to cover the costs of continuing services and to provide a reasonable profit on those services. (This means that some of the fee for the initial service may need to be deferred to satisfy this requirement).
5.2.7.3
Continuingfranchise fees
•
Recognise as revenue as the services are provided or the rights used.
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IAS 18 REVENUE
5.3
SPECIFIC EXAMPLES - Interest, Royalties and Dividends
5.3.1
Licencefees and royalties
•
Fees and royalties received are normally recognised in accordance with the substance of the agreement.
•
Such fees may be received for the use of an entity's assets e.g.
o
Trademarks
o
Patents
o
Software
o
Music copyright
o
Motion picture films
•
As a practical matter, this may be on a straight-line basis over the life of the agreement, for example, when a licensee has the right to use certain technology for a specified period of time.
•
If receipt of a licence fee or royalty is contingent on the occurrence of a future event revenue is recognised only when it is probable that the fee or royalty will be received, (which is normally when the event has occurred).
FOCUS You should now be able to: •
outline the principles of the timing of revenue recognition;
•
discuss and give examples of the various points in the production and sales cycle where it may, depending on circumstances, be appropriate to recognise gains and losses;
•
describe the lASH's "balance sheet approach" to revenue recognition within its Framework and compare this to the requirements of lAS 18 Revenue.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0711
IAS 18 REVENUE
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0712
IAS 11 CONTRUCTION CONTRACTS
OVERVIEW Objective
•
To describe and explain the accounting treatment for construction contracts.
INTRODUCTION
RECOGNTION AND MEASUREMENT
• • • • • •
Scope Definitions Key issues Revenue Contract costs Exam comments
• • •
The rules Calculations Recognition
PRESENTATION AND DISCLOSURE
© Accountancy Tuition Centre (International Holdings) Ltd 2005
080 I
IAS 11 CONTRUCTION CONTRACTS
1
INTRODUCTION
1.1
Scope
•
lAS 11 shall be applied in accounting for construction contracts in the financial statements of contractors.
1.2
Definitions
•
A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use
•
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses
•
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defmed costs, plus a percentage of these costs or a fixed fee.
•
Construction contracts include:
o
Contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and
o
Contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of assets.
Contrast with speculative building work without a firm sale contract. This is work-in- ro ess and is valued at the lowert 0 cost and net realisable value.
1.3
Key issues Revenue and profit recognition
•
Contracts may last several years. Costs are incurred, and customer is billed, over duration of contract.
•
Potential treatments
•
o
Recognise all revenue and related costs in the income statement only on completion of contract, or,
o
Recognise revenue and costs in the income statement as contract progresses.
Accruals and prudence
o
Should recognise revenues and costs as they are earned and incurred.
o
Should only recognise profits when cash realisation is reasonably certain, but make provision for costs and losses when foreseen.
o
Prudence may conflict with accruals.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0802
IAS 11 CONTRUCTION CONTRACTS
•
lAS 11 requires that the costs and revenues associated with a contract shall be recognised in the income statement as the contract activity progresses.
1.4
Revenue
•
Contract revenue shall comprise:
o
the initial amount of revenue agreed in the contract, and
o
variations in contract work, claims and incentive payments, to the extent that it is probable that they will result in revenue, and they are capable of being reliably measured.
•
Contract revenue is measured at the fair value ofthe consideration received or receivable.
•
Its measurement is affected by a variety of uncertainties that depend on the outcome of future events. The estimates often need to be revised as events occur and uncertainties are resolved. Therefore, the amount of contract revenue may increase or decrease from one period to the next. For example:
o
a contractor and a customer may agree variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed,
o
the amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses,
o
the amount of contract revenue may decrease as a result of penalties arising from delays caused by the contractor in the completion of the contract, or
o
when a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of units is increased.
1.5
Contract costs
•
Contract costs comprise:
•
o
costs that relate directly to the specific contract,
o
costs that are attributable to contract activity in general and can be allocated to the contract, and
o
such other costs as are specifically chargeable to the customer under the terms of the contract.
Costs that relate directly to a specific contract include:
o
site labour costs, including site supervision,
o
costs of materials used in construction,
o
depreciation of plant and equipment used on the contract,
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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IAS 11 CONTRUCTION CONTRACTS
o
costs of moving plant, equipment and materials to and from the contract site,
o
costs of hiring plant and equipment,
o
costs of design and technical assistance that is directly related to the contract,
o
the estimated costs of rectification and guarantee work, including expected warranty costs, and
o
claims from third parties.
•
These costs may be reduced by any incidental income that is not included in contract revenue, for example income from the sale of surplus materials and the disposal of plant and equipment at the end of the contract.
1.6
Exam comments
•
The examiner has stated that IAS 11 will not feature heavily in the 3.6 exam, these notes are provided as a refresher from your P2.5 studies. Do not spend to much time on this session.
2
RECOGNITION AND MEASUREMENT
2.1
The rules
2.1.1
CTeneral
•
Contracts shall be considered on a contract by contract basis.
•
The impact that a contract will have on the financial statements depends on the estimate of the future outcome of the contract.
•
The rules in lAS 11 provide for three possibilities.
o
Contracts which are expected to make a profit and where the outcome is reasonably certain.
o
Contracts where a loss is expected.
o
Contracts where the outcome cannot be assessed with reasonable certainty.
2.1.2
Specific
•
When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date. (Profit will be taken)
•
When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately.
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0804
IAS 11 CONTRUCTION CONTRACTS
•
2.1.3
When the outcome of a construction contract cannot be estimated reliably:
o
revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable, and
o
contract costs shall be recognised as an expense in the period in which they are incurred.
Commentary Situation
Profit is being taken
How is revenue measured?
How are costs measured for recognition in the income statement?
Comments
By reference to the stage of/percentage completion method
The costs incurred in reaching the stage of completion are taken to the income statement as cost of sales.
Revenue> costs therefore profit is recognised.
Often this is achieved by applying the percentage completion to the total costs that are expected to occur over the life of the contract.
If the same % completion is applied to revenue and costs then this will result in that percentage of the total estimated profit being recognised
Loss making contracts
By reference to the stage of/percentage completion method
As a balancing figure to interact with the revenue that has been recognised and generate the required loss.
Loss maybe recognised at any stage of a contract. Eg an entity may have signed a contract that it knows will make a loss. In such a case the loss shall be recognised when the contract is signed.
Contracts where the outcome is uncertain
To equal the cost figure
The costs incurred in the period shall be expensed
Revenue = costs
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0805
The usual source of uncertainty is that the contract is still quite young. Eg it may be deemed imprudent to take profit on a 10 year contract when it is only 1 year old.
IAS 11 CONTRUCTION CONTRACTS
•
The accounting shall be performed so as to recognise revenue and costs that have arisen in the period. This is done by calculating the amounts in total that shall be recognised by the year end and then adjusting them for what has been recognised in earlier years.
2.1.4
Stage ofcompletion
•
The recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method.
o
Contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed.
o
This method provides useful information on the extent of contract activity and performance during a period. The standard does not specify a single method for calculating the percentage of completion. Methods include the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs, surveys of work performed, or completion of a physical proportion of the contract work.
•
An expected loss on the construction contract shall be recognised as an expense immediately.
•
Note that:
o
amounts billed are irrelevant in determining revenue to be taken to the income statement;
o
costs incurred by the year end (and therefore appearing in the cost accounts) may be an irrelevant figure in determining cost of sales.
2.2
Calculations
2.2.1
Basics
•
Make all calculations on contract by contract basis. There is no netting-off of profits on, or assets relating to, one contract against losses or liabilities on another.
•
Steps to obtain figures for the income statement.
(a)
Calculate total expected profit
$ X (X) (X)
Contract price Less Costs to date Estimated future costs
X
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0806
IAS 11 CONTRUCTION CONTRACTS
(b)
Calculate the stage of completion
I
Acceptable methods include
I
I
I I
Sales basis
Cost basis
Value of work done to date Total sales value
Costs to date Total costs
(lAS 11 does not specify a method). (c)
Calculate revenue and costs for the year (i)
Calculate attributable revenue and costs to date (using proportion above)
(ii)
Deduct any revenue and costs taken in earlier income statements.
(iii)
If cannot prudently recognise profit, include same amount in the income statement for both revenue and cost of sales to give a nil profit.
Illustration 1 Tanner Ltd - year ended 31 December 2003 Costs to date Future expected costs
$ 1,500 1,000
Work certified to date Expected sales value
1,800 3,200
Revenue taken in earlier years' income statements Cost taken in earlier years' income statements
1,200 950
Required Calculate the figures to be taken to the income statement in respect of revenue and costs year ended 31 December 2003 on both a sales and a costs basis.
Solution 1 (a)
Calculate total expected profit $ 3,200 (1,500) (1,000)
Sales Less Costs to date Expected costs
700
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0807
IAS 11 CONTRUCTION CONTRACTS
(b)
(c)
Pecentage completion Sales basis
Costs basis
1,800/3,200 = 0.5625 = 56.25%
1,500/2,500 = 0.6 = 60%
Calculate revenue and costs for the year To date
To date
Prior period
Prior period
$
Revenue
3,200 x 56.25% = 1,800 -1,200=
600
Cost of sales
2,500 x 56.25% = 1,406 - 950 =
(456)
3,200 x 60% = 1,920 -1200 = 2,500 x 60% = 1,500 -
950 =
144
Profit
Recognition
•
The basic double entry for each contract is quite straightforward
X X
When payments on account are received/when amounts billed the double entry is: Dr Cash/Receivables Cr Contract account
D
X X
The double entry for the revenue to be recognised is: Dr Contract account X Cr Income statement - Sales
D
(550)
When costs are actually incurred on the contract the double entry is: Dr Contract account Cr Cash/accruals/expenses
D
720
170
2.3
D
$
X
The double entry for the costs to be recognised is Dr Income statement - Cost of sales Cr Contract account
X X
This transfers revenues and costs that have been accumulated in the contract account to the income statement.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0808
IAS 11 CONTRUCTION CONTRACTS
3
PRESENTATION AND DISCLOSURE
•
An entity shall disclose:
•
•
•
o
The amount of contract revenue recognised as revenue in the period,
o
The methods used to determine the contract revenue recognised in the period,and
o
The methods used to determine the stage of completion of contracts in progress.
An entity shall disclose each of the following for contracts in progress at the balance sheet date:
o
The aggregate amount of costs incurred and recognised profits (less recognised losses) to date,
o
The amount of advances received, and
o
The amount of retentions.
An entity shall present
o
The gross amount due from customers for contract work as an asset, and
o
The gross amount due to customers for contract work as a liability.
The standard says that the gross amount due to or from customers is the net amount of
o o
Costs incurred plus recognised profits, less The sum of recognised losses and progress billings.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0809
IAS 11 CONTRUCTION CONTRACTS
Illustration 2 Company Flora Contracts as at 31 December 2003
B $000 100
$000 80
40 30
2 58
75 25
A
Contract value Costs to date Estimated costs to complete
c
$000 100
Billings
15.6
Date started
1.1.2003 30.11.2003 1.1.2003
% completion
67
45%
3%
80%
Required: Prepare extracts from the accounts of Flora as at 31 December 2003.
Solution 2 WI Revenue COS
45 31.5
W2
W3
$000
2 2
64 84
111 (117.5)
13.5
(20)
(6.5)
Contract revenue recognised as revenue in the period:
111
Contract costs incurred and recognised profits ( less recognised losses) to date 110.5 Gross amounts due from customers for contract work (37.9 + 2)
39.9
Gross amounts due to customers for contract work
12
WORKINGS Contract costs incurred Profits /losses
Billings
C 75 (20)
Total 117 (6.5)
2
55 (67)
110.5 (82.6)
2
(12)
27.9
A
B
40 13.5
2
53.5 (15.6) 37.9
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0810
lAS 11 CONTRUCTION CONTRACTS
(1)
Contract A - Profit making Contract account $
$
Costs incurred
40
Billings
15.6
Revenue recognised
45
Costs recognised
31.5
Balance clf
85
85 Balance bId
37.9
37.9
Amount owed by customers = 37.9
(2)
Contract B - too soon to take profit Contract account
Costs incurred Revenue recognised
$ 2 2
Billings
$ 0
Costs recognised
2
Balance clf
4
4 Balance bId
2
2
Amount owed by customers = 2
(3)
Contract C - loss making contract Contract account
Costs incurred
75
Billings
$ 67
Revenue recognised
64
Costs recognised
84
Balance clf
12
$
151
151 Balance bId Amount owed to customers = 12
© Accountancy Tuition Centre (International Holdings) Ltd 200S
0811
12
IAS 11 CONTRUCTION CONTRACTS
FOCUS You should now be able to: •
define a construction contract and describe why recognising profit before completion is generally considered to be desirable;
•
discuss if the above may be profit smoothing;
•
describe the ways in which contract revenue and contract costs may be recognised;
•
calculate and disclose the amounts to be shown in the financial statements for construction contracts.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0812
IAS 16 PROPERTY,PLANT AND EQUIPMENT
OVERVIEW
Objective •
To prescribe the accounting treatment for tangible non current assets.
INTRODUCTION
• •
• RECOGNITION
•
Criteria
Scope Exclusions Definitions . --_ ...........
DISCLOSURES each class • For Others •• Items stated at revaluedamounts - ------- -------_. ---_.-----_..-----~_ ..-!?~~~- ---- ---- --
INITIAL MEASUREMENT AT COST
••
Componentsofcost Exchange ofassets
MEASUREMENT AFTER RECOGNITION Accountingpolicy Cost Model RevaluationModel
•• •
SUBSEQUENT COSTS
•• •
REVALUATIONS
•• •
•
Accounting standards Depreciableamount
RECOVERY OF CARRYING AMOUNT Impairment Compensation
Fair value Frequency AccumulatedDepreciation Increase/decrease NON DEPRECIATION
DEPRECIATION
••
Running costs Part replacement Major inspectionor overhaul costs
•••
Background Arguments employed IA.S 16
••
DERECOGNITION treatment • Accounting Derecognitiondate • IFRS 5 DISPOSAL OF NONCURRENT ASSETS AND PRESENTATION OF DISCONTINUED OPERATIONS • Reasonsfor ISsue • Mainfeatures
MEASUREMENT
II:> ~tancy Tuition Cen1re (InternationalHoldings)Ltd 2005
0901
IAS 16 PROPERTY, PLANT AND EQUIPMENT
1
INTRODUCTION
1.1
Scope
•
This standard shall be applied in accounting for property, plant and equipment except when another IAS requires or permits a different treatment.
1.2
Exclusions
•
lAS 16 does not apply to
o
biological assets that relate to agricultural activity (IAS 41)
o
mineral rights and reserves such as oil, natural gas and similar nonregenerative resources.
1.3
Definitions
•
Property, plant and equipment are tangible assets that:
o
are held for use in the production or supply of goods or services or for rental or for admin purposes and
o
are expected to be used during more than one period.
•
Depreciation is systematic allocation of depreciable amount of an asset over its useful life.
•
Depreciable amount is the cost (or other amount substituted for cost) less its residual value.
•
Useful life is either the period of time over which an asset is expected to be used, or the number of production or similar units expected to be obtained from the asset.
•
Cost is the amount of cash/cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction.
•
Residual value is the estimated amount that an entity would currently obtain from the disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of an age and in the condition expected at the end of its useful life.
•
Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.
•
Carrying amount is the amount at which an asset is recognised in the balance sheet after deducting any accumulated depreciation and accumulated impairment losses thereon.
•
Impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount.
•
Entity-specific value - The present value of the cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life.
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0902
IAS 16 PROPERTY, PLANT AND EQUIPMENT
2
RECOGNITION
2.1
Criteria
•
An item of property, plant and equipment shall be recognised when:
o
it is probable thatfuture economic benefits associated with the asset will flow to the entity, (satisfied when risks and rewards have passed to entity), and
o
the cost of the asset to the entity can be measured reliably.
Usually readily satisfied because exchange transaction evidencing purchase identifies cost. For self-constructed asset, a reliable measurement of cost can be made from transactions with third parties for the acquisition of materials, labour and other inputs used. •
In certain circumstances it is appropriate to allocate the total expenditure on an asset to its component parts and account for each component separately.
3
INITIAL MEASUREMENT AT COST
•
Property, plant and equipment shall initially be measured at cost.
3.1
Components of cost
•
Purchase price, including import duties and non-refundable purchase taxes (after deducting trade discounts and rebates.)
•
Directly attributable costs of bringing the asset to location and working condition, for example:
•
o
costs of employee benefits (e.g. wages) arising directly from construction or acquisition;
o
costs of site preparation;
o
initial delivery and handling costs;
o
installation and assembly costs;
o
costs of testing proper functioning (net of any sale proceeds of items produced); and
o
professional fees (e.g. architects and engineers).
An initial estimate of dismantling and removal costs (i.e. "decommissioning") the asset and restoring the site on which it is located. The obligation for this may arise either:
o o
on acquisition of the item; or as a consequence of using the item other than to produce inventory.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0903
IAS 16 PROPERTY, PLANT AND EQUIPMENT
3.2
Exchange of assets
•
Cost is measured at fair value of asset received, which is equal to fair value of the asset given up (e.g. trade-in or part-exchange) adjusted by the amount of any cash or cash equivalents transferred. Except when:
o
the exchange transaction lacks commercial substance; or
o
the fair value of neither the asset received nor the asset given up is reliably measurable.
•
Whether an exchange transaction has commercial substance depends on the extent to which the reporting entity's future cash flows are expected to change as a result of the transaction.
4
SUBSEQUENT COSTS
•
The issue is whether subsequent expenditure is capital expenditure (i.e. to the balance sheet) or revenue expenditure (i.e. to the income statement).
4.1
Running costs
•
The carrying amount of an item of property, plant and equipment does not include the costs of day-to-day servicing of the item.
•
Servicing costs (e.g. labour and consumables) are recognised in profit or loss as incurred.
•
Often described as "repairs and maintenance" this expenditure is made to restore or maintain future economic benefits.
4.2
Part replacement
•
Some items (e.g. aircraft, ships, gas turbines, etc) are a series of linked parts which require regular replacement at different intervals and so have different useful lives.
•
The carrying amount of an item of property, plant and equipment recognises the cost of replacing a part when that cost is incurred, if the recognition criteria are met.
•
The carrying amount of replaced parts is derecognised (i.e. treated as a disposal).
4.3
Major inspection or overhaul costs
•
Performing regular major inspections for faults, regardless of whether parts of the item are replaced, may be a condition of continuing to operate an item of property, plant and equipment (e.g. an aircraft).
•
The cost of each major inspection performed is recognised in the carrying amount, as a replacement, if the recognition criteria are satisfied.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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IAS 16 PROPERTY, PLANT AND EQUIPMENT
•
On initial recognition an estimate will be made of the inspection costs and that amount will be depreciated over the period to the 1st inspection. This amount is part of the original cost recognised and is not an additional component of cost.
•
Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is derecognised.
Illustration 1 An airline is required by law to perform a major overhaul on each aeroplane's engines every five years. The engines may be identified as assets with a separate life from the rest of the aeroplane and written off to zero over five years. Overhaul expenditure might at first sight seem to be a repair to the aeroplane but it is actually a replacement of the engine. As such it must be capitalised.
5
MEASUREMENT AFTER RECOGNITION
5.1
Accounting policy
•
An entity may choose between the cost model and the revaluation model. However, the same policy must be applied to each entire class of property, plant and equipment.
•
Classes include land, land and buildings, factory plant, aircraft, vehicles, office equipment, fixtures and fittings' etc
5.2
Cost Model
•
Carry at cost less any accumulated depreciation and any accumulated impairment losses.
5.3
Revaluation Model
•
Carry at a revalued amount, being fair value at the date of the revaluation less any subsequent accumulated depreciation and any accumulated impairment losses.
•
To use this model fair values must be reliably measurable.
•
Before the revision of lAS 16, these were referred to as the "benchmark" and "allowed alternative" treatments, respectively. The elimination of alternatives was one of the principal objectives of the Improvements project.
6
REVALUATIONS
6.1
Fair value
6.1.1
Land and buildings
•
Market value is determined by appraisal normally undertaken by professionally qualified valuers.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0905
IAS 16 PROPERTY, PLANT AND EQUIPMENT
6.1.2
Plant and equipment
•
Fair value is usually market value determined by appraisal.
•
If there is no market-based evidence of fair value (e.g. because items are of a specialised nature or rarely sold), fair value is estimated using: D
D
depreciated replacement cost; or Depreciated replacement cost is what a new equivalent asset would cost (i.e. replacement cost) less depreciation. Items of plant and equipment are often insured for this amount if not for replacement cost under a "new for old" policy. an income approach.
6.2
Frequency
•
Revaluations must be made sufficiently regularly to ensure no material difference between carrying amount and fair value at the reporting date.
•
Frequency depends on movements in fair values. When fair value differs materially from carrying amount, a further revaluation is necessary.
•
Items within a class may be revalued on a rolling basis within a short period of time provided revaluations are kept up to date.
6.3
Accumulated Depreciation
•
At the date of the revaluation accumulated depreciation is either:
6.4 •
(i)
restated proportionately with the change in gross carrying amount so that the carrying amount after revaluation equals its revalued amount;
(ii)
eliminated against gross carrying amount and the net amount restated to the revalued amount.
Increase/decrease On an asset-by-asset basis: D
Increase shall be credited directly to equity under heading "revaluation surplus".
D
However a revaluation increase must be taken to income to the extent that it reverses a revaluation decrease of the asset that was previously recognised as an expense.
D
Decrease shall be recognised as an expense in income statement for the period.
D
However, a revaluation decrease must be charged directly against any related revaluation surplus to the extent that it is covered by that surplus.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0906
lAS 16 PROPERTY, PLANT AND BQUIPMHNT
Rlustratio1l 2 An asset was purchased for $100 on the 1 January 2003. The entity has adopted the revaluation model for subsequent measurement ofthe asset.
Asset 1.1.2003 31.12.2003 1.1.2004 31.12.2004
1.1.2005 31.12.2005
Revaluation reserve
100 20 120
20Cr 20Cr
120 (15) 105
20Cr (15) Dr SCr
105 (9)
5Cr (5) Dr
Income statement
!" Therimj,iWi"iS" taken'to""""" :_~~!Y~ _ ~"A" deficit is"taken"to"the""""
: income statement unless : it reverses a surplus held
L~.~~.~.s.~
_ .
!- "AgaiIlthe- deBcit iii taken-4Dr
96
: to equity but only to the : extent it reverses the : previously recognised ~ surplus with the rest to
:"~~.s"~~~~" ..,""""""" 96
1.1.2006
15 31.12.2006
11 Cr
4 Cr
111 ---
~. ~tp~~f"th~'~i~"" : that reverses the . previously expensed deficitis taken to the income statement The rest is taken directly to equity.
•
For simplicity annual depreciation hasbeen excluded from this illustration. However, depreciation would be charged each year before the revaluation adjustment is made.
•
The revaluation surplus may be transferred directly to retained earnings when the surplus is realised. Realisation occurs as the asset is consumed or disposed of. Ifthe transfer is made over the remaining life of the asset then the transfer to retained earnings will be an annual transfer based on the difference in depreciation charge under historical cost and the revalued amount.
•
However, it is not recycled (i.e. it is not included within profit or loss on disposal).
@
AccmmIBDlly Tuition Centre (IntamatiODll1 HoldingB) Ltd 2005
0907
IAS 16 PROPERTY, PLANT AND EQUIPMENT
7
DEPRECIATION
7.1
Accounting standards
•
Depreciable amount shall be allocated on a systematic basis over the useful life of the asset. Note that the term depreciable amount is the cost or revaluation. Depreciation is based on the carrying value in the balance sheet.
•
Depreciation method, useful life and residual value must be reviewed at least at each financial year-end. If expectations differ from previous estimates the change(s) are accounted for as a change in an accounting estimate in accordance with lAS 8.
•
The depreciation method shall reflect the pattern in which the asset's economic benefits are consumed.
•
The depreciation charge for each period shall be recognised as an expense unless it is included in the carrying amount of another asset.
•
Each part of an item of property, plant and equipment that is significant (in relation to total cost) is separately depreciated.
7.2
Depreciable amount
7.2.1
Useful life
•
Factors to be considered:
o
expected usage assessed by reference to expected capacity or physical output;
o
expected physical wear and tear (depends on operational factors e.g. number of shifts, repair and maintenance programme, etc);
o
technical obsolescence arising from: changes or improvements in production; or change in market demand for product or service output;
o
legal or similar limits on the use (e.g. expiry dates of related leases).
•
Asset management policy may involve disposal of assets after a specified time therefore useful life may be shorter than economic life.
•
Repair and maintenance policy may also affect useful life (e.g. by extending it or increasing residual value) but do not negate the need for depreciation.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0908
IAS 16 PROPERTY, PLANT AND EQUIPMENT
7.2.2
Depreciation period
•
Depreciation commences when an asset is available for use.
•
Depreciation ceases at the earlier of
o
the date the asset is classed as held for sale in accordance with IFRS 5; or
o
the date the asset is derecognised.
•
Depreciation does not cease when an asset is idle or retired from active use (unless it is fully depreciated). However, depreciation may be zero under the ''units of production method" .
7.2.3
Land and buildings
•
These are separable assets and are dealt with separately for accounting purposes, even when they are acquired together.
o
Land normally has an unlimited useful life and is therefore not depreciated.
o
Buildings normally have a limited useful life and are depreciable assets.
8
RECOVERY OF CARRYING AMOUNT
8.1
Impairment
•
To determine whether an item of property, plant and equipment is impaired an entity applies lAS 36 - Impairment ofassets
•
Impairment losses are accounted for in accordance with lAS 36.
8.2
Compensation
•
In certain circumstances a third party will compensate an entity for an impairment loss, for example, insurance for fire damage or compensation for compulsory purchase ofland for a motorway.
•
Such compensation must be included in the income statement when it becomes receivable. Recognising the compensation as deferred income or deducting it from the impairment or loss or from the cost of a new asset is not appropriate.
9
DERECOGNITION
9.1
Accounting treatment
•
Balance sheet - Eliminate on disposal or when no future economic benefits are expected from use ("retirement") or disposal.
•
Income statement - Recognise gain or loss (difference between estimated net disposal proceeds and carrying amount) unless a sale and leaseback (lAS 17). Gains are not classified as revenue.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0909
IAS 16 PROPERTY, PLANT AND EQUIPMENT
Illustration 3 [19] Property, plant and equipment (extract) When assets are closed down, sold, or abandoned, the difference between the net proceeds and the net carrying amount of the assets is recognized as a gain or loss in other operating income or expenses, respectively.
Notes to Consolidated Financial Statements of the Bayer Group
9.2
Derecognition date
•
The revenue recognition principle in IAS 18 Revenue for sales of goods applies also to sales of items of property, plant and equipment.
10
IFRS 5 DISPOSAL OF NON-CURRENT ASSETS AND PRESENTATION OF DISCONTINUED OPERATIONS
10.1
Reasons for issuing the standard
•
"Norwalk Agreement" - Convergence of accounting standards around the world is one of the prime objectives of the IASB. IASB has agreed with the Financial Accounting Standards Board (FASB) in the United States a memorandum of understanding that sets out the two boards' commitment to convergence. As a result of that understanding the boards have undertaken a joint short-term project with the objective of reducing differences between IFRSs and US GAAP that are capable of resolution in a relatively short time and can be addressed outside current and planned major projects.
•
One aspect of that project involves the two boards considering each other's recent standards with a view to adopting recent high quality accounting solutions. The standard arises from the IASB's consideration of the FASB Statement No. 144 Accountingfor the Impairment or Disposal ofLong-Lived Assets (SFAS 144), issued in 2001.
•
SFAS 144 addresses three areas: (i) (ii) (iii)
impairment oflong-lived assets to be held and used (not addressed byIFRS 5); the classification, measurement and presentation of assets held for sale; and the classification and presentation of discontinued operations. The extensive differences between IFRSs and US GAAP on impairment oflong-lived assets to be held and used were not thought capable of resolution in a relatively short time.
•
The standard achieves substantial convergence with the requirements of SFAS 144 relating to held for sale assets and discontinued operations.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0910
IAS 16 PROPERTY, PLANT AND EQUIPMENT
10.2
Main features of the standard
•
The "held for sale" classification is adopted using the same criteria as those contained in SFAS 144.
•
It introduces the concept of a disposal group.
•
Held for sale assets or disposal groups are carried at the lower of carrying amount and fair value less costs to sell.
•
Held for sale assets or disposal groups are not depreciated.
•
Held for sale assets and assets and liabilities included in a disposal group are presented separately on the face of the balance sheet
•
IAS 35 Discontinuing Operations will be withdrawn (see later session)
•
The definition of a discontinued operation will be changed from "a separate major line of business or geographical area" to "any unit whose operations and cash flows can be clearly distinguished operationally and for financial reporting purposes".
•
The timing of the classification as a discontinued operation will also be changed.
•
IAS 35 classifies an operation as discontinuing at the earlier of: the entity entering into a binding sale agreement; and the board of directors approving and announcing a formal disposal plan.
•
The standard classifies an operation as discontinued: at the date the entity has actually disposed of the operation; or when the operation meets the criteria to be classified as held for sale.
•
Results of discontinued operations are presented separately on the face of the income statement.
•
Retroactive classification as a discontinued operation, when the discontinued criteria are met after the balance sheet date, is prohibited.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0911
IAS 16 PROPERTY, PLANT AND EQUIPMENT
11
DISCLOSURE
11.1
For each class
•
Measurement bases used for determining gross carrying amount.
•
Depreciation methods used.
•
Useful lives or the depreciation rates used.
Illustration 4
Notes to the consolidated financial statements (extract) Property, plant and equipment Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation is recorded on a straight-line basis over the expected useful lives of the assets as follows: Buildings and constructions 20-33 years Machinery and equipment 3-10 years Land and water areas are not depreciated.
NOKIA ANN U A LAC C 0 U N T S 2 0 0 2 •
Gross carrying amount and accumulated depreciation at beginning and end of period. Accumulated impairment losses are aggregated with accumulated depreciation.
•
A reconciliation of carrying amount at beginning and end of period showing:
o o o o o o o o o
additions (i.e. capital expenditure); disposals; acquisitions through business combinations; increases or decreases resulting from revaluations; impairment losses (i.e. reductions in carrying amount); reversals of impairment losses; depreciation; net exchange differences arising on translation of functional currency into reporting currency; other movements.
11.2
Others
•
Existence and amounts of restrictions on title, and property, plant and equipment pledged as security.
•
Expenditures on account of property, plant and equipment in the course of construction.
•
Contractual commitments for the acquisition of property, plant and equipment.
•
Compensation from third parties for items impaired, lost or given up that is included in profit or loss, if not disclosed separately on the face of the income statement.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0912
IAS 16 PROPERTY, PLANT AND EQUIPMENT
11.3
Items stated at revalued amounts
•
Effective date of revaluation.
•
Whether an independent valuer was involved.
•
Methods and significant assumptions applied to estimate fair values.
•
The extent to which fair values were determined:
o
directly (i.e. by reference to observable prices in an active market or recent market transactions on arm's length terms); or
o
estimated using other valuation techniques.
For example indices may be used to determine replacement cost. •
Carrying amount of each class of property, plant and equipment that would have been included in the fmancial statements had the assets been carried under the cost model.
•
Revaluation surplus, indicating movement for period and any restrictions on distribution of balance to shareholders.
11.4
Encouraged
•
Carrying amount of temporarily idle property, plant and equipment.
•
Gross carrying amount of any fully depreciated property, plant and equipment that is still in use.
•
Carrying amount of property, plant and equipment retired from active use and held for disposal.
•
When the cost model is used, the fair value of property, plant and equipment when this is materially different from the carrying amount.
12
NON - DEPRECIATION
12.1
Background
•
It has long been argued that certain assets shall not be subject to the general rule that all assets should be depreciated.
•
Many companies in some jurisdictions have taken to the practice of not depreciating certain of their assets.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0913
IAS 16 PROPERTY, PLANT AND EQUIPMENT
12.2
Arguments employed
•
Assets are maintained to a very high standard. This maintenance cost is charged to the income statement in lieu of depreciation.
•
The residual value is at least equal to the carrying value (maybe due to maintenance).
•
Assets have a very long useful economic life such that depreciation is not material.
•
Asset is not currently in use.
12.3
lAS 16
•
Repair and maintenance policy may affect useful life (eg by extending it or increasing residual value) but the standard says that this does not negate the need to charge depreciation. It would seem that the standard dictates that depreciation must be charged in all circumstances but it is likely that a case can be made for non depreciation on the grounds that the residual value is bigger than the carrying value of the asset.
FOCUS You should now be able to: •
define and explain the purposes of and necessity for depreciation;
•
discuss and illustrate methods of depreciation;
•
show and explain disclosure in accordance with lAS 16;
•
discuss non depreciation of non current assets;
•
account for revaluation gains and losses and the depreciation of revalued assets;
•
account for the disposal of revalued assets;
•
discuss the effect of revaluations on distributable profits;
•
discuss the problem areas in accounting for non current assets.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
0914
IAS 23 BORROWING COSTS
OVERVIEW Objective
•
To describe the accounting treatment of borrowing costs.
INTRODUCTION
BENCHMARK TREATMENT
ALLOWED ALTERNATIVE TREATMENT
• • • •
Recognition Arguments Scope Definitions
• •
Recognition Disclosure
• • • • • •
Recognition Borrowing costs eligible for capitalisation Commencement ofCapitalisation Suspension ofCapitalisation Cessation ofCapitalisation Disclosure
CONSICTENCY OF TREATMENT
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1001
IAS 23 BORROWING COSTS
1
INTRODUCTION
1.1
Recognition
•
Companies borrow in order to fmance their activities. Companies pay interest (fmance charges) on the amounts borrowed.
•
How should such debits for interest be recognised in the fmancial statements
1.2
o
always as an expense, or
o
are there circumstances which justify capitalisation as an asset? (This would defer recognition in the income statement to a later period.)
Arguments Capitalisation of interest Arguments for
Arguments against
1
1
Accruals Better matching of cost (interest) to benefit (use of asset).
2
Benefit is use of money. Interest should be reflected in the income statement in the period for which the company has the use of the cash.
Comparability
2
Improved. Better comparison between companies which buy the assets and those which construct.
3
Accruals
Distorted. Similar assets at different costs depending on the method of fmance.
3
Consistency
Comparability
Interest treated like any other costs.
Consistency Interest treated differently from period to period.
4
Reported profit distorted.
1.3
Scope
•
lAS 23 shall be applied in accounting for borrowing costs
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1002
IAS 23 BORROWING COSTS
1.4
Definitions
•
Borrowing costs are interest and other costs incurred by an entity in connection with the borrowing of funds.
o
Included within the defmition may be; Interest on bank overdraft and bank borrowings Amortisation of discounts or premiums related to borrowings Amortisation of any directly attributable costs related to borrowings Finance charges in respect of fmance leases Exchange differences arising from foreign currency borrowings to the extent they are regarded as an adjustment to interest costs Preference dividend when preference capital is classed as debt.
•
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
2
BENCHMARK TREATMENT
2.1
Recognition
•
Borrowing costs shall be recognised as an expense in the period in which they are incurred.
2.2
Disclosure
•
The financial statements shall disclose the accounting policy adopted for borrowing costs.
3
ALLOWED ALTERNATIVE TREATMENT
3.1
Recognition
•
Borrowing costs shall be recognised as an expense in the period in which they are incurred except to the extent that they are capitalised below.
•
Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset. The amount of borrowing costs eligible for capitalisation shall be determined in accordance with the provisions of the standard.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1003
IAS 23 BORROWING COSTS
•
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for it's intended use or sale. Examples include
o
Inventories that require a substantial period of time to bring them to a saleable condition e.g. Whisky
o
Manufacturing plant
o
Power generation facilities
o
Investment properties
but not
o
Inventories routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time, nor
o
Assets ready for their intended use or sale when acquired.
3.2
Borrowing costs eligible for capitalisation
•
Borrowing costs that are directly attributable to acquisition, construction or production is taken to mean those borrowing costs that would have been avoided if the expenditure on the qualifying asset had not been made.
•
When an entity borrows specifically for the purpose of funding an asset the identification of the borrowing costs presents no problem.
o
•
The amount capitalised shall be the actual borrowing costs net of any income earned on the temporary investment of those borrowings.
It is sometimes difficult to establish a direct relationship between asset and funding. eg:
o
Central coordination of financing activity
o
Groups may use a range of debt instruments at varying rates to lend to other members of the group
o
Borrowing in foreign currency when the group operates in a highly inflationary economy.
Judgement is required.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1004
IAS 23 BORROWING COSTS
•
•
If funds are borrowed generally; D
amount of borrowing costs eligible for capitalisation shall be determined by applying a capitalisation rate to the expenditures on that asset
D
the capitalisation rate shall be the weighted average ofthe borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset
D
the amount of borrowing costs capitalised during a period shall not exceed the amount of borrowing costs incurred during that period.
In some circumstances, it is appropriate to include all borrowings of the parent and its subsidiaries when computing a weighted average of the borrowing costs; in other circumstances, it is appropriate for each subsidiary to use a weighted average of the borrowing costs applicable to its own borrowings.
Example 1 An entity has three sources of borrowing in the period Outstanding liability $000 8,000 7 year loan 12,000 25 year loan 4,000 (average) Bank overdraft
Interest charge $000 1,000 1,000 600
Required:
a. Calculate the appropriate capitalisation rate if all of the borrowings are used to fmance the production of qualifying assets but none of the borrowings relate to a specific qualifying asset. b. If the 7 year loan is an amount which can be specifically identified with a qualifying asset calculate the rate which should be used on the other assets.
Solution
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1005
IAS 23 BORROWING COSTS
3.3
Commencement of Capitalisation
•
Capitalisation shall commence when:
•
o
expenditures for the asset are being incurred,
o
borrowing costs are being incurred, and
o
activities that are necessary to prepare the asset for its intended use or sale are in progress.
Expenditures on a qualifying asset include only
o
payments of cash,
o
transfers of other assets, or
o
the assumption of interest-bearing liabilities. Expenditures are reduced by any progress payments received and grants received in connection with the asset.
•
The average carrying amount of the asset during a period, including borrowing costs previously capitalised, is normally a reasonable approximation of the expenditures to which the capitalisation rate is applied in that period.
•
The activities necessary to prepare the asset for its intended use or sale include
•
o
physical construction of the asset.
o
technical and administrative work prior to the commencement of physical construction, such as the activities associated with obtaining permits prior to the commencement of the physical construction.
Such activities exclude
o
the holding of an asset when no production or development that changes the asset's condition is taking place.
o
e.g. borrowing costs incurred while land is under development are capitalised during the period in which activities related to the development are being undertaken. However, borrowing costs incurred while land acquired for building purposes is held without any associated development activity do not qualify for capitalisation.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1006
IAS 23 BORROWING COSTS
3.4
Suspension of Capitalisation
•
Capitalisation shall be suspended during extended periods in which active development is interrupted.
•
Capitalisation is not normally suspended
o
during a period when substantial technical and administrative work is being carried out.
o
when a temporary delay is a necessary part of the process of getting an asset ready for its intended use or sale.
o
e.g. capitalisation continues during the extended period needed for inventories to mature or the extended period during which high water levels delay construction of a bridge, if such high water levels are common during the construction period in the geographic region involved.
3.5
Cessation of Capitalisation
•
Capitalisation shall cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.
•
An asset is normally ready for its intended use or sale when the physical construction of the asset is complete even though routine administrative work might still continue. If minor modifications, such as the decoration of a property to the purchaser's or user's specification, are all that are outstanding, this indicates that substantially all the activities are complete.
•
When the construction of a qualifying asset is completed in parts and each part is capable of being used while construction continues on other parts, capitalisation of borrowing costs shall cease when substantially all the activities necessary to prepare that part for its intended use or sale are completed.
3.6
Disclosure
•
The financial statements shall disclose:
o
the accounting policy adopted for borrowing costs,
o
the amount of borrowing costs capitalised during the period, and
o
the capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation.
4
CONSISTENCY OF TREATMENT
•
lAS 8 requires an entity to be consistent in its use of accounting policies, once adopted that policy shall not be changed unless it is required to do so by a new standard or the change would give more reliable and relevant information.
•
If an entity applies the allowed alternative treatment to a qualifying asset then it must adopt that policy of capitalisation for all qualifying assets.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1007
IAS 23 BORROWING COSTS
FOCUS
You should now be able to: •
describe advantages and disadvantages to expensing and capitalising interest;
•
apply the benchmark and allowed alternative treatments of IAS 23;
•
calculate the amount of interest that should be capitalised under the allowed alternative treatment;
•
describe and identify qualifying assets as defined in IAS 23.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
l008
IAS 23 BORROWING COSTS
EXAMPLE SOLUTIONS
Solution 1 (a)
Capitalisation rate 1,000,000 + 1,000,000 + 600,000 8,000,000 + 12,000,000 + 4,000,000
= 10.833% (b)
Capitalisation rate 1,000,000 + 600,000 12,000,000 + 4,000,000
=10%
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1009
IAS 23 BORROWING COSTS
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1010
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
OVERVIEW Objective
•
To account for the transfer of resources from government and indicate the extent to which entity's benefit from such assistance during the reporting period.
•
To facilitate comparison of an entity's fmancial statements with prior periods and other entity's.
INTRODUCTION
GOVERNMENT ASSISTANCE
GOVERNMENT GRANTS • • •
• • • • •
Scope Definitions Effective date
Criteria Forgivable loans Broad approaches to accounting treatment lAS 20 treatment Non-monetary government grants Presentation ofgrants related to assets Presentation ofgrants related to income Repayment ofgovernment grants
DISCLOSURE
•
Matters
SIC 10 GOVERNMENT ASSISTANCE - NO SPECIFIC RELATION TO OPERATING ACTMTIES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1101
Definition Excludedfrom government grants but are included as government assistance Issue Loans at nil or low interest rates
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
1
INTRODUCTION
Government assistance takes manyforms varying both in nature ofthe assistance given and in conditions attached. Its purpose may be to encourage an entity to embark on a course ofaction that it would not otherwise have taken.
1.1
Scope
•
lAS 20 shall be applied in
•
o
accounting for and disclosure of government grants, and
o
disclosure of other forms of government assistance.
lAS 20 does not deal with
o
accounting for government grants in financial statements reflecting the effects of changing prices or in supplementary info of a similar nature
o
income tax benefits (eg income tax holidays, investment tax credits, accelerated depreciation allowances and reduced income tax rates)
o
Government participation in the ownership of the entity.
1.2
Definitions
•
Government refers to government, government agencies and similar bodies whether local, national or international.
•
Government grants are assistance by governments in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to operating activities. They exclude those forms of government assistance which cannot reasonably have a value placed on them and transactions with government which cannot be distinguished from the normal trading transactions of the entity.
•
Grants related to assets are government grants whose primary condition is that an entity qualifying for them shall purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held.
•
Grants related to income are government grants other than those related to assets.
•
Forgivable loans are loans which the lender undertakes to waive repayment of under certain prescribed conditions.
•
Government assistance is action by government designed to provide an economic benefit specific to an entity or range of entitys qualifying under certain criteria.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1102
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
2
GOVERNMENT GRANTS
2.1
Criteria
•
Government grants shall not be recognised until there is reasonable assurance that
o
the entity will comply with the conditions attaching to them, and
o
the grants will be received.
•
Receipt of a grant does not of itself provide conclusive evidence that conditions have been or will be fulfilled.
•
A grant is accounted for in the same manner whether received in cash or a reduction of a liability to the government.
2.2
Forgivable loans
•
Definition - the lender undertakes to waive repayment under certain prescribed conditions.
•
A forgivable loan from government is treated as a grant when there is reasonable assurance that the entity will meet the terms for forgiveness.
2.3
Broad approaches to accounting treatment Capital approach
•
Credit directly to shareholders' interests.
Income approach
•
Take to income over one or more periods
Arguments for
•
Financing device should be dealt with in balance sheet.
•
No repayment is expected :. credit directly to shareholders' interests.
•
Grants are not earned but are an incentive without related costs :. it is inappropriate to recognise the grant in the IS.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
Arguments for
•
Receipts from a source other than shareholders, should not be credited directly to shareholders'interests.
•
Government grants are rarely gratuitous but earned through compliance with conditions and meeting obligations.
•
Match with associated costs which the grant is intended to compensate.
•
As extension of fiscal policies, deal with IS as for taxes.
1103
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
2.4
lAS 20 treatment
•
Recognise as income over the periods necessary to match them with related costs which they are intended to compensate, on a systematic basis. Eg grants related to
o
depreciable assets - over periods in which depreciation is charged
o
non-depreciable assets - over periods bearing cost of meeting obligations
Receipts basis does not accord with accruals .: only acceptable if no other basis exists •
Do not credit directly to shareholders' interests.
•
Compensation for expenses or losses already incurred or for immediate financial support with no future related costs shall be recognised as income in the period receivable, as an extraordinary item if appropriate.
2.5
Non-monetary government grants
•
Where a grant takes the form of a transfer of a non-monetary asset for the use of the entity (Eg land or other resources) we usually account for both the grant and the asset at fair value. As an alternative, both the asset and the grant may be recorded at a nominal amount
2.6
Presentation of grants related to assets
•
Acceptable alternatives in the balance sheet are to: EITHER
•
OR
0
Set up grant as deferred income.
0
Deduct grant in arriving at carrying amount of asset.
0
Income recognised on a systematic and rational basis overUEL.
0
Income recognised over UEL by way of a reduced depreciation charge.
Disclose separately in the cash flow statement regardless of the balance sheet presentation.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1104
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
2.7
Presentation of grants related to income
•
Acceptable alternatives in income statement are to: EITHER D
Credit separately or under general heading eg "Other income".
OR D
Deduct in reporting related expense.
Argumentfor
Argumentfor
D
Inappropriate to net income and expense item.
D
Expenses might not have been incurred if grant had not been available.
D
Separation of grant from expense facilitates comparison with other expenses.
D
:. presentation without offsetting may be misleading.
2.8
Repayment of government grants
•
Account for as a revision to an accounting estimate. Related to income D
Apply first against any unamortised deferred credit
D
Recognised excess immediately as an expense.
Related to an asset D
Increase carrying amount of asset or reduce deferred income balance
D
Recognise cumulative additional depreciation immediately as an expense.
3
GOVERNMENT ASSISTANCE
3.1
Definition
•
Government action designed to provide an economic benefit specific to entity's qualifying under certain criteria.
Does not include indirect benefits (eg provision ofinfrastructure (transport/irrigation, etc) in development areas or imposition oftrading constraints on competitors.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1105
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
3.2
Excluded from government grants but are included as government assistance Assistance which cannot reasonably have a value placed on it
Transactions which cannot be distinguished from normal trading transactions
Examples
Example
• •
•
Government procurement policy responsible for a portion of sales.
•
Existence of benefit might be unquestioned but segregating trading activities from government assistance could be arbitrary.
Free technical or marketing advice Provision of guarantees.
3.3
Issue
•
Significance of benefit may be such that disclosure of nature, extent and duration of assistance is necessary in order that the financial statements may not be misleading.
3.3
Loans at nil or low interest rates
•
Such items are a form of government assistance, but benefit is not quantified by imputation of interest.
4
DISCLOSURE
4.1
Matters
•
Accounting policy adopted for government grants including methods of presentation adopted.
•
Nature and extent of government grants recognised and an indication of other forms of government assistance providing direct benefit.
•
Unfulfilled conditions and other contingencies attaching to government assistance recognised.
5
SIC - 10: GOVERNMENT ASSISTANCE - NO SPECIFIC RELATION TO OPERATING ACTIVITIES
•
Issue
o
•
The issue is whether such government assistance is "a government grant" within the scope of lAS 20 and shall therefore be accounted for in accordance with this Standard.
Consensus
o
Such assistance meets the definition of government grants in lAS 20. Such grants shall therefore not be credited directly to shareholders' interests.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1106
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
FOCUS You should now be able to: •
describe and apply the recognition criteria in lAS 20 Accountingfor government grants and disclosure ofgovernment assistance;
•
describe the different methods of presenting grants in the balance sheet and the income statement;
•
describe the disclosure requirements in relation to government assistance.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1107
IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1108
lAS 17 LEASES
OVERVIEW Objective To describe the accounting for leases from the viewpoint of the lessee and the lessor.
•
• • •• • • • • ••
INTRODUCTION
TYPES OF ARRANGEMENT
••
Traditional accountingfor leases Problem: Overview Scope Definitions Lease classification; 2 types Risks and rewards ofownership Indicators Terms ofthe lease Comment on classification Land and buildings SIC 27
........... ... .
!
LESSEE ACCOUNTING
1---- --- -------------------
LESSOR ACCOUNTING
-~:
L----------------
-----_.._- -------_.
:
!
1
ACCOUNTING FORA FINANCE LEASE
••• •
Principles Rentals in arrears Rentals in advance Disclosures - finance leases
ACCOUNTING FORAN OPERATING LEASE
• ••
ACCOUNTING FORA FINANCE LEASE
Lesseeaccounting for an 0 operating lease SIC 15 Disclosures
Background Sale and leaseback as finance lease Sale and leaseback as an operating lease
© Accountancy Tuition Centre (International Holdings) Ltd 2005
•
Background Recognition Allocation offinance income Disclosure in respect of finance leases
G4 + I DISCUSSION PAPER
SALE AND LEASEBACK TRANSACTIONS • • •
• • •
ACCOUNTING FORAN OPERATING LEASE
1201
lAS 17 LEASES
1
INTRODUCTION
1.1
Traditional accounting for leases (pre lAS 17)
•
In the books of the lessee:
o
Balance sheet
No accounting
o
Income statement -
Instalments due on an accruals basis.
1.2
Problem
•
Certain types oflease resulted in the lessee owning the asset in SUBSTANCE and being liable to future payments.
•
For all practical purposes the lessee would own the asset but the balance sheet would not show
o
the asset nor
o
the liability.
1.3
Overview
•
Leases were the first transactions where an accounting standard specifically applied the principle of substance over form in order for the accounts to show a true and fair view.
•
The original lAS I specified substance over form as a general consideration governing the selection of accounting policies.
•
Key ratios significantly affected by this treatment are
o
gearing, and
o
return on capital employed.
1.4
Scope
•
lAS 17 applies to accounting for all leases except for
o
lease agreements to explore for or use natural resources, such as oil, gas, timber, metals and other mineral rights
o
licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1202
lAS 17 LEASES
1.5
Definitions
•
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment, or series of payments, the right to use an asset for an agreed period of time.
•
Finance lease is a lease which transfers substantially all risks and rewards incident to ownership of an asset. Title mayor may not eventually be transferred.
•
Operating lease is a lease other than a finance lease.
•
Lease term is the non-cancellable period for which the lessee has contracted to lease the asset, together with any further terms for which the lessee has the option to lease the asset, with or without further payment.
•
Minimum lease payments are the payments over the lease term that the lessee is or can be required to make (excluding costs for services and taxes to be paid by and be reimbursable to the lessor) together with
o
in the case of the lessee, any amounts guaranteed by the lessee or by a party related to the lessee
o
in the case of the lessor, any residual value guaranteed to the lessor by either the lessee, a party related to the lessee, or an independent third party.
•
The inception ofthe lease is the earlier of the date of the lease agreement or of a commitment by the parties to the principal provisions of the lease.
•
Useful life is the estimated remaining period from the beginning of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity.
•
The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of:
o
the minimum lease payments, and
o
the unguaranteed residual value
to be equal to the fair value of the leased asset and any initial direct costs of the lessor.
•
The lessee's incremental borrowing rate ofinterest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1203
lAS 17 LEASES
Illustation 1 S is a bank. As at lotJanuary 2004 it purchased an asset, at a cost of $50,000, which it has just signed contracts to lease out as follows Lessee
Terms
Comments
B
5 years in arrears at $lO,OOOpa
A manufacturing company
C
Year 6 and 7 in arrears at $8,000 pa
A manufacturing company which is a subsidiary ofB
D
Year 9 and lOin arrears at $5,000 pa
A manufacturing company which is completely unrelated to B
The scrap value at year 10 is estimated at $2,000. Required: State which flows should be included in the following; a)
The lessees minimum lease payments
b)
The lessors minimum lease payments
c)
The calculation of the interest rate implicit in the lease
Solution 1 Time
Lessee's minimum lease payments
Lessor's minimum lease payments
Interest rate implicit in the lease
1-5
10,000
10,000
10,000
6-7
8,000
8,000
8,000
5,000
5,000
9-10
2,000
10
Tutorial note The interest rate implicit in the lease is 7.8%. You will not be required to calculate this for the purposes ofthe exam.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1204
lAS 17 LEASES
2
TYPE OF ARRANGEMENT
2.1
Lease classification; 2 types
•
Finance lease
•
o
Is a lease that transfers substantially all of the risks and rewards incident to ownership of an asset
o
title mayor may not eventually be transferred.
Operating lease
o
is a lease other than a finance lease.
2.2
Risks and rewards of ownership
•
Risks may be represented by the possibility of
•
o
losses from idle capacity or technological obsolescence
o
variations in return due to changing economic conditions.
Rewards may be represented by the expectation of
o
profitable operation over the asset's economic life
o
gain from appreciation in value or realisation of residual value.
2.3
Indicators
•
lAS 17 lists the following as examples of situations where a lease would normally be classified as a fmance lease:
o
the lease transfers ownership of the asset to the lessee by the end of the lease term
o
the lessee has the option to purchase the asset at a bargain price and it seems likely that, at the inception of the lease, that this option will be exercised
o
the lease term is for the major part of the useful life of the asset even if title is not transferred
o
at the inception of the lease, the present value of the minimum lease payments is greater than, or equal to substantially all of the fair value of the leased asset
o
the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made
o
if the lessee can cancel the lease any losses associated with the cancellation are borne by the lessee
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1205
lAS 17 LEASES
o
gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease) and
o
the lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent.
2.4
Terms of the lease
•
The status of the lease may often be determined from an examination of the lease terms. A transference of risks and rewards is assumed if
o
the lessee will use the asset for most of its useful economic life
o
the lessee bears the cost normally associated with ownership (eg insurance, maintenance, idle capacity)
o
the present value of the amounts guaranteed by the lessee is materially equivalent to the cost of purchase
o
any amounts accruing to the lessor at the end of the lease are relatively small.
2.5
Comment on classification
•
The criteria concentrates on the major risk of purchase - that of bearing the capital cost.
•
If the lessee guarantees to bear substantially all of the capital cost of the asset (fair value) then it shall be treated as a purchase ie a finance lease. (lAS 17 does not specify what "substantially all" means but it is often set at 90% or more in the GAAP of individual countries)
•
If a lessee bears substantially all of the cost then he would only do so if he was getting substantially all ofthe use of the asset i.e. if in substance he owned the asset.
2.6
Land and buildings
2.6.1
Land
•
Normally has an indefinite useful life.
•
Iftitle does not pass at the end of the lease term risks and rewards are not passed therefore the lease will normally be classified as an operating lease.
2.6.2
Buildings
•
Useful life will probably extend well beyond the lease term.
•
Iftitle does not pass at the end of the lease term risks and rewards are not passed the lease will be classed in the same way as other leased assets.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1206
lAS 17 LEASES
2.6.3
Separation
•
The land and buildings value inherent in the lease shall be accounted for separately. The lease payments shall be allocated between the two elements based on the relative fair values of the land and buildings elements.
•
Iftitle of both elements is expected to pass on completion of the lease both parts shall be classed as finance leases.
•
Iftitle does not pass and the land has an indefmite life then the land element shall be treated as an operating lease, the building element will be classed in accordance with the normal rules ofIAS 17.
•
If it is not possible to allocate the lease payments between the land and buildings element then the lease shall be treated as a fmance lease unless it is clear that both elements are an operating lease.
2.6.4
Investment property
•
The lessee may treat the asset as an investment property in accordance with IAS 40.
•
The lessee, however, must treat the lease as a finance lease, even if it would not normally be classed as a finance lease and the investment property must be valued using the fair value model under lAS 40.
2.7
SIC-27: Evaluating the Substance of Transactions Involving the Legal Form of a Lease
•
An entity may enter into a transaction or a series of structured transactions (an arrangement) with an unrelated party or parties (an Investor) that involves the legal form of a lease. For example, an entity may:
o
lease assets to an investor and lease the same assets back;
Such an arrangement may be designed to achieve a tax advantage for the Investor that is shared with the entity in the form ofa fee, and not to convey the right to use an asset. or
o
legally sell assets and lease the same assets back.
2.7.1
Issues
•
How to determine whether a series of transactions is linked and shall be accounted for as one transaction.
•
Whether the arrangement meets the definition of a lease (IAS 17); and if not:
o
whether a separate investment account and lease payment obligations that might exist represent assets and liabilities of the entity (e.g. consider Illustration 2);
o
how the entity shall account for other obligations resulting from the arrangement; and
o
how the entity shall account for a fee it might receive from an investor.
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lAS 17 LEASES
2.7.2
Consensus
•
A series of transactions involving the legal form of a lease is linked (and shall be accounted for as one transaction) when the overall economic effect cannot be understood without reference to the series of transactions as a whole.
•
For example, when the series of transactions are closely interrelated, negotiated as a single transaction, and takes place concurrently or in a continuous sequence.
Note that this principle is established in JAS 11 "Construction Contracts" . •
lAS 17 applies when the substance of an arrangement includes the conveyance ofthe right to use an asset for an agreed period oftime.
•
Indicators that individually demonstrate that, in substance, a lease is not involved include:
o
an entity retaining all the risks and rewards incident to ownership of the underlying asset and enjoying substantially the same rights to its use as before the arrangement;
o
the primary reason for the arrangement being to achieve a particular tax result, rather than to convey the right to use the asset; and
o
an option being included that make its exercise almost certain.
For example, a put option that is exercisable at a price sufficiently higher than the expectedfair value when it becomes exercisable. •
"The Framework" defmitions of asset and liability shall be applied in determining whether, in substance, a separate investment account and lease payment obligations shall be recognised.
•
Other obligations of an arrangement, including any guarantees provided and obligations incurred upon early termination, shall be accounted for under lAS 37 or lAS 39, depending on the terms.
•
lAS 18 criteria for revenue arising from rendering of services shall be applied to the facts and circumstances of each arrangement to determine when to recognise a fee.
•
The fee shall be presented in the income statement based on its economic substance and nature.
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Illustration 2 ABC leases an asset to an investor (the headlease) and leases the same asset back for a shorter period oftime (the sublease). At the end ofthe sublease period: •
ABC has a purchase option to buy back the rights of the Investor;
•
If ABC does not exercise that option, the Investor has options to receive a minimum return on its investment in the headlease (returning the underlying asset to ABC, or requiring ABC to provide a return on the Investor's investment in the headlease).
The arrangement is designed predominantly to generate tax benefits that are shared between ABC and the investor. ABC needs to use the underlying asset, which is specialised, to conduct its business.
The substance ofsuch arrangement is that the entity receives a fee for executing the agreements, and retains the risks and rewards incident to ownership ofthe specialised asset. 2.7.3
Disclosure
•
The following disclosure is required in each period for any arrangement that does not, in substance, involve a lease under lAS 17:
o
a description of the arrangement including: the underlying asset and any restrictions on its use; the life and other significant terms of the arrangement; the transactions that are linked together, including any options; and
o
the accounting treatment applied to any fee received, including: the amount recognised as income in the period; and the line item of the income statement in which it is included.
•
Disclosure shall be provided individually for each arrangement or in aggregate for each class of arrangement.
A class is a grouping ofarrangements with underlying assets ofa similar nature (e.g. electricity generators). Illustration 3 An airline leases an aircraft to another airline for its entire economic life and leases the same aircraft back under the same terms and conditions as the original lease. The two airlines have a legally enforceable right to set off the amounts owing to one another, and an intention to settle these amounts on a net basis.
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lAS 17 LEASES
The terms and conditions and period ofeach ofthe leases are the same, so the risks and rewards ofownership are the same before and after the arrangement. The amounts owing are offset so there is no retained credit risk. The substance ofthe arrangement is that no transaction has occurred. Illustration 4 Company X legally sells an asset to Company Y and leases the same asset back. Company Y is obliged to return. the asset to Company X at the end of the lease period at an amount that has the overall practical effect, when also considering the lease payments to be received, of providing Company Y with a yield of LIBOR plus 2% annually on the purchase price.
Company X's risks and rewards incident to ownership have not substantively changed. The substance ofthe arrangement is that Company X has obtained finance secured on the asset. Company Y's obligation to return the asset precludes recognition ofa sale by Company X
3
LESSEE ACCOUNTING FOR A FINANCE LEASE
3.1
Principles
•
Record the asset and the finance lease payable at the lower of
o
the present value of amounts guaranteed by the lessee (Minimum lease payments) or
o
the fair value of asset
•
Depreciation shall be charged on a consistent basis with those assets that are owned and in accordance with lAS 16.
•
If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term depreciate the asset over:
•
Rentals repay capital and fmance charge (interest)
•
Interest shall be allocated to the income statement so as to give constant rate of charge on outstanding balance, or an approximation thereto.
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lAS 17 LEASES
I
Use
I
I I
I
OR
Actuarial method (this uses the interest rate implicit in the lease)
Sum of the digits (this can be an effective approximation to the actuarial method)
Note that straight line recognition is generally not acceptable
Tutorial note Rentals in arrears •
Interest is carried by each of the rentals
Rentals in advance •
3.2
The first payment is capital only. Interest is carried by each of the rentals except the first
Rentals in arrears lllustration 5 H entered into a finance lease on l8tJanuary 2004. The terms of the lease were 20 payments of $100 6 monthly in arrears. The cash price of the asset was $1,200. The interest rate implicit in the lease is 5.5% (per 6 month period)
Required: a)
b)
Show the interest allocation for the first 3 six month periods using: (i)
Sum of the digits
(ii)
Actuarial method
Show how the lease would be carried in the financial statements of H as at 30th June 2004 using the sum of the digits to allocate interest.
Solution a WI
Total finance charge
s
Rentals (20 x $100)
2,000
Cash price of the asset
(l,200) 800
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lAS 17 LEASES
W2
Allocation of interest - sum of the digits
n(n + 1) 2
Period
Weighting
1 2 3 4
20 19 18 17
-!-
-!-
20
1
Fraction (x$800) 20/210 19/210 18/210 17/210
Interest charge 76 72 68 64
1/210
4
210
Allocation of interest - actuarial method
W3
Period 1 2 3 4
Amount owed at the start ofthe period 1,200 1,166 1,130 Etc
Interest@ 5.5% 66 64 62
Rental (100) (100) (100) (100)
Amount owed at the end ofthe period 1,166 1,130 1,092
Solution b Finance lease a able 1/1/04 Non current assets 100
30/06/04 Cash 30/06/04 Ba1c/d
30/06/04 Interest
1,200 76
1,176 1,276
1,276 01/07/04 Ba1bid
1,176
Tutorial note: 31112/04 Cash
100
31112/04Interest
72
30/06/05 Cash
100
30/06/05 Interest
68
Analysis of payable Current (100+ 100 - (72+68»
60
NonCurrent
1,116
(17 x 100 - (800 - (76+72+68))
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lAS 17 LEASES
Note to the accounts At the 30th June 2004 the company is committed to the following payments under a finance lease: MLP
PV
$
$
Not later than 1 year
200
185
Later than 1 year and not later than 5 years
800
631
Later than five years
900
360
1,900
1176
NOTE: The PV calculation has been calculated for you. This would probably not be an examination requirement Depreciation $1,200 x 6/12 = $60 lOyears Non current assets will include an amount of$1,140 (1,200 - 60) 3.3
Rentals in advance Illustration 6 H entered into a finance lease on 1st January 2004. The terms of the lease were 20 payments of $100 6 monthly in advance. The cash price of the asset was $1,200. The interest rate implicit in the lease is 6.1 % (per 6 month period) Required: (a)
(b)
Show the interest allocation for the first 3 six month periods using: (i)
Sum ofthe digits
(il)
Actuarial method
Show how the lease would be carried in the financial statements of H as at 30th June 2004 using the sum of the digits to allocate interest.
•
The first payment is capital only
•
Interest is not allocated to the final period because the loan was completely repaid at the beginning of that period - Therefore for the sum of the digits calculation n = 19
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lAS 17 LEASES
WI
Total finance charge
$ 2,000
Rentals (20 x $100)
(1,200)
Cash price of the asset
800 W2
Allocation of interest - sum of the digits
n(n + 1) 2
W2
Period
Weighting
1 2 3 4
19 18 17 16
J.
J.
19
1
Fraction (x$800) 19/190 18/190 17/190 16/190
Interest charge 80 76 72 67
1/190
4
190
Allocation of interest - actuarial method
Period
1 2 3
Amount owed at the start ofthe period 1,200 1,167 1,132
Rental
Interest @6.1%
(100) (100) (100)
1,100 1,067 1,032
67 65 63
Amount owed at the end ofthe period 1,167 1,132 etc
Solution b
1/1/04 Cash
Finance lease a able 100 1/1/04 Non current assets 30/06/04 Interest
30/06/04 Bal cld
80
1,180 1,280
01/07/04 Cash
1,200
1,280
100 01/07104 Bal bid
1,180
31/12/04 Interest
76
Tutorial note:
01/01/05 Cash
100
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lAS 17 LEASES
Analysis of payable
Current (100+ 100) -76) (of the $124, $44 is the repayment of capital and $80 is the interest to be paid in the next payment)
124
NonCurrent
1,056
(17
x
= 1,180
100 - (800 - (80+76)
Note to the accounts At the 30th June 2004 the company is committed to the following payments under a finance lease: MLP
PV
$
$
Not later than 1 year
200
194
Later than 1 year and not later than 5 years
800
585
Later than five years
900
401
1900
1,180
NOTE: The PV calculation has been calculated for you. This would probably not be an examination requirement
Depreciation
$1,200 x 6/12 = $60 lOyears Non current assets will include an amount of$I,140 (1,200 - 60)
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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lAS 17 LEASES
3.4
Disclosures - fmance leases
•
For each class of asset the net carrying amount of assets at each balance sheet date.
•
It is appropriate that the amount of assets used by the lessee that are the subject offmance leases be separately identified in the financial statements. It is often useful to have this disclosure presented by each major class of asset. Best practice is to either;
o
provide the same table reconciling opening and closing cost and depreciation as is given for owned assets, or
o
combine with owned assets and make disclosure of the total.
Illustration 7 [9] Interest expense - net (extract) Finance leases are capitalized under property, plant and equipment in compliance with lAS 17 (Leases). The interest portion of the lease payments, amounting to €34 million (2001: €9 million), is reflected in interest expense. [19] Property, plant and equipment (extract) In accordance with lAS 17 (leases), assets leased on terms equivalent to financing a purchase by a long-term loan (finance leases) are capitalized at the lower of their fair value or the present value of the minimum lease payments. The leased assets are depreciated over their estimated useful life except where subsequent transfer of title is uncertain, in which case they are depreciated over their estimated useful life or the respective lease term, whichever is shorter. The future lease payments are recorded as financial liabilities. Capitalized property, plant and equipment includes assets with a total net value of €504 million (2001: €588 million) held under finance leases. The gross carrying amounts of these assets total €1, 106 million (2001: €1 ,229 million). These assets are mainly machinery and technical equipment with a carrying amount of €358 million (gross amount: €864 million) and buildings with a carrying amount of€105 million (gross amount: €140 million). In the case of buildings, either the present value of the minimum lease payments covers substantially all of the cost of acquisition, or title passes to the lessee on expiration of the lease.
Notes to Consolidated Financial Statements of the Bayer Group
•
Liabilities related to these leased assets shall be shown separately from other liabilities, differentiating between the current and long-term portions.
•
Repayment terms and interest rates for loans falling due in more than one year.
•
A reconciliation between the total of minimum lease payments at the balance sheet date, and their present value.
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lAS 17 LEASES
•
In addition, an entity shall disclose the total of minimum lease payments at the balance sheet date, and their present value, for each of the following periods:
o
not later than one year
o
later than one year and not later than five years
o
later than five years.
Illustration 8 Liabilities under finance leases are recognized as financial obligations if the leased assets are capitalized under property, plant and equipment. They are stated at present values. Lease payments totaling €899 million (2001: €1,174 million), including €191 million (2001: €293 million) in interest, are to be made
to the respective lessors in
future years. The liabilities associated with finance leases mature as follows:
€million
Lease payments
Of which interest
Liability
2003
151
30
121
2004
103
28
75
2005
100
26
74
2006
71
17
54
2007 After 2007
53
15
38
421
75
346
899
191
708
Notes to Consolidated Financial Statements of the Bayer Group
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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lAS 17 LEASES
4
LESSEE ACCOUNTING FOR AN OPERATING LEASE
4.1
Lessee accounting for an operating lease
•
Rentals are charged as an expense in the income statement on a straight line basis over the lease term unless another systematic basis is representative of the time pattern of the users benefit.
•
No balances appear in the balance sheet other than accruals and prepayments on rented rather than owned assets.
Illustration 7 Under a lease agreement Williamson plc pays an initial installment of $100,000 and then 3 years rental of $100,000 pa on the first day of each year. The asset has a life of 6 years.
Required: Calculate the charge to the income statement each year and any balance on the balance sheet at the end of the first year.
Solution $100,000 + $300,000 3 years
Income statement
$133,333 Balance sheet at end of 1st year
=
$ 200,000 (133,333) 66,667
paid charged prepayment
4.2
SIC-15: Operating Leases - Incentives
4.2.1
Issue
•
Lessors often give incentives to induce a potential lessee to sign up for a lease. Incentives include:
•
o
rent-free periods; or
o
contributions by the lessor to the lessee's relocation costs.
The issue is how shall such incentives be recognised, in respect of operating leases, by both the lessee and lessor.
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lAS 17 LEASES
4.2.3
(7onsensus
•
Lease incentives shall be considered an integral part of the consideration for the use of the leased asset.
•
The lessee shall recognise the aggregate benefit of the incentives as a reduction of the rental expense over the lease term, on straight line basis unless another systematic basis is representative of the time pattern of the lessee's benefit from the use ofthe asset.
•
lAS 17 requires an entity to treat incentives as a reduction of lease income or lease expense. As they are an integral part of the net consideration agreed for the use of the leased asset, incentives shall be recognised by both the lessor and the lessee over the lease term, with each party using a single amortisation method applied to the net consideration.
4.3
Disclosures
•
Lessees shall make the following disclosures for operating leases:
o
the total of future minimum lease payments under non-cancellable operating leases for each of the following periods: not later than one year later than one year and not later than five years later than five years.
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lAS 17 LEASES
5
LESSOR ACCOUNTING FOR A FINANCE LEASE
5.1
Background
•
In substance the lessor does not own the asset.
•
In substance he has made a loan to the lessee at an amount equal to the net investment in the lease. Dr Receivable Cr Cash
•
The lessor receives rentals. These pay off the capital element of the loan and provide interest income (earnings).
5.2
Recognition
•
Lessors shall recognise assets held under a finance lease in their balance sheets and present them as a receivable at an amount equal to the net investment in the lease.
•
Net investment in the lease is the gross investment in the lease less unearned finance income.
•
Gross investment in the lease is the aggregate of the minimum lease payments under a finance lease from the standpoint of the lessor and any unguaranteed residual value accruing to the lessor.
•
Unguaranteed residual value is that portion of the residual value of the leased asset (estimated at the inception of the lease), the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.
•
Unearnedfinance income is the difference between the lessor's gross investment in the lease and its present value.
5.3
Allocation of finance income
•
Finance income shall be recognised based on a pattern reflecting a constant periodic rate of return on the lessors net investment outstanding.
5.4
Disclosure in respect of finance leases
•
Lessors shall make the following disclosures for finance leases:
o
a reconciliation between the total gross investment in the lease at the balance sheet date, and the present value of minimum lease payments receivable at the balance sheet date
o
the total gross investment in the lease and the present value of minimum lease payments receivable at the balance sheet date, for each of the following periods: not later than one year later than one year and not later than five years later than five years.
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lAS 17 LEASES
6
LESSOR ACCOUNTING FOR AN OPERATING LEASE
•
Lessors shall present assets subject to operating leases in the balance sheet in accordance with the nature of the asset.
•
Lease income shall be recognised in the income statement on a straight line basis, unless another systematic basis is more representative.
•
Lessors shall make the following disclosures for operating leases:
o
for each class of asset, the gross carrying amount, the accumulated depreciation and accumulated impairment losses at the balance sheet date the depreciation recognised in income for the period impairment losses recognised in income for the period impairment losses reversed in income for the period.
o
The future minimum lease payments under non-cancellable operating leases in the aggregate and for each of the following periods not later than one year later than one year and not later than five years later than five years.
o
A general description of the lessors significant leasing arrangements.
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lAS 17 LEASES
7
SALE AND LEASEBACK TRANSACTIONS
7.1
Background
•
Occurs where company transfers legal title to an asset to another party but retains use of asset on a lease. Usual purpose is to raise finance.
•
The rentals and the sale price are usually interdependent as they are negotiated as a package and need not represent fair values.
•
Accounting treatment depends on whether the leaseback is fmance or operating.
7.2
Sale and leaseback as finance lease
•
The substance of the transaction is that there is no sale - risks and rewards of ownership have not passed from the original lessee.
•
Any excess of sales proceeds over the carrying amount shall not be immediately recognised as income in the financial statements of a sellerlessee. If such an excess is recognised, it shall be deferred and amortised over the lease term.
•
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides fmance to the lessee, with the asset as security.
•
Treat the transaction as a sale followed by a leaseback
o
A "profit" is recognised but deferred. ie it is carried as a credit balance in the balance sheet and released to the income statement over the life of the lease.
o
The asset and lease creditor are reinstated at the fair value of the asset.
Example 1 Olga Inc disposes of an asset by way of a fmance lease. The net book value is $70,000, the sale proceeds are at fair value of $120,000 and the useful economic life is 5 years. There are 5 annual rentals of $28,000.
Required: Set out the journal entries on disposal, and spreading fmance charges and depreciation on a straight line basis, calculate the total profit effect of the lease each year.
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lAS 17 LEASES
Treat as a sale followed by a leaseback Journal entries on disposal
$ Dr Cr Dr Cr Income statement each year $
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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$
lAS 17 LEASES
7.3
Sale and leaseback as an operating lease
•
Substance of the transaction is that there is a sale and profit may be recognised.
•
If the leaseback is an operating lease, and the rentals and the sale price are established at fair value, there has in effect been a normal sale transaction and any profit or loss is normally recognised immediately.
•
If the sale price is below fair value, any profit or loss shall be recognised immediately except that:
o
•
if the loss is compensated by future rentals at below market price, it shall be deferred and amortised in proportion to the rental payments over the period for which the asset is expected to be used.
If the sale price is above fair value, the excess over fair value shall be deferred and amortised over the period for which the asset is expected to be used.
Example 2 Friends Inc has an asset with a net book value of $70,000. The fair value is $100,000. It would like to enter into a sale and operating leaseback agreement and it has been offered the following from three different banks. Sale price
Annual rental for 5 years
(a)
$100,000
$28,000
(b)
$120,000
$28,000
(c)
$80,000
(d)
$20,000 (ie below market price)
As (c) except that suppose the net book value was $95,000.
Required: Record the transaction in each case. Assuming the transaction occurs at the start of year 1 show the income statement effect on year 1 of the transaction in each case.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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lAS 17 LEASES
Solution (a)
Sale at fair value ($100,000) Recording of transaction
IS effect in year 1
$
$
Dr Cr Cr
(b)
Sale> fair value ($120,000) Recording of transaction
IS effect in year 1
$
$
Dr Cr Cr Cr
(c)
Sale < fair value ($80,000) with profit on sale Recording of transaction
IS effect in year 1
$
$
Dr Cr Cr
(d)
Sale < fair value ($80,000) with loss on sale and future rentals at < market price Recording of transaction
IS effect in year 1
$
$
Dr Cr Dr
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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lAS 17 LEASES
8
G4+1 DISCUSSION PAPER ON LEASES
•
lAS 17 requires radically different accounting for finance leases and operating leases. In the financial statement oflessees, a fmance lease will result in the recognition of an asset and an obligation for the leased asset and related fmancing. An operating lease will not give rise to either an asset or liability and the regular lease payments are recorded as they are incurred. A lessor in a finance lease records the asset associated with the lease receivables; under an operating lease this asset is not recognised.
•
The discussion paper (which dealt mainly with accounting by lessees) concluded the following:
•
o
The distinction between operating and financia11eases is arbitrary and unsatisfactory. lAS 17 does not provide for the recognition in lessees' balance sheets of material assets and liabilities arising from operating leases.
o
Comparability (and hence usefulness) of fmancial statements would be enhanced if present treatment of operating leases and financial leases were replaced by an approach that applied the same requirements to all leases.
It goes on to make the following specific recommendations.
o
For lessees, the objective shall be to record, at the beginning of the lease term, the fair value of the rights and obligations that are conveyed by the lease.
o
Leases currently classified as operating leases would be capitalised (giving rise to assets and liabilities), but only to the extent of the fair values of the rights and obligations that are conveyed by the lease. Thus, where a lease is for a small part of an asset's economic life, only that part would be reflected in the lessee's balance sheet.
o
The fair value of the rights obtained by a lessee would be measured as the present value of the minimum payments required by the lease.
o
Lessors shall report financial assets (representing amounts receivable from the lessee) and residual interests as separate assets, since they are subject to quite different risks. The amounts reported as financial assets by lessors would, in general, be the converse of the amounts reported as liabilities by lessees.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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lAS 17 LEASES
FOCUS
You shall now be able to: •
define the essential characteristics of a lease;
•
describe and apply the method of determining a lease type (i.e. an operating or finance lease);
•
explain the effect on the fmancial statements of a fmance lease being incorrectly treated as an operating lease;
•
account for operating leases in the fmancial statements;
•
account for finance leases in the fmancial statements oflessor and lessees;
•
outline the principles of IAS 17 and its main disclosure requirements;
•
discuss the problem areas in lease accounting, including classification, termination, tax variation clauses;
•
account for sale and leaseback transactions and recognition of income by lessors;
•
discuss and account for proposed changes in lease accounting and its impact on corporate fmancial statements.
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lAS 17 LEASES
EXAMPLE SOLUTIONS Solution 1
Treat as a sale followed by a leaseback
Journal entries on disposal
$ Dr
Dr
Cash 120,000 Cr Non current asset (NBV) Deferred profit (120,000 - 70,000) Non current asset Cr Lease creditor
120,000
$
Interest {
(5 x 28,000) -120,000)} 5
50,000 J Release of deferred profit ( --5-
24,000
4,000
(10,000) 18,000
© Accountancy Tuition Centre (International Holdings) Ltd 2005
70,000 50,000
120,000
Income statement each year
.. (120,000J D epreciation 5
$
1228
lAS 17 LEASES
Solution 2 (a)
Sale at fair value ($100,000) IS effect in year 1
Recording of transaction
Dr Cash Cr Asset Cr IS
(b)
$
$ 100,000
Profit on disposal Rental
70,000 30,000
$ 30,000 (28,000) 2,000
Sale> fair value ($120,000) IS effect in year 1
Recording of transaction
$ Dr Cash Cr Asset Cr IS Cr Deferred income
$ 120,000
$ 70,000 30,000 20,000
Profit on disposal - immediate f d (20,000 - -J - deerre 5 Rental
30,000 4,000 (28,000) 6,000
(c)
Sale < fair value ($80,000) with profit on sale IS effect in year 1
Recording of transaction
Dr Cash Cr Asset Cr IS
(d)
$ 80,000
$
Profit on disposal Rental
70,000 10,000
$ 10,000 (20,000) (10,000)
Sale < fair value ($80,000) with loss on sale and future rentals at < market price IS effect in year 1
Recording of transaction
$ Dr Cash Cr Asset Dr Deferred loss
$ 80,000
$ 95,000
15,000
15,000 5 -J Deferred loss ( Rental
(3,000) (20,000) (23,000)
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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lAS 17 LEASES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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IAS 38 INTANGIBLE ASSETS
OVERVIEW Objective •
To explain the accounting rules for intangible non-current assets.
INTRODUCTION TO IAS 38
•
L-------r---...J.
•
• • •
General criteria Initial measurement - cost Subsequent expenditure
RECOGNITION AND INITIAL MEASUREMENT
Scope Definitions Definition criteria
INTERNALLY GENERATED !NTANGIBLE ASSETS
• • • •
MEASUREMENT AFTER RECOGNITION
• • • •
Cost model Revaluation model Active market Accounting entries
IMPAIRMENT AND DERECOGNITION
• •
Impairment losses Retirements and disposals
USEFUL LIFE
• • •
Factors Finite Indefinite
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Internally generated goodwill Other internally generated assets Specific recognition criteria Expenses and costs
DISCLOSURE
• • •
Intangible assets Revaluations Research and development
IAS 38 INTANGIBLE ASSETS
1
INTRODUCTION TO lAS 38
1.1
Scope
•
The standard applies to all intangibles except:
o
those covered specifically by other standards (lAS 2, lAS 11, lAS 12, lAS 19, lAS 32, lAS 39, IFRS 3, IFRS 4 and IFRS 5); and:
o
mineral rights and expenditure on exploration for, development and extraction of minerals, etc.
1.2
Definitions
•
Intangible assets are identifiable non-monetary assets without physical substance. Some intangibles may be contained in or on a physical medium, eg software on a floppy disk or embedded within the hardware. Judgement has to be used to determine which element is more significant, i.e. the intangible or the tangible asset.
Example 1 Classify each of the following assets as either tangible or intangible: (l)
the operating system of a personal computer
(2)
an off-the-shelf integrated publishing software package
(3)
specialised software embedded in computer controlled machine tools
(4)
a "firewall" controlling access to restricted sections of an Internet website.
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•
An asset is a resource:
D D •
controlled by an entity as a result of past events; and from which future economic benefits are expected to flow to the entity.
Examples of intangibles include: D
Patents;
D
Copyrights (e.g. computer software);
D
Licences;
D
Intellectual property (e.g. technical knowledge obtained from development activity);
D
Trade marks including brand names and publishing titles;
D
Motion picture films and video recordings.
1.3
Definition criteria
1.3.1
"Identifiability"
•
An intangible asset, whether generated internally or acquired in a business combination, is identifiable when it:
D
is separable; or
So it is capable ofbeing separated or dividedfrom the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability.
D
arises from contractual or other legal rights.
These rights are regardless ofwhether they are transferable or separable from the entity or from other rights and obligations.
•
These criteria distinguish intangible assets from goodwill acquired in a business combination.
1.3.2
"Control"
•
Control means: D
the power to obtain the future economic benefits from the underlying resource; and
D
the ability to restrict the access of others to those benefits.
•
Control normally stems from a legal right that is enforceable in a court of law. However, legal enforceability is not a prerequisite for control as the entity may be able to control the future economic benefits in some other way.
•
Expenditure incurred in obtaining market and technical knowledge, increasing staff skills and building customer loyalty may be expected to generate future economic benefits. However, control over the actions of employees and customers is unlikely to be sufficient to meet the definition criterion especially where there are non-contractual rights.
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An entity may seek to protect the technical talent or knowledge ofcertain skilled staffby including a "non-compete" or "restraint oftrade" clause into their contracts ofemployment. The entity may be able to secure the future economic benefits ofsuch staffduring a notice period and restrict the access ofothers for a period after they have left (t'gardening leave "). 1.3.3
"Future economic benefits"
•
These are net cash inflows and may include increased revenues and/or cost savings.
The use ofintellectual property in a production process may reduce future production costs rather than increase future revenues. 2
RECOGNITION AND INITIAL MEASUREMENT
2.1
General criteria
•
An intangible asset should be recognised when it:
•
D
complies with the definition of an intangible asset (see above); and
D
meets the recognition criteria set out in the standard.
The recognition criteria are that: D
it is probable that future economic benefits specifically attributable to the asset will flow to the entity; and
D
the cost of the asset can be measured reliably.
•
The probability of future economic benefits should be assessed using reasonable and supportable assumptions, with greater weight being given to external evidence.
•
The recognition of internally generated intangible assets is covered later in this session.
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2.2
Initial measurement- cost
•
Intangible assets should be measured initially at cost.
•
An intangible asset may be acquired:
o o o o
separately; as part of a business combination; by way of a government grant; by an exchange of assets.
2.2.1
Separate acquisition
•
The cost of the intangible asset can usually be measured reliably when it has been separately acquired (e.g. purchase of computer software).
•
As the price paid will normally reflect expectations of future economic benefits, the probability recognition criteria is always considered to be satisfied for separately acquired intangible assets.
•
"Cost" is determined according to the same principles applied in accounting for other assets. For example:
•
o
Purchase price + import duties + non-refundable purchase tax.
o
Deferred payments are included at the cash price equivalent and the difference between this amount and the payments made are treated as interest.
As with other assets, expenditure that would not be classified as "cost" include those associated with:
o
Introducing a new product or service (including advertising and promotion);
o
Conducting business in a new location or with a new class of customer;
o
Administration and other general overheads;
o
Initial operating costs and losses;
o
Costs incurred while an asset capable of operating in the manner intended has not yet been brought into use;
o
Costs incurred in redeploying the asset.
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Worked example 1 Kirk is an incorporated entity. On 31 December it was successful in a bid to acquire the exclusive rights to a patent that had been developed by another entity. The amount payable for the rights was $600,000 immediately and $400,000 in one years time. Kirk has incurred legal fees of $87,000 in respect of the bid. Kirk operates in a jurisdiction where the government charges a flat rate fee (a "stamp duty") of $1,000 for the registration of patent rights. Kirk's cost of capital is 10%. Required: Calculate the cost of the patent rights on initial recognition.
Worked solution 1 $ 600,000 363,636 87,000 1,000
Cash paid Deferred consideration ($400,000 x 1/1.1) Legal fees Stamp duty Cost on initial recognition
1,051,636
2.2.2
Business combination
•
The cost of an intangible asset acquired in a business combination is its fair value at the date of acquisition, irrespective of whether the intangible asset had been recognised by the acquiree before the business combination. (IFRS 3 "Business Combinations")
•
The fair value of intangible assets acquired in business combinations can normally be measured with sufficient reliability to be recognised separately from goodwill.
•
There is a rebuttable presumption that if the intangible asset has a fmite useful life, its fair value can be measured reliably.
•
As fair value reflects market expectations about the probability of future economic benefits, the probability recognition criteria is always met for intangible assets acquired in a business combination.
•
Any In-Process Research and Development (IPRD) of the aquired entity shall be included as an intangible asset of the group even though the subsidiary would not have included it as an asset in its separate balance sheet.
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•
Fair value at the date of the acquisition might be measured using: D
the current bid price in an active market (where one exists);
D
the price of the most recent, similar transactions for similar assets;
D
multiples applied to relevant indicators such as earnings;
D
discounted future net cash flows.
Using a weightedprobability where there is a range ofpossible outcomes demonstrates uncertainty rather than inability to measure fair value reliably. •
Although an intangible asset acquired as part of the business combination must be separable, this may only be possible if it is considered to be part of a related tangible or intangible asset.
•
Such a group of assets is recognised as a single asset separately from goodwill if the individual fair values of the assets within the group are not reliably measured. Such recognition removes from goodwill as many intangible assets as possible.
Illustration 1 In acquiring a company, two separable intangible assets are identified - a magazine's publishing title and a related subscriber database. Although similar databases are traded, the fair value of the publishing title cannot be reliably measured as it cannot be sold without the database. The two intangible assets are therefore recognised as a single asset and the fair value of both as a single asset established.
Illustration 2 The term "brand" and "brand name" are general marketing terms that are often used to refer to a group of complimentary assets, eg a trademark, its related trade name, formulas, recipes and technical expertise. In a business combination, complementary assets are recognised and valued as one group of assets if the fair values of the individual assets comprising the "brand" cannot be reliably measured.
•
The only circumstances in which it might not be possible to measure fair value reliably are when the intangible asset arises from legal or other contractual rights and either: D
is not separable; or
D
is separable but there is no history or evidence of exchange transactions for the same or similar assets.
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Worked example 2 Picard is an incorporated entity. On 31 December it paid $10,000,000 for a 100% interest in Borg. At the date of acquisition the net assets of Borg as shown on its balance sheet had a fair value of $6,000,000. In addition Borg also held the following rights: (1)
The brand name "Assimilation", a middle of the range fragrance. Borg had been considering the sale of this brand just prior to its acquisition by Picard. The brand had been valued at $300,000 by Brand International, a reputable firm of valuation specialists, who had used a discounted cash flow technique.
(2)
Sole distribution rights to a product "Lacutus". It is estimated that the future cash flows generated by this right will be $250,000 per annum for the next 6 years. Picard has determined that the appropriate discount rate for this right is 10%. The 6 year, 10% annuity factor is 4.36.
Ignore taxation.
Required: Calculate goodwill arising on acquisition.
Worked solution 2 Picard will recognise the two intangible assets on consolidation. They are taken into account when the cost of acquisition is allocated in accordance with IFRS 3 Business Combinations. $000 10,000 Cost Net assets recognised in Borg's balance sheet 6,000 Brand acquired 300 Distribution rights (250,000 x 4.36) 1,090 7,390 Goodwill on acquisition
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Worked example 3 A water extraction company was obtained as part of a business combination for a cost of $1,000,000. The fair value of the net assets at the date of acquisition was $750,000. A licence for the extraction of the water had been granted to the company prior to the acquisition by the local authority for an administration fee of$l,OOO. Whilst extremely valuable to the company (as without the licence the business could not operate), the licence cannot be sold other than as part of the sale of the business as a whole.
Required: Calculate goodwill arising on acquisition.
Worked solution 3 The water extraction rights were obtained as part of a business combination. Without these rights, the acquiree cannot extract water and therefore could not operate as a business. The rights cannot be sold separately without the business and cannot be grouped with any other intangible assets acquired as part of the business. They cannot, therefore, be identified separately from goodwill.
$ 1,000,000 (750,000)
Cost Net assets recognised on balance sheet
250,000
Goodwill on acquisition
2.2.3
Government grant
•
Some intangible assets may be acquired free of charge, or for nominal consideration, by way of a government grant (e.g. airport landing rights, licences to operate radio or television stations, import quotas, rights to emit pollution).
•
Under lAS 20 Accountingfor Government Grants and Disclosure ofGovernment Assistance both the intangible asset (debit entry) and the grant (credit entry) may be recorded initially at either fair value or cost (which may be zero).
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Illustration 3 Neelix is an entity involved in the harvest and production of foodstuffs. On 31 December it was awarded a fishing quota of 1,000 tonnes of cod per annum for 5 years. The quota requires a registration fee of$l,OOO. The fair value of the fishing quota is $10,000,000 (net of the registration fee).
Analysis •
Measurement of the intangible asset on initial recognition is at either: Cost $1,000
•
or
Fair value $10,000,000
Note that the credit entry falls to be treated as a grant under IAS 20. It may be presented in the balance sheet in one of two ways: (1) (2)
As deferred income As a deduction from the carrying value of intangible asset.
Offsetting, i.e. (2), is equivalent to ignoring it completely (there would be no amortisation) and so not permitted under certain GAAP. Therefore the deferred credit treatment of a grant is likely to be preferable.
2.2.4
Exchanges ofassets
•
The cost of an intangible asset acquired in exchange for a non-monetary asset (or a combination of monetary and non-monetary assets) is measured at fair value unless:
o
the exchange transaction lacks commercial substance; or
o
the fair value of neither the asset received nor the asset given up is reliably measurable.
•
If the acquired asset is not measured at fair value, its cost is measured at the carrying amount of the asset given up.
•
An exchange transaction has commercial substance if, for example, there is a significant difference between the risk, timing and amount of cash flows from the asset received and those of the asset transferred.
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2.3
Subsequent expenditure
2.3.1
Intangible assets
•
In most cases, there are no additions to an intangible asset, nor the replacement of parts of such assets.
•
Most subsequent expenditures maintain the expected future economic benefits embodied in an existing intangible asset and do not meet the defmition of an intangible asset and lAS 38 recognition criteria.
•
Also, it is often difficult to attribute subsequent expenditure directly to a particular intangible asset rather than to the business as a whole.
•
Therefore, only rarely will subsequent expenditure be recognised in the carrying amount of an asset. Normally, such expenditure must be written off through profit and loss.
•
Subsequent expenditure on brands, mastheads, publishing titles, customer lists etc (whether internally or externally generated) must always be recognised as an expense.
•
In the rare circumstances that subsequent expenditure meets the basic asset recognition criteria, it is added to the cost of the intangible asset.
2.3.2
Acquired in-process research and development
•
Subsequent expenditure on an acquired in-process research and development project is accounted for like any cost incurred in the research of development phase of internally generated intangible asset (see next section).
o
Research expenditure - expense when incurred.
o
Development expenditure - expense when incurred if it does not satisfy the asset recognition criteria.
o
Development expenditure that satisfies the recognition criteria add to the carrying amount of the acquired in-process research or development project.
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3
INTERNALLY GENERATED INTANGIBLE ASSETS
3.1
Internally generated goodwill
•
Internally generated goodwill is not recognised as an asset.
•
Although goodwill may exist in any business its recognition as an asset is precluded because it is not an identifiable resource (i.e. it is not separable nor does it arise from contractual or other legal rights) controlled by the entity that can be measured reliably at cost.
•
When goodwill is "crystallised" by a business acquisition it is recognised as an asset and accounted for in accordance with IFRS 3.
3.2
Other internally generated assets
•
It is sometimes difficult to assess whether an internally generated intangible
asset qualifies for recognition. Specifically it is often difficult to:
•
o
identity whether there is an identifiable asset that will generate probable future economic benefits; and
o
determine the cost of the asset reliably.
It is sometimes difficult to distinguish the cost of generating an intangible
asset internally from the cost of maintaining or enhancing the entity's internally generated goodwill or of running day-to-day operations. •
Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance are not recognised as intangible assets. Such expenditures cannot be distinguishedfrom the cost ofdeveloping the business as a whole.
3.3
Specific recognition criteria for internally generated intangible assets
•
In addition to complying with the general requirements for the recognition and initial measurement of an intangible asset (see Section 2.1), an entity must also apply the following to all internally generated intangible assets.
•
Generation of the asset must be classified into:
o o •
a "research phase"; and a further advanced "development phase".
If the research and development phases of a project cannot be distinguished they should be regarded as research only and written off as expenditure through profit and loss.
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3.3.1
Accounting in the research phase
•
An entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits during the research phase.
•
Expenditure on research should be recognised as an expense when it is incurred.
•
Examples of research activities are:
o
activities aimed at obtaining new knowledge;
o
the search for, evaluation and fmal selection of, applications of research fmdings or other knowledge;
o
the search for alternatives for materials, devices, products, processes, systems or services; and
o
the formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or devices.
3.3.2
Accounting in the development phase
•
An intangible asset arising from development should be recognised if, and only if, an entity can demonstrate all of the following:
•
•
o
the technical feasibility of completing the intangible asset so that it will be available for use or sale;
o
its intention to complete the intangible asset and use it or sell it;
o
its ability to use or sell the intangible asset;
o
how the intangible asset will generate probable future economic benefits;
o
the availability of adequate technical, fmancial and other resources to complete the development and to use or sell the intangible asset; and
o
its ability to measure the expenditure attributable to the intangible asset during its development reliability.
Examples of development activities are:
o
the design, construction and testing of pre-production or pre-use prototypes and models;
o
the design of tools, jigs, moulds and dies involving new technology;
o
the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and
o
the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.
Expenditure on an intangible item that was initially recognised as an expense (e.g. research) should not be recognised as part of the cost of an intangible asset at a later date (e.g. after the development phase has commenced).
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Illustration 4
An entity is developing a new production process. The amount of expenditure in the year to 31 December 2004 is as follows: $
2,160 240
1 January to 30 November 1 December to 31 December
2,400 On 1 December the entity was able to demonstrate that the production process met the criteria for recognition as an intangible asset. The amount estimated to be recoverable from the process (including future cash outflows to complete the process before it is available for use) is $1,200.
Analysis •
At 31 December 2004 the production process is recognised as an intangible asset at a cost of $240 (expenditure incurred since 1 December when the recognition criteria were met). The intangible asset is carried at this cost (being less than the amount expected to be recoverable).
•
The $2,160 expenditure incurred before 1 December is recognised as an expense because the recognition criteria were not met until that date. This expenditure will never form part of the cost of the production process recognised in the balance sheet.
Illustration 4 - continued Expenditure in 2005 is $4,800. At 31 December 2005, the amount estimated to be recoverable from the process (including future cash outflows to complete the process before it is available for use) is $4,500. Analysis •
At 31 December 2005, the cost of the production process is $5,040 (240 + 4,800). The entity recognises an impairment loss of$540 to adjust the carrying amount before impairment loss ($5,040) to its recoverable amount ($4,500).
•
This impairment loss will be reversed in a subsequent period if the requirements for the reversal of an impairment loss in lAS 36 Impairment of Assets are met.
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3.3.3
Research and development acquired as part ofa business combination
•
An in-process research and development project acquired as part of a business combination should be recognised separately from goodwill if:
o
the project meets the definition of an intangible asset; and
o
its fair value can be measured reliably. (IFRS 3)
The strict recognition criteria are not required to be met. •
An acquiree's in-process research and development project meets the definition ofan intangible asset when it:
o
meets the definition of an asset; and
o
is identifiable, ie is separable or arises from contractual or other legal rights.
•
If the in-process research and development meets the definition of an intangible asset, it will be separately recognised from goodwill irrespective of whether the asset had been recognised by the acquiree before the business combination.
3.4
Recognition of expenses and costs
•
Expenditure on an intangible item shall be recognised as an expense when it is incurred unless:
o
it forms part of the cost of an intangible asset that meets the recognition criteria; or
o
the item is acquired in a business combination and cannot be recognised as an intangible asset.
•
Where an intangible item acquired in a business combination cannot be recognised as an intangible asset, the expenditure (included in the cost of the business combination) is subsumed within the amount attributed to goodwill at the acquisition date.
•
Reliable measurement of costs requires a costing system that is able to identify costs to particular courses of action.
•
The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce, and prepare the asset to be capable of operating in the manner intended by management.
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•
Examples include:
o o o o o o o •
•
•
costs of materials and services used; salaries, wages and other employment related costs; fees to register a legal right; depreciation of equipment used in the development phase; amortisation of patents and licences used to generate the intangible asset; other directly attributable costs; overhead costs that can be allocated on a reasonable and consistent basis.
Costs that are not components of the cost of an internally generated intangible asset include:
o
selling, administration and other general overhead costs;
o
identified inefficiencies and initial operating losses incurred before the asset achieves planned performance;
o
costs that have previously been expensed (e.g. during a research phase) must not be reinstated;
o
training expenditure.
Expenditure incurred to provide future economic benefits for which no intangible asset can be recognised is expensed when incurred. Examples, except when they form part of the cost of a business combination, include:
o
research costs;
o
pre-opening costs for a new facility;
o
plant start-up costs incurred prior to full scale production (unless capitalised in accordance with lAS 16);
o
legal and secretarial costs incurred in setting up a legal entity;
o
training costs involved in running a business or a product line;
o
advertising and related costs.
This does not preclude recognising a prepayment when payment for goods or services has been made in advance of the delivery of goods or the rendering of services.
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Illustration 5 $lm was paid to acquire a small cosmetics company to be accounted for under IFRS 3 "Business Combinations". At the date of acquisition a purchased brand with a fair value of $100,000 was separately identified and expenditure of $50,000 had been incurred by the cosmetics company in identifying a new product. It was anticipated that a further $75,000 would be spent before a commercial product could be identified and the development phase commenced. The $lm paid as the cost of the business combination, reflects the research and development already carried out by the business. Analysis •
The intangible assets of $100,000 at fair value would be recognised separately from goodwill.
•
Identification of a new product constitutes research. However, acquired inprocess research and development project is recognised if it meets the definition of an intangible asset and its fair value can be measured reliably. (IFRS 3) The fair value could be very different to cost.
•
The expected further costs of $75,0000 would not be recognised at the date of acquisition because they have not yet been incurred. When incurred, they would be expensed through profit and loss as research expenditure.
4
MEASUREMENT AFTER RECOGNITION
•
An entity can choose either a cost or revaluation model.
4.1
Cost model
•
Cost less any accumulated amortisation and any accumulated impairment losses.
4.2
Revaluation model
•
Revalued amount, being fair value at the date of the revaluation less any subsequent accumulated amortisation and any accumulated impairment losses.
•
Fair value must be determined by reference to an active market (see below).
•
This is different to the treatment of revaluation under lAS 16 where depreciated replacement cost can be used when there is no evidence of market value.
•
Revaluations must be sufficiently regular that carrying amount at the balance sheet is not materially different from fair value.
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•
•
The revaluation model does not allow:
o
the revaluation of intangible assets that have not previously been recognised as assets;
o
the initial recognition of intangible assets at amounts other than their cost.
The revaluation is carried out according to the same principles applied in accounting for other assets. For example:
o
Surplus is taken directly to equity;
o
Deficit is expensed unless covered by a previously recognised surplus;
o
All intangibles in the class must be revalued, etc.
4.3
Active markets
•
The revaluation of intangibles will be uncommon in practice as it is not expected that an active market will exist for most intangible assets in that:
o
they will not be homogeneous (most are unique);
o
willing buyers and sellers may not be normally found at any time;
o
prices are not usually available to the public.
•
For example, active markets cannot exist for brands, newspaper mastheads, music and film publishing rights, patents and trademarks. Each item is unique, transactions are relatively infrequent and contracts are negotiated between individual buyers and sellers.
•
However, examples do exist of active markets for intangible assets - freely transferable taxi licences, fishing licences and production quotas.
Illustration 6 In 1990, in the United States, legislation was introduced to authorise sulphur dioxide pollution at a limited rate from power-generating systems - an emission right. Such rights are no longer granted. Organizations reducing their emissions through, for example, modernisation, then had excess pollution rights (i.e. an ability to pollute which was surplus to their requirements). An active market in emission rights emerged as new plants sought to buy the excess.
4.4
Accounting entries on revaluation
•
A surplus is credited directly to equity as "revaluation surplus" (unless reversing a deficit in respect of the same asset which was previously recognised as an expense)
•
A deficit is recognised as an expense (unless covered by a revaluation surplus in respect ofthe same asset).
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•
Any balance on the revaluation surplus, which is included in equity, may be transferred to retained earnings when the surplus is realised (e.g. on retirement or disposal).
•
Where some of the surplus is realised as the asset is used by the entity, the difference between amortisation based upon the revalued amount and amortisation that would have been charged based on the asset's historical cost is a transfer to retained earnings. This is effected through the statement ofchanges in equity, not the income statement.
Worked example 4 Janeway is an entity that operates in a jurisdiction and in a type of business where production quotas are under strict government control. Demand for the quotas exceeds supply. Production quotas must be applied for and if awarded are held for a period of 5 years. There is an active market for production quotas based on production volume and the price per unit is regularly quoted in the fmancial press. A fee of $1,000 is payable on application for a quota and if awarded the quota can only be taken up on payment ofa further fee of $100,000. Janeway applied for a production quota in September 2004. A quota was awarded in December 2004. All fees have been paid.
Analysis Application fee Take up fee
1,000 100,000
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This fee is expensed. This fee is capitalised as an intangible asset.
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Worked example 4 (continued) Janeway wishes to adopt the revaluation model for the subsequent measurement ofthe intangible asset and to revalue the asset on an annual basis. The fair values of the quota at the next two year ends are as follows:
$ 98,000 79,000
December 2005 December 2006 Required:
Prepare a reconciliation of the carrying amount at the beginning and end of each of the next two years showing: (i)
amortisation recognised during the period;
(li)
increases or decreases resulting from revaluations.
Worked solution 4 Carrying value $
Income statement $
Revaluation reserve $
Carrying amount 1 January 2005
100,000
Amortisation for the year ended 31 December 2005
(20,000)
Historical cost carrying amount 31 December 2005
80,000
Revaluation
18,000
18,000
31 December 2005
98,000
18,000
Carrying amount 1 January 2006
98,000
18,000
Amortisation for the year ended 31 December 2006
73,500
Revaluation
5,500
3
5,500 (4,500)
79,000
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24,500
Realisation of revaluation reserve (24,500 - 20,000) 31 December 2006
Notes
1
20,000
(24,500)
Carrying amount before revaluation
Retained earnings $
19,000
1320
4,500
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IAS 38 INTANGIBLE ASSETS
1
Amortisation is chargedfor the period up to the date ofthe revaluation. This is based on the carrying value during the period.
2
The increase in carrying value is credited directly to the revaluation reserve. This will be reflected in the statement ofchanges in equity under lAS 1 Presentation ofFinancial Statements.
3
The amortisation is based on the carrying value of$98,000 written offover the remaining useful life of 4 years.
4
As the asset is amortised the revaluation surplus is realised. This realisation is reflected as a transfer between the revaluation reserve and retained earnings. It is measured as the difference between the historical cost depreciation ($20,000) and the depreciation ofthe revalued amount ($24,500).
5
USEFUL LIFE
5.1
Factors
•
The useful life of an intangible asset should be assessed as fmite or indefmite.
•
A fmite useful life is assessed as a period of time or number of production or similar units. An intangible asset with a fmite life is amortised. "Indefinite" does not mean "infmite".
•
Useful life is regarded as indefmite when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows.
This must be based on an analysis ofall ofthe relevantfactors. An intangible asset with an indefinite life is not amortised. •
Factors to be considered in determining useful life include:
o
expected usage of the asset by the entity;
o
typical product life cycles for the asset;
o
public information on estimates of useful lives of similar types of assets that are similarly used;
o
technical, technological, commercial or other obsolescence;
For example, computer software is susceptible to technological obsolescence and so has a short useful life.
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o
stability of the industry in which the asset operates;
o
changes in market demand for the output from the asset;
o
expected actions by competitors or potential competitors;
o
the level of maintenance expenditure or of funding required and the entity's ability and intent to reach this level;
o
legal or similar limits on the use of the asset, such as the expiry dates of related leases; and
o
whether or not the useful life ofthe asset is dependent on the useful life of other assets of the entity.
5.2
Finite useful lives
5.2.1
Contractual or other legal rights
•
The useful life of an intangible asset arising from contractual or other legal rights should not exceed the period of such rights, but may be shorter.
Illustration 7 An entity has purchased an exclusive right to operate a passenger and car ferry for thirty years. There are no plans to construct tunnels or bridges to provide an alternative river crossing in the area served by the ferry. It is expected that this ferry will be in use for at least thirty years.
Illustration 8 An entity has purchased an exclusive right to operate a wind farm for 40 years. The cost of obtaining wind power is much lower than the cost of obtaining power from alternative sources. It is expected that the surrounding geographical area will demand a significant amount of power from the wind farm for at least 25 years.
The entity amortises the right to generate power over 25 (rather than 40) years. •
Where such rights are renewable the useful life includes renewal periods if there is evidence that the entity will renew without significant cost.
Such evidence may be based on past experience or third party consent. If cost ofrenewal is significant it represents, in substance, a new intangible asset.
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5.2.2
Amortisation
•
The depreciable amount of an intangible asset should be allocated on a systematic basis over the best estimate of its useful life.
•
Amortisation begins when the asset is available for use.
When it is in the location and condition necessaryfor it to be capable of operating as intended. •
Amortisation ceases at the earlier of the date that the asset is:
o
classified as held for sale; or
IFRS 5 "Non-current Assets Held for Sale and Discontinued Operations" applies.
o
derecognised.
It does not cease when an intangible asset is temporarily idle, unless it is fully depreciated. •
The amortisation method used should reflect the pattern in which the asset's economic benefits are consumed by the entity. If that pattern cannot be determined reliably, the straight-line method should be adopted.
•
The amortisation charge for each period is recognised in profit or loss unless it is permitted to be included in the carrying amount of another asset.
For example, the amortisation ofa patent right exercised to manufacture a product would be a cost included in inventory.
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5.2.3
Residual value
•
The residual value of an intangible asset is assumed to be zero unless the following conditions are met:
o
there is a commitment by a third party to purchase the asset at the end of its useful life; or
o
there is an active market for that type of intangible asset; and: residual value can be measured reliably by reference to that market; and it is probable that such a market will exist at the end of the useful life.
If the residual value ofan intangible asset increases to an amount equal to or greater than the asset's carrying amount, the asset's amortisationcharge is zerounless and until its residual value subsequently decreases to an amount below the asset's carrying amount. •
An asset with a residual value implies an intention to dispose of it before the end of its economic life. Thus development costs, for example, are unlikely to have a residual value (other than zero).
5.2.4
Review
•
The amortisation period and the amortisation method should be reviewed at least at each financial year end.
•
Any changes in period or method are a change in estimate and accounted for in accordance with lAS 8 "Accounting Policies, Changes in Accounting Estimates and Errors".
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Example 2 On 1 April 2004 Brook established a new research and development unit to acquire scientific knowledge about the use of synthetic chemicals for pain relief. The following expenses were incurred during the year ended 31 March 2005. (1)
Purchase of building for $400,000. The building is to be depreciated on a straight line basis at the rate of 4% per annum on cost.
(2)
Wages and salaries of research staff $2,355,000.
(3)
Scientific equipment costing $60,000 to be depreciated using a reducing balance rate of 50% per annum.
Required: Calculate the amount of research and development expenditure to be recognised as an expense in the year ended 31 March 2005.
Proforma solution The following costs should be written off: $ Building depreciation Wages and salaries of research staff Equipment depreciation
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Example 3 In its first year of trading to 31 July 2005 Eco-chem incurred the following expenditure on research and development, none of which related to the purchase of property, plant and equipment. (1)
$12,000 on successfully devising processes to convert the sap extracted from mangroves into chemicals X, Y and Z.
(2)
$60,000 on developing an analgesic medication based on chemical Z.
No commercial uses have yet been discovered for chemicals X and Y. Commercial production and sales of the analgesic commenced on 1 April 2005 and are expected to produce steady profitable income during a five year period before being replaced. Adequate resources exist for the company to achieve this.
Required: Determine the maximum amount of development expenditure that may be carried forward at 31 July 2005 under lAS 38.
Solution
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5.3
Indefinite useful lives
•
An intangible asset with an indefinite useful life is: D D
not amortised; but tested for impairment: annually; and whenever there is an indication of impairment.
•
Reassessing a usefu11ife as fmite rather than indefinite is an indicator that the asset may be impaired.
•
The usefu11ife is reviewed each period to determine whether events and circumstances continue to support an indefmite useful life assessment.
Jfnot, the change in accounting estimate is accounted/or in accordance with lAS 8.
6
IMPAIRMENT AND DERECOGNITION
6.1
Impairment losses
•
lAS 36 Impairment 0/Assets contains provisions regarding: D D D
when and how carrying amounts are reviewed; how recoverable amount is determined; and when an impairment loss is recognised or reversed.
•
The purpose of testing for impairment is to ensure recovery of the carrying amount. Note that the uncertainty about recovering the cost of an intangible asset before it is available for use (e.g. development costs) is likely to be greater than when it is brought into use.
6.2
Retirements and disposals
•
An intangible asset should be derecognised (i.e. eliminated from the balance sheet): D D
•
on disposal; or when no future economic benefits are expected from its use or disposal.
Gains or losses arising are determined as the difference between: D D
the net disposal proceeds; and the carrying amount of the asset.
Gains or losses are recognised as income or expense in the period in which the retirement or disposal occurs. Gains are not classified as revenue.
However, lAS 17 "Leases" may require otherwise on a sale and leaseback.
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7
DISCLOSURE
Illustration 9
Notes to the consolidated financial statements (extract) Research and development Research and development costs are expensed as they are incurred, except for certain development costs, which are capitalized when it is probable that a development project will be a success, and certain criteria, including commercial and technological feasibility, have been met. Capitalized development costs, comprising direct labor and related overhead are amortized on a systematic basis over their expected useful lives between two and five years.
NOKIA ANN U A LAC C 0 U N T S 2 0 03
•
The disclosure requirements ofIAS 38 are comparable to, but more extensive than, those ofIAS 16 "Property, Plant and Equipment".
7.1
Intangible assets
7.1.1
General
•
The financial statements should disclose the accounting policies adopted for intangible assets and, in respect of each class of intangible assets:
o
whether useful lives are indefmite or finite and, if finite: the useful lives or the amortisation rates used; the amortisation methods used;
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Illustration 10 Accounting policies Intangible assets This heading includes separately acquired intangible assets such as management information systems, intellectual property rights and rights to carry on an activity (i.e. exclusive rights to sell products or to perform a supply activity). Intangible assets are depreciated on a straight-line basis, management information systems over a period ranging between three to five years, other intangible assets over five to twenty years. Where a period in excess of twenty years is used, this is separately disclosed for each element of intangible asset together with the principal factors determining that useful life. The recoverable amount, as well as depreciation period and depreciation method are reviewed annually. The depreciation is allocated to the relevant headings in the income statement. Internally generated intangible assets are recognized, provided they generate future economic benefits and their costs are well identified. They consist mainly of management information systems.
Nestle Consolidated accounts 2003
o
the gross carrying amount and any accumulated amortisation (including accumulated impairment losses) at the beginning and end of the period;
o
the line item of the income statement in which any amortisation is included;
o
a reconciliation of the carrying amount at the beginning and end of the period showing all movements that have arisen in the period analysed by type.
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Illustration 11 12. Intangible assets 2003
2002
EURm
EURm
1707
1314
Capitalized d v lopment costs Acquisition cost Ja n. 1
218
418
Impairment and write-offs
-455
- 25
Acc umula te d amortization Dec. 31
- 933
-635
537
1072
1429 20
1601
Additions Imp airment charges (Note 7)
- 151
- 182
- 1 112
-953
186
476
524
533
Addilions
Ne t carry ing amount Dec. 31
Goodwlll Ac quisition cost Jan . 1
Accumulated amorlization Dec . 31 Ne t carrying amount Dec . 31
10
Other IntangIble assets Acquisition cost Jan . 1 Addilions
87
75
Disposals
-44
- 72
Translalion differences Accumulated amortization Dec. 31 Ne t carrying amoun t Dec . 31
-13
-12
-369
-332
185
192
NOKIA ANN U A LAC C 0 U N T S 2 0 0 3
7.1.2
Individually material intangible assets
•
Disclose the nature, carrying amount and remaining amortisation period of any individual intangible asset that is material to the financial statements as a whole.
•
In determining whether or not an individual intangible asset "is material" consider, for example:
o
its cost or carrying value in relation to total intangible assets and total assets;
o
the amount expensed during the year (in respect ofamortisation and/or impairment) in relation to net profit or loss.
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Illustration 12 Accounting policies (extract) Intangible assets Acquired intangible assets other than goodwill are recognized at cost and amortized by the straight-line method over a period of 4 to 15 years, depending on their estimated useful lives. Write-downs are made for impairment losses. Assets are written back if the reasons for previous years' write-downs no longer apply. Scheduled amortization for 2003 has been allocated to the cost of goods sold, selling expenses, research and development expenses or general administration expenses. Goodwill, including that resulting from capital consolidation, is capitalized in accordance with lAS 22 (Business Combinations) and amortized on a straight-line basis over a maximum estimated useful life of 20 years. The value of goodwill is reassessed regularly based on impairment indicators and written down if necessary. In compliance with lAS 36 (Impairment of Assets), such write-downs of goodwill are measured by comparison to the discounted cash flows expected to be generated by the assets to which the goodwill can be ascribed. Amortization and write-downs of capitalized goodwill are recorded as other operating expense. Self-created intangible assets generally are not capitalized. Certain development costs relating to the application development stage of internally developed software are, however, capitalized in the group balance sheet. These costs are amortized over the useful life of the software from the date it is placed in service.
Notes to Consolidated Financial Statements of the Bayer Group
7.1.3
Indefinite useful life
•
Disclose the carrying amount and reasons supporting the assessment of an indefinite useful life (this includes describing the factors that played a significant role in determining that the asset has an indefinite useful life).
7.1.4
Change in accounting estimate
•
lAS 8 requires an entity to disclose the nature and amount of a change in an accounting estimate that has a material effect in the current period or is expected to have a material effect in subsequent periods. Such disclosure may arise from changes in: D D D
the assessment of an intangible asset's useful life; the amortisation method; or residual values.
7.1.5
Impairment
•
Information on impairment of intangible assets is made in accordance with lAS 36.
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7.1.6
Acquired by way ofgovernment grant
•
For intangible assets acquired by way of a government grant and initially recognised at fair value:
o
the fair value initially recognised for these assets;
o
their carrying amount; and
o
whether they are measured after recognition under the cost model or the revaluation model.
7.1.7
Other
•
The existence and carrying amounts of intangible assets whose title is restricted and the carrying amounts of intangible assets pledged as security for liabilities.
•
The amount of contractual commitments for the acquisition of intangible assets.
7.2
Revaluations
•
The following should be disclosed when assets are carried at revalued amounts:
o
the effective date of the revaluation (by class);
o
the carrying amount ofthe revalued intangible assets (by class);
o
the carrying amount that would have been recognised using the cost model (by class);
o
the amount of the revaluation surplus that relates to intangible assets at the beginning and end of the period, indicating movements in the period and any restrictions on the distribution of the balance to shareholders;
o
the methods and significant assumptions applied in estimating fair values.
7.3
Research and development expenditure
•
Disclose the total cost of research and development that has been recognised as an expense during the period.
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FOCUS
You should now be able to: •
distinguish between goodwill and other intangible assets;
•
discuss the nature and possible accounting treatments of internally-generated goodwill;
•
define the criteria for the initial recognition and measurement of intangible assets;
•
describe and apply the requirements ofIAS 38 to internally generated assets other than goodwill (e.g. research and development).
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EXAMPLE SOLUTIONS Solution 1 - Tangible versus intangible assets (1)
Tangible: the operating system (e.g. DOS or Windows) ofa personal computer is an integral part of the related hardware and should be accounted for under IAS 16 Property, Plant and Equipment.
(2)
Intangible: such computer software (e.g. QuarkXpress) is not an integral part of the hardware on which it is used.
(3)
Tangible: specialised software integrated into production line "robots" is similar in nature to (1).
(4)
Intangible: companies developing "firewall" software to protect their own websites may also sell the technology to other companies.
Solution 2 - Research and development write-off The following costs should be written off: $ 16,000 2,355,000 30,000
Building depreciation (400,000 x 4%) Wages and salaries of research staff Equipment depreciation (60,000 x 50%)
2,401,000
Solution 3 - Maximum carry forward Cost (1)
This is research expenditure which cannot be capitalised under any circumstances and must therefore be expensed to the income statement
(2)
Initially recognise cost $60,000. Residual value is presumed to be zero.
Amortisation Amortise from 1 April 2005 for a period of 5 years. Charge for 4 months is: 4/60 x $60,000 = $4,000 Carrying amount $60,000 - $4,000 = $56,000. This is the maximum carry forward, assuming no impairment.
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lAS 40 INVESTMENT PROPERTIES
OVERVIEW Objective
•
To describe the accounting treatment of investment properties.
• • • •
Objective Scope Definitions Effective Date
RECOGNITION AND MEASUREMENT
• • • •
Rule Initial Measurement Meaning ofcost Expenditure after initial recognition
MEASUREMENT AFTER RECOGNITION
• • • • • •
Fair value model Exceptional circumstances The cost model Transfers Disposals Change in method
INTRODUCTION
DISCLOSURE
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1
INTRODUCTION
1.1
Objective
•
lAS 40 prescribes the accounting treatment for investment property and the related disclosure requirements.
1.2
Scope
•
lAS 40 shall be applied in the recognition, measurement and disclosure of investment properties.
•
lAS 40 shall be applied in the measurement of investment properties:
o
held by a lessee under a finance lease, and
o
held by a lessor and leased out under an operating lease.
lAS 40 does not deal with those matters covered under lAS 17 Leases. lAS 17 states that if an asset obtained through a lease and is treated as an investment property by the lessee then that lease must be treated as a fmance lease with the investment property measured using the fair value model of lAS 40. •
The standard does not apply to
o
Biological assets in respect of agricultural activity, and
o
mineral rights and reserves and similar non-regenerative resources.
1.3
Definitions
•
Investment property is property (land or a building - or part of a building - or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
o
use in the production or supply of goods or services or for administrative purposes, or
o
sale in the ordinary course of business.
•
Owner-occupied property is property held by the owner (or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes.
•
Examples of property include:
o
land held for long-term capital appreciation rather than for shortterm sale in the ordinary course of business,
o
land held for a currently undetermined future use,
o
a building owned by the reporting entity (or held under a fmance lease) and leased out under operating leases, and
o
a building that is vacant but is held to be leased out.
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•
The following do not meet the definition of investment property:
o
property held for sale in the ordinary course of business,
o
property being constructed for third parties (included in lAS 11 Construction Contracts),
o
owner-occupied property (see lAS 16 Property, Plant and Equipment), and
o
property that is being constructed or developed for future use as an investment property. (lAS 16 - Property, plant and equipment applies).
2
RECOGNITION AND MEASUREMENT
2.1
Rule
•
Investment property shall be recognised as an asset when
o
it is probable that the future economic benefits that are attributable to the investment property will flow to the entity, and
o
the cost ofthe investment property can be measured reliably.
2.2
Initial Measurement
•
An investment property shall be measured initially at its cost, which is the fair value of the consideration given for it, and will include any transaction costs.
2.3
Meaning of cost
•
The cost of a purchased investment property comprises its purchase price, and any directly attributable expenditure. Directly attributable expenditure includes, for example, professional fees for legal services and property transfer taxes.
•
The cost of a self constructed investment property is its cost at the date when the construction or development is complete.
•
If an investment property is acquired through a fmance lease the initial cost recognised shall be in accordance with lAS 17 Leases.
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2.4
Expenditure after initial recognition
•
Day to day costs of running the investment property are expensed as incurred.
•
If a part of an investment property requires replacement during the useful life of the property the replacement part is capitalised when the cost is incurred as long as the recognition criteria are met. Any value remaining in respect of the replaced part will be de-recognised as the new cost is capitalised. This follows the replacement part principle oflAS 16 Property, Plant and Equipment.
3
MEASUREMENT AFTER RECOGNITION
•
An entity shall choose either the fair value model or the cost model as described in the standard and apply that policy to all of its investment properties.
3.1
Fair value model
•
After initial recognition, an entity that chooses the fair value model shall measure all of its investment property at its fair value (except in exceptional circumstances).
•
A gain or loss arising from a change in the fair value of investment property shall be included in net profit or loss for the period in which it arises.
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Fair Value Measurement Considerations
•
Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.
o
"knowledgeable, willing parties"- knowledgeable means that both the willing buyer and the willing seller are reasonably informed about: the nature and characteristics of the investment property, its actual and potential uses, and the state of the market as of the date of valuation.
o
a willing buyer is motivated, but not compelled to buy. He is neither overeager nor determined to buy at any price. This buyer is also one who purchases in accordance with the realities of the current market, and with the current market expectations.
o
a willing seller is neither an over-eager nor a forced seller, prepared to sell at any price, nor one prepared to hold out for a price not considered reasonable in the current market. The willing seller is motivated to sell the investment property at market terms for the best price attainable in the open market after proper marketing, whatever that price may be.
o
an arm's-length transaction is one between parties who do not have a particular or special relationship that makes prices of transactions uncharacteristic of the market. The fair value transaction is presumed to be between unrelated parties, each acting independently.
•
In summary, fair value is measured as the most probable price reasonably obtainable in the market at the date of valuation in keeping with the fair value definition. It is the best price reasonably obtainable by the seller and the most advantageous price reasonably obtainable by the buyer. The fair value of investment property shall reflect the actual market state and circumstances as of the effective valuation date, not as of either a past or future date.
•
The fair value of investment property is an estimated amount rather than a predetermined or actual sale price. It is the price at which the market expects a transaction that meets all other elements of the fair value definition would be completed on the date of valuation.
•
The fair value shall reflect the actual market and circumstances at the balance sheet date, not as of either a past or future date.
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3.2
Exceptional circumstances
•
There is a rebuttal presumption that an entity will be able to determine the fair value of an investment property reliably on a continuing basis.
•
However in exceptional circumstances where there is clear evidence, when an entity, that has chosen the fair value model, first acquires an investment property to which fair value cannot be determined on a reliable and continuing basis, then that property shall be measured in accordance with the cost model ofIAS 16
•
The entity measures all its other investment property at fair value.
3.3
The cost model
•
After initial recognition, an entity that chooses the cost model shall measure all of its investment property using the cost model in lAS 16 Property, Plant and Equipment, that is at cost less any accumulated depreciation and impairment losses.
•
An investment property, measured under the cost model, that is subsequently classed as held for sale in accordance with IFRS 5 NCA heldfor sale and discontinued operations shall be measured in accordance with that standard.
•
IFRS 5 requires NCA held for disposal to be measured at the lower of its carrying value and fair value less costs to sell. Once an asset is classed as held for disposal it will no longer be depreciated.
3.4
Transfers
•
Transfers to and from investment property shall be made when and only when there is a change in use evidenced by:
o
commencement of owner occupation for a transfer from investment property to owner occupied property
o
commencement of development with a view to sale for a transfer from investment property to inventories
o
end of owner occupation for a transfer from owner occupied property to investment property
o
commencement of an operating lease to another party for a transfer from inventories to investment property
o
end of construction or development for a transfer from property in the course of construction to investment property.
3.5
Disposals
•
An investment property shall be derecognised on disposal or when the investment property is permanently withdrawn from use and no future economic benefits are expected from its disposal.
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•
Any gains or losses on the retirement of an asset are calculated as the difference between the carrying value of the asset and the disposal proceeds and are included in the net profit or loss for the period.
3.6
Change in method
•
A change from one model to the other model shall be made only if the change will result in a more appropriate presentation. IAS 40 states that this is highly unlikely to be the case for a change from the fair value model to the cost model.
Example 1 A company has four investment properties, A, B, C and D. Before the implementation of IAS 40, it had the following accounting policy: "Investment properties are valued on a portfolio basis at the fair value at the year-end, with any net gain recognised in the investment property revaluation reserve. Dilly net losses from revaluation are transferred to income statement" At 1.01.2004, the carrying amounts of each of the four properties were $IOOm. At 31.12.2004, following a professional appraisal of value, the properties were valued at: A
$140m
B
$130m
C
$95m
D
$90m
Required Show how the application of IAS 40 would change the financial statements of the company if the fair value model is chosen.
Solution 1
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Example 2 An investment property company has been constructing a new building for the last 18 months. At 31.12.2003, the cinema was nearing completion, and the costs incurred to date were:
$m 14.8 2.5 1.3
Materials, labour and sub-contractors Other directly attributable overheads Interest on borrowings
It is the company's policy to capitalise interest on specific borrowings raised for the purpose of fmancing a construction. The amount of borrowings outstanding at 31.12.2003 in respect of this project is $18m, and the interest rate is 9.5%pa. During the three months to 31.3.2004 the project was completed, with the following additional costs incurred: $m $1.7 $0.3
Materials, labour and sub-contractors Other overhead
On 31.3.2004, the company obtained a professional appraisal of the cinema's fair value, and the valuer concluded that it was worth $24m. The fee for his appraisal was $0.1m, and has not been included in the above figures for costs incurred during the 3 months. The cinema was taken by a national multiplex chain on an operating lease as at 1.04.2004, and was immediately welcoming capacity crowds. The lease agreement allows for annual revisions, and thus it was clear that it was worth even more than the valuation at 31.3 .2004. Following a complete valuation of the company's investment properties at 31.12.2004, the fair value of the cinema was established at $28m.
Required Set out the accounting entries in respect of the cinema complex for the year ended 31.12.2004.
Solution 2
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4
DISCLOSURE
•
An entity shall disclose
o
The method and significant assumptions applied in determining fair value
o
The extent to which the fair value is based on a valuation by an independent valuer
o
The amounts included in the income statement for rental income direct operating expenses (including repairs) that generated rental income during the period direct operating expense (including repairs) that did not generate rental income during the period
•
When applying the fair value model an entity shall also disclose a reconciliation of the carrying amount at the beginning and end of the period and the movements in the period.
•
When applying the cost model an entity shall also disclose
o
the depreciation method used
o
the useful lives or the depreciation rates used
o
a reconciliation of the carrying amount at the beginning and end of the period and the movements in the period, and
o
the fair value of the property or a note stating that the fair value cannot be determined reliably and giving a description of the property for which we cannot obtain the fair value of and if possible a range of estimates within which the fair value is likely to be.
FOCUS •
Discuss the way in which the treatment of investment properties may differ from other properties;
•
apply the requirements of IAS 40 to Investment properties;
•
account for investment properties including fair value and cost models, and definitional issues.
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EXAMPLE SOLUTIONS Solution 1
Under the company's existing accounting policy, they would carry the investment properties in the Balance Sheet at 31.12.2004 at a total of $455m, and the net gain would be recorded in the revaluation reserve (455 - 400 = 55). Applying lAS 40 (fair value model), the company would still carry the properties at $455m, but the net gain of $55m would be recorded in the income statement. Solution 2
Costs incurred in the 3 months to 31.3.2004
Dr
Dr
Dr
$m 1.7
Asset under construction Cr Cash/Creditors
$m 1.7
Asset under construction Cr Cash/Creditors
0.3
Asset under construction Cr Interest expense
0.43
0.3
0.43
WORKING Outstanding borrowings Interest for 3 months
$18m $18m x 3/12 x 9.5%
=
0.43m
Accumulated costs at the date oftransfer into investment properties:
Note:
Costs to 31.12.2003 (14.8 + 2.5 + 1.3) Costs to 31.03.2004 (1.7 + 0.3 + 0.43)
$m 18.6 2.43
Investment property initially recognized
21.03
The receipt ofthe professional valuation at 31.3.2004 has not improved the profit earning potential ofthe asset. The valuation itselfis also irrelevant since lAS 40 states that initial recognition shall be at cost.
At 31.12.2004
Dr
Investment property (28 - 21.03) Cr Income statement
$m 6.97
$m 6.97
Being the increase in fair value following first subsequent re-measurement.
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1410
IAS 41 AGRICULTURE
OVERVIEW Objectives
•
To outline the accounting rules for agriculture.
INTRODUCTION
RECOGNITION AND MEASUREMENT
• • • •
Objective Scope Definitions Commentary
• • • •
•
Recognition Measurement Commentary Gains and losses Iffair value cannot be determined
• •
Presentation Disclosure
GOVERNMENT GRANTS
PRESENTATION AND DISCLOSURE
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lAS 41 AGRICULTURE
1
INTRODUCTION
1.1
Objective
•
The standard prescribes the accounting treatment and the presentation and disclosure s related to agricultural activity.
1.2
Scope
•
lAS 41 covers the following when they relate to agricultural activity:
•
o
biological assets,
o
agricultural produce at the point of harvest, and
o
government grants as described in the standard.
lAS 41 does not cover:
o
land related to agricultural activity (see lAS 16), or
o
intangible assets related to agricultural activity (see lAS 38).
1.3
Definitions
•
Agricultural activity is the management by an entity of the biological transformation of biological assets into agricultural produce for sale, into agricultural produce, or into additional biological assets.
•
A biological asset is a living animal or plant.
•
Biological transformation comprises the processes of growth, degeneration, production, and procreation that cause qualitative and quantitative changes in a biological asset.
•
Harvest is the detachment of produce from a biological asset or the cessation of a biological asset's life processes
•
Agricultural produce is the harvested product of the entity's biological assets.
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lAS 41 AGRICULTURE
1.4
Commentary
•
Agricultural activity covers a diverse range of activities, including raising livestock, forestry, annual or perennial cropping, cultivating orchards and plantations, floriculture, and aquaculture.
•
The common features of agricultural activity are as follows:
o
Capability to change - living animals and plants are capable of biological transformation.
o
Management of change - management facilitates biological changes by enhancing or stabilising conditions (ie temperature, moisture, nutrient levels, fertility and light).
o
Measurement of change - the change in quality (ie ripeness, density, fat cover, genetic merit) or quantity (weight, fibre length, cubic metres, and number of buds).
2
RECOGNITION AND MEASUREMENT
2.1
Recognition
•
An entity should recognise a biological asset when, and only when:
o
The entity controls the asset as a result of past event,
o
It is probable that future economic benefits associated with the asset will flow to the entity, and
o
The fair value can be measured reliably.
2.2
Measurement
•
A biological asset should be measured on initial recognition and at each balance sheet date at its fair value less estimated point of sale costs, except where the fair value cannot be measured reliably.
•
Agricultural produce harvested from an entity's biological assets should be measured at its fair value less estimated point of sale costs at the point of harvest. Such measurement is cost at that date when applying IAS 2 or another applicable lAS.
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lAS 41 AGRICULTURE
Illustration 1 A farmer owned a dairy herd at 1 January 2004. The number of cows in the herd was 100. The fair value of the herd at this date was $5,000. The fair values of two-year animals at 31 December 2003 and three-year old animals at 31 December 2004 are $60 and $75, respectively. Separating out the value increases of the herd into those relating to price change and those relating to physical change gives the following valuation: $
Fair value at 1 January 2004 Increase due to price change (100 x ($60 - $50)) Increase due to physical change (100 x ($75 - $60))
5,000 1,000 1,500
Fair value at 31 December 2004
7,500
2.3
Commentary
•
Point of sale costs include commissions to brokers/dealers, levies by regulatory agencies and transfer taxes and duties. They do not include transport and other costs necessary to get the asset to the market.
•
If an active market exists for a biological asset or agricultural produce, the quoted price in that market is the appropriate basis for determining the fair value of that asset. If an entity has access to different active markets, the entity uses the most relevant one, ie if the entity has access to two markets, it would use the price existing in the market expected to be used.
•
If an active market does not exist, an entity uses one or more of the following, when available, in determining fair value:
•
o
The most recent market transaction price, provided that there has been no significant change in economic circumstances between the date of that transaction and the balance sheet date,
o
Market prices for similar assets with adjustment to reflect differences, and
o
Sector benchmarks such as the value of an orchard expressed per export tray, bushel, or hectare, and the value of cattle expressed per kilogram of meat.
In some circumstances market determined prices or values may not be available for a biological asset in its present condition. In such cases, an entity uses the present value of expected net cash flows from the asset discounted at a current market determined pre-tax rate in determining fair value.
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lAS 41 AGRICULTURE
•
Cost may sometimes approximate fair value, particularly when:
o
Little biological transformation has taken place since initial cost incurrence (ie for fruit tree seedlings planted immediately before the balance sheet date), or
o
The impact of the biological transformation on price is not expected to be material (ie initial growth in a 30 year pine plantation production cycle).
2.3
Gains and losses
•
A gain or loss arising on initial recognition of a biological asset at fair value less point of sale costs (as point of sale costs need to be deducted) and from a change in fair value less estimated point of sale costs of a biological asset should be included in net profit or loss for the period in which it arises.
•
A gain or loss arising on initial recognition of agricultural produce at fair value less estimated point of sale costs should be included in net profit or loss for the period in which it arises.
2.4
If fair value cannot be determined
•
If the fair value on initial recognition cannot be determined for a biological asset as market determined prices or values are not available and for which alternative estimates of fair value are determined to be clearly unreliable, the biological asset should be valued at cost less accumulated depreciation and any impairment losses. Once the fair value of the asset can be reliably determined an entity should measure it at fair value less estimated point of sale costs.
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lAS 41 AGRICULTURE
Example 1
As at 31 December 2004, a plantation consists of 100 Insignis Pine trees that were planted 10 years earlier. Insignis Pine takes 30 years to mature, and will ultimately be processed into building material for houses or furniture. The entity's weighted average cost of capital is 6% per annum. Only mature trees have established fair values by reference to a quoted price in an active market. The fair value (inclusive of current transport costs to get 100 logs to market) for a mature tree of the same grade as in the plantation is: As at 31 December 2004: 171 As at 31 December 2005: 165 Required:
(a)
Assuming immaterial cash flow between now and the point of harvest, estimate the fair value of the plantation as at: (i) (ii)
(b)
31 December 2004; and 31 December 2005.
Analyse the gain between the two balance sheet dates into: (i) (ii)
a price change; and a physical change.
3
GOVERNMENT GRANTS
•
An unconditional government grant related to a biological asset measured at its fair value less estimated point of sale costs should be recognised as income when, and only when the government grant becomes receivable.
•
If a government grant related to a biological asset measured at its fair value less estimated point of sale costs is conditional, including where a government grant requires an entity not to engage in specified agricultural activity, an entity should recognise the government grant as income when, and only when, the conditions attaching to it are met.
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lAS 41 AGRICULTURE
4
PRESENTATION AND DISCLOSURE
4.1
Presentation
•
An entity should present the carrying amount of it biological assets separately on the face of its balance sheet.
4.2
Disclosure An entity should disclose
•
The aggregate gain or loss arising during the current period on initial recognition of biological assets and agricultural produce and from the change in the fair value less estimated point of sale costs of biological assets.
•
A description of each group of biological assets.
•
If not disclosed elsewhere in the financial statements:
o
The nature of its activities involving each group of biological assets, and
o
Non fmancial measures or estimates of the physical quantities of: each group of the entity's biological assets at the end of the period, output of agricultural produce during the period.
•
The methods and significant assumptions applied in determining the fair value of each group of agricultural produce at the point of harvest and each group of biological asset
•
The fair value less the estimated point of sale costs of agricultural produce harvested during the period, determined at the point of harvest.
•
The existence and carrying amount of biological assets whose title is restricted, and the carrying amounts of biological assets pledged as security for liabilities.
•
The amount of commitments for the development or acquisition of biological assets.
•
Financial risk management strategies related to agricultural activity.
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lAS 41 AGRICULTURE
•
A reconciliation of changes in the carrying amount of biological assets between the beginning and the end of the current period, including:
o
The gain or loss arising from changes in fair value less estimated point of sale costs,
o
Increases due to purchases and business combinations,
o
Decreases due to sales and harvests
o
Net exchange differences arising on the translation of financial statements of a foreign entity.
(Comparative information in not required)
If the fair value cannot be reasonable determined •
If the entity measures biological assets at their cost less any accumulated depreciation and any accumulated impairment losses:
o
A description of the biological assets,
o
An explanation of why the fair value cannot be measured reliably,
o
If possible, the range of estimates within which fair value is likely to lie,
o
The depreciation method used and the useful lives or depreciation rates used,
o
The gross carrying amount and the accumulated depreciation (and impairment losses) at the beginning and end of the period,
o
Any gain or loss recognised on disposal,
o
The impairment losses or reversals recognised in the period,
o
Depreciation charged in the period.
If the fair value ofbiological assets previously measured at their cost less any accumulated depreciation and any accumulated impairment losses becomes reliably measurable during the current period •
A description of the biological assets,
•
An explanation of why fair value has become reliably measurable, and
•
The effect of the change.
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lAS 41 AGRICULTURE
Government grants •
The nature and extent of government grants recognised in the fmancial statements,
•
Unfulfilled conditions and other contingencies attaching to government grants, and
•
Significant decreases expected in the level of government grants.
FOCUS
You should now be able to: •
account for biological assets, agricultural produce at the point of harvest and government grants.
•
discuss the recognition and measurement criteria including treatment of gains and losses, and the inability to measure fair value reliably.
•
identify what is and what is not scoped into the standard on agriculture.
•
present and disclose information relating to agriculture.
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lAS 41 AGRICULTURE
EXAMPLE SOLUTION (a)
Estimate offair value
(i)
31 December 2004
The mature plantation would have been valued at 17,100. 17,100 =5332 1.0620 ' (il)
31 December 2005
The mature plantation would have been valued at 16,500. 16,500 = 5,453 1.0619 (b)
Analysis ofgain
The difference in fair value of the plantation between the two balance sheet dates is 121 (5,453 - 5,332) which will be reported as a gain in the income statement, analysed as follows:
(i)
Price change
Relates to the biological asset's state as at the previous balance sheet date"
. V a1ue at pnces prevai"I"mg as at the current ba1ance sheet
16,500 1.06
--20-
5,145
less
value at prices prevailing as at the previous balance sheet date
187
Loss (il)
5,332
Physical change
This is calculated at current prices.
Value in its state as at the current balance sheet
5,453
less
value in its state as at the previous balance sheet date (as in (ij)
308
Gain
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5,145
1510
lAS 36 IMPAIRMENT OF ASSETS
OVERVIEW Objective
•
To give guidance on the recognition and reversal of impairment losses.
• •
INTRODUCTION
BASIC RULES
• •
All assets Intangible assets
•
Indications ofpotential impairment loss
MEASURMENT OF RECOVERABLE AMOUNT • • •
General principles Fair values less costs to sell Value in use
Objective ofthe standard Definitions
CASH GENERATING UNITS Basic concept Allocating shared assets ACCOUNTING FOR • IMPAIRMENT • LOSS
Basics Allocation within a cashgenerating unit
SUBSEQUENT REVIEW
• •
Basic provisions Reversals ofimpairment losses
DISCLOSURE
• • •
For each class ofasset Segment reporting Material impairment losses
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lAS 36 IMPAIRMENT OF ASSETS
1
INTRODUCTION
1.1
Objective of the standard
•
Prudence is a widely applied concept in the preparation of fmancial statements. A specific application of prudence is that assets should not be carried in the balance sheet at a value, which is bigger than the cash flows which they are expected to generate in the future.
•
Several standards (lAS 16, lAS 28 and lAS 31) include a requirement that states that if the recoverable amount of an asset is less than its carrying value ("impairment"), then the carrying value should be written down immediately to this recoverable amount.
•
lAS 36 prescribes detailed procedures to be followed in terms of identifying impairments and accounting for them. It applies to all assets (including subsidiaries, associates and joint ventures) except those covered by the specific provisions of other statements, i.e:
o o o o o o o o
inventories (lAS 2); assets arising from construction contracts (lAS 11); deferred tax assets (lAS 12); financial assets that are included in the scope of lAS 39; assets arising from employee benefits (lAS 19); investment property that is measured at fair value (lAS 40); biological assets measured at fair value less estimated point-of-sale costs (lAS 41); non-current assets classified as held for sale (IFRS 5).
1.2
Definitions
•
An impairment loss - is the amount by which the carrying amount of an asset exceeds its recoverable amount.
•
Recoverable amount - is the higher of an asset's fair value less costs to sell and its value in use.
•
Fair value less costs to sell- is the amount obtainable from the sale of an asset (in an arm's length transaction between knowledgeable, willing parties) less costs of disposal.
•
Value in use - is the present value of the future cash flows expected to be derived from an asset (or cash-generating unit).
•
A cash-generating unit - is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The concept ofa cash-generating unit is a solution to the problem of measuring value in use and comparison with carrying value.
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lAS 36 IMPAIRMENT OF ASSETS
2
BASIC RULES
2.1
All assets
•
At each balance sheet date an entity should assess whether there is any indication that an asset (or cash-generating unit) may be impaired. If any such indication exists, the entity should estimate the recoverable amount of the asset.
•
If no indications of a potential impairment loss are present there is no need to make a formal estimate of recoverable amount, except for intangible assets with indefinite useful lives.
2.2
Intangible assets
•
Irrespective of whether there is any indication of impairment, the following intangible assets must be test annually for impairment:
o
those with an indefmite useful life;
o
those not yet available for use;
o
goodwill acquired in a business combination.
•
The impairment tests for these assets may be performed at any time during an annual period, provided they are performed at the same time every year. Note that all other assets (including intangibles that are amortised) are tested at the end of a reporting period.
•
Where an intangible asset with an indefinite life forms part of a cashgenerating unit and cannot be separated, that cash-generating unit must be tested for impairment at least annually, or whenever there is an indication that the cash-generating unit may be impaired.
2.3
Indications of potential impairment loss
•
An entity should consider the following indications of potential impairment loss - both external and internal- as a minimum.
2.3.1
External sources ofinformation
•
During the period, an asset's market value has declined significantly more than would be expected as a result of the passage of time or normal use.
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lAS 36 IMPAIRMENT OF ASSETS
Illustration 1 Meade is an entity, which owns a subsidiary called Lee. Lee is a property development company with extensive holdings in Malaysia. The Malaysian economy has moved into a deep recession. The recession is an indication that the carrying value of Lee in Meade's accounts might be greater than the recoverable amount. Meade must make a formal estimate of the recoverable amount of its investment in Lee. •
Significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates.
Illustration 2 Buford is an entity involved in the manufacture of steel. It owns a steel production facility constructed in 1998. The facility has ten blast furnaces each of which is being written off over 30 years from the date of construction. Recent technological innovations have resulted in a new type of furnace coming onto the market. This furnace offers efficiency improvements which the manufacturers claim will reduce the unit cost of a tonne of steel by 15-20%. The company that supplied the furnaces for Buford has recently introduced a series of price cutting measures to try to preserve its own market share. The market for the grade of steel that Buford produces is very price sensitive and price is often used as a basis of competition in this market. A major competitor has announced that it is constructing a new plant that will utilise the new technology. The existence of the new technology and the announcement by the competitor are indications that Buford's blast furnaces might be impaired. Buford should make a formal estimate of the recoverable amount of its blast furnaces (or possibly the production plant as a whole if it is deemed to be a cash-generating unit - see later).
•
Market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset's value in use and decrease the asset's recoverable amount materially.
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lAS 36 IMPAIRMENT OF ASSETS
Illustration 3 Gibbon is an entity which owns a 60% holding in Pickett, an unquoted entity. Both entities operate in a country with a stable economy. The government ofthe country has recently announced an increase in interest rates. The increase in interest rates will cause a fall in value of equity holdings (all other things being equal). This is due to the fact that risk free investments offer a higher return making them relatively more attractive. The market value of equity will adjust downwards to improve the return available on this sort of investment. The increase in interest rates is an indication that Gibbon's holding in Pickett might be impaired. Gibbon should make a formal estimate of the recoverable amount of its interest in Pickett. •
The carrying amount of the net assets of the reporting entity is more than its market capitalisation.
Illustration 4 Sickles is a quoted entity. The carrying value of its net assets is $100m. The market capitalisation of the entity has recently fallen to $80m. The value of the entity as compared to the carrying value of its net assets indicates that its assets might be impaired. Sickles should make a formal estimate of the recoverable amount of its assets.
2.3.2
Internal sources ofinformation
•
Evidence is available of obsolescence or physical damage.
Illustration 5 Custer is an entity which manufactures machinery. It makes use of a large number of specialised machine tools. It capitalises the machine tools as a non-current asset and starts to depreciate the tools when they are brought into use. A review of the non-current asset register in respect of machine tools has revealed that approximately 40% of the value held relates to machine tools purchased more than two years ago and not yet brought into use. The age of the machine tools and the fact that they have not yet been brought into use is an indication that the asset may be impaired. Custer should make a formal estimate of the recoverable amount of its machine tools.
•
Significant adverse changes have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used.
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lAS 36 IMPAIRMENT OF ASSETS
Illustration 6 Hood is a small airline. It owns a Dash 8 aircraft which it purchased to service a contract for passenger flights to a small island. The rest of its business is long-haul freight shipping. It has been informed that its licence to operate the passenger service will not be renewed after the end of this current contract which finishes in 6 months time. It is proposing to use the aircraft in a new business venture offering pleasure flights.
The change in the use of the asset that is expected to take place in the near future is an indication that the aircraft may be impaired. Hood should make a formal estimate of the recoverable amount of its Dash 8 aircraft. •
Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected Such evidence that indicates that an asset may be impaired includes the existence of:
o
cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are significantly higher than those originally budgeted;
o
actual net cash flows or operating profit or loss flowing from the asset that are significantly worse than those budgeted;
o
a significant decline in budgeted net cash flows or operating profit, or a significant increase in budgeted loss, flowing from the asset; or
o
operating losses or net cash outflows for the asset, when current period figures are aggregated with budgeted figures for the future.
Illustration 7 Armistead is an entity in the professional training sector. It has produced a series of CD ROM based training products which have been on sale for 8 months. The entity has capitalised certain development costs associated with this product in accordance with the rules in lAS 38 Intangible Assets. Early sales have been significantly below forecast. The failure of the entity to meet sales targets is an indication that the development asset may be impaired. Armistead should make a formal estimate of the recoverable amount of the capitalised development cost.
The above lists are not exhaustive. •
Where there is an indication that an asset may be impaired, this may indicate that the remaining useful life, the depreciation (amortisation) method or the residual value for the asset needs to be reviewed and adjusted, even if no impairment loss is recognised for the asset.
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lAS 36 IMPAIRMENT OF ASSETS
3
MEASUREMENT OF RECOVERABLE AMOUNT
3.1
General principles
•
The recoverable amount is the higher of the asset's fair value less costs to sell and value in use. RECOVERABLE AMOUNT
•
I
I
Higher of
VALUE IN USE
and
I FAIR VALUE LESS COSTS TO SELL
Recoverable amount is determined for an individual asset, unless the asset does not generate cash inflows from continuing use that are largely independent of those from other assets or groups of assets. If this is the case, recoverable amount is determined for the cash-generating unit to which the asset belongs (see later).
Illustration 8 Recoverable amount is the greater of:
Value in use
Fair value less costs to sell
Therefore recoverable amount is:
Carrying amount
900
1,050
1,050
1,000
No impairment
900
980
980
1,000
An impairment loss of $20 must be recognised. The carrying value of the asset is written down to 980.
960
925
960
1,000
An impairment loss of $40 must be recognised. The carrying value of the asset is written down to $960.
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Commentary
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lAS 36 IMPAIRMENT OF ASSETS
•
It is not always necessary to determine both an asset's fair value less costs to sell and its value in use to determine the asset's recoverable amount if:
o
either of these amounts exceed the asset's carrying amount, the asset is not impaired, and it is not necessary to estimate the other amount; or
o
there is no reason to believe that the asset's value in use materially exceeds its fair value less selling costs, the asset's recoverable amount is its fair value less selling costs.
For example when an asset is heldfor imminent disposal the value in use will consist mainly ofthe net amount to be receivedfor the disposal ofthe asset. Future cash flows from continuing use ofthe asset until disposal are likely to be negligible. •
Where the asset is an intangible asset with an indefinite useful life, the most recent detailed calculation of the recoverable amount made in a preceding period may be used in the impairment test in the current period.
3.2
Fair value less costs to sell
•
Fair value less costs to sell- the amount obtainable from the sale of an asset in an arm's length transaction between knowledgeable, willing parties, less the costs of disposal.
o
The best evidence of an asset's fair value less costs to sell is a price in a binding sale agreement in an arm's length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset.
o
If there is no binding sale agreement but the asset is traded in an active market, the asset's market price (adjusted for costs of disposal) is the basis for calculating the fair value of the asset less costs to sell.
The appropriate market price will usually be the current bidprice. If current bidprices are not obtainable, the price ofthe most recent transaction can provide a basis for the estimation ofthe fair value.
o
If no binding sale agreement or active market exists for the asset, fair value less costs to sell is determined based on the best information available in the circumstances.
An entity should consider the results ofrecent transactions in the same industry.
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lAS 36 IMPAIRMENT OF ASSETS
•
An active market - is a market in which all the following conditions exist:
o o o •
the items traded within the market are homogeneous; willing buyers and sellers can normally be found at any time; and prices are available to the public.
Costs ofdisposal - are incremental costs directly attributable to the disposal of an asset, excluding finance costs, income tax expense and any cost which has already been included as a liability. Examples include:
o o o o
Legal costs Stamp duty Costs of removing the asset Other direct incremental costs to bring an asset into condition for its sale.
Examples ofcosts that are not costs ofdisposal include termination benefits and costs associated with reducing or re-organising a business following the disposal ofan asset. Illustration 9 X operates in leased premises. It owns a bottling plant which is situated in a single factory unit. Bottling plants are sold periodically as complete assets. Professional valuers have estimated that the plant might be sold for $100,000. They have charged a fee of $1,000 for providing this valuation. X would need to dismantle the asset and ship it to any buyer. Dismantling and shipping would cost $5,000. Specialist packaging would cost a further $4,000 and legal fees $1,500. Fair value less costs to sell:
$
Sales price
100,000
Dismantling and shipping
(5,000)
Packaging
(4,000)
Legal fees
(1,500)
Fair value less costs to sell
89,500
The professional valuers fee of$1,000 would not be included in thefair value less costs to sell as this is not a directly attributable cost ofselling the asset.
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lAS 36 IMPAIRMENT OF ASSETS
3.3
Value in use
•
Value in use - is the present value of the future cash flows expected to be derived from an asset. Estimating it involves:
o
estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and
o
applying the appropriate discount rate.
Worked example 1 X holds a patent on a drug. The patent expires in 5 years. During this period the demand for the drug is forecast to grow at 5% per annum. Experience shows that competitors flood the market with generic versions of a profitable drug as soon as it is no longer protected by a patent. As a result X does not expect the patent to generate significant cash flows after 5 years. Net revenues from the sale of the drug were $ 100m last year. The entity has decided that 15.5% is an appropriate discount rate for the appraisals of the cash flows associated with this product.
Time
Cash flow $m
1
100 x 1.05
2
100 x 1.052 = 110.3
=
Discountfactor
105
3
@15.5%
Present value ($m)
0.86580
91
0.74961
83
3
100 x 1.05 = 115.8
0.64901
75
4
100 x 1.054 = 121.6
0.56192
68
0.48651
62
5
5
100 x 1.05 = 127.6
Value in use
379
3.3.1
Cash flow projections
•
Projections should be based on reasonable and supportable assumptions that represent management's best estimate of the set of economic conditions that will exist over the remaining useful life of the asset.
Greater weight should be given to external evidence. •
They should be based on the most recent financial budgets/forecasts that have been approved by management.
•
Projections based on these budgets/forecasts should cover a maximum period of five years, unless a longer period can be justified.
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lAS 36 IMPAIRMENT OF ASSETS
•
Beyond the period covered by the most recent budgets/forecasts, the cash flows should be estimated by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified.
•
The growth rate should not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market, in which the asset is used, unless a higher rate can be justified.
•
Estimates of future cash flows should include:
o o •
projected cash inflows including disposal proceeds; projected cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset.
Estimates of future cash flows should exclude:
o
cash flows relating to the improvement or enhancement of the asset's performance;
o
cash flows that are expected to arise from a future restructuring that is not yet committed;
Future cash flows are estimated based on the asset in its current condition or in maintaining its current condition (e.g. maintenance, or the replacement of components ofan asset, to enable the asset as a whole to achieve its estimated current economic benefit).
o
cash outflows that will be required to settle obligations that have already been recognised as liabilities;
o
cash inflows or outflows from fmancing activities; and
Already taken account ofin discounting.
o
income tax receipts or payments.
•
The discount rate should be a pre-tax market rate (or rates) that reflects current market assessments of the time value of money and the risks specific to the asset.
•
When an asset-specific rate is not available from the market, an entity uses surrogates to estimate the discount rate. As a starting point, the entity may take into account the following rates:
o
the entity's weighted average cost of capital determined using techniques such as the Capital Asset Pricing Model;
o
the entity's incremental borrowing rate; and
o
other market borrowing rates.
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•
These rates are adjusted:
o
to reflect the way that the market would assess the specific risks associated with the projected cash flows; and
o
to exclude risks that are not relevant to the projected cash flows.
They do not include adjustments for risks that the estimated cash flows have already taken into account (e.g. bad debts). •
Consideration is given to risks such as country risk, currency risk, price risk and cash flow risk.
•
Where value-in-use is sensitive to a difference in risks for different future periods or to the term structure of interest rates, separate discount rates for each period should be used.
Example 1 Sumter is testing a machine, which makes a product called a union, for impairment It has compiled the following information in respect of the machine. $ 100
Selling price of a union Variable cost of production Fixed overhead allocation per unit Packing cost per unit
70 10 1
All costs and revenues are expected to inflate at 3% per annum. Volume growth is expected to be 4% per annum. 1,000 units were sold last year. This is in excess of the long term rate of growth in the industry. The management of Sumter have valid reasons for projecting this level of growth. The machine originally cost $400,000 and was supplied on credit terms from a fellow group entity. Sumter is charged $15,000 per annum for this loan. Future expenditure: In 2 years time the machine will be subject to major servicing to maintain its operating capacity. This will cost $10,000. In 3 years time the machine will be modified to improve its efficiency. This improvement will cost $20,000 and will reduce unit variable cost by 15%. The asset will be sold in 8 years time. Currently the scrap value of machines of a similar type is $10,000. All values are given in real terms (to exclude inflation). Required: Identify the cash flows that should be included in Sumter's estimate of the value in use of the machine. Explain the rationale of the inclusion or exclusion of each amount.
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lAS 36 IMPAIRMENT OF ASSETS
Solution Time
Narrative
Cash flow
Comment
Net revenue Per unit Volume 1
2 3 4 5 6 7
8
Other flows
2 8
4
CASH-GENERATING UNITS
•
A cash-generating unit - is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.
4.1
Basic concept
•
If there is any indication that an asset may be impaired, the recoverable amount (the higher of the fair value less costs to sell and value in use of the asset) must be estimated for the individual asset.
•
However, it may not be possible to estimate the recoverable amount of an individual asset because:
•
o
its value in use cannot be estimated to be close to its fair value less costs to sell (e.g. when the future cash flows from continuing use of the asset cannot be estimated to be negligible); and
o
it does not generate cash inflows that are largely independent of those from other assets
In this case the recoverable amount of the cash-generating unit to which the asset belongs (the asset's cash-generating unit) must be determined.
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lAS 36 IMPAIRMENT OF ASSETS
•
Identifying the lowest aggregation of assets that generate largely independent cash inflows may be a matter of considerable judgement.
•
Management should considers various factors including how they monitor the entity's operations (e.g. by product lines, individual locations, regional areas, etc) or how they make decisions about continuing or disposing of the entity's assets and operations.
Illustration 10 An entity owns a dry dock with a large crane to support its activities. The crane could only be sold for scrap value and cash inflows from its use cannot be identified separately from all of the operations directly connected with the dry dock. It is not possible to estimate the recoverable amount of the crane because its value in use cannot be determined. Therefore, the entity estimates the recoverable amount of the cash-generating unit to which the crane belongs, i.e., the dry dock as a whole.
•
Sometimes it is possible to identify cash flows that stem from a specific asset but these cannot be earned independently from other assets. In such cases the asset cannot be reviewed independently and must be reviewed as part of the cash-generating unit.
Illustration 11 An entity operates an airport that provides services under contract with a government that requires a minimum level of service on domestic routes in return for licence to operate the international routes. Assets devoted to each route and the cash flows from each route can be identified separately. The domestic service operates at a significant loss.
Because the entity does not have the option to curtail the domestic service, the lowest level of identifiable cash inflows that are largely independent of the cash inflows from other assets or groups of assets are cash inflows generated by the airport as a whole. This is therefore the cash-generating unit.
•
If an active market exists for the output produced by an asset or a group of assets, this asset or group of assets should be identified as a cash-generating unit, even if some or all of the output is used internally.
•
Where the cash flows are affected by internal transfer pricing, management's best estimate of future market (ie in an arm's length transaction) prices should be used to estimate cash flows for value in use calculations.
•
Cash-generating units should be identified consistently from period to period for the same asset or types of assets, unless a change is justified.
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4.2
Allocating shared assets
•
The carrying amount of a cash-generating unit should include the carrying amount of only those assets that can be directly attributed, or allocated on a reasonable and consistent basis, to it.
Goodwill acquired in a business combination and corporate (head office) assets are examples ofshared assets that will need to be allocated. 4.2.1
Goodwill acquired in a business combination
•
Goodwill acquired in a business combination must be allocated to each of the acquirer's cash-generating units that are expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units.
•
If the initial allocation of goodwill cannot be completed before the end of the financial year in which the business combination is effected, the allocation must be completed by the end of the following financial year.
•
Where an acquirer needs to account for a business combination using provisional values, adjustments can be made to such values within 12 months of the date of acquisition (IFRS 3). Until such provisional values have been finalised, it may not be possible to complete the initial allocation of goodwilL
•
IFRS 3 allows 12 months from the date of acquisition to finalise goodwill; lAS 36 allows up to the end of the following financial period (i.e. in most cases additional time) to allocate goodwill.
•
Each unit (or group of units) to which the goodwill is so allocated must:
o
represent the lowest level within the entity at which the goodwill is monitored for internal management purposes; and
o
not be larger than a segment (based on either the entity's primary or secondary reporting format determined in accordance with lAS 14 "Segment Reporting".
This aims to match the testing ofimpairment ofgoodwill with the monitoring level ofgoodwill within the entity. As a minimum, this is considered to be based on segmental reporting requirements such that listed companies will not be able to "net-off' and shield goodwill impairment at the entity level.
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lAS 36 IMPAIRMENT OF ASSETS
•
Once goodwill has been allocated to a cash-generating unit, that unit must be tested for impairment:
o
at least annually; or
o
as soon as there is an indication of impairment of: goodwill; or the cash-generating unit.
Worked example 2 Entity Q is a wholly owned subsidiary ofM and has 3 divisions, X, Y and Z. There are indications that Y is impaired and Q has estimated its recoverable amount to be $230m. There are no indications that X and Z are impaired. The value ofQ has been estimated, by M, to be $1,380m. The management ofM have allocated $450m of the goodwill held in the group accounts to Q. As X, Y and Z are separately reported to M, they are considered to be the lowest level within the entity that goodwill is monitored. Cash-generating unit
Z
X $m
Y $m
$m
Total $m
Net assets directly involved in the activities of the unit
350
150
250
750
Goodwill
210
90
150
450
Total
560
240
400
1,200
The goodwill has been apportioned in the ratio that the directly attributed assets bear to each other. The carrying value that would be compared to the recoverable amount is $240m.
Carrying amount
y $m 240
Recoverable amount
(230) 10
Impairment loss
Thus an impairment loss of $1Om should be recognised even though the fair value of Q as a whole is greater than its carrying value.
•
Different cash-generating units may be tested for impairment at different times. However, if some or all of the goodwill allocated to a cash-generating unit was acquired in a business combination during the current annual period, that unit is tested for impairment before the end of the current annual period.
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lAS 36 IMPAIRMENT OF ASSETS
Worked example 3 Facts as above except that Q is reported as a segment and is the level at which goodwill is monitored by the group, regardless of the fact that X, Y and Z are separate cash-generating units. Cash-generating unit Net assets directly involved in the activities of the unit
x
y
z
Total
$m
$m
$m
$m
350
150
250
750 450
Goodwill
1,200
Total
Step 1 Test the division (as a separate cash-generating unit)
y
$m Carrying amount
150
Recoverable amount
(230)
Impairment loss
Step 2 Test the goodwill (at the reporting level)
Q $m Carrying amount
1,200
(1,380)
Recoverable amount Impairment loss Thus there is no recognised goodwill impairment.
4.2.2
Corporate assets
•
Corporate assets - are assets, other than goodwill, that contribute to the future cash flows of both the cash-generating unit under review and other cash-generating units.
•
The distinctive characteristics of corporate assets are that they do not generate cash inflows independently of other assets or groups of assets and their carrying amount cannot be fully attributed to the cash-generating unit under review.
Examples could include head office or divisional buildings, central information system or a research centre. •
Because corporate assets do not generate separate cash inflows, the recoverable amount of an individual corporate asset cannot be determined unless management has decided to dispose of the asset.
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lAS 36 IMPAIRMENT OF ASSETS
•
If there is an indication that a cash-generating unit may be impaired, then the appropriate portion of corporate assets must be included within the carrying amount ofthat unit or group of units.
•
Corporate assets are allocated on a reasonable and consistent basis to each cash-generating unit.
•
If a corporate asset cannot be allocated to a specific cash-generating unit, the smallest group of cash-generating units that includes the unit under review must be identified.
•
The carrying amount of the unit or group of units (including the portion of corporate assets) is then compared to its recoverable amount. Any impairment loss is dealt with in the same way as dealing with an impairment loss for goodwill.
5
ACCOUNTING FOR IMPAIRMENT LOSS
5.1
Basics
•
If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount ofthe asset should be reduced to its recoverable amount. That reduction is an impairment loss.
•
An impairment loss should be recognised as an expense in the income statement immediately, unless the asset is carried at revalued amount under another lAS.
•
Any impairment loss of a revalued asset should be treated as a revaluation decrease under that other lAS. This will usually mean that the fall in value must be charged to the revaluation reserve to the extent that the loss is covered by the reserve. Any amount not so covered is then charged to the income statement.
Illustration 12 Carrying value (1)
Recoverable amount
Income statement
100
80
20 Dr
150
125
150
95
Directly to equity
Situation 1 Asset carried at historic cost
Situation 2 Historic cost of asset = 100 but revalued to 150
25 Dr
Situation 3 Historic cost of asset = 100 but revalued to 150
(l) Before recognition of impairment loss.
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5Dr
50Dr
lAS 36 IMPAIRMENT OF ASSETS
•
After impairment the carrying value of the asset less any residual value is depreciated (amortised) over its remaining expected useful life.
5.2
Allocation within a cash-generating unit
•
If an impairment loss is recognised for a cash-generating unit, the problem arises as to where to set the credit entry in the balance sheet.
•
The impairment loss should be allocated between all assets of the cashgenerating unit in the following order:
o o •
In allocating an impairment loss the carrying amount of an asset should not be reduced below the highest of:
o o o •
goodwill allocated to the cash-generating unit (if any); then, to the other assets of the unit on a pro-rata basis based on the carrying amount of each asset in the unit.
its fair value less costs to sell (if determinable); its value in use (if determinable); and zero.
The amount of the impairment loss that would otherwise have been allocated to the asset should be allocated to the other assets of the unit on a pro-rata
Example 2 At 1 January, an entity paid $2,800 for a company whose main activity consists of refuse collection. The acquired company owns four refuse collection vehicles and a local government licence without which it could not operate. At 1 January, the fair value less costs to sell of each lorry and of the licence are $500. The company has no insurance cover. At 1 February, one lorry crashed. Because of its reduced capacity, the entity estimates the value in use of the business at $2,220.
Required: Show how the impairment loss would be allocated to the assets of the business.
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lAS 36 IMPAIRMENT OF ASSETS
Solution
1 January
Impairment loss
1 February
Goodwill
Intangible asset
Lorries
Example 3 Following on from Example 2. At 22 May, the government increased the interest rates. The entity re-determined the value in use of the business as $1,860. The fair value less costs to sell of the licence had decreased to $480 (as a result of a market reaction to the increased interest rates). The demand for lorries was hit hard by the increase in rates and the selling prices were adversely affected. Required:
Show how the above information would be reflected in the asset values of the business.
Solution 1 February
Impairment loss
22 May
Goodwill
Intangible asset
Lorries
•
If an individual asset within the cash-generating unit is impaired, but the cash-generating unit as a whole is not, no impairment loss is recognised even if the asset's fair value less costs to sell is less than its carrying amount.
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lAS 36 IMPAIRMENT OF ASSETS
Illustration 13 Two machines within a production line (the cash-generating unit) have suffered physical damage, but are still able to work albeit at reduced capacities. The fair value less costs to sell of both machines are below their carrying amount. As the machines do not generate independent cash flows and management intend to keep the machines in operation, their value in use cannot be estimated. They are considered to be part of the cash-generating unit, the production line.
Analysis •
Assessment ofthe recoverable amount ofthe production line as a whole shows that there has been no impairment of the cash-generating unit. Therefore no impairment losses are recognised for the machines.
•
However, because of the damage to the machines, the estimated usefu11ife and residual values of the machines may need to be reassessed.
•
If, because of the damage, management decides to replace the machines and sell them in the near future, their value in use can be estimated as the expected sale proceeds less costs to sell. Where this is less than their carrying value, an impairment loss should be recognised for the individual machines.
•
No impairment will be recognised for the production line as the machines have been replaced.
6
SUBSEQUENT REVIEW
6.1
Basic provisions
•
Once an entity has recognised an impairment loss for an asset other than goodwill, it should carry out a further review in later years if there is an indication:
o o
that the asset may be further impaired; that the impairment loss recognised in prior years may have decreased.
•
An entity should consider, as a minimum, the following indications of both external and internal sources of information.
6.1.1
External sources ofinformation
o
Significant increase in the asset's market value during the period.
o
Significant favourable changes during the period, or taking place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which the asset is dedicated.
o
Decrease in market interest rates or other market rates of return likely to affect the discount rate used in calculating the asset's value in use and materially increase the asset's recoverable amount.
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lAS 36 IMPAIRMENT OF ASSETS
6.1.2
Internal sources ofinformation
o
Significant favourable changes in the actual or expected extent or manner of use of the asset.
For example, ifcapital expenditure incurred enhances the asset.
o
Evidence available from internal reporting indicates that the economic performance of the asset is, or will be, better than expected.
6.2
Reversals of impairment losses
6.2.1
On individual assets, other than goodwill
•
The carrying amount of an asset, other than goodwill, for which an impairment loss has been recognised in prior years should be increased to its recoverable amount only if there has been a change in the estimates used to determine the asset's recoverable amount since the last impairment loss was recognised.
•
The increased carrying amount of the asset should not exceed the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior years.
•
Any increase in the carrying amount of an asset above the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior years is a revaluation and should be treated accordingly.
•
A reversal of an impairment loss for an asset should be recognised as income immediately in the income statement, unless the asset is carried at revalued amount under another lAS.
•
Any reversal of an impairment loss on a revalued asset should be treated as a revaluation increase under the relevant lAS. This will usually mean that the increase in value will be credited to the revaluation reserve unless it reverses an impairment that has been previously recognised as an expense in income. In this case it is recognised as income in the income statement to the extent that it was previously recognised as an expense.
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lAS 36 IMPAIRMENT OF ASSETS
6.2.2
Reversal ofan impairment loss for a cash-generating unit
•
A reversal of an impairment loss for a cash-generating unit should be allocated to increase the carrying amount of the assets (but never to goodwill) pro-rata with the carrying amount of those assets.
•
Increases in carrying amounts should be treated as reversals of impairment losses for individual assets.
•
In allocating a reversal of an impairment loss for a cash-generating unit, the carrying amount of an asset should not be increased above the lower of:
o o
its recoverable amount (if determinable); and the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior years.
Equivalent to the "ceiling" for the reversal ofan impairment lossfor an individual asset. 6.2.3
Reversal ofan impairment loss on goodwill
•
An impairment loss recognised for goodwill cannot be reversed in a subsequent period.
•
lAS 38 prohibits the recognition of internally-generated goodwill. Any increase in the recoverable amount of goodwill in the periods following the recognition of an impairment loss is likely to be an increase in internally generated goodwill, rather than a reversal of the impairment loss recognised for the acquired goodwill.
7
DISCLOSURE
•
Extensive disclosure is required by lAS 36 especially for the key assumptions and estimates used to measure the recoverable amount of cash-generating units containing goodwill or intangible assets with indefmite useful lives.
7.1
For each class of assets
•
Impairment losses recognised during the period and the line item(s) of the income statement in which those impairment losses are included.
•
Reversals of impairment losses recognised during the period and the line item(s) of the income statement in which those impairment losses are reversed.
•
The amount of impairment losses recognised directly in equity during the period.
•
The amount of reversals of impairment losses recognised directly in equity during the period.
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lAS 36 IMPAIRMENT OF ASSETS
7.2
Segment reporting
•
An entity that applies lAS 14 Segment Reporting, should disclose the following for each reportable segment based on an entity's primary format:
o
the amount of impairment losses recognised in the income statement and directly in equity during the period; and
o
the amount of reversals of impairment losses recognised in the income statement and directly in equity during the period.
7.3
Material impairment losses recognised or reversed
7.3.1
Individual asset or cash-generating unit
•
The events and circumstances that led to the recognition or reversal of the impairment loss.
•
The amount of the impairment loss recognised or reversed.
•
Whether the recoverable amount of the asset (cash-generating unit) is its fair value less costs to sell or its value in use:
o
if fair value less costs to sell, the basis used (e.g. by reference to an active market); and
o
if value in use, the discount rate(s) used in the current estimate and previous estimate (if any) of value in use.
7.3.2
Individual asset
•
The nature of the asset.
•
The reportable segment to which the asset belongs, based on the entity's primary format (if applicable).
7.3.3
Individual cash-generating unit
•
A description of the cash-generating unit (e.g. product line, plant, business operation, geographical area, reportable segment as defined in lAS 14, etc).
•
The amount of the impairment loss recognised or reversed by class of assets and by reportable segment based on the entity's primary format (if applicable).
•
If the aggregation of assets for identifying the cash-generating unit has changed since the previous estimate of the cash-generating unit's recoverable amount (if any), a description of the current and former way of aggregating assets and the reasons for change.
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lAS 36 IMPAIRMENT OF ASSETS
7.3.4
Material aggregate
•
If impairment losses recognised (reversed) during the period are material in aggregate an entity should disclose a brief description of:
o
the main classes of assets affected by impairment losses (reversals of impairment losses); and
o
the main events and circumstances that led to the recognition (reversal) of these impairment losses.
This is only required to be disclosed if no information is otherwise disclosed (i.e. under the provisions for individual assets and CGUs as individually not material). Illustration 14 [5] Other operating expenses (extract) In the previous year, impairment write-downs of intangible assets, property, plant and equipment of the polyols and fibers operations in the Polymers subgroup together accounted for expenses of €289 million.
Notes to Consolidated Financial Statements of the Bayer Group
7.3.5
Non-allocation ofgoodwill
•
If any portion of the goodwill acquired in a business combination during the period has not been allocated to a cash-generating unit at the reporting date, the amount of the unallocated goodwill disclosed and the reasons why that amount remains unallocated.
7.3.6
Cash-generating units containing assets with indefinite lives
•
If significant disclose:
o
the carrying amount of goodwill allocated to the unit;
o
the carrying amount of intangible assets with indefinite useful lives allocated to the unit;
o
the basis on which the unit's recoverable amount has been determined (i.e. value in use or fair value less costs to sell).
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lAS 36 IMPAIRMENT OF ASSETS
•
If the unit's recoverable amount is based on value in use disclose:
o
a description of each key assumption on which management has based its cash flow projections;
Key assumptions are those to which the unit's recoverable amount is most sensitive.
o
a description of management's approach to determining the value(s) assigned to each key assumption;
o
the period over which management has projected cash flows based on fmancial budgets/forecasts approved by management and the justification for a period longer than five years (if applicable);
o
the growth rate used to extrapolate cash flow projections beyond the period covered by the most recent budgets/forecasts;
o
the discount rate(s) applied to the cash flow projections.
•
If the unit's recoverable amount is based on fair value less costs to sell, disclose the methodology used to determine fair value less costs to sell.
•
If fair value less costs to sell is not determined using an observable market price for the unit, disclose:
•
o
a description of each key assumption on which management has based its determination; and
o
a description of management's approach to determining the value(s) assigned to each key assumption.
If a reasonably possible change in a key assumption on which management has based its determination of the unit's recoverable amount would cause the unit's carrying amount to exceed its recoverable amount, disclose:
o
the amount by which the unit's recoverable amount exceeds its carrying amount; and
o
the value assigned to the key assumption; and
o
the amount by which the value assigned to the key assumption must change in order for the unit's recoverable amount to be equal to its carrying amount.
This means presenting a sensitivity analysis on key assumptions. •
For cash-generating units containing assets with indefinite lives which are not significant the above disclosures are made in aggregate.
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lAS 36 IMPAIRMENT OF ASSETS
FOCUS
You should now be able to: •
define the recoverable amount of an asset;
•
define impairment losses;
•
give examples of, and be able to identify, circumstances that may indicate that an impairment of an asset has occurred;
•
describe what is meant by a cash-generating unit;
•
state the basis in lAS 36 on which impairment losses should be allocated, and allocate a given impairment loss to the assets of a cash-generating unit;
•
explain the principle of impairment tests in relation to purchased goodwilL
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lAS 36 IMPAIRMENT OF ASSETS
EXAMPLE SOLUTIONS Solution 1 - Cash flows
Time
Narrative
Cash flow
Commentary
Net revenue Per unit Volume
1
29.87 (WI)
1,040 (WI)
31,065
2
30.77
1,082
33,293
3
31.69
1,125
35,651
4
32.64
1,170
38,189
5
33.62
1,217
40,916
6
34.63
1,217
42,145
7
35.67
1,217
43,410
8
36.74
1,217
44,713
2
Service (10,000 x 1.032)
10,609
8
Disposal (10,000 x 1.038)
12,668
Net revenue per unit inflates at 3% per annum for 8 years. Volume inflates at 4% per annum for 5 years. After this lAS 36 prohibits the use ofa growth rate which exceeds the industry average. In the absence of further information zero growth has been assumed. Efficiency improvements from the future capital improvement are not included.
The capital improvement is not included in the estimate of'future cash flows.
WORKING (1)
In the first year Net revenue per unit = (100- (70+ 1» x (1.03) = 29.87 Volume = 1,000 x 1.04 = 1,040
Commentary The finance cost of$15,000 is ignored. All cash flows have been inflated to money terms.
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lAS 36 IMPAIRMENT OF ASSETS
Solution 2 - Impairment loss 1 January
Impairment loss
1 February
Goodwill
300
(80)
220
Intangible asset
500
Lorries
500
2,000
(500)
1,500
2,800
(580)
2,220
An impairment loss of 500 is recognised first for the lorry that crashed because its recoverable amount can be assessed individually. (It no longer forms part of the cashgenerating unit that was formed by the four lorries and the licence.)
The remaining impairment loss (80) is attributed to goodwill. Solution 3 - Impairment loss
1
22
February
Impairment loss
Goodwill
220
(220)
Intangible asset
500
(20)
480
Notel
1,500
(120)
1,380
Note 2
2,220
(360)
1,860
Lorries
May
Note 1 220 is charged to the goodwill to reduce it to zero. The balance of 140 must be pro rated between the remaining assets in proportion to their carrying value. The ratio that the remaining assets bear to each other is 500:1,500. This implies that 25% x 140 = 35 should be allocated to the intangible asset. However this would reduce its carrying value to below its fair value less costs to sell and this is not allowed. The maximum that may be allocated is 20 and the remaining 15 must be allocated to the lorries. Note 2 The amount that is allocated to the lorries is 75% x 140 = 105 + 15 =120.
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lAS 36 IMPAIRMENT OF ASSETS
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
OVERVIEW Objective
•
To define provisions, contingent liabilities and contingent assets.
•
To explain the recognition and measurement of provisions, contingent liabilities and contingent assets.
• • • •
Objective Scope Definitions The relationship betwe en provisions and contingent liabiliti es
RECOGNITION
• • •
Recognition ofprovisions Recognition issues Contingent assets and liabilities
MEASURMENT
• •
General rules Specific points
INTRODUCTION
I
I
CHANGES IN PROVISIONS
IFRC 1
I
I
• • • •
Scope Issue Consensus Transition
APPLICATION OF THE RULES TO SPECIFIC CIRCUMSTANCES
• • •
Future operating losses Onerous contracts Specific application - Restructuring
REPAIRS AND MAINTENANCE
• •
No Legislative Requirement Legislative Requirement
DISCLOSURES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
1
INTRODUCTION
1.1
Objective
•
To ensure that appropriate recognition criteria and measurement bases are applied to
o
provisions
o
contingent liabilities and
o
contingent assets.
•
To ensure that sufficient information is disclosed in the notes to the financial statements in respect of each of these items.
1.2
Scope
•
The rules will apply to all provisions and contingencies except for those covered by more specific requirements in other IASs. eg those found in
o
IAS 11, Construction contracts
o
IAS 19, Retirement benefit costs
o
IAS 12, Income taxes, and
o
IAS 17, Accountingfor leases.
o
IFRS 3 Business Combinations
•
lAS 37 addresses only provisions that are liabilities, ie not provisions for depreciation, doubtful debts etc.
•
lAS 37 applies to provisions for restructuring (including discontinuing operations).
1.3
Definitions
•
Provisions are liabilities of uncertain timing or amount.
•
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
•
An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation. This is a key concept in the lAS 37 approach to the recognition ofprovisions.
•
A legal obligation is an obligation that derives from
o
a contract,
o
legislation, or
o
other operation oflaw.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
•
•
A constructive obligation is an obligation that derives from an entity's actions where
o
by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities, and
o
as a result the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
A contingent liability is
o
a possible obligation that arises from past events and whose existence will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the control of the entity, or
o
a present obligation that arises from past events but is not recognised because it is not probable that an outflow of benefits embodying economic benefits will be required to settle the obligation, or the amount of the obligation cannot be measured with sufficient reliability.
JAS 37 stresses that an entity will be unable to measure an obligation with sufficient reliability only on very rare occasions. •
A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
•
An onerous contract is one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received from it.
•
A restructuring is a programme that is planned and controlled by management, and materially changes either:
o
the scope ofa business undertaken by an entity, or
o
the manner in which that business is conducted.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
1.4
The relationship between provisions and contingent liabilities
•
In a general sense all provisions are contingent because they are uncertain in timing or amount.
•
lAS 37 distinguishes between the two by using the term "contingent" for assets and liabilities that are not recognised because their existence will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
•
The standard distinguishes between
o
provisions - because they are present obligations, and
o
contingent liabilities - which are not recognised because they are either possible obligations, or present obligations, which cannot be measured with sufficient reliability.
2
RECOGNITION
2.1
Recognition of provisions
•
A provision should be recognised when:
•
o
an entity has a present legal or constructive obligation to transfer economic benefits as a result of past events, and
o
it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and
o
a reliable estimate of the obligation can be made.
If these conditions are not met a provision should not be recognised.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
2.2
Recognition issues
2.2.1
Present obligation
•
A present obligation exists when the entity has no realistic alternative but to make the transfer of economic benefits because of a past event, (the "obligating event").
Illustration 1
Scenario A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On past experience, it is probable (i.e, more likely than not) that there will be some claims under the warranties.
Present obligation as a result of a past obligating event?
Sale of the product with a warranty gives rise to a legal obligation
An outflow of resources?
Probable
Conclusion
Provide for the best estimate of the cost of making good under the warranty of the goods sold by the balance sheet date
•
A provision should be made only if the liability exists independent of the entity's future actions. The mere intention or necessity to undertake expenditure related to the future is not sufficient to give rise to an obligation.
•
If the entity retains discretion to avoid making any expenditure, a liability does not exist and no provision is recognised.
o
the mere existence of environmental contamination, eg, even if caused by the entity's activities, does not in itself give rise to an obligation because the entity could choose not to clean it up
o
a board decision alone is not sufficient for the recognition of a provision because the board could reverse the decision
o
if a decision was made that commits an entity to future expenditure no provision need be recognised as long as the board have a realistic alternative.
Until the board makes public that offer, or commits itselfin some other way to making the repairs there is no obligation beyond that ofsatisfying the existing statutory and contractual rights ofcustomers. •
In rare cases it is not clear whether there is a present obligation. In these cases a past event should be deemed to give rise to a present obligation when it is more likely than not that a present obligation exists at the balance sheet date.
Clearly this is a matterfor judgement after taking into account all available evidence.
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JAS 37 PROVISIONS,CONTINGENTLIABiliTIES AND CONTINGENTASSETS
IUustration 2
Scenario After a wedding in 2003, ten people died, possibly as a result of food poisoning from products sold by the entity. Legal proceedings are started seeking damages from the entity but it disputes liability. Up to the date of approval of the fmancial statements for the year to 31 December 2003, the entity's lawyers advise that it is probable that the entity will not be found liable. However, when the entity prepares the fmancial statements for the year to 31 December 2004, its lawyers advise that, owing to developments in the case, it is probable that the entity will be found liable.
At 31 December 2003: Present obligation as a result of a past obligating event?
On the basis ofthe evidence available when the financial statements were approved, there is no obligation as a result of past events.
An outflow of resources?
Conclusion
No provision
At 31 December 2004: Present obligation as a result of a past obligating event?
On the basis ofthe evidence available, there is a present obligation.
An outflow of resources?
Probable
Conclusion
Provision should be recognised
2.2.2
Past event
•
A past event that leads to a present obligation is called an obligating event.
•
An obligating event exists when the entity has no realistic alternative but to make the transfer of economic benefits. This may be due to;
•
o
legal obligations or
o
constructive obligations
Examples of constructive obligations include
o
a retail store that habitually refunds purchases by dissatisfied customers even though it is under no legal obligation to do so, but could not change its policy without incurring unacceptable damage to its reputation, and
o
an entity that has identified contamination in land surrounding one of its production sites. The entity is not legally obliged to clean up, but because of concern for its long-term reputation and relationship with the local community, and because of its published policies or past actions, is obliged to do so.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
Illustration 3 Scenario A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. Present obligation as a result of a past obligating event?
The obligating event is the sale of the product, which gives rise to a constructive obligation because the conduct of the store has created a valid expectation on the part of its customers that the store will refund purchases.
An outflow of resources?
Probable, a proportion of goods are returned for refund.
Conclusion
A provision is recognised for the best estimate of the costs of refunds.
Illustration 4 Scenario An entity in the oil industry causes contamination and operates in a country where there is no environmenta11egis1ation. However, the entity has a widely published environmental policy in which it undertakes to clean up all contamination that it causes. The entity has a record of honouring this published policy.
Present obligation as a result of a past obligating event?
The obligating event is the contamination of the land, which gives rise to a constructive obligation because the conduct of the entity has created a valid expectation on the part of those affected by it that the entity will clean up contamination
An outflow of resources?
Probable.
Conclusion
A provision is recognised for the best estimate of the costs of clean-up.
•
Provisions are not made for general business risks since they do not give rise to obligations that exist at the balance sheet date.
•
It is not necessary to know the identity of the party to whom the obligation is owed in order for an obligation to exist.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
2.2.3
Reliable estimate ofthe obligation
•
A reasonable estimate can always be made where an entity can determine a reasonable range of possible outcomes.
•
Only in extremely rare cases will it be genuinely impossible to make any quantification of the obligation and therefore impossible to provide for it. (In these circumstances disclosure of the matter would be necessary).
2.3
Contingent assets and liabilities
•
These should not be recognised. They are dependent on the occurrence or non-occurrence of an uncertain future event not wholly within the control of the entity.
•
It follows that they are not obligations which exists at the balance sheet date.
•
There is an exception to non-recognition of contingent liabilities. IFRS 3 Business Combinations requires a subsidiaries contingent liabilities to be recognised and measured at fair value as part of the acquisition process, this will be considered in more detail in the group account sessions.
3
MEASUREMENT
3.1
General rules
•
The amount provided should be the best estimate at the balance sheet date of the expenditure required to settle the obligation. The amount is often expressed as
•
•
o
the amount which could be spent to settle the obligation immediately, or
o
to pay to a third party to assume it.
The best estimate may derive from the judgement of the management supplemented by
o
experience of similar transactions, and
o
evidence provided from experts (in some cases).
An entity should take account of the uncertainty surrounding the transaction This may involve
o
an expected value calculation (suitable in situations where there is a large population - eg determining the size of warranty provisions)
o
the use of the most likely outcome in situations where a single obligation is being measured (as long as there is no evidence to indicate that the liability will be materially higher or lower than this amount).
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
•
The following factors should be taken into account when deciding on the size of the obligation
o
the time value of money (the amount provided should be the present value of the expected cash flows)
o
evidence in respect of expected future events eg change in legislation improvements in technology
o
prudence.
3.2
Specific points
•
Reimbursement - If some (or all) of the expected outflow is expected to be reimbursed from a third party, the reimbursement should be recognised only when it is virtually certain that the reimbursement will be received if the entity settles the obligation.
o
The income statement expense in respect of the provision may be presented net of the amount recognised for a reimbursement.
o
The reimbursement should be treated as a separate asset and must not exceed the provision in terms of its value.
•
Gains from the expected disposal should not be taken into account when measuring a provision.
•
The provision should be measured as a pre tax amount.
4
CHANGES IN PROVISIONS
•
Provisions may be used only for expenditures that relate to the matter for which they were originally recognised.
•
Provisions should be reviewed regularly and if the estimate of the obligation has changed, the amount recognised as a provision should be revised accordingly.
5
IFRIC 1
5.1
Scope
•
IFRIC Interpretation 1 "Changes in Existing Decommissioning, Restoration and Similar Liabilities" applies to changes in the measurement of an existing decommissioning, restoration or similar liability that is recognised as:
o o
part of the cost of an item of property, reactor and equipment (lAS 16); and a liability (lAS 37).
Examples include liabilities for reactor decommissioning and environmental rehabilitation in extractive industries where the expectedfuture cost expenditure has been "capitalised" (i.e. recognised in the cost ofan asset).
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
5.2
Issue
•
How to account for the effects of the following events on the measurement of an existing liability:
o
the ''unwinding of the discount" (i.e. the increase that reflects the passage oftime);
o
a change in the estimate of the amount required to settle the obligation;
o
a change in the current market-based discount rate.
5.3
Consensus
5.3.1
Unwinding ofthe discount
•
This is recognised in profit or loss as a finance cost as it occurs. The allowed alternative treatment ofcapitalisation under lAS 23 is prohibited.
5.3.2
Other changes in measurement- Cost model
•
If the related asset is measured using the cost model, changes in the liability are added to (or deducted from) the cost of the related asset in the current period.
If there is an indication that an increase carrying amount may not be fully recoverable the asset is testedfor impairment and any impairment loss accountedfor (lAS 36). A deduction cannot exceed the carrying amount ofan asset. Any excess must be recognised immediately in profit or loss. 5.3.3
Other changes in measurement-Revaluation model
•
If the related asset is measured using the revaluation model, changes in the liability alter the revaluation surplus or deficit previously recognised:
o
a decrease in the liability is credited directly to revaluation surplus in equity;
But is recognised in profit or loss to the extent that it reverses a revaluation deficit previously recognised in profit or loss.
o
an increase in the liability is recognised in profit or loss
But is debited directly to equity to the extent ofany credit balance on the revaluation surplus. •
If a decrease in the liability exceeds the carrying amount that would have been recognised had the asset been carried under the cost model, the excess is recognised immediately in profit or loss.
•
Any change in the liability is an indication that the asset may have to be revalued (to ensure that carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date).
If a revaluation is necessary, •
all assets ofthat class must be revalued.
Any change in revaluation surplus arising from a change in liability must be separately identified and disclosed on the face of the statement of changes in equity (lAS 1).
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
5.3.4
Depreciation
•
The adjusted depreciable amount of an asset is depreciated over its useful life.
•
Once the related asset has reached the end of its useful life, all subsequent changes in the liability are recognised in profit or loss as they arise.
This applies under both the cost and revaluation models. 5.4
Transition
•
IFRIC 1 is effective for annual periods beginning on or after 1 September 2004.
•
The changes in accounting policies should be accounted for in accordance with lAS 8 "Accounting Policies, Changes in Accounting Estimates and Errors".
Worked example Alpha has an nuclear reactor and a related decommissioning liability. The reactor started operating on 1 January 1995 and had an expected useful life of 50 years. Its initial cost, $150,000, included $14,000 for decommissioning costs (representing $160,300 estimated cash flows payable in 50 years discounted at 5%). Alpha's financial year end is 31 December. On 31 December 2004, the discount rate has not changed. However, Alpha estimates that the net present value of the decommissioning liability has decreased by $10,000 due to the advances made in environmental clean-up technology.
Required: Calculate the carrying amount of the reactor at 1 January 2005 and the resulting charges to the income statement for the year to 31 December 2005.
Solution - Change in existing decommissioning liability Carrying amount On 31 December 2004, the reactor is 10 years old. Accumulated depreciation is $30,000 ($150,000..;50 = $3,000 per annum). The decommissioning liability is now $22,800.
$14,000
X
1.0510 = $22,800 for the unwinding ofthe discount.
Omega makes the following journal entry to reflect the decrease:
$ 10,000
Dr Decommissioning liability Cr Cost of reactor
$ 10,000
The carrying amount of the reactor is now ($150,000 - $10,000 - $30,000) $110,000
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
2005 Income statement Depreciation expense ($110,000 + 40 years remaining useful life) Finance cost ((22,800 - $10,000) = $12,800 @ 5%)
$2,750 $640
If the change in the liability had resultedfrom a change in the discount rate, rather than a change in the estimatedfuture cash flows, the change would be similarly accounted. However, the 2005 finance cost would reflect the new discount rate.
6
APPLICATION OF THE RULES TO SPECIFIC CIRCUMSTANCES
6.1
Future operating losses
•
Provisions should not be recognised for future operating losses because
o
they do not arise out of a past event, and
o
they are not unavoidable.
•
An expectation of future losses is an indication that the assets of the entity may be impaired. The assets should be tested for impairment according to IAS 36.
6.2
Onerous contracts
•
If an entity has a contract that is onerous the present obligation under that contract should be recognised as a provision.
Illustration 5
Scenario An entity operates profitably from a factory that it has leased under an operating lease. During December 2004 the entity relocates its operations to a new factory. The lease on the old factory continues for the next four years, it cannot be cancelled and the factory cannot be re-let to another user.
Present obligation as a result of a past obligating event?
The obligating event is the signing of the lease contract, which gives rise to a legal obligation.
An outflow of resources?
When the lease becomes onerous, an outflow of resources embodying economic benefits is probable. (Until the lease becomes onerous, the entity accounts for the lease under lAS 17, Leases).
Conclusion
A provision is recognised for the best estimate of the unavoidable lease payments.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
6.3
Specific application - Restructuring
•
Examples of restructurings include
o
sale or termination of a line of business
o
closure of business locations in a region
o
relocation from one region to another
o
changes in management structure
o
fundamental reorganisations that have a material effect on the nature and focus of the entity's operations.
•
A provision in respect of a liability for restructuring should only be recognised when the general recognition criteria are met. These are applied as follows.
•
A constructive obligation to restructure arises only when an entity:
o
has a detailed formal plan for the restructuring identifying as a minimum: the business or part of a business concerned the principal locations affected the location, function, and approximate number of employees who will be compensated for terminating their services the expenditures that will be undertaken, and when the plan will be implemented.
If there is a long delay before the plan will be implemented then it is unlikely that the plan will raise a valid expectation that the entity is committed to the restructuring.
o •
and has raised a valid expectation that it will carry out the restructuring by starting to implement the plan or by announcing its main features to those affected by it.
A management decision to restructure does not give rise to constructive obligation unless the entity has (before the balance sheet date)
o
started to implement the restructuring plan eg by the sale of assets, or
o
announced the main features of the plan to those effected in a sufficiently specific manner to raise a valid expectation in them that the restructuring will occur.
•
No obligation arises for the sale of an operation until there is a binding sales agreement.
•
IFRS 3 Business Combinations does not allow a provision to be set up in respect of the restructuring of a subsidiary on initial acquisition. The only restructuring provision that can be recognised on acquisition will be those of the subsidiary that had met the lAS 37 requirements and had been provided for before acquisition.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
Illustration 6 Scenario On 12 December 2004 the board of an entity decided to close down a division. Before the balance sheet date (31 December 2004) the decision was not communicated to any of those affected and no other steps were taken to implement the decision. Present obligation as a result of a past obligating event?
No
An outflow of resources? Conclusion
No provision is recognised
Illustration 7 Scenario On 12 December 2004, the board of an entity decided to close down a division making a particular product. On 20 December 2004 a detailed plan for closing down the division was agreed by the board; letters were sent to customers warning them to seek an alternative source of supply and redundancy notices were sent to the staff of the division.
•
Present obligation as a result of a past obligating event?
The obligating event is the communication of the decision to the customers and employees, which gives rise to a constructive obligation from that date, because it creates a valid expectation that the division will be closed.
An outflow of resources?
Probable
Conclusion
A provision is recognised at 31 December 2003 for the best estimate of the costs of closing the division.
Provisions for restructuring should include only those expenditures that are both
o
necessarily entailed by a restructuring, and
o
not associated with the ongoing activities of the entity.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
7
PROVISIONS FOR REPAIRS AND MAINTENANCE
•
Some assets require, in addition to routine maintenance, substantial expenditure every few years for major refits or refurbishment and the replacement of major components. lAS 16, Property, plant and equipment, gives guidance on allocating expenditure on an asset to its component parts where these components have different useful lives or provide benefits in a different pattern.
7.1
Refurbishment Costs - No Legislative Requirement Illustration 8
Scenario A furnace has a lining that needs to be replaced every five years for technical reasons. At the balance sheet date, the lining has been in use for three years. Present obligation as a result of a past obligating event?
There is no present obligation.
An outflow of resources? Conclusion
No provision
The cost of replacing the lining is not recognised because, at the balance sheet date, no obligation to replace the lining exists independently of the company's future actions even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, i.e. it is depreciated over five years. The re-lining costs then incurred are capitalised with the consumption of each new lining shown by depreciation over the subsequent five years.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
7.2
Refurbishment Costs - Legislative Requirement
Illustration 9 Scenario An airline is required by law to overhaul its aircraft once every three years. Present obligation as a result of a past obligating event?
There is no present obligation.
An outflow of resources? Conclusion
No provision
The costs of overhauling aircraft are not recognised as a provision for the same reasons as the cost of replacing the lining is not recognised as a provision in the previous example Even a legal requirement to overhaul does not make the costs of overhaul a liability, because no obligation exists to overhaul the aircraft independently of the entity's future actions - the entity could avoid the future expenditure by its future actions, for example by selling the aircraft. Instead of a provision being recognised, the depreciation of the aircraft takes account of the future incidence of maintenance costs, i.e. an amount equivalent to the expected maintenance costs is depreciated over three years.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
8
DISCLOSURES
•
Disclose for each class of provision D
the carrying amount at the beginning and end of the period with movements by type including additional provisions in the period including increases to existing provisions amounts used amounts reversed increase during the period of any discounted amount arising due to the passage of time or change in rate.
•
D
a brief description of the nature of the obligation and expected timing of the expenditure.
D
an indication of the nature of the uncertainties about the amount or timing of the outflows
D
the amount of any expected reimbursement with details of asset recognition.
An entity should disclose the following for each class of contingent liability unless the
contingency is remote
•
D
a brief description of the nature of the contingency; and where practicable,
D
the uncertainties that are expected to affect the ultimate outcome of the contingency,
D
an estimate of the potential financial effect, and
D
the possibility of any reimbursement.
An entity should disclose the following for each class of contingent asset when the inflow of
economic benefits is probable
•
D
a brief description of the nature of the contingency, and where practicable,
D
an estimate of the potential financial effect.
In extremely rare cases, disclosure of some or all of the information required above might seriously prejudice the position of the entity in its negotiations with other parties in respect of the subject matter for which the provision, contingent liability or asset is made. In such cases the information need not be disclosed, but entitys should D
explain the general nature of the dispute, and
D
explain the fact, and reason why, that information has not been disclosed.
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IAS 37 PROVISIONS, CONTINGENT LIABILmES AND CONTINGENT ASSETS
FOCUS You should now be able to: •
discuss the issues relating to the recognition and measurement of provisions, including best estimates, discounting, future events;
•
explain the use of restructuring provisions and other practical uses of provisioning;
•
discuss the problem with current standards on provisions and contingencies, including definitional and discounting problems.
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IAS 12INCOME TAXES
OVERVIEW Objective •
To describe the rules for recognition and measurement of taxes.
INTRODUCTION
DEFERRED TAX INTRODUCTION
DEFERRED TAX -THE CONCEPT ILLUSTRATED
ACCOUNTING FOR DEFERRED TAX - THE BASICS
ACCOUNTING FOR DEFERRED TAX DETAILED RULES
COMPLICATIONS
BUSINESS COMBINATIONS
• • • • •
Overview Scope Definitions Recognition ofcurrent tax liabilities and current tax assets Accountingfor withholding tax
•
Underlying problem
• • •
Scenario Analysis - balance sheet approach After the company has accountedfor deferred tax the financial statements will be as follows
• • •
Introduction Calculation ofthe balance sheet amounts Jargon
• • •
Recognition ofdeferred tax liabilities Recognition ofdeferred tax assets Accountingfor the movement on the deferred tax balance
• • • •
Rates Change in rates SIC 21 SIC25
• •
•
Introduction Temporary differences arising on the calculation of goodwill Temporary differences arising due to the carrying amount ofthe investment and the tax base Inter company transactions
• •
Presentation Disclosure
•
PRESENTATION AND DISCLOSURE
APPENDIX
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1
INTRODUCTION
1.1
Overview
•
In financial reporting, the fmancial statements need to reflect the effects of taxation on a company. Guidance is provided by the fundamental accounting concepts of accruals and prudence. Tax rules determine the cash flows; these must be matched to the revenues which gave rise to the tax and tax liabilities must be recognised as they are incurred, not merely when they are paid.
•
The consistency must be applied in the presentation of income and expenditure.
1.2
Scope
•
lAS 12 should be applied in accounting for income taxes including
o
current tax
o
tax on distributions
o
deferred tax.
1.3
Definitions
•
Accounting profit is profit or loss for a period before deducting tax expense.
•
Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable (recoverable).
•
Tax expense (tax income) is the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax.
•
Current tax is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period
•
Deferred tax liabilities are the amounts of income taxes payable in future period in respect of taxable temporary differences.
•
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
o
deductible temporary differences,
o
the carry forward of unused tax losses, and
o
the carry forward of unused tax credits.
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•
Temporary differences are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. Temporary differences may be either
o
taxable temporary differences which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled, or
o
deductible temporary differences which are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.
•
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
1.4
Recognition of current tax liabilities and current tax assets
•
Current tax for current and prior periods should, to the extent unpaid, be recognised as a liability. If the amount already paid in respect of current and prior periods exceeds the amounts due for those periods, the excess should be recognised as an asset.
•
The benefit relating to a tax loss that can be carried back to recover current tax of a previous period should be recognised as an asset.
•
A company is a separate legal entity and is therefore liable to income tax.
•
The income tax charged in the income statement is an estimate. Any over/under provisions are cleared in the following period's income statement and do not give rise to a prior period adjustment.
1.5
Accounting for withholding tax
•
Companies make payments net of tax, eg dividends. Income tax is deducted at source and paid to the tax authorities according to specified local rules.
•
Companies are themselves taxed on their taxable profit. If they have received interest net of a deduction then they will have already suffered taxation on this piece of income which will then be taxed again in the tax computation for the year. Therefore they need to account for the fact that they have been taxed in order to reduce the future liability.
•
If company has an income tax payable at year end, include in payable.
•
If company has income tax recoverable, ie company has net income tax suffered for year
o
deduct from income tax payable
o
include any excess debit balance in receivables.
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2
DEFERRED TAXATION - INTRODUCTION
2.1
Underlying problem
•
In most jurisdictions accounting profit and taxable profit differ, meaning that the tax charge may bear little relation to profits in a period.
•
Differences arise due to the fact that tax authorities follow rules which differ from lAS rules in arriving at taxable profit.
•
Transactions which are recognised in the accounts in a particular period may have their tax effect deferred until a later period.
Illustration 1 Many non current assets are depreciated. Most tax authorities will allow companies to deduct the cost of purchasing non current assets from their profit for tax purposes but only according to a set formula. If this differs from the accounting depreciation then the asset will be written down by the tax authority and by the company but at different rates. Thus the tax effect ofthe transaction (which is based on the tax laws) will be felt in a different period to the accounting effect.
•
It is convenient to envisage two separate sets of accounts
o
one set constructed following lAS rules, and
o
a second set following the tax rules of the jurisdiction in which the company operates. (we will refer to these as the "tax comps").
Ofcourse there is not really a full set oftax accounts but there could be. Tax files in reality merely note those areas ofdifference between the two systems •
•
The differences between the two sets of rules will result in different numbers in the financial statements and in the tax comps. These differences may be viewed from
o
a balance sheet perspective, or
o
an income statement perspective.
The current tax charge for the period will be based on the tax authorities view of the profit, not the accounting view. This will mean that the relationship between the accounting profit before tax and the tax charge will be distorted. It will not be the tax rate applied to the accounting profit figure but the tax rate applied to a tax comp figure.
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3
DEFERRED TAXATION - THE CONCEPT ILLUSTRATED
3.1
Scenario Illustration 2 Tom Inc bought a non current asset on 1 January 2004 for $9,000. This asset is to be depreciated on a straight line basis over 3 years. Accounting depreciation is not allowed as a taxable deduction in the jurisdiction in which the company operates. Instead tax allowable depreciation (capital allowances), under the tax regime in the country of operation is available as follows. 2004 2005 2006
$4,000 $3,000 $2,000
Accounting profitfor each ofthe years 2004 to 2006 is budgeted to be $20,000 (before accountingfor depreciation) and income tax is to be charged at the rate of30%.
Differences arising Difference in the Carrying amount
Tax base
Cost at 1 Jan 2004
9,000
9,000
Charge for the year
(3,000)
(4,000)
Cost at 31 Dec 2004
6,000
5,000
Charge for the year
(3,000)
(3,000)
Cost at 31 Dec 2005
3,000
2,000
Charge for the year
(3,000)
(2,000)
Balance sheet
Income statement
(1,000) 1,000
1,000 1,000
Cost at 31 Dec 2006 •
At each balance sheet date the deferred tax liability might be identified from a balance sheet or an income statement view.
•
In this example the difference in the balance sheet amounts is the sum of the differences that have gone through the income statement.
•
The balance sheet view identifies the deferred taxation balance that is required in the balance sheet whereas the income statement approach identifies the deferred tax that arises during the period.
•
lAS 12 takes the first approach.
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3.2
Analysis - balance sheet approach
•
The balance sheet approach calculates the liability (or more rarely the asset) that a company would need to set up on the face of its balance sheet.
Carrying amount
Tax base
Balance sheet view of the differences (known as the temporary difference)
Tax@ 30%
At 31 Dec 2004
6,000
5,000
1,000
300
At 31 Dec 2005
3,000
2,000
1,000
300
At 31 Dec 2006
•
Application of the tax. rate to the balance sheet difference will give the deferred tax:balance that should be recognised in the balance sheet.
•
In 2004 the company will recognise a deferred tax:liability of $300 in its balance sheet. This will be released to the income statement in later years.
•
The $300 is a liability that exists at the balance sheet date and which will be paid in the future. In years to come (i.e. looking forward from the end of 2004) the company will earn profits against which it will charge $6,000 depreciation but will only be allowed $5,000 capital allowances. Therefore taxable profit will be $1,000 bigger than accounting profit in the future. This means that the current tax: charge in the future will be $300 (30% x $1,000) bigger than would be expected from looking at the fmancial statements. This is because of events that have occurred and been recognised at the balance sheet date. This satisfies the defmition and recognition criteria for a liability as at the balance sheet date.
•
•
The charge to the income statement is found by looking at the movement on the liability
Balance sheet liability required
Income statement entry
2004
300
Dr 300
2005
300
NIL
2006
NIL
Cr300
In summary the process involves a comparison of the accounting balance to the tax. authority's version of the same transaction and applying the tax:rate to the difference.
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3.3
After the company has accounted for deferred tax the financial statements will be as follows
•
Balance sheet - extracts
Deferred taxation liability
•
2004
2005
2006
$
$
$
300
300
2004
2005
2006
$
$
$
17,000
17,000
17,000
Income statements
Profit before tax Income tax @ 30% WI Deferred tax
Profit after tax
[;] C:J 300
5,400 (300)
(5,lDO)
(5,lDO)
(5,lDO)
11,900
11,900
11,900
•
Accounting for the tax on the differences through the income statement restores the relationship that should exist between the accounting profit and the tax charge. It does this by taking a debit or a credit to the income statement. This then interacts with the current tax expense to give an overall figure that is the accounting profit multiplied by the tax rate.
•
As can be seen from this example, the effect of creating a liability in 2004 and then releasing it in 2006 is that profit after tax ($11,900 for all three years) is not distorted by temporary timing differences. As such, a user of the fmancia1 statements now has better information about the relationship between profit before tax and profit after tax.
•
Accruals and provisions for taxation will impact on earnings per share, net assets per share and gearing.
WI
Calculations of tax for the periods
2004
2005
2006
$
$
$
Accounting profit (after depreciation)
17,000
17,000
17,000
Add back depreciation
3,000
3,000
3,000
(4,000)
(3,000)
(2,000)
Deduct capital allowances
(1,000) Taxable profit Tax@30%
1,000
16,000
17,000
18,000
4,800
5,lDO
5,400
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4
ACCOUNTING FOR DEFERRED TAXATION - BASICS
4.1
Introduction
•
lAS 12 takes a balance sheet perspective. Accounting for deferred taxation involves the recognition of a liability (or more rarely an asset) in the balance sheet. The difference between the liability at each year end is taken to the income statement.
Illustration 3 $ Deferred taxation balance at the start of the year Transfer to the income statement (as a balancingfigure) Deferred taxation balance at the end of the year
1,000 500 1,500
Most ofthe effort in accountingfor deferred taxation goes into the calculation ofthis figure
4.2
Calculation of the balance sheet amounts
•
The calculation of the balance to be put onto the balance sheet is, in essence, very simple. It involves the comparison of the carrying values of items in the accounts to the tax authority's view of the amount (known as the tax base ofthe item). The difference generated in each case is called a temporary difference.
•
The basic rule in lAS 12 is that deferred taxation should be provided on all taxable temporary differences. (Note that this is a simplification. Complications will be covered later).
Illustration 4
Non current assets
Carrying value in financial statements
Tax base
Temporary differences
Deferred tax balance required at 30%
s
s
s
s
20,000
14,000
6,000
1,800
1,000
1,000
300
(2,000)
(2,000)
(600)
5,000
1,500
Other transactions A (accrued income) B (an accrued expense)
The transactions in respect ofitems A and B are taxed on a cash basis, therefore the tax authority's balance sheet would not recognised accrued amounts in respect ofthese items.
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4.3
Jargon
4.3.1
Definitions
•
Temporary differences are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. •
•
o
debit balances in the financial statements compared to the tax computations. These will lead to deferred tax credit balances. These are known as taxable temporary differences, or
o
credit balances in the fmancial statements compared to the tax computations. These will lead to deferred tax debit balances. These are known as deductible temporary differences.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. •
4.3.2
Temporary differences may be either
The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefit that will flow to an entity when it recovers the carrying amount of the asset.
Commentary
Illustration 5 (Revisiting illustration 2) 2004 $ Net book value
6,000
Tax base of the asset
(5,000)
Temporary difference
1,000
Deferred tax balance required (@30%)
300
•
The difference between the net book value of the asset and the tax authority's value is described as a temporary difference because it is temporary in nature - it will disappear in time.
•
The lAS 12 justification is that ownership of this asset will lead to income of $6,000 in the future. The company will only have $5,000 as an expense to charge against this for tax purposes. The $1,000 that is not covered will be taxed and should be provided for now.
•
Temporary differences may lead to deferred tax credits or debits, though the standard imposes a tougher recognition criteria in respect of debit balances.
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IAS 12INCOME TAXES
•
Deferred tax accounting is about accounting for items where the tax effect of items is deferred to a later period. Circumstances under which temporary differences arise include
o
When income or expense is included in accounting profit in one period but included in the taxable profit in a different period. eg items which are taxed on a cash basis but which will be accounted for on an accruals basis.
Illustration 6 The accounts of Bill Inc show interest receivable of $10,000. No cash has yet been received and interest is taxed on a cash basis. The interest receivable has a tax base of nil. Deferred tax will be provided on the temporary difference of$10,000. situations where the accounting depreciation does not equal tax allowable depreciation. Illustration 7 Bill Inc has non current assets at 31 December 2004 with a cost of $4,000,000. Aggregate depreciation for accounting purposes is $750,000. For tax purposes, depreciation of $1,000,000 has been deducted to date. The non current assets have a tax base of $3,000,000. The provision for deferred tax will be provided on the taxable temporary difference of $250,000. finance leases recognised in accordance with the provisions ofIAS 17 but which fall to be treated as operating leases under local tax legislation.
o
Revaluation of assets where the tax authorities do not amend the tax base when the asset is revalued.
•
Unfortunately the defmition oftemporary difference captures other items which should not result in deferred taxation accounting. eg accruals for items which are not taxed or do not attract tax relief.
•
The standard includes provisions to exclude such items. The wording of one such provision is as follows
"If those economic benefits will not be taxable, the tax base ofthe asset is equal to its carrying amount" •
The wording seems a little strange but the effect is to exclude such items from the deferred taxation calculations. Illustration 8 Bill Inc provided a loan of $250,000 to John Inc. At 31 December 2004 Bill Inc's accounts show a loan payable of $200,000. The repayment of the loan has no tax consequences. Therefore the loan payable has a tax base of $200,000. No temporary taxable difference arises.
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Example 1 The following information relates to Boniek Sp. z.o.o. as at 31 December 2004.
Note Non current assets
Carrying value $
Tax base $
Plant and machinery
200,000
175,000
Receivables: Trade receivables
1
Interest receivable
50,000 1,000
Payables Fine
10,000
Interest payable
2,000
Note 1 The trade receivables balance in the accounts is made up of the following amounts;
$ Balances
55,000
Doubtful debt provision
(5,000) 50,000
Further information; 1. The deferred tax balance as at 1 January 2004 was $1,200. 2. Interest is taxed on a cash basis. 3. Provisions for doubtful debts are not deductible for tax purposes. Amounts in respect of receivables are only deductible on application of a court order to a specific amount. 4. Fines are not tax deductible. 5. Deferred tax is charged at 30%.
Required: Calculate the deferred tax provision which is required at 31 December 2004 and the charge to the income statement for the period.
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Solution 1
Non current assets
Carrying value $
Tax base $
Temporary difference
Plant and machinery Receivables: Trade receivables Interest receivable Payables Fine Interest payable Temporary differences
Deferred tax@ 30%
Deferred tax liabilities Deferred tax assets
Deferred tax@ 30% $
1,200
Deferred tax as at 1 January 2004 Income statement (balancing figure) Deferred tax as at 31 December 2004
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5
ACCOUNTING FOR DEFERRED TAX - DETAILED RULES
5.1
Recognition of deferred tax liabilities
5.1.1
The rule
•
A deferred tax liability should be recognised for all taxable temporary differences, unless the deferred tax liability arises from D
the initial recognition of goodwill; or
D
goodwill for which amortisation is not deductible for tax purposes; or
D
the initial recognition of an asset or liability in a transaction which is not a business combination and at the time of the transaction, affects neither accounting profit nor taxable profit.
•
If the economic benefits are not taxable the tax base of the asset is equal to its carrying amount.
5.1.2
Commentary
•
"all taxable temporary differences" The definition oftemporary differences includes all differences between accounting rules and tax rules, not just the temporary ones! The standard contains other provisions to correct this anomaly and excludes items where the tax effect is not deferred, but rather, is permanent in nature.
•
"goodwill for which amortisation is not deductible" In the vast majority ofsituations goodwill is a group accounting concept. In mostjurisdictions it is the individual companies that are taxed, not the group. Therefore it would be quite rare for goodwill to be an item which attracted tax relief The rule here is an application ofthe idea that if an item is not taxable it should be excluded from the calculations.
•
"initial recognition ---- not a business combination"
If the initial recognition is a business combination deferred tax may arise. •
"effects neither accounting profit nor loss" The rule here is an application ofthe idea that if an item is not taxable it should be excluded from the calculations.
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•
Taxable temporary differences also arise in the following situations:
o
Certain lASs permit assets to be carried at a fair value or to be revalued. if the revaluation of the asset is also reflected in the tax base then no temporary difference arises. if the revaluation does not affect the tax base then a temporary difference does arise and deferred tax. must be provided.
o
When the cost of acquiring a business is allocated by reference to fair value of the assets and liabilities acquired, but no equivalent adjustment has been made for tax. purposes.
This is basically the same rule as above applied to a group accounting situation
Example 2 The following information relates Lato Sp Z.O.o.
At 1 January 2004 Depreciation At 31 December 2004
Carrying value $ 1,000 (100)
Tax base
900
650
$ 800 (150)
At the year end the company decided to revalue the asset to $1,250. The tax. base is not affected by this revaluation.
Required: Calculate the deferred tax provision required in respect of this asset as at 31 December 2004.
Solution 2
Carrying value $
Deferred tax. at 30%
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Tax base
$
Temporary difference
IAS 12INCOME TAXES
5.2
Recognition of deferred tax assets
5.2.1
The rule
•
A deferred tax asset should be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised, unless the deferred tax asset arises from
o
the initial recognition of an asset or liability in a transaction which: is not a business combination, and at the time of transaction, affects neither accounting profit nor taxable profit (tax loss).
•
The carrying amount of a deferred tax asset should be reviewed at each balance sheet date. The carrying value of a deferred tax asset should be reduced to the extent that it is no longer probable that sufficient taxable profit will be available to utilise the asset.
5.2.2
Commentary
•
Most of the comments made in respect of deferred tax liabilities also apply to deferred tax assets.
•
Major difference between the recognition of deferred tax assets and liabilities is in the use of the phrase "to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised".
This means that lAS 12 brings a different standard to the recognition ofdeferred tax assets than it does to deferred tax liabilities. In short liabilities will always be provided in full (subject to the specified exemptions) but assets may not be provided infull or, in some cases at all. This is an application ofthe concept ofprudence. •
An asset should only be recognised when the company expects to receive a benefit from its existence. The existence of deferred tax liability (to the same jurisdiction) is strong evidence that the asset will be recoverable.
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Illustration 9 Situation 1 $
Situation 2 $
Deferred tax liability
10,000
5,000
Deferred tax asset
(8,000)
(8,000)
2,000
(3,000)
Net position •
In situation 1 the existence of the liability ensures the recoverability of the asset and the asset should be provided.
•
In situation 2 the company would provide for $5,000 of the asset but would need to consider carefully the recoverability of the $3,000 net debit balance.
•
In short debit balances which are covered by credit balances will be provided (as long as the tax is payable/recoverable to/from the same jurisdiction), but net debit balances will be subject to close scrutiny.
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5.3
Accounting for the movement on the deferred tax balance
•
Deferred tax should be recognised as income or an expense and included in the profit or loss for the period, except to the extent that the tax arises from
•
o
a transaction or event which is recognised, in the same or a different period, directly in equity, or
o
a business combination that is an acquisition.
Deferred tax should be charge or credited directly to equity ifthe tax relates to items that are credited or charged, in the same or different period, directly to equity.
Example 3 Following on from example 2 Carrying value
At 1 January 2004 Depreciation At 31 December 2004
Tax base
$
$
1,000 (100)
800 (150)
900
650
At the year end the company revalued the asset to $1,250. The tax base is not affected by this revaluation. Carrying value
Tax base
$
$
1,250
650
Temporary difference
600 180
Deferred tax at 30%
Required: Assuming that the only temporary difference that the company has relates to this asset construct a note showing the movement on the deferred taxation and identify the charge to the income statement in respect of deferred taxation for the year ended 31 December 2004.
Solution 3
Deferred tax@ 30%
$ Deferred tax as at 1 January 2004 To equity Income statement Deferred tax as at 31 December 2004
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6
COMPLICATIONS
6.1
Rates
•
The tax rate that should be used is the rate that is expected to apply to the period when the asset is realised or the liability is settled, based on tax rates that have been enacted by the balance sheet date.
Example 4 The following information relates to Tomasefski Sp. Z.o.o. at 31 December 2004:
Non-current assets Tax losses
Carrying value $ 460,000 90,000
Tax base $ 320,000
Further information: 1.
2. 3. 4.
Tax rates (enacted by the 2004 year end) 2004 2005 36% 34%
2006 32%
2007 31%
The loss above is the tax loss incurred in 2004. The company is very confident about the trading prospects in 2005. The temporary difference in respect of non-current assets is expected to grow each year until beyond 2007. Losses may be carried forward for offset, one third into each of the next three years
Required: Calculate the deferred tax provision that is required at 31 December 2004.
Temporary difference $
Proforma solution
Non-current assets (460 - 320) Losses Deferred tax liability Deferred tax asset; Reversal in 2005 Reversal in 2006 Reversal in 2007 Deferred tax
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IAS 12INCOME TAXES
•
The tax rate used should reflect the tax consequences of the manner in which the entity expects to recover or settle the carrying amount of its assets and liabilities. Illustration 10
Bill Inc has an asset with a carrying amount of $5000 and a tax base of $3000. A tax rate of 25% would apply if the asset were sold and a tax rate of33% would apply to other income. The entity would recognise a deferred tax liability of$500 ($2000 @ 25%) if it expects to sell the asset without further use and a deferred tax liability of $660 ($2000 @33%) if it expects to retain the asset and recover its carrying value through use. 6.2
Change in rates
•
Companies are required to disclose the amount of deferred taxation in the tax expense that relates to change in the tax rates.
Example 5 Carrying value $ 460,000
Non current assets Accrued interest: Receivable
Tax base
$ 320,000
18,000
Payable
(15,000)
The balance on the deferred tax account on lotJanuary 2004 was $10,000. This was calculated at a tax rate of 30%. During 2004 the government announced an unexpected increase in the level of
corporate income tax up to 35%. Required: Set out the note showing the movement on the deferred tax account showing the charge to the income statement and clearly identify that part of the charge that is due to an increase in the rate of taxation. Solution 5
Deferred tax $
Deferred tax as at lotJanuary 2004 Income statement - rate change Opening balance restated Income statement- origination of temporary differences
(Balancing figure)
Deferred tax as at 31st December 2004
(WORKING below)
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WORKING
Carrying value $
Tax base
Temporary difference
$
Non current assets Accrued interest: Receivable Payable Deferred tax liability Deferred tax asset Deferred tax at 35%
6.3
SIC 21 - Income Taxes - Recovery of Revalued Non-Depreciable Assets
•
Issue
•
•
o
lAS 12 requires that the measurement of deferred tax liabilities and assets at the balance sheet date, should reflect the tax consequences that would follow from the manner in which the entity expects, to recover or settle the carrying amount of those assets and liabilities that give rise to the temporary differences.
o
Revaluation of an asset with no corresponding adjustment to its tax base gives rise to a temporary difference. If the future recovery of the carrying amount will be taxable, any difference between the carrying amount of the revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset.
o
The issue is how to interpret the term "recovery" in relation to a revalued asset that is not depreciated.
Consensus
o
The deferred tax liability or asset that arises from the revaluation of a nondepreciable asset should be measured based on the tax consequences that would follow from recovery of the carrying amount of that asset through sale, regardless of the basis of measuring the carrying amount of that asset.
o
Ifthe tax law specifies a tax rate applicable to the sale of an asset that differs from the tax rate applicable to its use, the former rate is used for the measurement of deferred tax balances relating to a non-depreciable asset.
Basis for Conclusions
o
The Framework indicates that an entity recognises an asset if it is probable that the future economic benefits associated with the asset will flow to the entity.
o
Future economic benefits will be derived (and therefore the carrying amount of an asset will be recovered): through sale, through use, or, or through use and subsequent sale.
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o
Recognition of depreciation implies that the carrying amount of a depreciable asset is expected to be recovered through use to the extent of its depreciable amount, and through sale at its residual value.
o
If an asset is not depreciated its, the carrying amount will be recovered only through sale. If the asset is not depreciated, no part of its carrying amount is expected to be recovered (that is, consumed) through use. Deferred taxes associated with the nondepreciable asset reflect the tax consequences of selling the asset.
6.4
SIC 25 - Income Taxes - Changes in the Tax Status of an Entity or its Shareholders
•
Issue
o
A change in the tax status of an entity or of its shareholders may have consequences for an entity by increasing or decreasing its tax liabilities or assets. (eg upon the public listing of an entity's equity instruments, the restructuring of an entity's equity or on relocation to a foreign country).
o
An entity may be taxed differently as a result of, eg:
gain or lose tax incentives becoming subject to a different rate of tax in the future.
•
o
Such changes in tax status may have an immediate effect on the entity's current tax liabilities or assets. The change may also increase or decrease the deferred tax liabilities and assets recognised by the entity, depending on the effect the change in tax status has on the tax consequences that will arise from recovering or settling the carrying amount of the entity's assets and liabilities.
o
The issue is how an entity should account for the tax consequences of a change in its tax status or that of its shareholders.
Consensus
o
•
The current and deferred tax consequences of a change in tax status should be included in net profit or loss for the period, unless those consequences relate to transactions and events that result, in the same or a different period, in a direct credit or charge to the recognised amount of equity. In those cases the tax consequences should themselves be recognised directly in equity
Basis for Conclusions
o
The treatment is consistent with the lAS 12 guidance on dealing with the tax consequences of transactions and events and in particular those transactions or events that are recognised directly in equity.
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7
BUSINESS COMBINATIONS
7.1
Introduction
7.1.1
Background
•
Acquisition accounting, equity accounting and proportionate consolidation share certain features in common which are relevant to an understanding of the deferred taxation consequences of employing these techniques.
•
Each involves the replacement of cost with a share ofnet assets and goodwill arising on acquisition, the subsequent impairment ofthe goodwill and the crediting ofpost acquisition growth in equity balances to the equivalent equity balances of the group. lliustration 11
At the date of acquisition
At a subsequent balance sheet
H's own financial statements COST
SHARE OF NET ASSETS
600
450
COST
SHARE OF NET ASSETS
600
520 Also
H group financial statements
GOODWILL
+
GOODWILL
+
Through the income statement into equity ~
~J.fl
=
150
150 (30) 120
a!lL-__
a net debit of600
•
TIlls is effectively what takes place under each of the techniques. They differ in the way that the share of net assets is reflected in the "group" financial statements.
•
Note that the carrying value of the investment in the illustration above is $640 (520+120).
7.1.2
Sources oftemporary differences
•
Temporary differences may arise from the above due to the following reasons.
o
The calculation of goodwill requires a fair valuation exercise. This exercise may change the carrying amounts of assets and liabilities but not their tax bases. The resulting deferred tax amounts will affect the value of goodwill but lAS 12 prohibits the recognition of deferred tax arising (see session 4.1) Retained earnings of subsidiaries, branches, associates and joint ventures are included in consolidated retained earnings, but income taxes will be payable if the profits are distributed to the reporting parent.
•
Furthermore, lAS 27 requires the elimination ofunrealised profitsllosses resulting from intragroup transactions. This treatment will generate temporary differences.
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7.2
Temporary differences arising on the calculation of goodwill
•
The cost ofthe acquisition is allocated to the identifiable assets and liabilities acquired by reference to their fair values at the date of the exchange transaction.
•
Temporary differences arise when the tax bases of the identifiable assets and liabilities acquired are not affected by the business combination or are affected differently.
•
Deferred tax must be recognised in respect of the temporary differences. This will affect the share of net assets and thus the goodwill (one of the identifiable liabilities ofS is the deferred tax balance).
•
The goodwill itself is also a temporary difference but IAS 12 prohibits the recognition of deferred tax on this item.
Illustration 12 Entity H paid $600 for 100% ofSon 1'1 January 2004.
S had not accountedfor deferred taxation up to the date ofits acquisition. The following information is relevant in respect ofS Fair value at the date of acquisition Property plant and equipment Accounts receivable Inventory Retirement benefit obligations Accounts payable
270 210 174
Tax base
Temporary differences
155
115
210
124
(30) (120)
(30) (120)
135
504
$ 600
Goodwill arising Cost ofinvestment Fair value ofnet assets acquired Per balance sheet ofS Deferred tax liability arising in the fair valuation exercise (40%x 135)
504
(54)
_.l.::-:L.-_
GOODWILL
© Accountancy Tuition Centre (International Holdings) Ltd 2005
50
(450) 150
1823
IAS 12INCOME TAXES
7.3
Temporary differences arising due to the carrying amount of the investment and the tax base
7.3.1
Background
•
Temporary differences arise when the carrying amount of investments in subsidiaries, (branches and associates or interests in joint ventures) becomes different from the tax base (which is often cost) of the investment or interest.
•
The carrying amount is the parent or investor's share of the net assets plus the carrying amount of goodwill. Such differences may arise in a number of different circumstances.
Illustration 13 (following on from illustration 11)
r
Entity H paid $600 for 100% ofSon January 2004. At this date the carrying amount in H's consolidatedfinancial statements, ofits investment in S was made up as follows: Fair value ofthe identifiable net assets ofS (including deferred taxation)
450
Goodwill
150
Carrying amount
600
Tutorial note The carrying amount at the date ofacquisition is equal to cost. This must be the case as the costfigure has been allocated to the net assets to leave goodwill as a residue The tax base in H'sjurisdiction is the cost ofthe investment. Therefore there is no temporary difference at the date ofacquisition.
sr
During the year ended December 2004 S traded profitably and accumulated earnings of$70. This was reflected in the net assets ofthe entity and in its equity. Since acquisition, goodwill has been impaired by 30.
sr
At December 2004 the carrying amount in H's consolidatedfinancial statements, of its investment in S was made up as follows: Fair value ofthe identifiable net assets ofS (450 + 70)
520
Goodwill (150- 30)
120
640 This means that there is a temporary difference of$40. (640-600).
•
An entity should recognise a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests injoint ventures, except to the extent that both of the following conditions are satisfied:
o
the parent, investor or venturer is able to control the timing ofthe reversal of the temporary difference, and
o
it is probable that the temporary difference will not reverse in the foreseeable future.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1824
IAS 12INCOME TAXES
7.3.2
Subsidiaries and branches
•
A parent controls the dividend policy of its subsidiary (and branches). It is able to control the timing of the reversal of temporary differences associated with that investment. When the parent has determined that those profits will not be distributed in the foreseeable future the parent does not recognise a deferred tax liability. Illustration 13 continued
If H has determined that it will not sell the investment in the foreseeable future and that S will not distribute its retained profits in the foreseeable future, no deferred tax liability is recognised in relation to H's investment in S (H discloses the amount (40) ofthe temporary difference for which no deferred tax is recognised).
If H expects to sell the investment in S, or that S will distribute its retained profits in the foreseeable future, H recognises a deferred tax liability to the extent that the temporary difference is expected to reverse. The tax rate reflects the manner in which H expects to recover the carrying amount of its investment.
7.3.3
Associates
•
An investor in an associate does not control that entity and is usually not in a position to determine its dividend policy.
•
Therefore, in the absence of an agreement requiring that the profits of the associate will not be distributed in the foreseeable future, an investor recognises a deferred tax liability arising from taxable temporary differences associated with its investment in the associate. Illustration 13 continued
IfS were an associate ofH it would need to provide for deferred tax in respect ofthe $40 unless there was an agreement that the profits ofS would not be distributed in the future. The tax rate must reflect the manner in which H expects to recover the carrying amount of its investment.
7.3.4
Joint ventures
•
The arrangement between the parties to a joint venture usually deals with the sharing of the profits and identifies whether decisions on such matters require the consent of all the venturers or a specified majority of the venturers. When the venturer can control the sharing of profits and it is probable that the profits will not be distributed in the foreseeable future, a deferred tax liability is not recognised.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1825
IAS 12INCOME TAXES
7.4
Inter company transactions
•
lAS 27 requires that unrealised profits and losses arising on inter company trading must be eliminated in full on consolidation. Such adjustments may give rise to temporary differences. In many tax jurisdictions it is the individual members of the group that are the taxable entities. As far as the tax authorities are concerned the tax base of an asset purchased from another member of the group will be the cost that the buying company has paid for it. Furthermore the selling company will be taxed on the sale of the asset even though it is still held within the group.
•
Note that the deferred tax is provided for at the buyers tax rate.
Illustration 14 S has sold inventory to Hfor $700. The inventory cost S $600 originally. S has therefore made a profit of$100 on the transaction. S will be liable to tax on this amount at say 30%. Thus S will reflect a profit of$100 and a tax expense of$30 in its own financial statements.
If H has not sold the inventory at the year-end it will include it in its closing inventory figure at a cost (to itself) of$700. On consolidation the unrealisedprofit must be removed by Dr Income statement $100 Cr Balance sheet inventory $100 In the consolidatedfinancial statements the inventory will be measured at $600 (700-100) but its tax base is still $700. There is a deductible temporary difference of$100. This requires the recognition ofa deferred tax asset of $30 (30% x 100). Note that the other side ofthe entry to set this up will be a credit to the income statement. This will remove the effect ofthe tax on the transaction. (However if H operated in a different tax environment such that it was taxed at 40% the deferred tax asset would be $40 (40% x 100).
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1826
IAS 12INCOME TAXES
8
PRESENTATION AND DISCLOSURE
8.1
Presentation
•
Tax assets and tax liabilities should be presented separately from other assets and liabilities in the balance sheet. Deferred tax assets and liabilities should be distinguished from current tax assets and liabilities.
•
When an entity makes a distinction between current and non-current assets and liabilities in its financial statements, it should not classify deferred tax assets (liabilities) as current assets (liabilities).
•
An entity should offset current tax assets and current tax liabilities if, and only if, the entity
•
o
Has a legally enforceable right to set off the recognised amounts, and
o
Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
An entity should offset deferred tax assets and deferred tax liabilities if, and only if:
o
The entity has a legally enforceable right to set off current tax assets against current tax liabilities, and
o
The deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same taxation authority on either: the same taxable entity; or different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realise the assets and settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled or recovered.
•
The tax expense (income) related to profit/loss from ordinary activities should be presented on the face of the income statement.
8.2
Disclosure
The following should be disclosed separately •
The major components of tax expense (income) These include
o
Current tax expense (income),
o
Adjustments in respect of a prior period,
o
Deferred tax expense/income,
o
Deferred tax expense /income arising due to a change in tax rates,
o
Deferred tax consequence of a change in accounting policy or a correction of a fundamental error.
•
The aggregate current and deferred tax relating to items that are charged or credited to equity.
•
Tax expense (income) relating to extraordinary items recognised during the period.
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1827
IAS 12INCOME TAXES
•
An explanation of the relationship between tax expense (income) and accounting profit in either or both of the following forms:
o
A numerical reconciliation between tax expense (income) and the product of accounting profit multiplied by the applicable tax rate(s) disclosing also the basis on which the applicable tax rate(s) is (are) computed, or
o
A numerical reconciliation between the average effective tax rate and the applicable tax rate, disclosing also the basis on which the applicable tax rate is computed.
•
An explanation of changes in the applicable tax rate(s) compared to the previous accounting period.
•
The amount (and expiry date, if any) of deductible temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset is recognised in the balance sheet.
•
The aggregate amount of temporary differences associated with investments in subsidiaries, branches and associates and interests in joint ventures.
•
In respect of each type of temporary difference, and in respect of each type of unused tax losses and unused tax credits:
•
•
o
The amount of deferred tax assets and liabilities recognised in the balance sheet for each period presented,
o
The amount of the deferred tax income or expense recognised in the income statement, if this is not apparent from the changes in the amounts recognised in the balance sheet, and
In respect of discontinued operations, the tax expense relating to:
o
The gain or loss on discontinuance, and
o
The profit or loss from the ordinary activities of the discontinued operation for the period, together with the corresponding amounts for each prior period presented.
An entity should disclose the amount ofa deferred tax asset and the nature of the evidence supporting its recognition, when:
o
The utilisation of the deferred tax asset is dependent on future taxable profits in excess of the profits arising from the reversal of existing taxable temporary differences, and
o
The entity has suffered a loss in either the current or preceding period in the tax jurisdiction to which the deferred tax asset relates.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1828
IAS 12INCOME TAXES
9
APPENDIX Deferred taxation calculations
(a)
Debits in the fmancial statements compared to the taxman's view give rise to deferred tax credits. Credits in the financial statements compared to the taxman's view give rise to deferred tax debits.
(b)
Full provision accounting is easy! DT = TAX RATE x TEMPORARY DIFFERENCE = BALANCE SHEET AMOUNT FOR DEFERRED TAX
(c)
Steps Step 1:
Summarise the accounting carrying amounts and the tax base for every asset and liability.
Step 2:
Calculate the temporary difference by deducting the tax base from the carrying amount - see proforma below.
Asset/Liability
Carrying Amount
$
(d)
Tax Temporary Base Difference
$
$
Step 3:
Calculate the deferred tax liability and asset. To calculate the deferred tax liabilities we sum all positive temporary differences and apply the tax rate. To calculate the deferred tax asset we sum all negative temporary differences and apply the tax rate.
Step 4:
Calculate the net deferred tax liability or asset by summing the two amounts in Step 3. THIS WILL BE THE ASSET OR LIABILITY CARRIED IN THE BALANCE SHEET.
Step 5:
Deduct the opening deferred tax liability or asset. THE DIFFERENCE WILL BE THIS YEARS THE CHARGE/CREDIT TO THE INCOME STATEMENTIEQUITY/GOODWILL.
Where there has been a change in the tax rate it is necessary to calculate the effect of this change on the opening deferred tax provision. Follow steps 1 to 5 above, calculating the required closing deferred tax liability or asset and the charge/credit to the income statement. The charge/credit to the income statement is then analysed into the amount that relates to the change in the tax rate and the amount that relates to the temporary differences. The amount that relates to the change in tax rate will equal the amount of the temporary difference in the previous period x the change in the tax rate.
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1829
IAS 12INCOME TAXES
FOCUS You should now be able to: •
discuss the different approaches to accounting for deferred tax;
•
discuss the recognition of deferred tax in the balance sheet and performance statements including revaluations, unremitted earnings of group companies and deferred tax assets;
•
explain the nature of the measurement of deferred tax including tax rates and discounting;
•
calculate deferred tax amounts in the financial statements.
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1830
IAS 12INCOME TAXES
EXAMPLE SOLUTIONS Solution 1 Carrying value
Tax base
Temporary difference
Non current assets
$
$
Plant and machinery
200,000
175,000
25,000
Trade receivables
50,000
55,000
(5,000)
Interest receivable
1,000
Receivables:
1,000
Payables Fine
10,000
Interest payable
2,000
10,000 (2,000)
Temporary differences
Deferred tax@ 30%
Deferred tax liabilities
26,000
7,800
Deferred tax assets
(7,000)
(2,100) 5,700
Deferred tax@ 30%
$ Deferred tax as at 1 January 2004 Income statement
1,200 4,500 Balancing figure _----"'--'-'--_
Deferred tax as at 31 December 2004
5,700
Solution 2
Deferred tax at 30%
© Accountancy Tuition Centre (International Holdings) Ltd 2005
Carrying value
Tax base
Temporary difference
$ 1,250
$ 650
$ 600 180
1831
lAS 12INCOME TAXES
Solution 3 Deferred tax@ 30% $
Deferred tax as at 1st January 2004
(1,000 - 800) x 30%
60
To equity
30% x (1,250 - 900)
105
Income statement
Balancing figure (or as (150 - 100) x 30%)
15
Deferred tax as at 31st December 2004
180
Solution 4 Temporary difference $ 140,000 (90,000)
Non-current assets (460,000 - 320,000) Losses Deferred tax liability (31% Deferred tax asset Reversal in 2005 (30,000 Reversal in 2006 (30,000 Reversal in 2007 (30,000
43,400
x 140,000) x 34%) x 32%) x 31%)
(10,200) (9,600) (9,300) 14,300
Deferred tax
Solution 5 Deferred tax $
Deferred tax as at 1st January 2004
10,000
Income statement - rate change
1,667
Opening balance restated
«10,000 x 35/30 )
11,667
Income statement- origination of temporary differences
(Balancing figure)
38,383
Deferred tax as at 31st December 2004
(WORKING)
50,050
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1832
IAS 12INCOME TAXES
WORKING
Carrying value $ 460,000
Fixed assets Accrued interest: Receivable Payable
Tax base
$ 320,000
Temporary difference
140,000
18,000
18,000
(15,000)
(15,000)
Deferred tax liability (35% x 158,000) Deferred tax asset (35% x 15,000)
55,300 (5,250)
Deferred tax at 35%
50,050
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1833
IAS 12INCOME TAXES
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1834
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
OVERVIEW Objective •
To explain the rules on measurement, recognition, presentation and disclosure of financial instruments.
lAS 32 &39 BACKGROUND
• • •
Traditional accounting Financial instruments History
• •
lAS 32 lAS 39
• •
lAS 32 lAS 39
I APPLICATION AND SCOPE
I DEFINITIONS
PRESENTATION
• •
Liabilities and equity Own equity instruments
• •
Offset Interest, dividends, losses and gains Compound instruments Contingent settlement provisions Treasury shares
• • •
RECOGNITION
• •
Rules Illustrative notes - Nokia
•
ED7
© Accountancy Tuition Centre (International Holdings) Ltd 2005
Initial recognition Examples
• •
Financial asset Financialliability
MEASUREMENT
• • •
Initial Fair value considerations Subsequent measurement
HEDGING
• • •
lAS 39 definitions Hedging instruments Hedged items
HEDGE ACCOUNTING
• • •
Background Fair value hedges Cash flow hedges
DISCWSURE
• •
DERECOGNITION
I--
1901
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
1
BACKGROUND
1.1
Traditional accounting
•
Traditional accounting practices are based on serving the needs of manufacturing companies. Accounting for such entities is concerned with accruing costs to be matched with revenues. A key concept in such a process is revenue and cost recognition.
•
The global market for financial instruments has expended rapidly over the last twenty years, not only in the sheer volume of such instruments but also in their complexity. Entities have moved from using "traditional" instruments (e.g. cash, trade debtors, longterm debt and investments) to highly sophisticated risk management strategies based around derivatives and complex combinations of instruments.
•
The traditional cost-based concepts are not adequate to deal with the recognition and measurement of fmancial assets and liabilities. Specifically:
o
Traditional accounting bases recognition on the transfer of risks and rewards. It is not designed to deal with transactions that divide up the risks and rewards associated with a particular asset (or liability) and allocate them to different parties.
o
Some fmancial instruments have no or little initial cost (e.g. options) and are not adequately accounted for (if at all) under traditional historical cost based systems.
•
If a transaction has no cost, traditional accounting cannot Dr and CR. In addition, the historical cost of fmancial assets and liabilities has little relevance to risk management activities.
1.2
Financial instruments
•
Afinancial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
•
Instruments include:
o
primary instruments (e.g. receivables, payables and equity securities); and
o
derivative instruments (e.g. financial options, futures and forwards, interest rate swaps and currency swaps).
1.3
History
•
lAS 32 "Financial Instruments: Disclosure and Presentation" was first issued in June 1995.
•
lAS 39 "Financial Instruments: Recognition and Measurement" was first issued in December 1998.
•
Both standards have been revised and updated since they were first issued.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1902
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
•
This time difference of the initial issue ofIAS 32 and lAS 39, reflects the complexity of the recognition and measurement issues. The first exposure draft on fmancial instruments (issued in 1991) had sought to address disclosure, presentation, recognition and measurement in one standard. The subsequent revisions reflect the "learning process" of dealing with the complexities of financial instruments and new issues that have been raised since the standards were first issued.
2
APPLICATION AND SCOPE
2.1
lAS 32
2.1.1
Application
•
Classification of financial instruments between: D D D
financial assets; financial liabilities; and equity instruments.
•
Presentation, disclosure and offset of financial instruments and the related interest, dividends, losses and gains.
•
Disclosure of: D
factors affecting the amount, timing and certainty of cash flows;
D
the use of financial instruments and the business purpose they serve; and
D
the associated risks and management's policies for controlling those risks.
2.1.2
Scope
•
This Standard should be applied in presenting and disclosing information about all types of financial instruments, both recognised and unrecognised, exceptfor financial instruments that are dealt with by other standards, i.e: D
interests in subsidiaries, associates, and joint ventures accounted for under lAS 27, lAS 28 and lAS 31 respectively,;
D
contracts for contingent consideration in a business combination under IFRS 3 (only applies to the acquirer);
D
employers' rights and obligations under employee benefit plans, to which lAS 19 applies;
D
certain insurancecontractsaccountedfor under IFRS 4; and
D
fmancial instruments, contracts and obligations under share-based payment transactions to which IFRS 2 applies (unless relating to treasury shares).
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1903
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
2.2
lAS 39
2.2.1
Application
•
Recognition and derecognition of fmancia1 assets and financia11iabi1ities.
•
Classification of financial assets and financia11iabi1ities.
•
Initial measurement and subsequent measurement of financial assets and financial liabilities.
•
Defmition of hedge accounting, and criteria and rules for hedge accounting.
2.2.2
Scope
•
This Standard should be applied by all entities to the recognition and measurement of all fmancial instruments exceptfor financial instruments that are dealt with by other standards, i.e:
o
interests in subsidiaries, associates, and joint ventures that are accounted for under lAS 27, lAS 28 and lAS 31 respectively,.
The Standard does not change the requirements relating to accounting by a parentfor investments in subsidiaries, associates or joint ventures in the parent's separate financial statements as set out in lAS 27, 28 and 31.
o
rights and obligations under leases, to which lAS 17 applies;
o
employers' assets and liabilities under employee benefit plans, to which lAS 19 applies;
o
fmancial instruments issued by the entity that meet the definition of an equity instrument (lAS 32) including options and warrants;
However, the holder ofsuch equity instruments applies lAS 39 to those instruments, unless they meet the exception relating to lAS 27, lAS 28 or lAS 31.
o
contracts for contingent consideration in a business combination under IFRS 3 (only applies to the acquirer);
o
contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date; and
o
fmancial instruments, contracts and obligations under share-based payment transactions to which IFRS 2 applies.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1904
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
3
DEFINITIONS
3.1
From lAS 32
•
Afinancial asset is any asset that is:
o
cash;
o
a contractual right to receive cash or another fmancial asset from another entity;
o
a contractual right to exchange financial instruments with another entity under conditions that are potentially favourable;
o
an equity instrument of another entity; or
o
certain contracts that will (or may) be settled in the entity's own equity instruments.
For this purpose the entity's own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments. •
Afinancialliability is any liability that is a contractual obligation:
o
to deliver cash or another financial asset to another entity;
o
to exchange financial instruments with another entity under conditions that are potentially unfavourable; or
o
certain contracts that will (or may) be settled in the entity's own equity instruments.
Physical assets (e.g. prepayments), liabilities that are not contractual in nature (e.g. taxes), operating leases, and contractual rights and obligations relating to non-financial assets that are not settled in the same manor as a financial instrument) are not financial instruments. Preferred shares that provide for mandatory redemption by the issuer, or that give the holder the right to redeem the share, meet the definition ofliabilities and are classified as such even though, legally, they may be equity. •
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
•
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1905
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
3.2
From lAS 39
3.2.1
Derivatives
•
A derivative is a financial instrument:
o
whose value changes in response to the change in a specified interest rate, fmancial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the "underlying");
o
that requires little or no initial net investment relative to other types of contracts that would be expected to have a similar response to changes in market conditions; and
o
that is settled at a future date.
3.2.2
Categories offinancial assets
•
lAS 39 currently identifies four categories offmancial assets.
•
A financial asset or financial liability at fair value through profit or loss is a financial asset or financial liability that is either:
o o
classified as held for trading; or designated initially at fair value through profit or loss.
Except for investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured, anyfinancial asset or financial liability within the scope oflAS 39 may be designated when initially recognised at fair value through profit or loss. Once a financial asset has been designated as at fair value through profit or loss, it must remain in that category until de-recognition. •
Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intent and ability to hold to maturity other than those:
o
o o
designated as at fair value through profit or loss on initial recognition; designated as available for sale; or meeting the definition of loans and receivables.
Fixed or determinable payments andfixed maturity means a contractual arrangement that defines the amounts and dates ofpayments to the holder, such as interest and principal payments on debt.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1906
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
•
•
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than those:
o
intended for immediate sale (classified as held for trading);
o
designated initially as at fair value through profit or loss or available for sale; or
o
se loans where repayment of the initial loan is in doubt (other than where there is a fall in credit rating), in which case they will be classed as available for sale.
Available-for-salefinancial assets are those non-derivative financial assets that are designated available-for-sale or are not classified as:
o
o o
loans and receivables; held-to-maturity investments; or fmancial assets at fair value through profit or loss.
This category captures all financial assets which do not fit into the other categories. 3.2.3
Recognition and measurement
•
Amortised cost of a financial asset or financial liability is:
o
the amount at which it was measured at initial recognition; minus
o
principal repayments; plus or minus
o
the cumulative amortisation of any difference between that initial amount and the maturity amount; and minus
o
any write-down (directly or through the use of an allowance account) for impairment or uncollectability.
•
The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability, using the effective interest rate and of allocating the interest.
•
The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected useful life of the financial instrument to the net carrying amount of the financial asset (or financial liability). The computation includes all cash flows (e.g. fees, transaction costs, premiums or discounts) between the parties to the contract.
•
The effective interest rate is sometimes termed the "level yield-to-maturity" (or to the next repricing date), and is the internal rate of return of the fmancial asset (or liability) for that period.
•
Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset (or fmancialliability).
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1907
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed ofthe financial instrument. Examples include fees and commissions paid to agents. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs. Illustration 1 - Amortised cost using the effective interest rate method A company issues a $100,000 zero coupon bond redeemable in 5 years at $150,000. The internal rate ofretum (the yield) on these flows is 8.45%. This should be used to allocate the expense. Period
Opening balance
Interest@ 8.45%
Closing balance
1
100,000
8,450
108,450
2
108,450
9,164
117,614
3
117,614
9,938
127,552
4
127,552
10,778
138,330
5
138,330
11,689
150,019 This should be 150,000. The difference of 19 is due to rounding
3.2.4
lledging
•
Defmitions relating to hedging are given later in this session.
4
PRESENTATION (lAS 32)
4.1
Liabilities and equity
•
On issue, fmancial instruments should be classified as liabilities or equity in accordance with the substance of the contractual arrangement on initial recognition.
•
Some financial instruments may take the legal form of equity, but are in substance liabilities.
•
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1908
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
Illustration 2 - Preference shares
Redeemable preference shares are not classified as equity under lAS 32 as there is a contractual obligation to transfer fmancial assets (e.g. cash) to the holder of the shares. They are therefore a financial liability. If such shares are redeemable at the option of the issuer, they would not meet the defmition of a fmancialliability as there is no present obligation to transfer a financial asset to the holder of the shares. When the issuer becomes obliged to redeem the shares, they become a financial liability and will then be transferred out of equity. For non-redeemable preference shares, the substance of the contract would need to be studied. For example, if distributions to the holders of the instrument are at the discretion of the issuer, the shares are equity instruments.
4.2
Settlement in own equity instruments
•
A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity's own equity instruments.
•
A financial liability will arise when:
•
o
there is a contractual obligation to deliver cash or another financial asset, to exchange financial assets or financial liabilities, under conditions that are potentially unfavourable to the issuer;
o
there is a non-derivative contract to deliver, or be required to deliver, a variable number of own equity instruments;
o
there is a derivative that will or may be settled other than by issuing a fixed number of own equity instruments.
An equity instrument will arise when:
o
there is a non-derivative contract to deliver, or be required to deliver a fixed number of own equity instruments;
o
there is a derivative that will or may be settled by issuing e fixed number of own equity instruments.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1909
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
Illustration 3 - Settlement in the entity's own equity instruments (a)
A company enters into a contract to deliver 1,000 of its own common shares to a third party in settlement of an obligation. As the number of shares are fixed within the contract to meet the obligation, it is an equity instrument. There is no obligation to transfer cash, another financial asset or an equivalent value.
(b)
The same company enters into another contract that requires it to settle a contractual obligation using its own shares in an amount that equals the contractual obligation. In this case the number of shares to be issued will vary depending on, for example, the market price of the shares at the date of the contract or settlement. If the contract was agreed at a different date, a different number of shares may be issued. Whilst cash has not been paid, the equivalent value in shares will be transferred. The contract is a financial liability.
(c)
Company G has an option contract to buy gold that if exercised, would be settled net in the company's shares based on the share price at the date of settlement. As the company will deliver as many shares (i.e, variable) as are equal to the value of the option contract, the contract is a financial asset or a financial liability. This will be so even if the amount to be paid was fixed or based on the value of the gold at the date of exercising the option. In both cases the number of shares issued would be variable.
4.3
()ffset
•
Financial assets and liabilities must be offset where the entity: D
has a legal right of offset; and
D
intends to settle on a net basis or to realise the asset and settle the liability simultaneously.
Offset might be oftrade receivables and payables, or ofaccounts in debit and credit at a bank.
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1910
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
4.4
Interest, dividends, losses and gains
•
Interest, dividends, losses and gains relating to a fmancia1 instrument (or a component) that is classified as a liability, shall be recognised in the profit or loss as income or expense.
•
Dividends on preferred shares classified as a financia11iabi1ity are accounted for as expenses, rather than as distributions of profit.
•
Distributions to holders of equity instruments should be debited directly to equity.
•
Gains or losses on refmancing or redemption of a financial instrument are classified as income/expense or equity according to the classification of the instrument.
•
Transaction costs relating to the issue of a compound financial instrument are allocated to the liability and equity components in proportion to the allocation ofproceeds.
Basically, such items follow the classification ofthe underlying component.
4.5
Compound instruments
4.5.1
Presentation
•
Financial instruments that contain both a liability and an equity element are classified into separate component parts.
•
As an example, convertible bonds are primary fmancialliabilities of the issuer which grant an option to the holder to convert them into equity instruments in the future. Such bonds consist of:
o
the obligation to repay the bonds, which should be presented as a liability; and
o
the option to convert, which should be presented in equity.
•
The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares.
4.5.2
Carrying amounts
•
The equity component is the residual amount after deduction of the more easily measurable debt component from the value of the instrument as a whole.
•
The liability is measured by discounting the stream of future payments at the prevailing market rate for a similar liability without the associated equity component.
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1911
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
Example 1 An entity issues 2,000 convertible, $1,000 bonds at par on 1 January 2004. Interest is payable annually in arrears at a nominal interest rate of 6%. The prevailing market rates of interest at the date of issue of the bond was 9%. The bond is redeemable 31 December 2006.
Required: Calculate the values at which the bond will be included in the fmancial statements of the entity at initial recognition.
Solution
4.6
Contingent settlement provisions
•
An entity may issue a fmancial instrument where the rights and obligations regarding the manner of settlement (in cash or in equity) depend on the outcome of uncertain future events that are beyond the control of both the issuer and the holder of the instrument.
•
Examples include:
•
o
bonds that require the issuer to settle in shares if a market price exceeds a certain mark; and
o
issuing potential shares that will be issued as shares if revenues exceed a certain amount or as bonds if the revenues do not.
As the issuer of the instrument does not have the unconditional right to avoid delivering cash or another financial asset, the instrument shall be classified as a financial liability.
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1912
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
4.7
Treasury shares
•
If an entity acquires its own equity instruments, those instruments ('treasury shares') are deducted from equity.
•
No gain or loss is recognised in profit or loss on the purchase, sale, issue or cancellation of an entity's own equity instruments.
•
Such treasury shares may be acquired and held by the entity or by other members of the consolidated group.
•
Consideration paid or received is recognised directly in equity.
•
The amount of treasury shares held is disclosed separately either on the face of the balance sheet or in the notes, in accordance with lAS 1.
•
If own equity instruments are acquired from related parties lAS 24 disclosure requirements apply.
5
DISCLOSURE (lAS 32)
5.1
Rules
5.1.1
Introduction
•
The purpose of disclosure is to:
•
o
enhance understanding of the significance of fmancial instruments to an entity's fmancial position, performance and cash flows;
o
assist in assessing the factors affecting the amount, timing and certainty of future cash flows associated with those instruments; and
o
provide information to assist users of financial statements in assessing the extent ofrelated risks.
Transactions in financial instruments may result in an entity assuming or transferring to another party one or more of the following financial risks:
o
currency risk (related to changes in foreign exchange rates);
o
fair value interest rate risk (related to changes in interest rates);
o
price risk (related to changes in market prices);
o
credit risk (the risk of "bad debts");
o
liquidity/funding risk (the risk of an inability to meet commitments); and
o
cash flow interest rate risk (the risk that future cash flows will fluctuate because of changes in marker interest rates, for example, those relating to floating rate debt instruments).
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1913
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
5.1.2
Risk management and hedging activities
•
An entity must describe its fmancia1 risk management objectives and policies including its policy for hedging forecasted transactions.
The level ofdetail to be given needs to strike a balance between excessive detail and over aggregation. •
•
For each type of hedge:
o
a description of the hedge;
o
a description of the financial instruments designated as hedging instruments and their fair values at the balance sheet date; and
o
the nature of the risks being hedged.
When a gain or loss on a hedging instrument in a cash flow hedge has been recognised directly in equity (through the statement of changes in equity) disclose:
o
the amount recognised in equity during the current period;
o
the amount removed from equity and reported in profit or loss for the period; and
o
the amount transferred from equity into the acquisition cost of a non-fmancia1 asset or liability.
Sometimes referred to as the "basis adjustment". 5.1.3
Terms, conditions and accounting policies
•
For each class of asset, liability and equity instrument, both recognised and unrecognised, information should be disclosed covering:
o
the extent and nature of fmancial instruments;
o
significant terms and conditions affecting the amount, timing and certainty of future cash flows;
o
the accounting policies and methods adopted, including the criteria for recognition and the basis of measurement applied (usually cost or fair value).
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1914
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
•
When financial instruments held or issued by an entity create a potentially significant exposure to financial risks, the terms and conditions that warrant disclosure include:
o
details of the principal or nominal amounts on which future payments are based;
o
dates of maturity, expiry or execution;
o
early settlement options;
o
options to convert, the amount and timing of future cash receipts and payments, interest or dividend rates;
o
collateral held or pledged;
o
the amount and timing of scheduled future cash receipts or payments of the principal amount of the instrument;
o
stated rate or amount of interest, dividend or other periodic return on principal and the timing of payments;
o
any condition of the instrument or an associated covenant that, if contravened, would significantly alter any of the other terms.
•
Where the balance sheet presentation differs from legal form, this should be explained as should hedging relationships.
5.1.4
Interest rate risk
•
An entity must disclose information about its exposure to interest rate risk. Such information includes:
o
contractual repricing or maturity dates;
o
effective interest rates; and
o
which fmancial assets and liabilities are exposed to fair value or cash flow interest rate risk and those that are not directly exposed to interest rate risk.
5.1.5
C7reditrisk
•
An entity must disclose information about its exposure to credit. Such information includes:
o o
the maximum credit exposure risk; and significant concentrations of credit risk.
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1915
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
5.1.6
Fair value risk
•
An entity must disclose information about the fair value of each class of financial asset and financial liability.
•
It must disclose the methods and significant assumptions applied in estimating fair values of financial assets and financial liabilities that are carried at fair value, separately for each significant class of fmancial assets.
In applying the above, an entity will disclose prepayment rates, rates of estimated credit losses, and interest or discount rates. •
Whether fair values are determined directly by reference to published price quotations in an active market or are estimated using a valuation technique.
•
Whether the financial statements include financial instruments measured at fair values that are determined using a valuation technique based on assumptions that are not supported by market prices or rates.
•
The total amount of the change in fair value that was estimated using a valuation technique.
•
If fair value cannot be reliably measured for financial assets, disclose: D D D D D
that fact; a description of them; carrying amount; an explanation of why fair value cannot be reliably measured; and if possible, the range of estimates within which fair value is highly likely to lie.
5.1.7
Other disclosures
•
Disclose material items of income, expense, and gains and losses resulting from fmancial assets and financial liabilities, whether included in net profit or loss or as a separate component of equity. For this purpose:
•
D
total interest income and total interest expense should be disclosed separately;
D
for available-for-sale financial assets, the amount of any gain or loss recognised directly in equity during the period and the amount that was removed from equity and recognised in profit or loss for the period; and.
Disclose the carrying amount of financial assets pledged as collateral and any material terms and conditions relating to such pledged assets.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1916
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
•
•
Disclose the carrying amounts of financial assets and financial liabilities that:
o
are classified as held for trading; and
o
were, upon initial recognition, designated by the entity as financial assets and financial liabilities at fair value through profit or loss (i.e. those that are not financial instruments classified as held for trading).
For a financial liability designated as at fair value through profit or loss, disclose:
o
the amount of change in its fair value that is not attributable to changes in a benchmark interest rate (e.g. LIBOR); and
o
the difference between its carrying amount and the amount the entity would be contractually required to pay at maturity to the holder of the obligation
•
If the entity has reclassified a financial asset as one required to be reported at amortised cost rather than at fair value, disclose the reason for that reclassification.
•
Disclose the nature and amount of any impairment loss or reversal of an impairment loss recognised for a fmancial asset, separately for each significant class of financial asset.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1917
lAS 32 AND lAS 39 FINANCIAL INSTRUMENTS
5.2
Illustrative notes - Nokia A very good example ofhow the requirements oflAS 32 may be fulfilled. 34. Risk management ~neral
risk management principles
Nokia 's overall risk management concept is based on visibility of the key risks preventing Nokia from reaching its business objectives. This covers all risk areas; strategic, operational financial and hazard risks. Risk management at Nokia is a systematic and pro-active way to analyze, review and manage 011 opportunities, threats and risks related to Nokia's objectives rather than to solely eliminate risks. The principles documented in Nokia's Risk Policy and accepted by the Audit Committee of the Roan! of Directors require risk management and its clements to be integrated into business processes. One of the main principles is that the business or function owner is also the risk owner, however, it is everyone's responsibility at Nokia to idcntify risks preventing us from reaching our objectives. Key risks are reported to the business and Group level management to create assurance on business risks and to enable prioritization of risk management implementation at Nokia. In addition to general principles there arc specific risk management polieics covering, for example, treasury and customer finance risks.
Financial rl.b The key financial targets for Nokia are growth, profitability, operational cffieicney and a strong balance sbeet, The objective for the Treasury function is lwofold: to guarantee cost-effic ient funding for the Group at all times, and to identify, evaluate and hedge financial risks in close co-operation with the business groups. There is a strong focus in Nokia on creating sbarcbolder value. The Treasury functioo supports this aim by minimizing the adverse effects caused by fluctuations in the financial markets on the profitability of the underlying businesses and by managing the balance sheet structure of the Group. Nokia has Treasury Centers in Geneva, Singapore/Beijing and Dallas ISao Paolo, and a Corporate Treasury unit in Espoo. This international organization enables Nokia to provide the Group companies with financial services according to local needs and requirements, The Treasury function is governed by policies approved by top management. Treasury Policy provides principles for overall financial risk management and determines the allocation of responsibilities for financial risk management in Nokia. Operating Policies cover specific areas such as foreign exchange risk, interest rate risk, usc of derivative financial instruments, as well as liquidity and credit risk, Nokia is risk averse in its Treasury activities. Business Groups have detailed Standard Operating Procedures supplementing the Treasury Policy in financial risk management related issues.
Ma rket ris k Foreign exchange ris k Nokia operates globally and is thus exposed to foreign exchange risk arising from various currency combinations. Foreign currency denominated assets and liabilities together with expected cash flows from highly probable purchases and sales give rise to foreign exchange exposures, These tmnsaction exposures arc managed against various local currencies because of Nokia's substantial production and sales outside the Eurozonc.
© Accountancy Tuition Centre (International Holdings) Ltd 2005
1918
lAS 32 AND lAS 39 FINANCfAL fNSTRUMBNTS
IDtereit rate risk
The Groql is exposed to interest ratI: risk cilberthrough maUd value fluctuations of balance sheet itemlJ (i.e. price ri8k) aDd GBP3I)% JPV28%
Olherl7% U8C15% 88
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