Improving the application of and compliance with International Financial Reporting and Auditing Standards in Trinidad and Tobago.

ATN/MT 8114 TT

Guidance notes on International Financial Reporting Standards (IFRS)

Graham Fairclough April 2007

Institute of Chartered Accountants of Trinidad and Tobago

Contents
IASB Framework IFRS 3: Business Combinations IAS 27: Consolidated and Separate Financial Statements IFRS 4: Insurance Contracts Financial Instruments: IAS 32: Presentation IAS 39: Recognition and Measurement IFRS 7: Disclosures IAS 12: Income Taxes IAS 17: Leases IAS 19: Employee Benefits IAS 21: Effects of Foreign Exchange Rates IAS 36 Impairment of Assets IAS 37: Provisions, contingent liabilities and contingent assets IAS 38: Intangible Assets IAS 40 Investment Property

Page
2 57

87 104

131 137 155 175 192 203 220 229

Chapter 1: Introduction Purpose and Status 1. This Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users. The purpose of the Framework is to: assist the Board of IASC in the development of future International Accounting Standards and in its review of existing International Accounting Standards; assist the Board of IASC in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by International Accounting Standards;

Tutors note: IFRS/ IAS has greatly reduced the number of permitted alternative
assist national standard-setting bodies in developing national standards;

Tutors note: EU listed companies from 2005 have had to report under IFRS. The convergence project to harmonise IFRS with US GAAP is progressing well.
assist preparers of financial statements in applying International Accounting Standards and in dealing with topics that have yet to form the subject of an International Accounting Standard; assist auditors in forming an opinion as to whether financial statements conform with International Accounting Standards;

Tutors note: Compliance with IFRS is effectively the definition of financial statements that give a true and fair view.
assist users of Financial statements in interpreting the information contained in financial statements prepared in conformity with International Accounting Standards; and

provide those who are interested in the work of IASC with information about its approach to the formulation of International Accounting Standards.

2.

This Framework is not an International Accounting Standard and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Framework overrides any specific International Accounting Standard. The Board of IASC recognises that in a limited number of cases there may be a conflict between the Framework and an International Accounting Standard. In those cases where there is a conflict, the requirements of the International Accounting Standard prevail over those1ASB Framework of the Framework. As, however, the Board of IASC will be guided by the Framework in the development of future Standards and in its review of existing Standards, the number of cases of conflict between the Framework and International Accounting Standards will diminish through time.

3.

Tutors note: The instances where this happens are becoming rarer as IFRS is developed to be ever more consistent in principles with the
4. The Framework will be revised from time to time on the basis of the Board' experience of working s with it.

Scope 5. The Framework deals with: the objective of financial statements; the qualitative characteristics that determine the usefulness. of information in financial statements; the definition, recognition and measurement of the elements from which financial statements are constructed; and concepts of capital and capital maintenance.

6.

The Framework is concerned with general purpose financial statements (hereafter referred to as "financial statements") including consolidated financial statements. Such financial statements are prepared and presented at least annually and are

directed toward the common information needs of a wide range of users. Some of these users may require, and have the power to obtain, information in addition to that contained in the financial statements. Many users, however, have to rely on the financial statements as their major source of financial information and such financial statements should, therefore, be prepared and presented with their needs in view. Special purpose financial reports, for example, prospectuses and computations prepared for taxation purposes, are outside the scope of this Framework. Nevertheless, the Framework may be applied in the preparation of such special purpose reports where their requirements permit. 7. Financial statements form part of the process of financial reporting. A complete set of financial statements normally includes a balance sheet, an income statement, a statement of changes in financial position (which may be presented in a variety of ways, for example, as a. statement of cash flows or a statement of funds flow), and those notes and other statements and explanatory material that are an integral part of the financial statements. They may also include supplementary schedules and information based on or derived from, and expected to be read with, such statements.. Such schedules and supplementary information may, deal, for example, with financial information about industrial and geographical segments and disclosures. about the effects of changing prices. Financial statements do not, however, include such items as reports by directors, statements by the chairman, discussion and analysis by management and similar items that may be included in a financial or annual report. The Framework applies to the financial statements of all commercial, industrial and business reporting enterprises, whether in the public or the private sectors. A reporting enterprise is an enterprise for which there are users who rely on the financial statements as their major source of financial information about the enterprise.

8.

Tutors note: There is currently no IFRS light approach to IFRS for smaller and medium sized entities, although certain standards such as IAS 33 earnings per share are only mandatory for listed companies. In general though, preparation of financial statements under IFRS requires compliance with all IFRS standards. This is seen 4 as making full compliance with IFRS onerous for all but large or listed companies. A future IFRSSE (IFRS for smaller entities) may be

Users and Their Information Needs 9. The users of financial statements include present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. They use financial statements in order to satisfy some of their different needs for information. These needs include the following: Investors. The providers of risk capital and their advisers are concerned with the risk inherent in, and return provided by, their investments. They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends.

Tutors note: Investors and investment analysts are the focus of IFRS. A major aim of IFRS is to present historical information in such a way that informed readers of the information can make intelligent estimates about future performance of the company.
Employees. Employees and their representative groups are interested in information about the stability and profitability of their employers. They are also interested in information which enables them to assess the ability of the enterprise to provide remuneration, retirement benefits and employment opportunities. Lenders. Lenders are interested in information that enables them to determine whether their loans, and the interest attaching to them, will be paid when due.

Suppliers and other trade creditors. Suppliers and other creditors are interested in information that ' enables them to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be interested in an enterprise over a shorter period than lenders unless they are dependent upon the continuation of the enterprise as a major customer. Customers. Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. Governments and their agencies. Governments and their agencies are interested in the allocation of resources and, therefore, the activities of enterprises. They also require information in order to regulate the activities of enterprises, determine taxation policies and as the basis for national income and similar statistics. Public. Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways including the number of people they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities.

10.

While all of the information needs of these users cannot be met by financial statements, there are needs which are common to all users. As investors are providers of risk capital to the enterprise, the provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy.

Tutors note: In practice, companies may publish multiple financial statements for different important user groups, perhaps including: Financial statements under IFRS 6 Financial statements under local GAAP; Tax returns using tax accounting rules A published reconciliation between the

11.

The management of an enterprise has the primary responsibility for the preparation and presentation of the financial statements of the enterprise. Management is also interested in the information contained in the financial statements even though it has access to additional management and financial information that helps it carry out its planning, decision making and control responsibilities. Management has the ability to determine the form and content of such additional information in order to meet its own needs. The reporting of such information, however, is beyond the scope of this Framework. Nevertheless, published financial statements are based on the information used by management about the financial position, performance and changes in financial position of the enterprise.

Case Illustration:

EXTRACT FROM THE ANNUAL REPORT OF CSA FOR YEAR ENDED 31.12.02 RECONCILIATION OF RESULTS AND EQUITY TO STATUTORY ACCOUNTS The following adjustments have been made to the statutory profit in arriving at the result for the year under International Financial Reporting Standards.

Note

2002 USD 000

2001 USD 000

Statutory loss for the year under Czech GAAP (translated at average rate) Translation adjustments depreciation Translated statutory loss for the year IAS adjustments: Lease adjustments: Depreciation Finance costs Lease expense Aircraft/engine overhaul adjustments Deferred taxation Other Profit per International Financial Reporting Standards (b) (b) (b) (c) (d) (a)

(1,974) (2,205)

(11,932) (3,885)

(43,790) (7,202) 70,919 12,546 (11,721) (1,928) 14,645

(41,698) (16,995) 69,555 8,937 2,275 1,577 7,834

The following are the accumulated adjustments made to the statutory equity in arriving at the equity for the year under International Financial Reporting Standards.

Note

2002 USD 000

2001 USD 000

Closing equity per statutory accounts (translated at closing rate) Lease adjustments: Depreciation of leased aircraft Finance lease costs Elimination of lease charges Overhaul cost adjustments (note 13) Capitalised overhaul costs Depreciation of capitalized overhaul costs Elimination of provisions for overhaul costs Deferred taxation (note 26) Gain on available-for-sale financial assets (note 35) Loss on cash flow hedges (interest rate swap) (note 35) Other Total adjustment Closing equity per International Financial Reporting Standards (c) (c) (c) (d)

60,383

67,496

(b) (322,880) (b) (110,346) (b) 512,728

(282,850) (103,144) 441,809

18,712 (9,820) 52,588 (30,822) (9,395) 3,736 (13,273) 91,228 151,611

15,413 (6,060) 41,077 (22,449) 9,395 (3,736) (12,326) 77,129 144,625

(a) Depreciation adjustments The main adjustments required in preparing IFRS financial statements denominated in US dollars is to restate depreciation on assets acquired in the past in Czech Crowns to reflect depreciation at historic rates. In the current year, the Company has implemented an asset register in Oracle to record US dollar values for all property, plant and equipment, based on the exchange rates at the historic date of acquisition. (b) Finance leases Under Czech accounting standards, finance leases are generally accounted for as operating leases. The total cost of the rental obligations is charged to the income statement so as to produce a constant periodic rate of charge (note-prepayments and accruals are raised to account for deposit payments and changes in instalment amounts over the period of the lease). The asset is captialised in the accounts of the lessor. The lessee does not account for the fixed asset until full legal title is acquired. Under IFRS, assets held under leasing arrangements that substantially transfer risks and rewards of ownership, are capitalized and depreciated over their expected useful lives. The present value of the related obligation is included in the long and short-term liabilities as appropriate. The interest element of the rental obligation is charged to the income statement. (c) Aircraft overhaul costs The Czech statutory financial statements include provisions in respect future overhauls for airframe and aero-engines. These costs are accrued each year in order to spread the costs over the maintenance cycle period on a systematic basis. The Company has applied IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) that requires that such provisions be eliminated on the grounds that the Company has no legal or constructive obligation in respect of these liabilities. Overhaul costs have been capitalized and are being amortised over the maintenance cycle period on a systematic basis. (d) Deferred taxation The Czech statutory financial statements include deferred tax balances in respect of certain taxable temporary timing differences. Under IFRS, deferred tax liabilities are provided on all taxable temporary timing differences, and deferred tax assets are recognized 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 utilized.

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Case illustration Extract from the 2005 financial statements of BP Amoco The extract below demonstrates how companies may present whatevere financial information they believe that their users will find useful, so long as this supplementary information is not given a higher profile in the financial statements than the IFRS accounts. It is normal practice where additional information is provided to reconcile it to the IFRS figures. It is currently a requirement of any company listed in the USA that reports under IFRS that although IFRS figures can be presented as the primary basis of corporate reporting, these figures must be reconciled fully to US GAAP figures. The SECs requirement for this reconciliation looks likely to be withdrawn in the next few years.

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Chapter 2: The Objective of Financial Statements 12. The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide, range of users in making economic decisions. Financial statements prepared for this purpose meet the common needs of most users. However, financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non-financial information. Financial statements also show the results of the stewardship of management, or the accountability of management for the resources entrusted to it. Those users who wish to assess the stewardship or accountability of management do so in order that they may make economic decisions; these decisions may include, for example, whether to hold or sell their investment in the enterprise or whether to reappoint or replace the management.

13.

14.

Financial Position, Performance and Changes in Financial Position 15. The economic decisions that are taken by users of financial statements require an evaluation of the ability of an enterprise to generate cash and cash equivalents and of the timing and certainty of their generation. This ability ultimately determines, for example, the capacity of an enterprise to pay its employees and suppliers, meet interest payments, repay loans and make distributions to its owners. Users are better able to evaluate this ability to generate cash and cash equivalents if they are provided with information that focuses on the financial position, performance and changes in financial position of an enterprise. The financial position of an enterprise is affected by the economic resources it controls, its financial structure, its liquidity and solvency, and its capacity to adapt to changes in the environment in which it operates. Information about the economic resources controlled by the enterprise and its capacity in the past to modify these resources is useful in predicting the ability of the enterprise to generate cash and cash equivalents in the future. Information about financial structure is useful in predicting future borrowing needs and how future

16.

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profits and cash flows will be distributed among those with an interest in the enterprise; it is also useful in predicting how successful the enterprise is likely to be in raising further finance. Information about liquidity and solvency is useful in predicting the ability of the enterprise to meet its financial commitments as they fall due. Liquidity refers to the availability of cash in the near future after taking account of financial commitments over this period. Solvency refers to the availability of cash over the longer term to meet financial commitments as they fall due 17. Information about the performance of an enterprise, in particular its profitability, is required in order to assess potential changes in the economic resources that it is likely to control in the future. Information about variability of performance is important in this respect. Information about performance is useful in predicting the capacity of the enterprise to generate cash flows from its existing resource base. It is also useful in forming judgements about the effectiveness with which the enterprise might employ additional resources. Information concerning changes in the financial position of an enterprise is useful in order to assess its investing, financing and operating activities during the reporting period. This information is useful in providing the user with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise those cash flows. In constructing a statement of changes in financial position, funds can be defined in various ways, such as all financial resources, working capital, liquid assets or cash. No attempt is made in this Framework to specify a definition of funds. Information about financial position is primarily provided in a balance sheet. Information about performance is primarily provided in an income statement. Information about changes in financial position is provided in the financial statements by means of a separate statement. The component parts of the financial statements interrelate because they reflect different aspects of the same transactions or other events. Although each statement provides information that is different from the others, none is likely to serve only a single purpose or provide all the information necessary for particular needs of users. For example, an income statement provides an incomplete picture of performance unless it is used

18.

19.

20.

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in conjunction with the balance sheet and the statement of changes in financial position. Notes and Supplementary Schedules 21. The financial statements also contain notes and supplementary schedules and other information. For example, they may contain additional information that is relevant to the needs of users about the items in the balance sheet and income statement. They may include disclosures about the risks and uncertainties affecting the enterprise and any resources and obligations not recognised in the balance sheet (such as mineral reserves). Information about geographical and industry segments and the effect on the enterprise of changing prices may also be provided in the form of supplementary information.

Case Illustration The financial statements of British Airways also include the following supplementary information which is not governed by IFRS but is recognised by IFRS as being useful to investors:

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Chapter 3: Underlying Assumptions Tutors note: These principles are so fundamental under IFRS that companies are not required to state that they have followed them - it is simply assumed. Accrual Basis 22. In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions. Tutors note: The accruals concept is also known as the matching concept also. It involves two things: Matching amounts received or paid to the period they are due (eg. An insurance premium is treated as an expense in the period when it is used up, not when its paid) and Matching costs as far as reasonably possible to the revenues they generate/are expected to generate.

In many cases, applying the generally accepted principles of prudence and matching may yield different results. In these circumstances, the matching

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Going Concern 23. The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed. Tutors note: The financial statements will look very different if the accounts are produced on a break-up basis. CASE ILLUSTRATION 1: Accruals A company purchases an asset at the start of 2001. For tax purposes, it is to be written off immediately as an expense, as this is the tax rule. The management of the company believes that it will bring benefits to the company for a period of approximately 5 years, when it will be sold for scrap at approximately 24% of its purchase price. The company observes that the machine requires much more maintenance in the later years than the earlier years. Required: Suggest an accounting treatment in order to best match costs and revenues.

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CASE ILLUSTRATION 2: Accruals A business holds inventory, which it sells at an average price of $200 per unit. The inventory count at the start of the year showed 130 units of inventory with an average cost to the company of $150 each. During the year, 4,200 units were purchased at a price of $170 each and 4,010 units were sold at the expected price. The year-end stock count showed 230 units were held by the company. Required: Estimate profit for the year. Suggested solution Sales revenue ($200 x 4,010) Less: Cost of sales Opening inventory (130 x $150) Purchases (4,200 x $170) Less: Closing inventory (230 x $170) Total cost of sales Gross profit 19,500 714,000 -39,100 694,400 107,600 802,000

This familiar method of calculating cost of sales is an application of the matching principle. The cost of inventory purchased but not sold (ie not matched to revenue) is deferred as an asset in the balance sheet in order to match it to the future revenues.

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Chapter 4: Qualitative Characteristics of Financial Statements 24. Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability.

Understandability 25. An essential quality of the information provided in financial statements is that it is readily understandable by users. For this purpose, users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. However, information about complex matters that should be included in the financial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the grounds that it may be too difficult for certain users to understand.

Relevance 26. To be useful, information must be relevant to the decision-making needs of users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future- events or confirming, or correcting, their past evaluations. The predictive and confirmatory roles of information are interrelated. For example, information about the current level and structure of asset holdings has value to users when they endeavour to predict the ability of the enterprise to take advantage of opportunities and its ability to react to adverse situations. The same information plays a confirmatory role in respect of past predictions about, for example, the way in which the enterprise would be structured or the outcome of planned operations.

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28.

Information about financial position and past performance is frequently used as the basis for predicting future financial position and performance and other matters in which users are directly interested, such as dividend and wage payments,, security price movements and the ability of the enterprise to meet its commitments as they fall due. To have predictive value, information need not be in the form. of an explicit forecast. The ability to make predictions from financial statements is enhanced, however, by the manner in which information on past transactions and events is displayed. For example, the predictive value of the income statement is enhanced if unusual, abnormal and infrequent items of income or expense are separately disclosed.

Tutors note: A number of IFRS/ IAS standards have their focus on presenting historical information in a way that maximizes its predictive value. This is discussed further below.
Materiality 29. The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is sufficient to determine its relevance. For example, the reporting of a new segment may affect the assessment of the risks and opportunities facing the enterprise irrespective of the materiality of the results achieved by the new segment in the reporting period. In other cases, both the nature and materiality are important, for example, the amounts of inventories held in each of the main categories that are appropriate to the business. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

30.

Tutors note: Materiality is of key importance to an auditor as an immaterial error or omission does not affect the truth and fairness20 the financial of statements. IFRS is intended to be applied to all transactions, even if they are immaterial but any such non-compliance would not necessarily result

Reliability 31. To be useful, information must also be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under a legal action are disputed, it may be inappropriate for the enterprise to recognise the full amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim.

32.

Tutors note: Paragraph 32 is a description of the rare situation of a contingent liability. A contingent liability exists where a business has an obligation to pay some money, but has not way of making a meaningful/reliable estimate of how much will be payable. In virtually all cases, an estimate can be made, although nobody expects it to be entirely accurate. Even a highly imperfect estimate is seen to be better than no estimate.

Tutors note: Predictive value Investors make decisions to buy (or hold) a shared based on that shares expected future performance, ie profits of the entity. Past performance is not directly relevant.

21 There is an inevitable conflict between the need for reliable information and relevant information in what investors are looking for in financial information.

Tutors note

A number of IAS and IFRS standards deal with the disclosures required to make historical information as relevant as possible to the reader (ie maximise its predictive value), including:

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Standard IAS 8

Shows Extraordinary items Fundamental errors Effect of changing accounting policies Each of these items is expected to have a one-off effect or profit affecting only this year.

IAS 10 IAS 14 IAS 24

Gives information on significant events after the balance sheet date that may affect the users opinion. Shows where a company is deriving its revenues and profits, so investors can assess sensitivity to market changes. Related party disclosures Shows where the figures should be taken with a dose of skepticism, since they may not be at true market value.

IFRS 5

Where a company has closed down a major business segment in the year, so the profits or losses from that segment will not arise in the future.

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Case Study: Usefulness of segment information under IAS 14 BRITISH AIRWAYS OR CSA? Extracts from recent segment analyses of British Airways and CSA in their published financial statement prepared under IFRS: BRITISH AIRWAYS: YEAR ENDED 31 MARCH 2006 Geographical analysis of turnover Turnover GBP million Europe United Kingdom Continental Europe The Americas Africa, Middle East & Indian sub-continent Far East and Australasia Total By area of original sale 2006 2005 5,406 4,169 1,237 1,611 826 672 8,515 5,079 3,906 1,173 1,364 747 582 7,772

CSA CZECH AIRLINES: YEAR ENDED 31 DECEMBER 2005 Geographical segments Segment revenue by geographical area (based on location of customer) is as follows: USD 000 Czech Republic Western Europe Eastern Europe Middle East USA and Canada Total Revenues Required: Discuss how an investor or investment analyst might make use of the above segment information when deciding in which airline to invest in 2007. What information does this reveal about risks and each companys strategy? Would any further breakdown be useful to analysts? 2005 300,171 341,713 122,209 46,962 84,652 895,707 2004 236,486 303,829 94,648 41,735 68,564 745,262

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Tutors note: Below is an extract of some of the segment information given by BP Amoco in its 2005 annual report and accounts. The depth of information provided to readers of IFRS accounts to enable users to make informed predictions about the companys past and likely future performance can be enormous.

Faithful Representation 33. To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria. Most financial information is subject to some risk of being less than a faithful representation of that which it purports to portray. This is not due to bias,

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but rather to inherent difficulties either in identifying the transactions and other events to be measured or in devising and applying measurement and presentation techniques that can convey messages that correspond with those transactions and events. In certain cases, the measurement of the financial effects of items could be so uncertain that enterprises generally would not recognise them in the financial statements; for example, although most enterprises generate goodwill internally over time, it is usually difficult to identify or measure that goodwill reliably. In other cases, however, it may be relevant to recognise items and to disclose the risk of error surrounding their recognition and measurement. Substance over form 35. If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, an enterprise may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the enterprise continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction).

Tutors note: The principle of reporting substance over form is crucial to understanding IAS accounting techniques. Oddly for something of such fundamental important and pervasive influence there is no IAS or IFRS specifically that deals with the issue of reporting commercial substance over form. The Framework document is the only place where this principle is elaborated specifically.

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Consignment inventories This is an arrangement where inventories are held by one party (eg. a distributor) but are owned by another party (for example a manufacturer or a finance company). Consignment inventories are common in the motor trade and is similar to goods sold on a sale or return basis. To identify the correct treatment, it is necessary to identify the point at which the distributor acquired the benefits of the asset (the inventory item) rather than the point at which legal title was acquired. If the manufacturer has the right to require the return of the inventories, and if that right is likely to be exercised, then the inventories are not assets of the dealer. If the dealer is rarely required to return the inventories, then this part of the transaction will have little commercial effect in practice and should be ignored for accounting purposes. The potential liability would need to be disclosed in the accounts.

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Case Illustration Rover Co owns a number of car dealerships throughout Paris. The terms of the arrangement between dealership and manufacturer are as follows. Legal title passes when the cars are either used by Rover Co for demonstration purposes or sold to a third party. The price of vehicles is fixed at the date of transfer. Rover Co has no right to return vehicles Rover Co pays a finance charge between delivery and the date that legal title passes.

Required (i) (ii) (iii) What are the risks inherent in holding inventories? What features of the arrangement indicate risk? On the basis of the above how should Rover Co account for the transaction?

Sale and repurchase transactions These are arrangements under which the company sells an asset to another person on terms that allow the company to repurchase the assets in certain circumstances. The key question is whether the transaction is a straightforward sale, or whether it is, in effect, a secured loan. It is necessary to look at the arrangement to determine who has the rights to the economic benefits that the asset generates, and the terms on which the asset is to be repurchased. If the seller has the right to the benefits of the use of the asset, and the repurchase terms are such that the repurchase is likely to take place, the transaction should be accounted for as a loan.

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Case Illustration X Co are brandy distillers. They normally hold inventories for 6 years before selling it. A large quantity of 2 year old inventories have been sold to a bank at cost. The normal selling price is cost + 100% profit. X Co has an option to buy back the brandy in 4 years time at a price which represents the original sale price plus interest at current market rates. Required Outline the principle features of the transaction and how it should be dealt with in the books of X Co in order to provide the most relevant and reliable information to the shareholders of X Co.

Factoring of debts Where debts are factored, the original creditor sells the debts to the factor. The sales price may be fixed at the outset or may be adjusted later. It is also common for the factor to offer a credit facility that allows the seller to draw upon a proportion of the amounts owed. In order to determine the correct accounting treatment it is necessary to consider whether the benefit of the debts has been passed on to the factor, or whether the factor is, in effect, providing a loan on the security of the debtors. If the seller has to pay interest on the difference between the amounts advanced to him and the amounts that the factor has received, and if the seller bears the risk of non-payment by the debtor, then the indications would be that the transaction is, in effect, a loan.

Case Illustration Apple Co sells all of its trade receivables to Factor Co, the terms of the arrangement being as follows: Factor Co administers the sale ledger of Apple Co charging 1% of factored debts.

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Neutrality 36. To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgement in order to achieve a predetermined result or outcome.

Prudence 37. The preparers of financial statements do, however, have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collectability of doubtful receivables, the probable useful life of plant and equipment and the number of warranty claims that may occur. Such uncertainties are recognised by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability.

Completeness 38. To be reliable, the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in tem-is of its relevance.

Comparability 39. Users must be able to compare the financial statements of an enterprise through time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position,

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performance and changes in financial position. Hence, the measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an enterprise and over time for that enterprise and in a consistent way for different enterprises.

40.

An important implication of the qualitative characteristic of comparability is that users be informed of the accounting policies employed in the preparation of the financial statements, any changes in those policies and the effects of such changes. Users need to be able to identify differences between the accounting policies for like transactions and other events used by the same enterprise from. period to period and by different enterprises. Compliance with International Accounting Standards, including the disclosure of the accounting policies used by the enterprise, helps to achieve comparability. The need for comparability should not be confused with mere uniformity and should not be allowed to become an impediment to the introduction of improved accounting standards. It is not appropriate for an enterprise to continue accounting in the same manner for a transaction or other event if the policy, adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and reliable alternatives exist.

41.

Tutors note: Under IFRS, companies are allowed a degree over their choice of accounting policies. For example, each company chooses an appropriate rate to change depreciation in order to most fairly apply the matching principle. The need to charge depreciation itself is not a matter of choice however.
42. Because users wish to compare the financial position, performance and changes in financial position of an enterprise over time, it is important that the financial statements show corresponding information for the preceding periods.

32

Tutors note: Companies need to state their accounting policies in plain language as well as comparative figures produced under the same accounting policies. If the accounting policies are changed in the year the comparative figures need to be restated using the new accounting policies in order to ensure that they are comparable.

Constraints on Relevant and Reliable Information Timeliness 43. If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information. To provide information on a timely basis it may often be necessary to report before all aspects of a transaction or other event are known, thus impairing reliability. Conversely, if reporting is delayed until all aspects are known, the information may be highly reliable but of little use to users who have had to make decisions in the interim. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the economic decision-making needs of users.

Balance between Benefit and Cost 44. The balance between benefit and cost is a pervasive constraint rather than a qualitative characteristic. The benefits derived from information should exceed the cost of providing it. The evaluation of benefits and costs is, however, substantially a judgmental process. Furthermore, the costs do not necessarily fall on those users who enjoy the benefits. Benefits may also be enjoyed by users other than those for whom the information is prepared; for example, the provision of further information to lenders may reduce the borrowing costs of an enterprise. For these reasons, it is difficult to apply a cost-benefit test in any particular case. Nevertheless, standard setters in particular, as well as the preparers and users of financial statements, should be aware of this constraint.

33

Balance between Qualitative Characteristics 45. In practice a balancing, or trade-off, between qualitative characteristics is often necessary. Generally the aim is to achieve an appropriate balance among the characteristics in order to meet the objective of financial statements. The relative importance of the characteristics in different cases is a matter of professional judgment.

True and Fair View/Fair Presentation 46. Financial statements are frequently described as showing a true and fair view of, or as presenting fairly, the financial position, performance and changes in financial position of an enterprise. Although this Framework does not deal directly with such concepts, the application of the principal qualitative characteristics and of appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view of, or as presenting fairly such information. Tutorss note: In most legislatures, compliance with IFRS will automatically be considered to be a true and fair presentation.

34

Chapter 5: The Elements of Financial Statements 47. Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements. The elements directly related to the measurement of financial position in the balance sheet are assets, liabilities and equity. The elements directly related to the measurement of performance in the income statement are income and expenses. The statement of changes in financial position usually reflects income statement elements and changes in balance sheet elements; accordingly, this Framework identifies no elements that are unique to this statement. The presentation of these elements in the balance sheet and the income statement involves a process of sub-classification. For example, assets and liabilities may be classified by their nature or function in the business of the enterprise in order to display information in the manner most useful to users for purposes of making economic decisions.

48.

Financial Position 49. The elements directly related to the measurement of financial position are assets, liabilities and equity. These are defined as follows: An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

Tutors note: An obligation is an unavoidable obligation to act in a certain way whether that obligation is legally enforceable or just commercially unavoidable.
Equity is the residual interest in the assets of the enterprise after deducting all its liabilities.

35

50.

The definitions of an asset and a liability identify their essential features but do not attempt to specify the criteria that need to be met before they are recognised in the balance sheet. Thus, the definitions embrace items that are not recognised as assets or liabilities in the balance sheet because they do not satisfy the criteria for recognition discussed in paragraphs 82 to 98. In particular, the expectation that future economic benefits will flow to or from an enterprise must be sufficiently certain to meet the probability criterion in paragraph 83 before an asset or liability is recognised. In assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form. Thus, for example, in the case of finance leases the substance and economic reality are that the lessee acquires the economic, benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. Hence, the finance lease gives rise to items that satisfy the definition of an asset and a liability and are recognised as such in the lessee' balance sheet. s Tutors note: Lease accounting is under review by the IASB in order to make it more consistent with the Framework principles concerning recognition and presentation of liabilities.

51.

52.

Balance sheets drawn up in accordance with current International Accounting Standards may include items that do not satisfy the definitions of an asset or liability and are not shown as part of equity. The definitions set out in paragraph 49 will, however, underlie future reviews of existing International Accounting Standards and the formulation of further Standards.

Assets 53. The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the enterprise. The potential may be a productive one that is part of the operating activities of the enterprise. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when

36

an alternative manufacturing process lowers the costs of production. 54. An enterprise usually employs its assets to produce goods or services capable of satisfying the wants or needs of customers; because these goods or services can satisfy these wants or needs, customers are prepared to pay for them and hence contribute to the cash flow of the enterprise. Cash itself renders a service to the enterprise because of its command over other resources. The future economic benefits embodied in an asset may flow to the enterprise in a number of ways. For example, an asset may be: used singly or in combination with other assets in the production of goods or services to be sold by the enterprise; exchanged for other assets; used to settle a liability; or distributed to the owners of the enterprise.

55.

56.

Many assets, for example, property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset; hence patents-and copyrights, for example, are assets if future economic benefits are expected to flow from them to the enterprise and if they are controlled by the enterprise. Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership. In determining the existence of an asset, the right of ownership is not essential; thus, for example, property held on a lease is an asset if the enterprise controls the benefits which are expected to flow from the property. Although the capacity of an enterprise to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an enterprise controls the benefits that are expected to flow from it. The assets of an enterprise result from past transactions or other past events. Enterprises

57.

58.

37

normally obtain assets by purchasing or producing them, but other transactions or events may generate assets; examples include property received by an enterprise from government as part of a programme to encourage economic growth in an area and the discovery of mineral deposits. Transactions or events expected to occur in the future do not in themselves give rise to assets; hence, for example, an intention to purchase inventory does not, of itself, meet the definition of an asset. 59. There is a close association between incurring expenditure and generating assets but the two do not necessarily coincide. Hence, when an enterprise incurs expenditure, this may provide evidence that future economic benefits were sought but is not conclusive proof that an item satisfying the definition of an asset has been obtained. Similarly the absence of a related expenditure does not preclude an item from satisfying the definition of an asset and thus becoming a candidate for recognition in the balance sheet; for example, items that have been donated to the enterprise may satisfy the definition of an asset.

CASE STUDY Discuss which of the following meet the definition of asset above: A new aircraft leased for 20 years by an airline; 1,000 copies of wall calendars from the previous year A right to produce drugs under a patent.

Liabilities 60. An essential characteristic of a liability is that the enterprise has a present obligation. An obligation is a duty or responsibility to act or perform in, a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. If, for example, an enterprise decides as a matter of policy to rectify faults in its products even when

38

these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities. 61. A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an enterprise to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the enterprise enters into an irrevocable agreement to acquire the asset. In the latter case, the irrevocable nature of the agreement means that the economic consequences of failing to honour the obligation, for example, because of the existence of a substantial penalty, leave the enterprise with little, if any, discretion to avoid the outflow of resources to another party.

Tutors note: Historically, prudence has been used to make unnecessary provisions in years with good profits in order to smooth profits as provisions would then be released to reduce expenses in years with poorer profits. This is now made impossible by the definition of a provision as a liability and the incorporation of the above
62. The settlement of a present obligation usually involves the enterprise giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for example, by: payment of cash; transfer of other assets; provision of services; replacement of that obligation with another obligation; or conversion of the obligation to equity An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights.

63.

Liabilities result from past transactions or other past events. Thus, for example, the acquisition of goods and the use of services give rise to trade payables (unless paid for in advance or on

39

delivery) and the receipt of a bank loan results in an obligation to repay the loan. An enterprise may also recognise future rebates based on annual purchases by customers as liabilities; in this case, the sale of the goods in the past is the transaction that gives rise to the liability. 64. Some liabilities can be measured only by using a substantial degree of estimation. Some enterprises describe these liabilities as provisions. In some countries, such provisions are not regarded as liabilities because the concept of a liability is defined narrowly so as to include only amounts that can be established without the need to make estimates. The definition of a liability in paragraph 49 follows a broader approach. Thus, when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has to be estimated. Examples include provisions for payments to be made under existing warranties and provisions to cover pension obligations. CASE STUDY Decide, with reasons, which of the following represent a liability and how that liability should be valued. A firm intention equipment to purchase some agricultural

An airlines aircraft fleet being due for an expensive major service in one year A claim on an insurance policy incurred but not reported; The balance on an airlines frequent flyer program where customers are promised free flights above a certain balance; A lease signed by a company to lease some machinery for five years, with onerous penalties for early

Equity 65.

Although equity is defined in paragraph 49 as a residual, it may be sub-classified in the balance sheet. For example, in a corporate enterprise, funds contributed by shareholders, retained earnings, reserves representing appropriations of retained earnings and reserves representing capital maintenance adjustments may be shown separately. Such classifications can be relevant to the decision-making needs of the users of financial statements when they indicate legal or other restrictions on the ability of the enterprise to

40

distribute or otherwise apply its equity. They may also reflect the fact that parties with ownership interests in an enterprise have differing rights in relation to the receipt of dividends or the repayment of capital. 66. The creation of reserves is sometimes required by statute or other law in order to give the enterprise and its creditors an added measure of protection from the effects of losses. Other reserves may be established if national tax law grants exemptions from, or reductions in, taxation liabilities when transfers to such reserves are made. The existence and size of these legal, statutory and tax reserves is information that can be relevant to the decision-making needs of users. Transfers to such reserves are appropriations of retained earnings rather than expenses. The amount at which equity is shown in the balance sheet is dependent on the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with the aggregate market value of the shares of the enterprise or the sum that could be raised by disposing of either the net assets on a piecemeal basis or the enterprise as a whole on a going concern basis. Commercial, industrial and business activities are often undertaken by means of enterprises such as sole proprietorships, partnerships and trusts and various types of government business undertakings. The legal and regulatory framework for such enterprises is often different from that applying to corporate enterprises. For example, there may be few, if any restrictions on the distribution to owners or other beneficiaries of amounts included in equity. Nevertheless, the definition of equity and the other aspects of this Framework that deal with equity are appropriate for such enterprises.

67.

68.

Performance 69. Profit is frequently used as a measure of performance or as the basis for other measures, such as return on investment or earnings per share. The elements directly related to the measurement of profit are income and expenses. The recognition and measurement of income and expenses, and hence profit, depends in part on the concepts of capital and capital maintenance used by the enterprise in preparing its financial

41

statements. These concepts are discussed in paragraphs 102 to 110. 70. The elements of income and expenses are defined as follows: Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Tutors note: These definitions of expenses and income illustrate the balance sheet focus of IFRS. If something increases the assets held by an investor, it is a gain/ income; if something decreases assets held by an investor, it is a loss/ expense.
Transactions with shareholders arent income or expense! Tutors note: Transactions with equity holders are not income or expenditure, since they do not increase or decrease the assets ultimately controlled by the reader of the accounts. For example, if a company issues share capital of $100,000 for cash, it increases the assets of the business but it decreases the assets personally held by shareholders by the same amount. From the perpective of the reader of the accounts there is therefore no increase or decrease. As the IFRS accounts (and audit opinions) are addressed to the shareholders such items are not reported as gains. Similarly, dividends paid are not an expense in the income statement but are instead reported in the statement of changes in equity. 71. The definitions of income and expenses identify their essential features but do not attempt to specify the criteria that would need to be met before they are recognised in the income statement. Criteria for the recognition of income

42

and expenses are discussed in paragraphs 82 to 98. 72. Income and expenses may be presented in the income statement in different ways so as to provide information that is relevant for economic decision-making. For example, it is common practice to distinguish between those items of income and expenses that arise in the course of the ordinary activities of the enterprise and those that do not. This distinction is made on the basis that the source of an item is relevant in evaluating the ability of the enterprise to generate cash and cash equivalents in the future; for example, incidental activities such as the disposal of a longterm investment are unlikely to recur on a regular basis. When distinguishing between items in this way consideration needs to be given to the nature of the enterprise and its operations. Items that arise from the ordinary activities of one enterprise may be unusual in respect of another. Distinguishing between items of income and expense and combining them in different ways also permits several measures of enterprise performance to be displayed. These have differing degrees of inclusiveness. For example, the income statement could display gross margin, profit from ordinary activities before taxation, profit from ordinary activities after taxation, and net profit.

73.

Income 74. The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an enterprise and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an enterprise. Gains represent increases in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as constituting a separate element in this Framework. Gains include, for example, those arising on the disposal of non-current assets. The definition of income also includes unrealised gains; for example, those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long term assets. When gains are recognised in the income statement, they are usually displayed separately

75.

76.

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because knowledge of them is useful for the purpose of making economic decisions. Gains are often reported net of related expenses. 77. Various kinds of assets may be received or enhanced by income; examples include cash, receivables and goods and services received in exchange for goods and services supplied. Income may also result from the settlement of liabilities. For example, an enterprise may provide goods and services to a lender in settlement of an obligation to repay an outstanding loan.

Tutors note: Summary of gains, income and revenue.

Expenses 78. The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the enterprise. Expenses that arise in the course of the ordinary activities of the enterprise include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the enterprise. Losses represent decreases in economic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Framework. Losses include, for example, those resulting from disasters such as fire and flood, as well as those arising on the disposal of non-current assets. The definition of expenses also includes unrealised losses, for example, those arising from the effects of increases in the rate of exchange for a foreign

79.

80.

44

currency in respect of the borrowings of an enterprise in that currency. When losses are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Losses are often reported net of related income.

Tutors note: Total expenses

Case Study Consider which of the following are likely to be classified as expenses under IAS rules: Fines levied on a company for environmental damage caused by waste from a factory The suffering caused to local communities from this pollution.

Capital Maintenance Adjustments 81. The revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity. While these increases or decreases meet the definition of income and expenses, they are not included in the income statement under certain concepts of capital maintenance. Instead these items are included in equity as capital maintenance adjustments or revaluation reserves. These concepts of capital maintenance are discussed in paragraphs 102 to 110 of this Framework.

45

Tutors note: Capital maintenance adjustments are unlikely to be relevant to any company operating in a country where inflation is less than 100% in any three year period. This is the requirement of IAS 29. Adjusting accounts to remove the distorting effects of inflation has been a highly controversial area in accounting for years.

Chapter 6: Recognition of the Elements of Financial Statements

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82.

Recognition is 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 set out in paragraph 83. It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or income statement totals. Items that satisfy the recognition criteria should be recognised in the balance sheet or income statement. The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material. An item that meets the definition of an element should be recognised if: it is probable that any future economic benefit associated with the item will flow to or from the enterprise; and the item has a cost or value that can be measured with reliability.

83.

84.

In assessing whether an item meets these criteria and therefore qualifies for recognition in the financial statements, regard needs to be given to the materiality considerations discussed in paragraphs 29 and 30. The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element, for example, an asset, automatically requires the recognition of another element, for example, income or a liability.

The Probability of Future Economic Benefit 85. The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the enterprise. The concept is in keeping with the uncertainty that characterises the environment in which an enterprise operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, when it is probable that a receivable owed by an enterprise will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognise the receivable as an asset. For a large population of receivables, however, some degree of nonpayment is normally considered probable; hence

47

an expense representing the expected reduction in economic benefits is recognised.

Case Study A company purchased a machine on 1 January 2001, with an expected life of 10 years and no scrap value. The machine cost $140,000. At 31 March 2003, the company observes that the performance of the asset has been poorer than expected and it is estimated that the machine will produce only the following revenues: 2003 21,000 2004 20,000 2005 15,000 2006 10,000 2007 zero

Assuming that the company has a cost of capital of 10%, what is the amount of the machines remaining value that still meets the definition of an asset at 31 December 2003? Reliability of Measurement 86. The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability as discussed in paragraphs 31 to 38 of this Framework. In many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When, however, a reasonable estimate cannot be made the item is not recognised in the balance sheet or income statement. For example, the expected proceeds from a lawsuit may meet the definitions of both an asset and income as well as the probability criterion for recognition; however, if it is not possible for the claim to be measured reliably, it should not be recognised as an asset or as income; the existence of the claim, however, would be disclosed in the notes, explanatory material or supplementary schedules. An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 83 may qualify for recognition at a later date as a result of subsequent circumstances or events. An item that possesses the essential characteristics of an element but fails to meet the criteria for recognition may nonetheless warrant disclosure in the notes, explanatory material or in supplementary schedules. This is appropriate when knowledge of the item is considered to be

87.

88.

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relevant to the evaluation of the financial position, performance and changes in financial position of an enterprise by the users of financial statements.

Recognition of Assets 89. An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably. An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the enterprise beyond the current accounting period. Instead such a transaction results in the recognition of an expense in the income statement. This treatment does not imply either that the intention of management in incurring expenditure was other than to generate future economic benefits for the enterprise or that management was misguided. The only implication is that the degree of certainty that economic benefits will flow to the enterprise beyond the current accounting period is insufficient to warrant the recognition of an asset.

90.

Recognition of Liabilities 91. A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. In practice, obligations under contracts that are equally proportionately unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements. However, such obligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition. In such circumstances, recognition of liabilities entails recognition of related assets or expenses.

Tutors note: These recognition tests arise in many places throughout IAS and IFRS standards. The only significant exception is financial instruments which are recognised as soon as a company49 contractually is bound to a transaction even if there is no initial gain or loss.

Recognition of Income 92. Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable). The procedures normally adopted in practice for recognising income, for example, the requirement that revenue should be earned, are applications of the recognition criteria in this Framework. Such procedures are generally directed at restricting the recognition as income to those items that can be measured reliably and have a sufficient degree of certainty. Tutors note: The recognition of income and expenses is a side effect of the double entry of the associated asset or liability. Recognition of Expenses 94. Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment). Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the

93.

95.

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matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities. 96. When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematic and rational allocation procedures. This is often necessary in recognising the expenses associated with the using up of assets such as property, plant, equipment, goodwill, patents and trademarks; in such cases the expense is referred to as depreciation or amortisation. These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits associated with these items are consumed or expire. An expense is recognised immediately in the income statement when an expenditure produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset. An expense is also recognised in the income statement in those cases when a liability is incurred without the recognition of an asset, as when a liability under a product warranty arises.

97.

98.

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Chapter 7: Measurement of the Elements of Financial Statements 99. Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement. Tutors note: There are still significant differences in the method used to measure different assets and liabilities in the financial statements. This is a legacy of the past rather piecemeal approach to accounting standard setting. There is a general move towards reflecting assets in the balance sheet at their fair values and liabilities at the net present value of the liability. 100. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following: Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability m the normal course of business. Tutors note: This base is common. Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently. Tutors note: This base is rare. Realisable (settlement) value. Assets are carried at the amount of cash or cash

52

equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the 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. Tutors note: This base is increasingly common. It is the prescribed method for many provisions and financial liabilities such as loans. 101. The measurement basis most commonly adopted by enterprises in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some enterprises use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non. monetary assets.

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Chapter 8: Concepts of Capital and Capital Maintenance

Tutors note: This principle is related to inflation accounting. It is an important principle but one that is not particularly controversial or likely to change in the short-term. It is included here for completeness sake. In virtually all cases, nominal financial capital maintenance is the chosen capital maintenance concept in IFRS. This means that if the balance sheet total increases, even if this is just by inflation, then a gain will be reported.

Concepts of Capital 102. A financial concept of capital is adopted by most enterprises in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the enterprise. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the enterprise based on, for example, units of output per day. 103. The selection of the appropriate concept of capital by an enterprise should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital. If, however, the main concern of users is with the operating capability of the enterprise, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational. Concepts of Capital Maintenance and the Determination of Profit 104. The concepts of capital in paragraph 102 give rise to the following concepts of capital maintenance: Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the

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beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the enterprise (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

105. The concept of capital maintenance is concerned with how an enterprise defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an enterprise' return on s capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a net loss. 106. The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the enterprise is seeking to maintain. 107. The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the enterprise. In general terms, an enterprise has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit.

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108. Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity. 109. Under the concept of physical capital maintenance when capital is defined in tem-is of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the enterprise are viewed as changes in the measurement of the physical productive capacity of the enterprise; hence they are treated as capital maintenance adjustments that are part of equity and not as profit. 110. The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. This Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such ' for those enterprises as reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.

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IFRS 3: Business Combinations IAS 27: Consolidated and Separate Financial Statements
This chapter deals initially with the accounting for a new business combination, together with methods used to calculate goodwill. There is a substantial practical overlap between IFRS 3/ IAS 27 and the following accounting standards: IAS 21: Foreign currency (where an acquired company is abroad) IAS 28: Investments in Associates IAS 31: Interests in Joint Ventures IAS 36: Impairment of Assets IAS 38: Intangible Assets These standards are covered in outline through this chapter and an outline of their key requirements is given at the end of this chapter. This outline is not a complete description of these additional standards and you should make reference to the full IFRS/ IAS as necessary. The need for the standard It is very common for larger companies to trade as a group of companies. Rather than have all activities in one company, a large company may set up or acquire subsidiary companies. This may enable more efficient tax planning, may be necessary where activities are outside the parent companys own country and a host of other resaons. The investor in the parent company does not personally pay any consideration for the interest in these subsidiary companies. Rather the parent pays its own resources to either set up the subsidiary company (in the case of organic growth) or pays consideration to the previous owners of a new subsidiary (in the case of acquisitive growth). Investor

Parent company

Subsidiary company Traditionally there had been two methods of accounting for when a parent obtains control of a subsidiary: the purchase method (also known as the acquisition method) or the merger method (also

57

known as the uniting of interests method). The merger method had the effect of presenting figures that appeared to be better and there was no need to calculate any premium for acquiring control. IFRS 3 prohibits the use of the merger method for any new business combination. This is to prevent abuse of the previous provisions of merger accounting and to recognise that true mergers, ie where neither party is dominant over the other, are sufficiently rare to be irrelevant. Framework focus The Framework definition of an asset is a resource controlled by an entity, not necessarily owned by that entity. So although the shareholder in the parent company does not legally own the shares in the subsidiary, these investors control that subsidiary and thus all the subsidiarys assets and liabilities. The individual assets and liabilities of the subsidiary should therefore be recognised in the parent companys financial statements. This is also a further application of the principle of reporting commercial substance over legal form. Requirements of the standard IFRS 3 requires that for all new business combinations (being any transaction that confers the ability of one company to control another), the following should be determined: Which company is the acquirer and which is the acquired Measure the cost of the combination to the acquirer (this will be more relevant where an acquirer buys a pre-existing business than when it sets up a new legal entity as a subsidiary company) Determine the fair values of each of the identifiable assets and liabilities of the acquired company Determine the premium for control, ie goodwill, as the difference between the fair value of consideration paid to acquire control less the fair value of net assets acquired Prepare consolidated, ie group, financial statements in addition to the parents individual financial statements for each reporting period after the combination. This involves eliminating any intra-group transactions as these are effectively a single economic entity trading with itself. If the subsidiary is subsequently disposed of, cease to consolidate the financial statements from the date that

58

control of the subsidiary is lost by the parent. Recognise a gain or loss on derecognition of the subsidiary. These notes attempt to explain group accounting by following an imaginary transaction through each of these stages.

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Identification of control (IAS 27 paragraphs 12-21) A subsidiary is an entity, including unincorporated business entities such as partnerships, that is under the control of the parent company. It is not necessary to have more than 50% of the voting shares in a company to be that companys parent, although this is the normal way of obtaining control. Case study 3.1 Beatles Co owns 55% of the voting shares in Abbey Co. Abbey Co owns 55% of the voting shares in Road Co. Road Co owns 25% of the voting shares in Zebra Co.

Required Identify, with reasons, which of the above companies is a subsidiary of Beatles Co. Solution to case study 3.1 This provides a chain of control to Beatles Co. Beatles Co owns 55% of Abbey Co, which gives Beatles Co control of Abbey. This makes Abbey a subsidiary of Beatles. In turn, Abbey has 55% of the shares in Road Co, giving Abbey control of Road. This makes Road a subsidiary of Abbey. As Abbey is itself a subsidiary of Beatles, Road is also a subsidiary (a sub-subsidiary) of Beatles. Roads 25% of Zebra can be presumed to give Road significant influence in Zebra, making Zebra an associate of Road. Since Road is ultimately controlled by Beatles, Beatles has the ability to use this significant influence, making Zebra an associate of Beatles.

Case study 3.2 Highrisk Bank Co is the legal owner of one $1 share in SPE Co. SPE Co owns only one asset, which is a factory with a value of $5 million. It also has a loan from Highrisk Bank Co of $4,999,999. SPE is managed by Neveron Co, which charges SPE a management fee equal to all the profits of SPE Co, including payment of interest to Highrisk Bank Co at market rates. SPE Co has also given a call option to Neveron Co so that Neveron can purchase the factory for $5 million at any time. Neveron Co has granted SPE Co a put option that can require Neveron Co to buy the factory from Neveron Co for $5 million at any time. Required

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Identify the principal characteristics of the above agreement. State which is the parent and subsidiary relationship and why. Solution to case study 3.2 SPE is an unusual company, since it is entirely managed by Neveron Co, but is actually legally owned by Highrisk Bank Co. It is almost totally financed by debt, with only a nominal share capital. Theonly asset of SPE is the factory, which is currently managed by Neveron and which will certainly eventually revert to Neveron, given the parallel existence of the put and call options. The put option means that if the value of the factory should fall, the bank would exercise their put option, meaning that ownership would revert to Neveron. Similarly, if the value should greatly increase, Neveron would exercise its call option to regain ownership of the factory. Applying the Framework criteria for control and recognition, Neveron should continue to recognise the factory on its balance sheet. SPE is simply a vehicle that provides security for a loan to Neveron. In the event that Neveron should go bankrupt, Highrisk Bank can claim its security since it is the legal owner of SPE and its assets. However, in substance over form, Neveron controls SPE and all its assets. So despite the fact that Neveron owns none of the equity capital in SPE, Neveron should continue to consolidate SPE as its subsidiary, including a secured loan from Highrisk Bank.

Identification of acquirer and acquired (IFRS 3 paragraphs 17 23) No matter how much companies may wish to present their business combinations to the world as a merger, IFRS 3 requires that in all circumstances an acquirer is identified. The acquirer is the company that has the ability to exercise control over the other and the moment of acquisition is when this ability to possibly exercise control occurs. This is even if the actual exercise of control comes later or if the legal formalities are not completed for some time after the ability to exercise control is conferred. In some circumstances, it may not be obvious which party is the acquirer and which is acquired. These are the rare situations where a business combination has characteristics close to a true merger. The acquirer is likely to: Have the higher market capitalisation Pay the greater amount of cash to effect the combination

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Dominate the new combined management team

Where a combination happens by an exchange of equity, the acquirer is more likely to be the issuer of the new equity instruments. Case study 3.3 Tiddler and Bloater are two companies in the same market sector. They announce that they have been in merger negotiations for some time. The board of Bloater makes a recommendation to its shareholders that the shareholders should vote to accept the following offer, with which the directors of Tiddler had approached the directors of Bloater some months previously: Tiddler will issue to the current shareholders of Bloater five shares in Tiddler for each four shares that the shareholders currently hold in Bloater. Immediately before the offer, Bloater had 310 million shares in issue with a market value of $2.11 each and Tiddler had 125 million shares with a market value of $1.85 each. The name of Tiddler will be changed to Tiddler Bloater Corporation immediately after the merger. Tiddler will pay the necessary professional fees in cash to affect the merger. The new board will be made up roughly equally of directors from each company. The chief executive of Tiddler will become the chief executive of the new merged entity. The other roles will be decided after the deal is completed but it is agreed that the board other than the chief executive should be initially made up equally from managers from each legacy company.

The offer was accepted by 92% of the shareholders of Bloater in a general meeting on 14 September, although the actual share issue was not completed until 19 November.

Required Discuss the features of the above transaction and decide which company is the acquirer and why. What date should be treated as the acquisition date?

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Solution to case study 3.3 Factors that suggest Bloater should be treated as the acquirer: Bloaters market capitalisation before the announcement is much bigger than Tiddlers ($654.1 million compared to Tiddlers $231.25 million). Factors that suggest Tiddler should be treated as the acquirer: The deal was proposed by the directors of Tiddler to the directors of Bloater. Tiddler appears to be driving the deal. Tiddler has undertaken to pay the cash disbursements The new group chief executive is the CEO of Tiddler There is an apparent control premium to the current shareholders of Bloater. Compare the positions of a shareholder of two shares in Bloater: Before the offer: Held 4 shares at a value of $2.11 each $8.44 After exchanging two shares in Bloater for five in Tiddler: Holds 5 shares at a value of $1.85 each: $9.25 Conclusion This is a reverse takeover, ie where a smaller entity acquires control of an underperforming larger entity by means of a share for share exchange. The effective date is 14 September, since the board of Tiddler will be able to control the activities of Bloater after that date.

Determining cost of acquiring control (IFRS 3 paragraphs 24 35) The guiding principle here is that any consideration given or promised should be shown at its fair value. Where there is an earnout arrangement, which is where the amount to be paid is determined by the profits of the business acquired after the acquisition date, a best estimate of the likely consideration to be paid must be made. The same is true of all other contingent consideration. Any amendments to the estimates are treated as an amendment to the goodwill figure in subsequent years. These adjustments are treated as a prior period adjustment in accordance with IAS 8. This requires retrospective restatement of the recognised asset or liability

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of the acquiree, with a consequential change to the carrying value of goodwill. (IFRS 3, paragraphs 63 64). Marginal costs incurred by the acquirer to obtain control of the new subsidiary are also capitalised. Any ongoing costs such as the cost of the acquirers own corporate finance team must be expensed in full in the period incurred. Case study 3.4 Company A makes an offer to the shareholders of company B to acquire control of company B. B is owned by a private equity group which accepts the following consideration for the sale on 31 December 20x2: A will pay $20 million to the current shareholders of B. One half of that will be paid in cash immediately and one half will be paid in four years time. This element of the consideration is unconditional. An additional payment in cash of 1% of the average turnover of the next three years will be paid at the end of year four. The most recent accounts of B show turnover of $700 million, and this is expected to grow by $50 million in each of the next three years. Investment bank fees of $140,000 were incurred by A as part of the takeover and it estimates that the cost of time by its own corporate finance department has been $90,000. An additional payment of $500,000 will be paid to the shareholders of B if Bs average turnover for the next three years is above $850 million per year. This will be paid in 4 years. A also issued new shares in A to give to the current shareholders of B. Immediately after these shares were issued, the share price of A was $1.24 - $1.34. 500,000 such shares were issued. Company A guarantees that if its share price falls below $1.00 per share within 3 months of the takeover, it will pay the shareholders of B extra cash to ensure that their minimum value of the shares they accept will not fall below $500,000.

Required Calculate the fair value of consideration given to acquire control of B at 31 December 20x2. Case study 3.4 continued On 31 December 20x3, the following facts emerge: Turnover of B has risen to $780 million. It is now expected to

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rise to $890 million in the following year then remain stable. The share price of B fell after the takeover. Its shares were trading at $0.88-$0.98 by 31 March 20x3.

Company A uses a discount rate of 5% to discount long-term liabilities.

Required Calculate a revised figure for this fair value of consideration at 31 December 20x3 and state how the revised figures should be presented. Solution to case study 3.4, part one
$000 Cash paid now: Cash in 4 years time: $10m x 1/(1.05) External investment bank fees Internal expenses Additional fee if turnover > $850m (not expected) Shares issued: $1.24 x 500,000 Guaranteed minimum value (per para 35, IFRS 3) Total cost of combination to acquirer
4

10,000 8,227 140 0 0 620 0 18,987

Solution to case study 3.4, part two In addition to the figure above, the following payments are expected: Additional $500,000 if turnover > $850m (now expected) This is a correction to the initial estimates. It has been discovered within 12 months of the control date so in accordance with paragraphs 62 et seq of IFRS 3, it will be treated as a prior period error in accordance with IAS 8. This means that goodwill is recalculated as if this figure had been known at the time. This will generate retrospective recognition of a further liability of: $500,000 x 1/(1.05)4 = Dr Goodwill initially recognised $411,351 $411,351

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Cr Provisions

$411,351.

Determining the fair value of net assets acquired (IFRS 3 paragraphs 36 50) The amount that an acquirer pays to acquire control of a business is inevitably going to be the figure that both buyer and seller agree represents a fair value for the business as a going concern. In deciding how much to pay to acquire control of the business, the acquirer will make their own estimation of the fair value of the targets assets and liabilities. On top of this will be a premium for control of the acquired company and its expected future profits. It is highly unlikely that the acquired companys balance sheet value of individual assets and liabilities will represent their fair value. For example, IAS 2 inventories requires that inventory is valued at the lower of cost and net realisable value. This means that if the value of inventory has increased since it was bought by the target company, this will not be reflected in the balance sheet of the target company. Case study 3.5 Imagine a simplified scenario where company B has only long-term inventory such as whisky that requires ten years to mature. The historic cost of producing this was $50,000 but as it is almost ready for sale it could be sold to another company at an arms length value of $200,000. If this company were to be acquired by company A, company A would actually be buying only some long-term inventory. However if there were no need to revalue to fair values, the figure for goodwill would be grossly overstated: With fair values Without

Fair value of consideration Less: Net assets acquired Goodwill

$200,000 ($200,000) 0

$200,000 ($50,000) $150,000

To avoid holding gains erroneously overstating the value of goodwill it is therefore necessary to revalue individual assets and liabilities of a target company to fair values. This also includes placing a value on contingent liabilities. Although the rules of IAS 37 normally forbids recording a contingent liability in the balance sheet, the existence of a contingent liability would very probably reduce the amount of consideration that a buyer would be willing to pay for the acquired company.

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Fair values often have the effect of changing the post-acquisition profits of the new group of companies. For example in case study 3.3 above if the inventory were to be sold immediately after the acquisition of company B for $220,000 this would report a group profit of $20,000. Without a fair value adjustment, it would report a group profit of $170,000. On the acquisition, it is necessary to look at each of the acquired companys assets and liabilities and assign a fair value to them. The identifiable assets of the acquired company are all the assets and liabilities of the acquired company other than goodwill. This may include intangible assets if it is possible to identify a fair value for these intangible assets, which will normally only be possible if there is a reliable market value for the intangible asset. This is rare. As explained in the notes on IAS 37 provisions, it cannot include any provisions for any future intentions of the acquirer since these do not represent an obligating event. Case study 3.6 (continuation of case study 3.4 above) Company A acquires company. At the date of acquisition, the summary balance sheet of company B shows the following: values Balance sheet $000s Tangible non-current assets Intangible non-current assets Inventory Receivables Bank balances and cash Current liabilities & provisions Non-current liabilities Deferred tax liability 9,000 1,900 2,100 3,200 700 (2,200) (3,200) (800) $000s 14,000 see below 2,300 3,200 700 (2,200) (3,200) (800) Fair

Included within tangible non-current assets of the company are a number of printing plants that the acquirer does not want, but which came bundled with the sale. These have a balance sheet value of $250,000. The acquirer intends discontinuing the printing activities. The fair value of these assets is $235,000 and it is expected that the staff will need to be made redundant at a cost of $60,000 although efforts will be made to find work for them elsewhere in the new combined business. It is expected to cost $20,000 to sell the

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surplus printing equipment. The intangible assets recognised in the balance sheet are deferred development costs of an unpatented project that is producing profits. The product is expected to produce profits of at least $1.9 million. The acquirer believes that the cost of integrating the acquired business into its own business will be $1.3m. This includes such matters as replacing corporate logos of B. A also believes that B will make trading losses of $0.75m in each of the two years after the acquisition. At the acquisition date, B was being sued for past pollution damage. It believes that it is not liable for this pollution although it is recognised that there is a 30% chance of it being found liable. B recently turned down an offer from the person suing it to reach an out-of-court settlement of $0.65m. Certain senior members of staff at company B had poison pill terms in their contracts stating that if B were to be taken over by another company they would be paid bonuses of $0.2m and their contracts would immediately be terminated. Company B owns a number of brands which it uses to market its products. It has been estimated internally that the brands generate an extra $1.2 million each year in profit compared to unbranded products. It is felt that it would be possible to sell some of these brands without selling the business of B as a going concern. These brands are not included in intangible non-current assets in the balance sheet.

Required Suggest a fair value to be ascribed to each of the assets listed above. For simplification, assume that none of the further adjustments to fair values will affect the deferred tax liability. Solution to case study 3.6
Assets at fair values: Per list Tangible non-current assets Intangible non-current assets Inventory Receivables Bank 14,000 1,900 Note 2 2,300 3,200 700 Adjustments (35) Note 1 1,200 Note 6 0 0 0 Fair value 13,965 3,100 2,300 3,200 700

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Current liabilities & provisions

(2,200)

(650) Note 4 (200) Note 5

(3,050)

Non-current liabilities Deferred tax Net assets

(3,200) (800)

0 0

(3,200) (800) 16,215

Notes 1. Fair value less costs to sell, per para 36 IFRS 3 is 235 20 = 215. This implies an impairment of 35 below current recognised fair values. The staff redundancies are not highly probable and are not costs to sell, so are not deducted from the carrying value of the assets in this disposal group. 2. Development costs do not appear to be impaired. Payment by the acquirer is evidence of their value. They are not therefore impaired and can be recognised in full. 3. The intentions to rebrand and reorganise cannot be recognised as a pre-acquisition provision in the books of the acquired company. Similarly there is no obligation to trade at a loss, so no provision can be made. 4. Contingent liabilities normally are only disclosed in the notes to the financial statements, rather than recognised as a liability/ provision in the balance sheet. Assuming that Company B has properly applied IFRS, this means that the balance sheet of B will need to be amended to include a value for the contingent liability in order to apply paragraph 37 of IFRS 3 The recent offer to settle the liability at $0.65 million may be a reasonable fair value. Although Company B rejected this offer (implying it believed its true value to be less), Company A may wish to settle legacy liabilities of B quickly. It will therefore increase provisions by up to $0.65 million. 5. The poison pills will crystallise and become a liability in the event of a takeover. These would not have been in the balance sheet as there was no liability prior to As takeover, so $0.2 million will need to be added to current liabilities. 6. The brands are separable from Company Bs business without threatening its going concern status. They may therefore be recognised as an asset, since Company As payment is evidence of a reliable value. Normally brands are not recognised as assets as they do not have a reliable value.

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Positive Goodwill on Acquisition (IFRS 3 paragraphs 51 55) Goodwill represents the expected future earnings potential of a business. The extra amount that an acquirer is willing to pay above the fair value of individual assets and liabilities of a business is goodwill. Goodwill is measured at its initial purchase price and is subject to annual impairment reviews in accordance with IAS 36 Impairment of Assets. It is therefore shown at its initial purchase cost less accumulated impairment reviews. It cannot be revalued upwards, even if circumstances leading to an impairment have reversed. Goodwill must not be amortised or debited directly to reserves, as previous accounting standards on goodwill have required.

Case study 3.7 Using the figures from case studies 3.4 (part one) and 3.6, estimate the goodwill on As acquisition of B. Assume that all Company Bs shareholders accept Company As offer to acquire their shares.

Solution to case study 3.7 $000 Fair value of consideration Less: Fair value of identifiable and separable net assets 16,215 (16,215) Goodwill initially recognised Group share x 100% 2,772 18,987

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Negative Goodwill on Acquisition (IFRS paragraph 56-57) If the calculation of goodwill shows a negative figure, this is probably due to an error being made in the fair value exercise. A reassessment should be made of each fair value for completeness and accuracy. If the fair value exercise shows no errors, then it appears that the acquirer has simply obtained a bargain in the purchase of the subsidiary, perhaps because the previous owners were forced to sell the subsidiary to meet short-term cash flow needs. If the preparer of the accounts is satisfied that the calculation is correct yet it has yielded negative goodwill, this negative goodwill must be recognised immediately as a credit in the income statement. This situation is rare. By far the most common cause of negative goodwill is a failure to identify possible contingencies or revalue assets that are normally required to be shown at historic cost to their fair values. Step-by-Step Acquisitions (IFRS 3 paragraphs 58 60) It is common that control is built up through a number of individual transactions. In such circumstances, the goodwill calculation is broken into separate components, as the fair values would be different for each tranche of the equity of the target company acquired. Although IFRS 3 doesnt say so specifically, this would become an issue from the first tranche of shares that gave the eventual acquirer a significant influence in the activities of the target, since this would be the first tranche to require that the target is accounted for as an associate under IAS 28. Normally, significant influence starts to build up from when the acquirer owns at least 20% of the voting shares of the target company. Case study 3.8

Save Co progressively acquires control of Day Co over a period of slightly less than a year using the following investments, all of which are properly measured at fair value: 1 December 20x4: Bought 10% of the equity of Day Co at a cost of $100,000. 1 March 20x5: Bought a further 15% of the equity of Day Co at a cost of $160,000.

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1 May 20x5: Bought a further 40% of the equity of Day Co at a cost of $560,000. 1 September 20x5: Bought a further 15% of the equity of Day Co at a cost of $74,000.

The fair values of the identifiable net assets of Day Co on these dates were: 1 December 20x4: $800,000 1 March 20x5: $850,000 1 May 20x5: $900,000 1 September 20x5: $1,100,000.

Both companies have a year-end of 31 December each year.

Required Assuming that no impairment of goodwill has been identified by 31 December 20x5, show goodwill in the group accounts of the Saves Co group at that date. Solution to case study 3.8 The first purchase was for only 10% of the equity of the target company. This would be presumed not to give significant influence, so would be accounted for only as a normal trade investment. Goodwill would not therefore be recorded on this transaction. However, it would be added to the cumulative cost of acquiring the first 25% that confers significant influence. All figures in $' 000s Fair value of consideration FV assets Percentage acquired FV assets acquired Goodwill on this tranche Total goodwill @ 31 Dec x5 850 25% (212.5) 47.5 1 Mar x5 260 900 40% (360) 200 1 May x5 560 1100 5% (55) 19 1 Sep x5 74

266.5

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Year-end consolidation The principal requirements for consolidation of a subsidiary and parent entity accounts to produce an additional set of consolidated accounts are: Necessary task There should be a line-by-line consolidation of each item controlled by the parent in both group balance sheet and group income statement. Logically, the income statement is only consolidated for the period when the parent had control. The parent and subsidiary should have coterminous year-ends. If the legal entities dont have the same year-end, interim accounts of the subsidiary should be consolidated. All group companies should prepare accounts for consolidation using uniform accounting policies. All intra-group transactions should be fully eliminated in preparation of the group accounts. This may have an effect on deferred tax as it will amend reported profit but probably not affect the tax base of each group company. An intermediate parent company can avoid the need to prepare group accounts if it is consolidated itself into another group reporting under IFRS, it is not a listed company or seeking listing and if the intermediate parent companys shareholders agree to not receive group accounts. If minority interests in the balance sheet are negative, this negative balance should be allocated to the parent companys funds unless there is a legally binding obligation on the minority to make good any cumulative losses. When a parent loses control of a subsidiary, the line-by-line consolidation must end. If the parent retains any investment in that company, the value of the net assets of the subsidiary at the date of losing control becomes the base cost of the investment under IAS 39. Required by: IAS 27 para 22

IAS 27 para 26 - 27

IAS 27 para 28 - 30

IAS 27 para 24 - 25

IAS 27 para 10

IAS 27 para 33-36

IAS 27 para 31-32

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Comprehensive example 1 Source: ACCA Diploma in International Financial Reporting June 2006 On 1 October 2005 Hydan, a publicly listed company, acquired a 60% controlling interest in Systan paying $9 per share in cash. Prior to the acquisition Hydan had been experiencing difficulties with the supply of components that it used in its manufacturing process. Systan is one of Hydans main suppliers and the acquisition was motivated by the need to secure supplies. In order to finance an increase in the production capacity of Systan, Hydan made a non-dated loan at the date of acquisition of $4 million to Systan that carried an actual and effective interest rate of 10% per annum. The interest to 31 March 2006 on this loan has been paid by Systan and accounted for by both companies. The summarised draft financial statements of the companies are: Income statements for the year ended 31 March 2006 Hydan $000 Systan $000 preacquisition Revenue Cost of sales Gross profit Operating expenses Interest income Finance costs Profit/ (loss) before tax Income tax (expense)/ relief Profit/ (loss) for the period 98,000 (76,000) 22,000 (11,800) 350 (420) 10,130 (4,200) 5,930 24,000 (18,000) 6,000 (1,200) nil nil 4,800 (1,200) 3,600 postacquisition 35,200 (31,000) 4,200 (8,000) nil (200) (4,000) 1,000 (3,000)

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Balance sheets at 31 March 2006 Hydan $000 Non-current assets Property, plant and equipment Investments (including loan to Systan) 34,400 Current assets Total assets 18,000 52,400 9,500 7,200 16,700 18,400 16,000 9,500 nil Systan $000

Equity and liabilities Ordinary shares of $1 each Share premium Retained earnings 10,000 5,000 20,000 35,000 2,000 500 6,300 8,800

Non-current liabilities 7% bank loan 10% loan from Hydan Current liabilities Total equity and liabilities 6,000 nil 11,400 52,400 nil 4,000 3,900 16,700

You are also told the following information: (i) At the date of acquisition, the fair values of Systans property, plant and equipment were $12 million in excess of their carrying amounts. This will have the effect of creating an additional depreciation charge (to cost of sales) of $300,000 in the consolidated financial statements for the year ended 31 March 2006. Systan has not adjusted its assets to fair value.

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(ii)

In the post acquisition period Systans sales to Hydan were $30 million on which Systan had made a consistent profit of 5% of the selling price. Of these goods, $4 million (at selling price to Hydan) were still in the inventory of Hydan at 31 March 2006. Prior to its acquisition Systan made all its sales at a uniform gross profit margin. Included in Hydans current liabilities is $1 million owing to Systan. This agreed with Systans receivables ledger balance for Hydan at the year end. An impairment review of the consolidated goodwill at 31 March 2006 revealed that its current value was 125% less than its carrying amount. Neither company paid a dividend in the year to 31 March 2006.

(iii)

(iv)

(v)

Required: Prepare the consolidated income statement for the year ended 31 March 2006 and the consolidated balance sheet at that date.

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Suggested solution to comprehensive example H' s control of Systan Consolidation adjustments (30,000) (W1) 30,000 (W1) (200) (W2) (375) (W6) (200) (W4) 200 (W4) Consolidation adjustments Consolidation adjustments

Income statement consolidation schedule Hydan

Consolidated

Revenue Cost of sales Gross profit Operating expenses Interest income Finance costs Profit/ (loss) before tax Income tax (expense)/ relief Profit/ (loss) for the period 98,000 (76,000) 22,000 (11,800) 350 (420) 10,130 (4,200) 5,930 35,200 (31,000) 4,200 (8,000) 0 (200) (4,000) 1,000 (3,000) (W10) (W10)

(300) (W3)

103,200 (77,500) 25,700 (20,175) 150 (420) 5,255 (3,200) 2,055

Attributable to: Equity holders of the parent Minority interests

(W1)

(W2)

(W3)

The intra-group trading must be removed at its transfer price. Failure to do this would effectively be showing the entity trading with itself. There is an unrealised profit from the intra-group transfer. This must be eliminated since failing to do this would enable groups to generate profits simply by moving inventory around the group at bogusly inflated values. The goods that have been sold outside the group are proven profit: only the element remaining needs to be removed. This is $4m x 5% = $200,000. The fair value adjustment to non-current assets at acquisition will initially lift the group balance sheet value. This increased balance sheet value will increase the depreciable amount. This additional depreciation figure is given in the question but will have been calculated as the additional non-current asset value depreciated using Systans depreciation policy.

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(W4)

The intra-group finance charges do not represent transactions between the group and third parties, so must be removed. This doesnt affect overall profit as it reduces finance costs and interest income by the same amount. It is calculated as $4m x 10% x 6/12 to show only the post-acquisition figure, as only post-acquisition figures (those under the control of H) are consolidated. H' s control of Consolidation Consolidation Balance sheet consolidation Systan adjustments adjustments Consolidated schedule Hydan

Non-current assets Property, plant and equipment Goodwill Investments (including loan to Systan) 18,400 0 9,500 0 0 7,200 16,700 (200) (W8) (10,800) 1,200 (W5) 3,000 (W6) 16,000 18,000 52,400 (300) (W5) (375) (W6) (4,000) (W7) (1,000) (W5)

28,800 2,625 1,200 24,000 56,625

Current assets Total assets

Equity and liabilities Ordinary shares of $1 each Share premium Retained earnings Minority interests 10,000 5,000 20,000 2,000 500 6,300

See workings below

10,000 5,000 17,525 3,800

Non-current liabilities 7% bank loan 10% loan from Hydan Current liabilities Total equity and liabilities 6,000 0 11,400 52,400 0 4,000 3,900 16,700

(4,000) (W7) (1,000) (W9)

6,000 0 14,300 56,625

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(W5) Property, plant and equipment is that of the parent, plus all the property, plant and equipment of the subsidiary at its recognised value (ie fair value less additional depreciation on the fair value adjustment). This is $18,400 + 9,500 + (1,200 300)) = 28,800

(W6) Goodwill on acquisition of Systan 10,800 1.10.05 Net assets line-by-line (w7) 5,200 1.10.05 => Goodwill on acquisition 16,000 3,000 31.3.06 Impairment loss 31.3.06 C/d 3,000 375 2,625 3,000 16,000 3,000 13,000

1.10.05 Cash (2,000 x 60% x $9)

1.10.05 Minority interest on acquisition

1.10.05 B/d

(W7) Net assets of Systan at acquisition Utitling the fact that net assets = equity (by definition) and that equity is capital & reserves (by definition) 2,000 500 9,300 1,200 13,000

Capital of S Share premium of S Reatined profits of S (6,300 + 3,000) Fair value adjustments

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Minority @ 40% thereon

5,200

Minority interest (balance sheet) 1,400 1.10.05 3,800 5,200 5,200 On acquisition 5,200

31.3.06

Share of post-acquisition loss

31.3.06

C/d

Note: Minority interest is based on capital and reserves of the subsidiary at the group balance sheet date. The figure of 3,800 above therefore includes 40% of the retained earnings of S at 31 March 2006. Retained group earnings 20,000 3,780

31.3.06

Reserves S x 60%

31.3.06 31.3.06 375 17,525 23,780

Extra depreciation x 60% Unrealised profit x 60% Cumulative godwill 31.03.06 impaired 31.3.06 C/d

5,580 1.10.05 Retained earnings of H Retained earnings of S x 180 1.10.05 60% 120

23,780

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Disposal of group companies

When a parent loses control of its subsidiary, it means that that the shareholders interests will have been depleted, although some consideration may have been received from the disposal. This will generate a profit or loss on disposal of the shares in the subsidiary. This reflects the fact that the gain or loss on disposal of anything is the difference between the assets newly recognised in the balance sheet and the net assets derecognised from the balance sheet. The group income statement will show a line-by-line consolidation of the subsidiarys income statement up until the date of the disposal.

Case study 3.9

Parent has held control of Subsidiary for a number of years with a 60% interest in the voting shares of the subsidiary having been purchased by Parent for $1.6 million. On 1 July 20x4, Parent sold the shares in Subsidiary to Purchaser Co for consideration of $2.4 million. The unamortized goodwill relating to the purchase of Subsidiary by Parent in the group balance sheet at 30 June 20x4 was $350,000 and the net assets of Subsidiary in the Parent group balance sheet at that date were $3.4 million.

Required

Calculate the profit or loss on disposal of S in: The individual financial statements of Parent Co for the year ended 31 December 20x4, and The group financial statements of the Parent Co group at 31 December 20x4.

Solution to case study 3.9

Gain in the individual financial statements of Parent Co The individual accounts of Parent never decomposed the cost of investment in Subsidiary into the identifiable individual assets of Subsidiary and goodwill on acquisition. The gain or loss no disposal is therefore simply:
$000s

Proceeds (ie net assets newly recognised in Parents individual financial statements)

2,400

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Less: Cost of investment Gain on disposal in individual accounts

(1,600) 800

In the group financial statements of Parent Co group: In the group accounts, the cost of investment is replaced by the goodwill on the acquisition, less cumulative impairments, plus each indentifiable asset and liability as a line-by-line consolidation. The gain or loss on disposal is therefore different, as different assets and liabilities are being derecognised in the group financial statements compared to the individual financial statements:
$000s $000s

Proceeds (ie net assets newly recognised in Parents individual financial statements) Less: Items derecognised from the group financial statements: Unimpaired goodwill Identifiable net assets of S at 1 July 20x4 Minority interest at 40% of above 3,400 (1,360)

2,400

(350)

(2,040) Gain on disposal in the group accounts

Case study 3.10 (continuation of case study 3.9)

10

Suppose that rather than disposing of the shares in Subsidiary, Parent had instead sold 10% of its holding to Investor Co for consideration of $190,000.

Required

Explain how this would be shown in the group financial statements of the Parent Co group at 31 December 20x4.

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Solution to case study 3.10

The balance sheet of the Parent group would still consolidate Subsidiary as Parent would still have control of Subsidiary. This is because Parent would still own 54% of Subsidiarys voting shares. The minority interest in the balance sheet would be calculated using a minority interest of 46%.
Income statement

The income statement would include a gain or loss on part disposal of Subsidiary, effectively the increase in minority interest:
$000s

Proceeds (ie net assets newly recognised in Parents individual financial statements) Less: Derecognised goodwill* ($350,000 x 10%) Less: Effective transfer of group assets to enlarged minority interest (46% x 3,400) (40% x 3,400) Loss on part disposal in group income statement

190 (35)

(204) (49)

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Advanced group accounting issues: Group reorganisations and demergers

Neither IAS 27 nor IFRS 3 deal specifically with the issue of group reorganisations and demergers. The following is therefore general best practice, based on a combination of principles in IAS 27, IFRS 3 and the Framework.
Reorganisations

These may happen where a group benefits from some logical reordering of its investments. For example, the group below is an inefficient group for tax purposes:
SHAREHOLDERS

Parent Co (Trinidad and Tobago registered)

Subsidiary A (Registered in Germany)

Subsidiary B (Trinidad and Tobago registered) In this situation, if one of the Trinidad and Tobago registered companies is loss making and the other is profit making it may not be possible to group relieve losses against the profits as the other as a foreign entity is in the way. A more efficient structure would be:
SHAREHOLDERS

Parent (Trinidad and Tobago registered)

Subsidiary A (Germany)

Subsidiary B (T & T)

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The issue arises in the group accounts of Subsidiary A, since this company will lose control of subsidiary B and therefore will need to cease to consolidate it and de-recognise the cost of the investment in its own entity accounts. Say that the original cost of As investment in B had been $50 million, representing goodwill of $10 million and other net assets of $40 million. If B had net assets in its balance sheet at the date of the reorganisation of $54 million, then the necessary double entries would be: Individual accounts of A: Dr Proceeds from disposal (presumably zero) $0 Cr Cost of investment in B $50 million Dr Loss on derecognition/ disposal $50 million. Individual accounts of Parent: Dr Cost of investment in B Cr Gain on initial recognition of B $50 million $50 million.

In the group accounts of Parent, the cost of investment in B would be eliminated and replaced instead with goodwill and the individual net assets of B. The gain in the entity accounts of Parent would be cancelled by the loss in the entity accounts of A, showing no group gain or loss overall. This is sensible, as the shareholders (for whom the accounts are prepared) have neither lost nor gained anything; they have simply placed a group company in a different place in the same group. This situation could be complicated where not all subsidiaries are fully owned by the parent, since there would be a change in the minority interest figures.
Demergers

Where a group of companies contains a number of different activities, especially where the different activities have significantly different risks and returns there may be pressure to break up the group and allow investors to decide which activities they wish to invest in. For example, a conglomerate telecoms company with activities in traditional landlines and mobile telephones may demerge into two separate companies as given below:

BEFORE DEMERGER:

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SHAREHOLDERS Telecom Co

Landline and broadband subsidiary Mobile phones subsidiary

AFTER DEMERGER:

SHAREHOLDERS Telecom Co

Landline and broadband subsidiary Mobile phones subsidiary A demerger such as this can be achieved by a number of means, one of which is for Telecom co to transfer its shares in the mobile phone subsidiary directly to Telecom Cos own shareholders. This means that the shareholders have a new asset that they gold directly and Telecom Co has lost control of one of its subsidiaries. The loss of control means that the demerged subsidiary needs to be derecognised from the group accounts. After the demerger, the shareholders can decide to keep their investment in both operating companies or decide to sell one part of their holding. The issue in this scenario is that Telecom Co will dispose of its subsidiary and so the individual assets and liabilities of the mobile phones subsidiary will be derecognised from Telecom Cos group balance sheet. As the demerger of the mobile phones subsidiary is normally for no consideration, this will generate a substantial debit in the group accounts. It is normal to report this as a debit to reserves of Telcom Co rather than as a debit to the income statement. Reporting the derecognition as a loss may be misleading, since immediate after the demerger the shareholders have not lost an interest in any assets. An expense would report a depletion of shareholders interests that does not exist.

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IFRS 4: Insurance Contracts

The need for the standard

IFRS 4 was introduced by the IASB in response to a number of needs: Growing globalisation of the market for investment in insurance companies Growing use of insurance contracts by non-insurance companies Widespread lack of confidence in profits reported by writers of insurance contracts as unusually large losses were often inappropriately smoothed by amortising the cost of past large losses or building up catastrophe provisions for future large losses. The lack of international consensus on how to account for insurance prior to this.

Scope of the standard

There are a number of transactions specifically not within the scope of IFRS 4, such as weather derivatives which are covered by IAS 39. It is critical to note that IFRS 4 covers insurance contracts, rather than insurance companies. All persons responsible for corporate reporting should be familiar with IFRS 4s definition of insurance risk in order to make sure that they adequately identify transactions that would be covered by IFRS 4. There are probably a number of situations where companies unexpectedly have to apply IFRS 4, despite not being insurance companies. Some examples of unexpected application or non-application of IFRS 4 include: An insurance company with policies in place that do not meet the IFRS 4 definition of an insurance contract will have to be accounted for using different methods to those prescribed by IFRS 4, and Non-insurance companies who sell services or products that contain a transfer of uncertainties to the company from the customer may well have to apply IFRS 4. An example of this is where a company sells extended warranty agreements over goods.

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Requirements of IFRS 4

The standard imposes a number of changes to insurance contracts (which may include non-insurance companies too).. In particular, it requires: Potential exposure to losses on an insurance contract to be recognised at the inception of an insurance contract. Underwriting result to be reported in the year that the premium is written, essentially as the movement on the expected claims.that the issuer of an insurance contract is ever expecting to pay. Un-bundling of endowment style policies between deposit (investment) and life insurance elements. The identification and separate accounting for any derivative features of insurance contracts (eg guaranteed returns to endowment policy holders). Prohibition of all catastrophe and equalisation provisions.
Framework focus: Relevance and reliability

The IASB Framework document identifies relevance and reliability as key desirable features of financial reporting. The Framework uses certain highly important definitions in deciding what is both relevant and reliable:

Asset (IASB Framework)

An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.
Liability (IASB Framework)

A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.
Equity (IASB Framework)

Equity is the residual interest in the assets of the enterprise after deducting all its liabilities.

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An interim accounting standard

IFRS 4 in its current form is an interim solution. Although it addresses most of the key matters to accounting for insurance, there are a number of significant things still left unresolved, especially the issue of discounting provisions. A revised standard (Phase 2 of the project) is expected to be issued in the next few years. This revised standard will address the issues around discounting of provisions for future claims, which are only partially resolved in the existing standard.
Definition of insurance contract (IFRS 4, Appendices A and B)

There is widespread confusion over what actually constitutes an insurance contract. Its scope may be considerably wider than many expect.
Insurance contract

A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary.

Unbundling components of business risk

An individual or a business face a number of different types of risk, some of which will be transferred by an insurance policy. The rest will be retained, some of which may be managed by tactics such as hedging.

Total business risks 90 Risks transferred

Risks retained by the business.

Financial risks (see below)

Insurance risk
(Non-financial risks transferred from the policyholder to the insurer)

Financial risk (IFRS 4, Appendix A)

The risk of a possible future change in one or more of: a specified interest rate security price commodity price foreign exchange rate index of prices or rates a credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.

Insurance risk

Risks, other than financial risks, transferred from the holder of a contract to the issuer. It is irrelevant what the legal form of the contract is. If, in substance over form, a contract gives rise to significant transfer

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of an insurance risk, it is an insurance contract, even if it describes itself using other terms. Equally, a contract that describes itself as an insurance contract but does not substantially transfer an insurance risk is not an insurance contract.

Interaction with IAS 39

An individual or a company may transfer financial risk by a number of means, including: Foreign currency futures or options Commodity futures or options Index-linked investments.

It may also manage non-financial risks retained within the business. For example, it may contract to purchase a weather derivative if its revenues are significantly weather-dependent. In each of these cases, the holder of such a contract holds a derivative, which is accounted for under IAS 39.

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Case study 4.1

An insurance company offers a number of savings based policies. A particular savings based policy guarantees a certain level of return of 5% per year for a fixed period of 10 years. An investor deposits $1,000 on 1 January 20x0 into this fund, with a guaranteed 5% return fixed until the fund matures on 31 December 20x9. In the event of the early death of the investor, the contract provides that the accumulated value of his investment will be repaid, at its actual value, or its value compounded at 5% if that is higher. This early redemption does not incur any penalties in the event of death of the policyholder. If redeemed early, a significant penalty applies. In effect, both the insurance company and the investor are making a bet that the investments will achieve a return of not less that 5% a year. As with all bets, one party will win and the other will lose. Imagine if the actual average compound return over that period were either 3.5% or 6%. In these circumstances, the value of the fund would be: 3.5% Actual (outcome in the spot market) $1,411 Guaranteed return given to the investor $1,629 Difference $218 To the investor this is a gain 6% $1,791 $1,629 $162 loss

This difference is the value of an embedded derivative. For further details of embedded derivatives, see our notes on IAS 39. This derivative is not covered by IFRS 4. The investor is effectively investing $1,000 in the spot market, using actual investment returns. At the same time, he/ she is buying a future, linked to a 5% compound return. If the actual returns in the period were 3.5%, the investor has transferred this risk of poor returns to the insurance company by taking a guaranteed return. This is no tan insurance contract since the death during the policy of the policyholder only requires the policy to be cashed out at its accumulated value. The occurrence or non-occurrence of the single event (ie death of the policyholder) in the period would not cause any actual loss to the writer of the insurance contract. Although it would cause the writer of the contract to suffer an opportunity loss, since it will not be able to make a return on the funds invested for as long as expected, an opportunity loss is not an expense.

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Case studies 4.2 4.10

Decide whether these contracts substantially transfer risk or not. If so, decide whether they transfer financial risk, insurance risk or an element of both. Accordingly, state whether each is an insurance policy, an investment fund or a hybrid. 4.2 A term life cover that is renewed at the start of each year for a premium set at the start of that year. In the event of death of the policyholder in the year, a set amount is paid. If the policyholder survives, nothing is paid to them. An endowment fund, with a fixed maturity date. In the event of death of the policyholder, the valuation of the policyholders investments is paid to their estate, with no transaction fees, early redemption penalties or supplements to fund value. An endowment fund to repay a household mortgage. The endowment fund is of a unit linked variety, meaning that the valuation of the fund is decided by the actual performance of the investments during the period. In the event of the death of the endowment holder before the 20 year maturity date of the endowment, the insurance company agrees to pay off the household mortgage immediately. A whole-life with profits life insurance policy. The policy provides for an endowment at a maturity date and a guaranteed return. In the event of the death of the policyholder before the maturity date, a lump sum benefit of twice the accrued value of the policyholders fund is immediately paid. In addition, if investment returns exceed the guaranteed minimum, the life insurance company may choose to pay dividends to policyholders each year. This is at the discretion of the insurance company. A funeral director sells funeral pre-need plans. This plan involves pre-paying funeral expenses during a persons life and agreeing what the funeral costs will be. The funeral director then invests the funds and keeps the return from the investments. The undertaker agrees to never charge a surcharge on the membership fee of the plan nor any adjustment to the cost of delivering the agreed funeral, even if actual expenses are much higher or lower than expected. A contract agrees to pay a member an annuity every month from the date of their retirement to the date of their death. The annuity was purchased for a fixed amount during a persons working life.

4.3

4.4

4.5

4.6

4.7

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4.8

A manufacturer gives warranties of one year on their products, offering to repair or replace the goods if they are faulty. A distributor of electrical goods offers to sell extended warranties on goods they sell. In return for a payment at the time of purchase, the warranty can be extended to either three or five years. If the goods go wrong, the distributor either pays the manufacturer to repair them, or bears the cost of replacement.

4.9

4.10 A reinsurance policy, which pays excess of loss benefits to the insured party (to the direct insurer). The policy is for a period of ten years, and the premium is set each year, based on the experience of the previous years. If there are claims, these are paid by the insurer to the insured in the year that the claim is made, but the premium for the following year is adjusted to include this amount, plus a small additional administration charge. In the final year, the premium is retrospectively changed to take into account claims in that year.
Solutions to case studies 4.2 4.10

4.2

This is an insurance risk only, since it is a contract that transfers a risk that is normally inherent to the buyer of the policy to the issuer of the policy. This is an investment fund only. The amount of the cash flow is not increased or decreased depending on the death of the policyholder. This is a hybrid of insurance risk and financial risk. The death of the policyholder is not normally something that would be a risk assumed by a company, but the contract transfers the risk of this to the policy issuer, as it has to write off the loan. This causes a loss as defined in the IASB Framework. Contrast this with example 4.3 above, which causes an opportunity loss only to the issuer of the policy. This is a hybrid of insurance risk and financial risk, with discretionary participation features as well (see further notes on discretionary participation features below). The guaranteed return is an embedded derivative per IAS 39. The issuer has a risk of having to pay double the benefits if the holder of the contract dies. This puts the issuer of the policy on risk for something they would normally not be on risk for. This transfer of risk to the issuer of the policy makes this component of the contract an insurance contract.

4.3

4.4

4.5

4.6

This is an insurance policy and is one of the examples

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given in the standard (paragraph B18, Appendix A, IFRS 4). Although death is certain, the timing of the death will potentially cause a loss to the funeral director, as if the funeral director has to pay for a funeral sooner than expected, it will generate a loss. 4.7 This is an insurance contract. Normally, the risk of living longer than a persons savings last is a risk the person themselves takes. This contract effectively transfers the risk of greater longevity than a persons savings can cover from the buyer of the policy to the issuer. If the annuity is sold for a fixed sum but the insured person dies shortly afterwards, derecognition of the expected liability to pay the annuity until death from the issuers balance sheet will generate a gain in the income statement of the issuer. As with 4.6, this contract means the issuer of the contract is now exposed to making a gain or loss depending on whether the other person dies in the period. This therefore is a transfer of insurance risk so this is an insurance contract. This is neither insurance risk nor finance risk, but is normal business risk. The transaction would be covered by IAS 37. It is a normal feature of business to have to bear the costs of rectifying or replacing defective goods sold under a warranty for repair/ replacement. A distributor would normally be liable to pay for repairs or replacement for goods in an extended period. Normally, the risk of goods breaking some months after the sale would be borne by the buyer of the goods. The contract therefore transfers this inherent risk from the buyer of the goods to the retailer. This is therefore an insurance contract.

4.8

4.9

4.10 This is a rather specialist examples. It is neither insurance risk nor financial risk transfer. There is no transfer of insurance risk to the writer of the policy since the writer of the policy is able to recover any amounts they pay out by adjusting the following years premium. This type of financial reinsurance in substance is just an overdraft facility. Any amounts claimed by the policyholder under such a policy would be shown as liabilities in the policyholders balance sheet.

Provisions

Provisions are liabilities of uncertain timing or amount. Applying the principles of the Framework document, this covers potential liabilities under an insurance contract.

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If a policyholder has transferred insurance risk to another person (or company), then the issuer of this policy could be expected to be required to apply IAS 37. IAS 37 specifically does not apply to insurance contracts, since IFRS 4 gives more specific rules for insurance contracts than the generic rules of IAS 37. It partially forms the base of the current IFRS 4 and is likely to form the of the finalised standard in a few years.

Long-tail insurance

The tail of an insurance claim is the time delay between a loss being incurred and that loss being reported to the insurer. For example, whiplash injuries in a road traffic collision may only become apparent to the victim several years after being involved in a crash. Pollution and industrial disease claims can also take years to become apparent, even if the event causing the loss occurs today, so is covered by the insurance contract in force today. Where an insurance policy is written, with the expectation that if a claim is made, it will be made in a long time, it may be appropriate to discount the provision in order to show a true and fair view of the insurers balance sheet.

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This is consistent with the principles of IAS 37. The effect of discounting and the choice of discount rate can have a drastic effect on the results and reported liabilities of an insurer.

IFRS 4 and discounting

The IASB has not prescribed any rules on which discount rates to use, since this is considered largely subjective and it was impossible for them to reach a consensus in the time available in the time available for issuing the current version of IFRS 4. The transitional rules with discounting given in IFRS 4 are: (i) (ii) If companies currently use discounting to measure technical provisions, they may either: Continue to use their existing policies, or Change to a policy of presenting insurance liabilities on an undiscounted basis. New insurance companies, or insurance companies that currently do not present financial statements to shareholders on a discounted basis, must present insurance liabilities on an undiscounted basis. If such companies write a large volume of long-tail business, this may significantly overstate the true value of their liabilities and thus understate their solvency.

This is largely because of the subjectivity associated with the choice of discount rate to use when calculating the present values.

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Case study 4.11

Imagine that an insurance company invests wholly in irredeemable government bonds, which pay a fixed interest rate of 5% per annum. If the company has just enough assets (invested in government bonds, as above) to pay off its estimated insurance liabilities as they fall due, changes in the general rate of interest will change the value of the assets that it holds, as above. Changes in general interest rates will change the valuation of the companys investments. If the company held assets of $10,000,000 and liabilities of $7,500,000 (at NPV, discounted at 5%) on 1 January 2001, the insurance company is solvent. Imagine now that interest rates rise to 8%. The investments valuation will now fall to (62.5/100 x $10million) $6,500,000. If the insurance liabilities are shown as the same value, the balance sheet will become insolvent. This would not give a true and fair view, since the company could invest $6,500,000 now and be confident that the funds would grow to the amount needed to pay off the liabilities, since investment returns have increased.

Matching discounting of provisions to the assets held

The discount rates used to discount long-term insurance liabilities should be based on conservative estimates of the rates that the company expects to obtain from its investments.

Liability adequacy test

Although IFRS 4 does not require insurers to discount provisions for the figures routinely given to investors, it is still necessary for insurance companies to use some of this methodology. Issuers of insurance contracts are required to assess if the presented liabilities are adequate to cover expected claims. This is true even if claims are shown on an undiscounted basis.

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Case study 4.12

Glum Co is an insurance company that specialises in long-tail general insurance. It has written policies for environmental damage with income in the past of $15,000,000. These policies cost $1,000,000 to acquire and these acquisition costs are being deferred over a period of 5 years. At the end of the current year, remaining deferred acquisition costs are $450,000. The liabilities for these types of policy were estimated in the most recent accounts to be $18,000,000, on an undiscounted basis. Recent experience has shown that this type of insurance policy is likely to experience much greater losses than originally expected. It is now expected that the total amount of claims expected will be around $25,000,000 and that these claims will be paid in 5 years. Glum Co has investments that yield an average return of 6% per year and the company considers that this would be an appropriate rate to discount this liability, in accordance with the rules of IAS 37.
Required:

Assess whether the companys recorded liability for expected claims on these insurance policies is adequate. If not, outline the impact on the financial statements for these types of insurance policy. Note: This requirement is the same as saying Conduct a liability adequacy test in accordance with paragraphs 11 13 of IFRS 4

Solution to case study 4.12

Current provision Less: Deferred acquisition costs Net credit in balance sheet Required provision: 25,000 x 1/ (1.06)5 Dr Income statement (18,681 17,550) Cr Insurance liabilities

$000s 18,000 17,550 18,681 1,131

(450)

1,131

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Case study 4.12 continued

Imagine that the following year, Glum finds that the conditions are worse than expected. The amount that is now expected to be paid out on these policies is $32,000,000. These amounts are still expected to be paid on the originally estimated date, but expected investment returns have now increased from 6% to 8%.
Required:

Describe the impact on the balance sheet and income statement of Glum Co in this following year.
Solution to case study 4.12 continued

Following year provision required: 32,000 x 1/ (1.08)4 Dr Income statement (23,521 18,681) Cr Insurance liabilities

23,521 4,840 4,840

Equalisation provisions

It is common practice for issuers of insurance contracts to build up provisions (reserves) over a number of years to smooth profits when a large series of claims comes into the insurer, such as to cover the cost of claims arising from expected future hurricanes. IFRS 4 forbids the use of any such provisions, since they do not meet the definition of a liability, as there is no obligating event to incur a catastrophe in the future. In effect, results must be shown with no smoothing. This can be expected to produce much more variable results for insurers that apply IFRS 4 than those currently using equalisation provisions. This may increase the perceived risk by investors of investing in companies issuing insurance contracts.
Reinsurance

The income statement of a life insurer should classify the gross written premiums and net written premiums, in order to give an indication of how much insurance risk is being reinsured outwards.

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IAS 36 applies to amounts recoverable from reinsurers. A company presenting results under IFRS 4 is required to assess the willingness and ability of reinsurers to pay, both for determination of: Current amounts due from reinsurers (on claims notified) On future claims expected from reinsurers for claims incurred but not reported.

Deferred Acquisition Costs

IFRS 4 permits the policy of deferral of acquisition costs and of premiums earned and unearned. Little precise guidance is given on how to apply this, as these are areas left for phase 2 of the insurance accounting project.

Issues specific to life insurance

Life insurance policies vary widely in what they cover. The issues that particularly need to be addressed when accounting for life insurance policies are: Unbundling life policies between deposit and insurance element Accounting for discretionary participation features (eg with profits life insurance policies).

Example of unit-linked endowment

Imagine a whole life insurance policy, in the form of an endowment policy. These types of policies are common with endowments that are used to repay mortgage loans to purchase homes. Imagine that the investor invests a fixed amount of $50 per month. This is then accumulated in a fund, with the life office withdrawing an annual management fee of 2% of the funds value. The policy is designed to mature in 20 years to an amount sufficient to repay the policyholders mortgage loan, plus provide some funds extra. The value of the fund is not guaranteed, and if the value of the fund in 20 years is not sufficient to repay the policyholders mortgage loan, the life office offers no compensation for this.

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In the event of the early death of the policyholder before the policy matures, the life office agrees to pay over the greater of (i) the accrued value of the endowment fund and (ii) the outstanding mortgage loan. This type of arrangement is both an investment vehicle for the policyholder and also a form of insurance. There is no transfer of financial risk to the insurance company from the policyholder, since the insurance company offers no guarantee of the funds value. The policy, however, contains both a deposit component and also an insurance component. Both need to be shown separately by the issuer of the policy.

Impact of the balance sheet approach to life insurance accounting

Each time that a new member joins a policy with a life insurance element, the recognition of the life insurance element drastically reduces profit compared to the profit reported under a more cash accounting based system.

Discretionary participation features

It is common for life insurance policies that contain many of the characteristics of investment vehicles to offer discretionary bonuses to policyholders if investment returns are strong. If a life insurance office has a return greater than a guaranteed return, this may be retained by the life office as a profit, or awarded to investors as a bonus. This bonus is normally awarded in the form of bonus units, which increases the valuation of each endowment holders deposit. The managers of a fund such as this one have a number of choices as to what to do with the results of a better-thanexpected performance by investors: Award it to investors as a bonus Withdraw it as profits by the life office Some mixture of the two.

In practical terms, it is generally a competitive decision between life insurance companies how much of this surplus is given in bonuses to policyholders and how much is retained. It is also common for companies to hold it in a suspense account on the balance sheet. If the amount is given to policyholders as bonus

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units, this reduces the life insurers solvency. Equally, withdrawing it as profit can have adverse effects in the marketplace relative to other insurers. If such a surplus fund exists, but there is no obligation to pay it as bonuses to investors, it fails to meet the definition of an obligation in the IASB Framework document. If it is not declared as shareholders profit, it similarly fails to meet the intended definition of equity (eg shareholders accumulated profits). Many companies used to present the results of this in a mezzanine presentation between liabilities and equity.
CASE ILLUSTRATION

Extract from the accounting policies section in the financial statements of Aviva plc (the parent company of Commercial Union life insurer): The fund for future appropriations is used in conjunction with long-term business where the nature of the policy benefits is such that the division between shareholder reserves and policyholder liabilities is uncertain. Amounts whose allocation either to policyholders or shareholders has not been determined by the end of the financial year are held in the fund for future appropriations. Since this accounting policy note was published, Aviva has reclassified this fund as a liability, in order to better comply with IFRS 4. IFRS 4 specifically prohibits this treatment, since it requires that all items in the balance sheet are classified as one of the elements of financial statements, being: Assets Liabilities Equity Gains Losses.

A mezzanine, or hanging, presentation of a number that can be highly material in the balance sheet is not allowed. Issuers of insurance contracts such as this one need to decide an accounting policy on whether the entire discretionary amounts are shown as liabilities, equity or some split between the two.

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Financial Instruments IAS 32: Presentation IAS 39: Recognition and Measurement IFRS 7: Disclosures

Purpose of these notes

IAS 32 and IAS 39 are rather complicated accounting standards which mostly affect much larger entities. The purpose of these notes is to help the reader identify which types of transactions a smaller entity is likely to engage in that may unexpectedly require compliance with these standards. The notes are intended to be an introduction to the pervasive themes of the standards, in order to enable the reader to then be able to navigate through IAS 32, IAS 39 and IFRS 7 with greater efficiency and confidence. These notes do not cover most of the technical content of these standards, but are instead intended to be a bridge enabling a reader with little prior experience of accounting for financial instruments to then be able to read and apply the standards with greater confidence and efficiency.

Scope

These three standards together give the rules for accounting for financial instruments and for hedging transactions. The rules for hedging are included within IAS 39 since derivatives are a common means of hedging risk. The standards do not cover certain transactions governed by other standards, including: those interests in subsidiaries, associates and joint ventures that are consolidated, or are accounted for using the equity method or proportionate consolidation in accordance with IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investment in Associates or IAS 31 Interests in Joint Ventures; rights and obligations under leases (IAS 17 Leases). However: lease receivables recognised by a lessor are subject to the derecognition and impairment provisions of IAS 39; finance lease payables recognised by a lessee are subject to the derecognition provisions of IAS 39; and

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derivatives that are embedded in leases are subject to the embedded derivatives provisions of IAS 39. employers rights and obligations under employee benefit plans (IAS 19 Employee Benefits); financial instruments issued by the entity that meet the definition of an equity instrument in IAS 32 (including options and warrants). rights and obligations under an insurance contracts as defined by IFRS 4 Insurance Contracts, and under a contract that is within IFRS 4 because it contains a discretionary participation feature. However, IAS 39 applies to derivatives embedded in such a contract; contracts for contingent consideration in a business combination (IFRS 3Business Combinations); contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date; loan commitments that cannot be settled net in cash or another financial instrument (except those that are designated as financial liabilities at fair value through profit or loss); and financial instruments, contracts and obligations under share-based payment transactions (IFRS 2 Share Based Payment), except certain contracts to buy or sell a nonfinancial item as noted below.

These notes cover the various stages necessary to decide an appropriate IFRS-compliant accounting treatment of financial instruments, being: Initial recognition of financial instruments The debt/equity split Initial classification, for which the motive for buying the financial instrument is critical Initial valuation Subsequent valuation Reporting changes in value Derecognition Disclosures about risk.

The need for the standard

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Financial instruments are now mainstream commercial transactions, with trillions of unsettled derivatives (see definition below) unsettled at any point in time. Accounting rules for accounting for financial instruments became more necessary as the transactions themselves became much more common over time. Prior to the introduction of IAS 39, there were great inconsistencies in classification of financial instruments, especially where some financial instruments have some characteristics of debt and other characteristics of equity such as with convertible bonds. To enable comparability between companies and consistent calculation of important ratios such as the gearing ratio, IAS 32 requires a standard presentation of such items. There has been an enormous growth over the last decade in the use of derivatives for managing risk or, in direct opposite motivation, for speculation in high risk investments. Many such contracts often dont require any cash flow until the final outcome of the bet is known. Prior to the introduction of IAS 39, many companies were failing to show large expected losses in their year-end financial statements, since there had been no cash flow by the balance sheet date as the bet was not yet required to be settled. The spectacular failure of companies such as Barings Bank created a demand for consistent, timely reporting of expected gains or losses on financial investments as well as thorough disclosures of what investment activities companies were undertaking and the likely risks associated with these investments.

Transactions typically caught by these standards

For the smaller reporting entity that doesnt intentionally engage in hedging strategies using financial investments or have an active investment activity, IAS 39 is likely to apply to two types of transactions: Long-term investments, including investments in redeemable bonds. Guarantees given over the value of something, including the value of an exchange rate, perhaps by guaranteeing an exchange rate in a sale of goods to a foreign buyer. Anything which appears to have the characteristic of a bet is likely to be covered by IAS 39, as this may well be a derivative.

Definitions (paraphrased for simplification)

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A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A financial asset is cash, an equity investment in another entity (eg an investment in shares) or a contractual right to receive cash or some other benefit from another entity. A financial liability is a contractual obligation that will require the entity to deliver cash or some other value to another entity. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. In other words, its an interest in the net assets of another business, such as a share in that other business. A derivative is a contract which varies in value in response to a change to some underlying asset (eg exchange rate, interest rate, commodity price); which requires little initial investment and which is settled at a future date. Derivatives have many of the characteristics of a bet on the future value of something. An embedded derivative is a bet hidden within an otherwise normal appearing contract.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arms length transaction.

Note: Fair values are a pervasive theme in IAS 39. The full definitions are given in IAS 32 paragraph 11 and IAS 39 paragraphs 8 13.

RECOGNITION Initial recognition and disclosure

All financial instruments are recognised as soon as the entity becomes contractually bound by them. This means that they are often recognised in the financial statements before any cash is paid over. This is consistent with the Framework definitions of asset and liability. For example, a financial liability is recognised where at any point there is an obligation on the reporting entity to transfer funds to a third party, even if this obligation is not due for immediate settlement. A derivative which looks likely to lose money is therefore a financial liability that must be recognised

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even if it is due to be cashed out (ie settled) some time in the future. Upon recognition, even if there has been no cash flow, the entity must make all of the disclosures of IFRS 7. These are left to the end of these notes. In summary, the disclosures should enable an investor to understand what financial instruments the entity is exposed to, why they chose to take the exposure and what the perceived risks of the investment in the financial instruments are. The disclosure requirements of IFRS 7 are given at the end of this chapter.

THE DEBT/ EQUITY SPLIT

A significant thrust of IAS 32 is to ensure consistency in recognition of financial liabilities and equity. Reporting entities are typically keen to minimise the amount of debt reported on the balance sheet, since the presence of debt is seen to increase business risk and thus increase cost of capital. IAS 32 requires that where a financial instrument has the characteristics (ie commercial substance) of debt, it must be reported as debt regardless of its legal form. For example, a redeemable preference share imposes a clear obligation on the issuer to transfer out economic benefits in the future, so must be classified as debt in the IFRS financial statements, despite legally being a share. Other financial instruments may have some of the characteristics of debt and some of equity. The approach is to identify what asset has been received on the issue of a financial instrument, identify how much of this represents a liability with the residual amount being reported in equity.

Compound instruments

A compound instrument is one that combines the characteristics of both debt and equity. The principal example of these is a convertible bond. A convertible bond is a loan note which contains a right, but not obligation, for the holder of the bond to require the issuer to issue a pre-set number of shares upon redemption of the bond instead of redeeming it for its stated redemption value. The existence of the obligation means that there is an element of debt within the instrument. However, a convertible bond will be initially issued for a greater value than a non-convertible (often called straight) debt as the option to convert will have some intrinsic value. Note that an option can only ever have a positive value, although that positive value may be very small and close to zero.

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From the perspective of the issuer, application of Framework principles will produce the correct results.

Case study 39.11

On 1 January 20x1, Manjet Ltd issues convertible bonds with a nominal value of $1,000,000. Each bond pays an annual coupon in arrears of 4% of nominal value. The bonds are redeemable by the holder on 31 December 20x5 at their nominal value. Assume that no transaction costs were incurred in the issue. The holder of the bond has the option to convert each $100 block of debt into 40 ordinary shares in Manjet on 31 December 20x5. The issuer has no option to require that the bonds are converted. Manjet has a BBB credit rating. Bonds issued by companies with a BBB credit rating and a similar redemption date are currently trading with a yield of 5%.

Required

If the bonds were not convertible, suggest a maximum price that Manjet would be able to issue the bonds for on 1 January 20x1. Ignore transaction costs. If the bonds were issued with the holders option to convert and were issued for total consideration of $1,025,000 show how this would be reported in the financial statements of Manjet at the issue of the bond and at 31 December 20x1.

Solution to case study 39.11

If the bonds were not convertible, the initial issue price would be such that an investor could expect to receive a yield of 5% over the life of the bonds. This means that the issue price would be the net present value of the expected cash flows, discounted at 5% pa.

Net present value of coupon annuity: $40,000 pa for 5 years, discounted @ 5% Net present value of redemption: $1 million end of year 5, discounted @ 5% Total initial liability @ 1 January 20x1 783,526 956,705 173,179

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This means that for a straight debt with these terms (coupon 4%) to sell in a market that is currently demanding a return of 5%, it would need to be priced at a discount so that each $100 block would sell for a maximum price of approximately $95.67.

Assuming that the bond contained the option to convert at issue and was issued at a premium of 2.5% on nominal value the initial recognition in the financial statements on 1 January 20x1 would be: Proceeds from issue Less: Net present value of non-convertible debt (with same coupon and redemption: see above) Equity as residual interest (956,705) 68,295 1,025,000

As with the bonds in the case studies below, this bond would then be shown at amortised cost, using an annual effective rate of the initial internal rate of return (here 5%). So at the end of year 1, the charges in the income statement and year-end value in the balance sheet would be: Interest expense (5% x $956,705) Liability in balance sheet ($956,705 + $47,835 - $40,000) $964,540 47,835

This technique of determining year-end liability is elaborated further below. Do not be too concerned if it seems unclear at this stage. If the convertible is eventually redeemed without conversion into shares, the $68,295 will be transferred to retained earnings on 31 December 20x5. If the shares are issued, this figure will be credited to share capital and share premium account to show the consideration effectively received for the issue of these extra shares.

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Framework focus This accounting treatment in the books of the issuer of a convertible bond is consistent with the framework definitions of asset and liability. The liability to the issuer (ie the unavoidable obligation to transfer out assets) is the obligation to pay coupon and redeem the bond. If the option to convert is exercised, it does not result in an outflow of resources, so does not meet the definition of a liability. Equity is defined as the residual interest of assets less liabilities, meaning that the premium paid for the option to convert is credited on issue of the bond directly to equity.

Convertible bonds from holders perspective

The holder of a convertible bond will also have to unbundle the bond into its pure debt and option elements. The initially recognised values are likely to be as given above. In each subsequent period, however, the option value must be revalued to market value and the gain or loss reported either in equity or the income statement, depending on whether the convertible is held for trading, available-for-sale, etc as elaborated below. Valuation of non-traded options is a highly complicated matter and may involve techniques such as the Black-Scholes options valuation model. It is likely that many companies use subjective valuations based on what their investment manager or department would be willing to pay for each convertible bond at the end of each period and comparing that to the amortised cost of straight debt.

Initial classification

In order to comply with IAS 32 and IAS 39, it is critical to ensure that the financial instrument is appropriately classified. To do this, it is probably logical to first identify and document the motive for acquiring the financial instrument. Motives will typically be one of: Hedging Short-term gain Longer-term gain.

Motive 1: Hedging

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If an entity wishes to manage its risk to some uncertain future event, it may well choose to take out a financial instrument as a hedging item.

Case study 39.1

Fearful Co is an oil producer, based in Trinidad. It is obviously exposed to the risks of the international market for oil, with the price of oil being almost entirely outside Fearfuls control. The company is concerned that if oil prices were to fall much further below current spot prices, it would run into short-term cash flow difficulties. To protect against this risk, Fearful may take a number of options, such as contracting to sell some of its oil forward, meaning that it agrees a price with a buyer today for delivery at some point in the future. This provides Fearful Co with certainty of what its income will be. If spot oil prices then fall, Fearful will win from the bet as it will sell at a price above spot prices. Conversely, if oil prices were to rise, the contact to sell forward will have an intrinsic negative value, since it imposes an obligation on Fearful to sell at below market rates. If Fearful cannot find a buyer that is willing to buy at a forward price, it may hedge its risk by buying an oil price future. This is a technique that effectively places a bet with another party on the future price of oil. When the actual price is known, one party wins and the other loses. The important point at this stage is to recognise and thoroughly document the motive for entering into the contract. In this case, it was to hedge (ie protect against) a future drop in cash flow arising from future sales. As will be shown later, this transaction would be classified as a cash flow hedge under IAS 39.

Motive 2: Short-term gain

This motive is given the name trading in IAS 39. It means to contact to buy or sell some financial instrument in the short-term, very probably because the investor believes that the market for that financial instrument (eg the value of a share) is getting the price wrong. The investment in trading is to enter into a contract such as to buy shares with an intention to reverse that position quite soon after. This enables the investor to make a short-term gain or dealers margin with a view to short-term profit taking.

Motive 3: Longer-term gain

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This is where an investor intends holding a financial asset for a long period of time, quite often where there is a maturity date to the investment, such as an investment in dated US government stock. Ordinary equity shares may be held for long-term investment, but they cannot be intended to be held to a maturity date since shares dont have a maturity when the investor is given their money back by the company. An entity may also advance a loan to a third party for long-term speculation or gain, such as a bank providing a household mortgage to a lender.

CATEGORIES OF FINANCIAL INSTRUMENT

Upon identification of the motive for entering into the transaction, the financial asset or liability must be categorised into one of the four categories in paragraph 9 of IAS 39, being: Loans and receivables Held-to-maturity investments Available-for-sale financial assets Financial assets or financial liabilities at fair value through profit or loss.

Category: Loans and receivables

This is quite a simple category. These are loans with known payments that are not quoted on an active market, or if quoted on an active market are held with a view to short-term resale. For example, this category would include any loans advanced by an entity such as a loan made to a customer on ordinary commercial terms to enable the customer to buy a home.

Category: Held-to-maturity investments

There are non-derivative financial assets with known payments and a fixed maturity date that the entity has both the positive intention and ability to hold to maturity.

Category: Financial assets and financial liabilities at fair value through profit or loss

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Any asset or liability that is held for trading is automatically included in this category. As the name implies, any financial instrument in this category must be maintained at up to date fair value with the moment in fair value being reported in full each period in the income statement. An entity may designate any financial instrument as being held at fair value through profit or loss at its initial recognition.

Category: Available for sale financial assets

This is a residual catch-all category for financial assets that are not any of the above categories. An entity may designate any financial asset as available for sale on its initial recognition. An available for sale financial asset is one which the entity does not have any immediate intention of selling, but would be able to sell without causing damage to the entity if it were advantageous to do so.

VALUATION BASES

There are two valuation bases for all financial assets and liabilities in IAS 32and IAS 39: Fair value (mostly governed by IAS 39) Amortised cost (mostly governed by IAS 32).

The reporting entity has some choice over which base to use, although in some cases, the base is stated by IAS 32 or IAS 39. For example, all derivatives are required to be recorded at fair value.

Valuation base: Fair value (IAS 39 Appendix A, paragraphs AG69 AG82)

Where a financial instrument is valued each period to its fair value, it is initially recognised at its fair value. This is logical, since it is likely to have been purchased for its fair value in the first place. If an item is to be held at fair value through profit or loss (see below), any transaction costs associated with its purchase must be written off immediately to the income statement. Otherwise, transaction costs are added to the initial carrying value (IAS 39, paragraph 43). Determination of fair values for quoted instruments is a relatively straightforward matter, normally being the bid price (ie the lower of the bid-offer spread if one exists), without deducting any expected transaction costs. If the entity has access to more

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than one market, items should be valued at the highest available bid price. Valuation of non-traded financial instruments is a more challenging task. In the absence of an active market for the financial asset, the entity must use other bases for deciding a value, which might include (Paragraph 74, Appendix A, IAS 39): Recent arms length transactions in similar (or the same) financial instrument, or Reference to the value of similar securities in an active market (although presumably making some allowance for relative liquidity; evidence suggests that shares in unquoted companies are worth around 30% less than shares in quoted companies to reflect the greater difficulty in finding buyers), or Discounted cash flow analysis of expected cash flows, timing of cash flows and an appropriate risk adjusted discount rate, or Options pricing models such as the Black-Scholes model (this would be a very complicated means of deciding a fair value in almost all cases so is probably not to be preferred).

If discounted cash flows are used, these are inherently judgemental and thus difficult to both question and to defend. Care should be taken, however, not to make errors of principle such as: Mixing inflation adjusted cash flows with non-inflation adjusted discount rates, and/or Producing highly cautious discounted cash flows on something close to a worst-case scenario and then double counting risk by discounting these cash flows at a high risk adjusted discount rate rather than a general return expected on similar securities.

Valuation base: Amortised Cost

Amortisation is the process of transforming one number into another number over time. The phrase is commonly used to describe the process of transforming an intangible asset such as a patent with a known life to zero value by periodic write-off. The same process is often used in IAS 32 and IAS 39 to transform one smaller number over time into a larger number. Amortised cost is probably the more simple basis for determining numbers for financial instruments under IAS 32 and

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IAS 39 as it does not require annual restatement of asset or liability values to fair values. It does, however, require reasonable certainty about what the cash flows will be. IAS 32 requires that assets recognised initially at cost are then subsequently valued to amortised cost, using the effective interest method (paragraph 9 IAS 39). Definition: The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, where appropriate, a shorter period to the net carrying amount of the financial asset or liability. In other words, the effective interest rate is the internal rate of return of the financial instrument: the discount rate where its net present value is zero. In practical terms, this can be estimated by using the =IRR() function in Excel or similar spreadsheets or calculators.

Case study 39.2

Globe Co issues deep discount bonds on 1 January 20x1. The bond carries an annual coupon (payable in arrears) of 3% of nominal value. Each $100 block of the bond was issued for consideration of $84.40. The bond is due for redemption on 31 December 20x5. The total nominal value of bonds in this issue were $10 million. Globe Co paid $80,000 to a bank to administer the issue. Globe Co designates the bond under the category of loans and receivables per IAS 39. It has the positive intention and ability to hold the bond to its maturity.

Required

Show the carrying value of the bond in Globes financial statements for the year to 31 December 20x1.
Suggested solution

The total expected cash flows relating to this bond first need to be identified. 1 January 20x1: Cash inflow from issue Issue costs $8,440,000 ($80,000)

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Total initial cash flow 31 December 20x1: Coupon annuity 31 December 20x2: Coupon annuity 31 December 20x3: Coupon annuity 31 December 20x4: Coupon annuity

$8,360,000 ($300,000) ($300,000) ($300,000) ($300,000)

31 December 20x5: Coupon annuity 31 December 20x5: Redemption Total cash flow 31 December 20x5: 1 Jan 20x1 31 Dec 20x1 31 Dec 20x2 31 Dec 20x3 31 Dec 20x4 31 Dec 20x5 IRR 8,360,000 (300,000) (300,000) (300,000) (300,000) (10,300,000) 7.00%

($300,000) ($10,000,000) ($10,300,000)

This is calculated in Excel as =IRR(B1:B6) The annual interest charge is then charged using the interest rate implicit in the bond, ie its IRR. This is a similar principle to accounting for finance leases (IAS 17) and accounting for provisions (IAS 37). 1 Jan 20x1 31 Dec 20x1 31 Dec 20x1 31 Dec 20x1 31 Dec 20x2 31 Dec 20x2 31 Dec 20x2 1 Jan 20x3 1 Jan 20x3 1 Jan 20x3 31 Dec 20x4 31 Dec 20x4 31 Dec 20x4 31 Dec 20x5 31 Dec 20x5 31 Dec 20x5 31 Dec 20x5 Initial value Interest @ 7% Coupon Liability Interest @ 7% Coupon Liability Interest @ 7% Coupon Liability Interest @ 7% Coupon Liability Interest @ 7% Coupon Liability Cash 8,360,000 585,200 (300,000) 8,645,200 605,164 (300,000) 8,950,364 626,525 (300,000) 9,276,889 649,382 (300,000) 9,626,272 673,839 (300,000) 10,000,111 (10,000,000)

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Rounding error

111

Financial statements extracts Balance sheet

Financial liability: bonds

$8,645,200

Income statement

Interest expense

$585,200.

The principle of amortised cost requires up-front calculation of internal rate of return but unless there is a change in the expected cash flows leading to an impairment, or a reclassification as available for sale, the figures are comparatively stable. There is then no need to establish fair values.

Case study 39.3 (continuation of 39.2)

Suppose that bonds with a nominal value of $100,000 were purchased by Chiquitita Co on 1 January 20x1, incurring transaction costs of $3,000. At 31 December 20x1, prevailing market interest rates for this type of bond have risen from 7% as they were at the issue of the bond to 8%. The bonds had an ex-interest price of $77.26 per $100 block at this date.

Required

Explain how Chiquitita will show the bond in its financial statements in each of the following situations: If the bond had been designated on its purchase as held-to-maturity by Chiquitita if Chiquitita has the positive intention and ability to hold the bond to its maturity on 31 December 20x5 If the bond was designated by Chiquitita on its original purchase as being held at fair value through profit or loss If the bond at its original purchase had been designated by Chiquitita as an available for sale financial asset.

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Solution

If the bond has been designated as held-to-maturity and Chiquitita has the ability to designate it as such, the bond would be measured at amortised cost, using the internal rate of return of the bond from Chiquititas perspective. This would involve estimating all of Chiquititas cash flows including its acquisition costs and finding the bonds IRR from those cash flows. This would be the basis of the interest cost and balance sheet carrying value. The variation in market price would not be relevant as the asset would not be shown at fair value unless it is necessarily reclassified as an available for sale financial asset (eg if Chiquitita lost the ability to hold to bond to maturity or stood ready to sell it).

If the bond had been designated at its purchase as being held at fair value through profit or loss, then the variation in market value would need to be recorded. Assuming that there was no difference between the fair value of the bond at its purchase and the value Chiquitita paid for it, it would initially be recorded at a fair value of $84,400. The $3,000 transaction costs would be written off immediately as an expense as they do not increase the fair value of the bond. At the year end, the bonds would be revalued to their bid price of $77,260, meaning that a loss would be reported in the income statement of $7,140 ($84,400 - $77,260).

If the bond is designated as an available-for-sale financial asset, the balance sheet must show the latest fair value. The loss may be reported either in the income statement or in equity (see below for further details of this).

SUMMARY: INITIAL RECOGNITION AND SUBSEQUENT VALUATION

The table below summarises the appropriate accounting treatments for various financial instruments bought for investment purposes (but not for hedging purposes).

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HTM Initial value

A-F-S FA

FVPL

L&R

Cost, including acquisition costs Amortised cost

Cost, excluding acquisition costs Fair value

Cost, including acquisition costs Fair value

Cost, including acquisition costs Amortised cost

Subsequent value

POSSIBLE MEANS OF REPORTING GAINS AND LOSSES

Method 1: All inclusive reporting of gains and losses

Generally gains are reported in the income statement, with the result that they reach equity as part of retained earnings. All gains increase net assets of a business with the result that they must somehow increase equity if the balance sheet is to balance. This is how gains on financial assets or liabilities held at fair value through profit or loss are reported each period in the income statement and so also equity, thus:

Method 2: Reporting gains directly in equity

It is also possible to report gains directly in equity, which is how revaluation gains on property plant and equipment are reported. When the asset is then sold, the reported gain in the income statement is calculated as the difference between the sales proceeds and the revalued amount. This has the effect that a realised gain between the purchase price and sale value is never reported through profit. This is seen as a disadvantage of this method.

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Method 3: The hybrid approach of recycling

This method is refined for reporting gains on available-for-sale financial assets. These are reported at fair value with the gain reported directly in equity until the financial asset is eventually derecognised. Upon derecognition, the cumulative gain in equity is then reported in the income statement (Dr Equity, Cr Income statement). This gain in income statement has the effect of being then reported once more in equity as shown below:

This has the perceived disadvantage of reporting the same gain twice; once initially in equity and then later recycled through the income statement and so to equity again. There is conceptually no perfect means of reporting gains! IAS 39 specifies different reporting requirements depending on the classification of each financial instrument, as given below.

HTM Gain or losses reported in

A-F-S FA

FVPL

L&R

Amortisation expense or impairments in income statement

Change in fair value in income statement or directly to equity using recycling approach (see below).

Change in fair value in income statement.

Amortisation or impairments in income statement.

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Case studies 39.3 39.6

Howard Co purchased the following investments in the year ended 31 December 20x2: 39.3 On 1 January 20x2, it bought 400 bonds in Russell Co at a price of $102.40. The bonds pay an annual coupon at the end of each year of 7% and mature on 31 December 20x4. In the previous year, Howard Co had reclassified some bonds from held-to-maturity to available for sale. The bid market price of the bonds on 31 December 20x2 was $104.30. 39.4 On 1 December 20x2 it had entered into a forward contract with a bank to sell USD 500,000 at a forward exchange rate on 31 January 20x3 of TTD/USD = 6.45. At 31 December 20x2, the spot rate was TTD/USD = 6.36. 39.5 On 29 December 20x2, it short sold 5,000 in Dara Co, a listed company at a price of $4.60 each. (This means that it sold shares that it did not own by borrowing them from somebody else with a promise to replace them). On 31 December 20x2 it could have bought the shares in Dara Co for $4.45. 39.6 On 18 December 20x2, it bought 1,000 shares in Frankie Co for $2.34 each. The year end spread of prices was $2.45 - $2.55. It pays 1% of all fees in transaction costs to buy or sell investments.

Required

Calculate the figures to be shown in the income statement and balance sheet of Howard co for the year ended 31 December 20x2 for the above transactions.

Impairment of financial assets held at amortised cost (IAS 39 paragraphs 63 65)

If there is objective evidence that a financial asset is impaired, the carrying amount of the asset is reduced and an impairment loss is recognised. All financial assets whether held at fair value or at amortised cost must be recognised at an impaired value if there is external evidence of their value being reduced. Paragraph 61 of IAS 39 states that a significant or prolonged decline in the value of an equity instrument should be considered to be external evidence requiring impairment. Unfortunately, the standard does not define what is meant by

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either significant or prolonged, which creates practical difficulty. Given that the standard is not prescriptive in this regard, it is a matter of accounting policy selection for the reporting entity what significant and prolonged in this context means. A policy should be established and applied consistently to all financial assets. It may enhance the credibility of the financial statements to state what the entitys policy is for identifying such losses. Where a market value is available by reference to a deep market in the financial asset (for example major shares traded on one of the Worlds larger exchanges), then it would be difficult to justify not recording a drop in market value rapidly. However, where an entity holds a financial asset that is thinly traded and where that entity does not appear to have the intention or the need to sell the seemingly impaired asset in the near future, there is greater doubt whether the recoverable value of the asset truly has been impaired. It may be possible for an entity to devise a formula for recognition of impairment losses, taking into account the size of the apparent impairment below carrying value and the number of days that the most recent traded price for that asset has been below carrying value. It may be wise for entities to designate certain financial assets on initial recognition as thinly traded assets, which would be slower to recognise impairment losses than other financial assets. This is only a suggestion and it is up to each entity to decide an appropriate methodology and apply it transparently and consistently. A financial asset carried at amortised cost is not carried at more than the present value of estimated future cash flows. This net present value is calculated using the revised cash flows of the asset, but discounted at the original discount rate used to make the estimates of amortised cost. An impairment loss on an available-for-sale asset that reduces the carrying amount below acquisition cost is recognised in profit or loss in full in the year that the impairment becomes evident. For investments in unquoted equity instruments that cannot be reliably measured at fair value, impaired assets are measured at the present value of the estimated future cash flow, discounted using the current market rate of return for a similar financial asset. Any difference between the previous carrying amount and the new measurement of the impaired asset is recognised as an impairment loss in profit or loss.

Case study 39.7: Impairment of financial asset held-tomaturity

At the beginning of 20x5, a company makes a five-year loan of $5,000 that has an effective and original interest rate of 7%, received at the end of each year, and a principal amount of $5,000 at maturity. At the beginning of 20x9, there is evidence of impairment due to the financial difficulties of the borrower, and it is estimated that remaining future cash flows will be

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$2,500 instead of $5,350 (principal plus interest). The impaired asset is measured at the present value of the estimated future cash flow, discounted using the original effective interest rate, ie $2,500 discounted for one year at 7% ($2,336). Accordingly, the impairment loss recognised at the beginning of 20x9 is $2,664 ($5,000 - $2,336). IAS 39 requires accrual of interest on impaired loans and receivables at the original effective interest rate. In this case, therefore, an accrual of interest at 7% would be made on the carrying amount of $2,336, ie $164 in 20x9. For available-forsale financial assets, impaired assets continue to be measured at fair value. Any unrealised holding losses that had previously been recognised as a separate component of equity are removed from equity and recognised as an impairment loss in profit or loss.
Embedded derivatives

An embedded derivative is a hidden derivative, ie an option or a bet hidden within another commercially dissimilar contract. Embedded derivatives are still derivatives even if theyre hidden and so, like all derivatives, they must be separately recognised and shown each period end at their fair value. The embedded derivative must be unbundled from its host contract. Normally the change in fair value of a derivative is shown through profit or loss, with the only exception being for a derivative held for hedging (see below). It seems likely that any change in value of an embedded derivative would be shown each period in profit or loss therefore. Guidance on what constitutes closely related and dissimilar risks between a term that is suspected to be an emedded derivative and its host contract is given in IAS 39 Appendix A paragraphs AG 27 AG 33. An important matter for oil companies is that if oil is sold in US Dollars at an implied contracted rate, this is not normally seen as an embedded derivative, since it is normal world practice to price oil in US Dollars (IAS 39 Appendix A, paragraph AG 33(d)(ii)).

Case study 39.8: Embedded derivative

A company invests in a convertible debt instrument at a cost of $25,000. The fixed interest rate is 7% and it can be converted into ordinary shares in 10 years time, at the companys option, or, the capital can be repaid at $25,000. The investment is classed as available-for-sale. The equity conversion option (the embedded derivative) is separated from the host debt instrument because:

there is an embedded derivative

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it is not measured at fair value with changes in fair value recognised in profit or loss equity and debt are not closely related characteristics.

The fair value of the equity conversion option is $3,250: Dr Available-for-sale investment Dr Derivative asset Cr Cash $21,750 $3,250 $25,000

The derivative asset is accounted for at fair value with changes in fair value recognised in profit or loss. The debt instrument is accounted for as an available-for-sale asset at fair value with changes in fair value recognised directly in reserves. The difference between the initial carrying amount and the amount of the available-for-sale financial asset of $3,250 is amortised to profit or loss using the effective interest rate method. If it is not possible to reliably measure the embedded derivative element, then the instrument is treated as a financial asset or financial liability that is held for trading.

Derecognition of financial instruments (IAS 39 paragraphs 15 42)

A financial liability is derecognised when the liability is extinguished. A financial asset is derecognised when, and only when: the contractual rights to the cash flows from the asset expire; or the entity transfers the financial asset to an unrelated third party such that there is only an immaterial chance that the entity may continue to benefit from any future inflows that the financial asset may produce.

It is common in certain types of transactions for an entity to close out a financial investment by becoming party to a financial instrument that moves in the opposite way. For example, an entity may buy a future that requires it to buy gold on 31 March for a set price of $600 per ounce. A month later it may close out its exposure here if the futures price have moved against it by entering into a contract to sell the same amount of gold on the same date for a set price of $560 per ounce. Whatever happens to the price of gold on 31 March, the entitys exposure is known. However, the initial buy future cannot be derecognised since if the counterparty to the second contract goes bankrupt, the entity still would have a one-sided exposure. To derecognise financial assets, paragraphs 15 42 of IAS 39 give a number of conditions that require it to be virtually certain that the entitys exposure to the financial asset or financial liability is ended.

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HEDGING

Hedging is the process of protecting against adverse changes in business circumstances affecting the future cash flows of a business, or reducing the net asset value of assets recognised in the balance sheet, or of increasing the fair value of liabilities. IAS 39 provides for two kinds of hedge accounting, recognising that entities commonly hedge both the possibility of changes in the functional currency value of future cash flows (ie a cash flow hedge) and the possibility of changes in fair value of an asset or liability already recognised in the entitys balance sheet (ie a fair value hedge). The first step in hedging is to identify which is the hedged item (eg a receipt of USD that will need to be sold at an uncertain future exchange rate to yield TDD) and which is the hedging instrument (eg a forward currency contract for a Trinidad company to sell USD in exchange for TDD at a set date in the future). All hedging transactions will have a hedged item and a hedging instrument. If the hedged item loses value, the hedging instrument will gain in value and vice versa. As some of the hedging rules allow for gains and losses not to be reported in the income statement, strict conditions must be met before hedge accounting is applied in order to prevent companies using the hedging rules below to hide losses in reserves which are: There is formal designation and documentation of a hedge at inception. The hedge is expected to be highly effective (ie the hedging instrument is expected to almost fully offset changes in fair value or cash flows of the hedged item that are attributable to the hedged risk). Any forecast transaction being hedged is highly probable. Hedge effectiveness is reliably measurable (ie the fair value or cash flows of the hedged item and the fair value of the hedging instrument can be reliably measured). The hedge must be assessed on an ongoing basis and be highly effective. This means that the band between which the hedged item and hedging instrument can vary is only within a range of 80% -125%.

When a fair value hedge exists, the fair value movements on the hedging instrument and the corresponding fair value movements on the hedged item are recognised in profit or loss. When a cash flow hedge exists, the fair value movements, on the part of the hedging instrument that is effective, are recognised in equity until such time as the hedged item affects profit or loss. Any ineffective portion of

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the fair value movement on the hedging instrument is recognised in profit or loss.
Case study 39.9: Fair value hedge

A company purchases a debt instrument that has a principal amount of $1 million at a fixed interest rate of 6% per year. The instrument is classed as an available-for-sale financial asset. The fair value of the instrument is $1 million. The company is exposed to a risk of the decline in the fair value of the instrument if the market interest rate increases because of the fixed interest rate. The company enters into an interest rate swap. It exchanges the fixed interest rate payments it receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair value. If the derivative hedging instrument is effective, any decline in the fair value of the bond should be offset by opposite increases in the fair value of the derivative instrument. The company designates and documents the swap as a hedging instrument. On entering into the swap, the swap has a fair value of zero. Assuming market interest rates have increased to 7%, the fair value of the bond will have decreased to $960,000. The instrument is classified as available-for-sale, therefore the decrease in fair value would normally be recorded directly in reserves. However, since the instrument is a hedged item in a fair value hedge, this change in fair value of the instrument is recognised in profit or loss, as follows: Dr Income statement Cr Available-for-sale financial asset $40,000 $40,000

At the same time, the company determines that the fair value of the swap has increased by $40,000. Since the swap is a derivative, it is measured at fair value with changes in fair value recognised in profit or loss. The changes in fair value of the hedged item and the hedging instrument exactly offset each other: the hedge is 100% effective and the net effect on profit or loss is zero.

Case study 39.10: Cash flow hedge

A company trades in TDD and considers the TDD to be its functional currency. It expects to purchase a piece of plant for 1 million Euro in one year from 1 May 20x6. In order to offset the risk of adverse changes in the Euro rate, the company enters into a forward contract to purchase 1 million Euro in 1 year for a fixed amount (TDD 8.2 million). The forward contract is

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designated as a cash flow hedge. At inception, the forward contract has a fair value of zero. At the year-end of 31 October 20x6, the Euro has appreciated and the value of 1 million Euro is TDD 8.4 million. The machine will still cost 1 million Euro so the company concludes that the hedge is 100% effective. The highly probable future cash flow (to purchase the machine) has increased by TDD 200,000 but the value of the contract to buy Euro at a cheaper than market rate has gained in value by the same amount. Thus the entire change in the fair value of the hedging instrument is recognised directly in reserves in full. It is not recognised in the income statement, since there is no gain or loss on the hedged item yet in the income statement (as the hedged item is a forecast future transaction that hasnt yet been recognised in the financial statements). Dr Forward contract Cr Equity TDD 200,000 TDD 200,000

The forward contract is settled with no further change in the exchange rate: Dr Cash Cr Forward contract TDD 200,000 TDD 200,000

The company purchases the machine for 1 million Euro and makes the following journal entry: Dr Machine Cr Accounts Payable TDD 8,400,000 TDD 8,400,000

The deferred gain or loss of TDD 200,000 should either remain in equity and be released from equity as the machine depreciates, or be deducted from the initial carrying amount of the machine. A hedge of net investment in a foreign operation is accounted for similarly to a cash flow hedge.

Summary diagram for determining type of hedge

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Discontinuation of hedge accounting

If any of the following circumstances arise a company should discontinue hedge accounting prospectively, meaning that figures already reported are not changed, but that from this moment onwards the hedged item and the hedging instrument are treated as wholly independent transactions:

the hedging instrument expires or is sold, terminated, or exercised the hedge no longer meets the hedge accounting conditions the company revokes the hedge designation a hedged forecasted transaction is no longer expected to occur (in the case of a cash flow hedge).

For discontinued fair value hedges, any previous hedge accounting adjustments made to the carrying amount of hedged items are amortised over the remaining maturity of those assets and liabilities. For discontinued cash flow hedges, hedging gains and losses that have been deferred in equity generally remain in equity until the hedged item affects profit or loss, except in certain circumstances with forecast transactions.

DISCLOSURES ABOUT ACTIVITIES AND RISK: IFRS 7

IFRS 7 is a comparatively simple standard compared to IAS 32 and IAS 39. Its function is to enable readers of the financial statements to have a clear understanding of the activities, valuation bases and risks taken by the reporting entity.

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The standard requires extensive, but largely self-explanatory, disclosures about the value of each financial instrument by category (eg available-for-sale, held-to-maturity); any reclassifications and reasons for reclassifications. It also requires disclosure of any financial instruments pledged as collateral and the terms of any such pledges made. Any hedges are required to be disclosed with description of the items hedged, the hedging instruments, any changes in values and offsets made in accordance with IAS 39. The standard requires a number of qualitative and quantitative disclosures about risks, separated into different types of risk. Appendix A of IFRS 7 identifies the following types of risk (wording simplified) which require significant disclosures: Credit risk Liquidity risk The risk of the other party failing to pay their obligations on a financial instrument. The risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities. Often called risk of gearing or leverage. The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk can be decomposed into currency risk, interest rate risk and other price risk.

Market risk

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IAS 12: INITIAL CASE STUDY

John, Paul, George, Ringo and Robbie are all sole traders in different businesses. They each have received $100,000 in cash in the current year in sales revenue. They all live in the same country, where there is a uniform corporate tax rate of 30% on all profits. The tax system where they live is to charge tax based on cash profits, with the exception of non-current assets which are depreciated on various standard bases, depending upon the type of asset. For simplicity, none of these traders has any assets. You are given the following information about the traders:
John

John is a public relations consultant. He spends approximately 40% of his revenue on extremely expensive client entertaining and corporate gifts. None of this entertaining or gift buying is allowed by the tax authority as a legitimate business expense. His total expenses in the year were $69,350, $39,500 of which was not allowed as a deduction against tax.

Paul

Paul is a fast food retailer, using the name of a major chain under a franchise agreement. At the start of this year, he paid the franchise owner $180,000 for the right to use the franchise name over a period of 6 years. The tax authority allowed all of this payment as a deduction from tax in the current year. His total expenses (in addition to the franchise fee) in the year were $46,000, $250 of which was not allowed as a deduction against tax.

George

George sells foreign holidays. He is the only one of the traders not to have started in business this year. He made tax losses in the previous four years to a total of $450,000. Under the tax laws of the country, he is entitled to carry forward these losses as a deduction against future profits from the same trade for an unlimited time. He is not allowed to carry them back against profits of previous years. His total expenses in the year were $83,000, $500 of which was not allowed as a deduction against tax.

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Ringo

Ringo operates a car rental business. Normally, people pay in cash at the same time as renting a car, but for big events using the most expensive cars (mainly weddings) Ringo requires full payment in advance. This can be up to six months in advance. At the year end of 31 December 2002, Ringo had received cash of $24,500 for services that he had not yet provided, but was required to provide in the following year. His total expenses in the year were $64,700, $200 of which was not allowed as a deduction against tax.

Robbie

Robbie has been trading for one year only, but has already managed to find himself the subject of a lawsuit, which his lawyer advises him that he will probably have to settle early in the new year. The lawsuit relates to an incident two months before the year end. The lawyer advises that Robbie will probably have to pay $9,000 to settle the case and that the lawyers own fees will be about $900. His total expenses paid in the year were $65,500, $1,000 of which was not allowed as a deduction against tax.
Required:

Decide an appropriate set of accounting policies for the traders in the light of the above information. Prepare outline income statements for the traders for the year, including a calculation of the tax that will be demanded by the tax authority in that year. Unless you are told otherwise, none of the traders had any prepayments, accruals or inventory. Assess whether the potential investors in each of these businesses is being given reliable information about sustainable profits before tax and sustainable information about profits after tax. Which transactions are creating a problem and what remedy might we suggest?

Suppose the following year they all continue to trade at exactly the same levels of trade, with the only exception being that Ringo has not received any prepayments for car rental. There were no changes to tax rates or tax law.

Required:

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Draft budgeted income statements for the five traders, including your estimate of tax payable. Compare the tax rate that each trader is paying in the two years. Discuss whether this gives a true and fair view.

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Suggested solution to case study John

John is paying a high rate of tax relative to his profits. This is sustainable, though, as a high proportion of his expenses are not allowable for tax and this is a core feature of his business. There are therefore no financial reporting issues to consider in preparing Johns financial statements, as the tax charge and tax rate he is paying already give a true and fair view of his current and likely future profit. Johns effective rate of tax (tax as a % of profit before tax) has been: Year 1: Year 2: General rate of tax: 68.7% 68.7% 30%

This is a permanent feature of his business, as John spends a lot of money on unnecessary things. He is effectively being punished by the tax authority and there is no evidence that this will change in the future. Any investor investing money in Johns business can expect to see approximately this rate of his profits being paid over to the tax authority in the future on an ongoing basis. Although his effective tax rate is therefore very much higher than the general rate of tax, it is a sustainable figure that gives a true and fair view.

Paul

The payment for the franchise fee meets the definition of an asset in the IASB Framework document, since it is something that Paul owns (or controls) that has an identifiable cost and will give benefits into the future. The appropriate accounting treatment therefore is to write this cost off over its expected useful life, which here is $180,000/6 = $30,000 per year. The cost is initially recognised as an intangible asset under IAS 38 but is written off over its useful life. The tax treatment is different, with an immediate write off in the current year. This means that the tax rate that Paul is reporting (ie a zero tax charge) is completely unsustainable. In the next year, he will be charging $30,000 amortisation for the lease, but will receive no tax

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relief on this expense. This will make his tax charge next year very high. At the moment, there is no warning to shareholders about this inevitable increase in tax in the future so we are failing to give them a true and fair view of sustainable profits. Using the tax actually payable to the tax authority on an unadjusted basis, this gives Paul tax rates (as a % of profit before tax as the shareholder sees) in year 1 and year 2 of: Year 1: Year 2: General rate of tax: 0% 67.8% 30%

There is clearly something very misleading here, as neither Pauls business, the tax rate, nor tax law have changed and yet the tax rate is exceptionally variable!
George

As George has tax losses, he has not paid tax in either year. The investor may think that this will continue forever and assume that Georges business is exempt from tax. In fact, one day the tax losses will run out and George will be paying more than 30% of his profits to the tax authority. At the moment, an investor has no way of knowing this.
Ringo

Although nothing has changed in Ringos business other than the fact that he did not have any revenue to defer at the end of year 2, his effective tax rate (tax charge as a % of profit before tax) has shown this pattern: Year 1: Year 2: General rate of tax: 98.6% 17.8% 30%

Again, this is almost certainly misleading to an investor.

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Robbie

Robbie had recognised an expense as due in year 1, but he paid the cash over in year 2. This had the effect of distorting his effective tax charge a great deal. Year 1: Year 2: General rate of tax: 43.3% 22.3% 30%

Again, nothing in the tax law and nothing in Robbies business had changed. This means that his year 1 effective tax rate of 43.3% gave a misleading impression of what a recurring tax rate would be for him. Compare this to John, whose tax rate was very high, but permanently so. Robbies tax rate was only temporarily very high. The terms permanent and temporary will come up often in our study of deferred tax!

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IAS 17: Leases

This chapter deals initially with the accounting for a transaction by a lessee, as this is the main focus of lease accounting for most businesses. An outline of accounting by lessors is given at the end of the chapter.
The need for the standard

Companies will often use assets held under lease agreements. The contracts that give the right to use the asset will often generate a liability that is difficult or commercially impossible to avoid. Leasing is seen commercially as an alternative means of acquiring assets compared to borrowing funds to buy the asset outright. Although legally the asset may remain the property of the lessor, the lessee often effectively has control of the leased asset for most or even all of its useful life. The lessee also has an obligation to pay future lease payments. Applying the principle of substance over form from the Framework document, if a company controls a large value of assets these assets should be shown on the lessees balance sheet, even if they are not owned by the lessee.
Framework focus The Framework definition of an asset is a resource controlled by an entity, rather than owned. If an entity controls an asset, that asset should be recognised at some appropriate value on the lessees balance sheet, even if there is no option for the lessee to buy the asset from the lessor. The Framework also defines a liability as an obligation to transfer economic benefits, whether this is a legal or constructive obligation. Often lease agreements are for long periods of time, with no effective ability to avoid the contract and thus avoid the future payments. This means that leases often produce obligations that meet the definition of liabilities in the framework document. Case study 17.1

An airline signs ten agreements to lease ten new Boeing 787 aircraft. Each lease is not cancellable by the airline (or can only be cancelled under terms that are so onerous that it is unlikely that they would be cancelled) until the lease expires in ten years. Each lease allows the airline to use each aircraft for ten years, but then also allows it to extend the period of the lease for a further five years at an annual rental of $1 after the initial lease

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term expires. The aircraft always remains the legal property of Boeing and Boeing may seize the asset if rental payments are not made on time. There is no clause in the agreement that allows the lessee to purchase any of the aircraft at any time. The design life of a new Boeing 787 is 25 years.

Required

Discuss the possible problems accounting for this transaction, paying attention to: The Framework definition of an asset The Framework definition of a liability The concept of reporting commercial substance over legal form How the company can give the most useful information to investors about the sustainability of its profit and cash flows.

Solution to case study 17.1

The legal form of the transaction is that the aircraft is never owned by the airline, although it is under the airlines use for the majority of the expected life of 25 years. It seems highly likely that the airline would lease the aircraft for 15 years rather than 10 years, as the final 5 years involve very little cash expenditure to retain use and control of the asset. Through the expected life of the lease, the airline have control of the aircraft and the aircraft is expected to generate benefits for the airline (ie enable the airline to make sales). The aircraft thus provides an expected inflow of benefits and is under the airlines control. This meets the definition of an asset under the Framework and so the aircraft should be recognised in the airlines balance sheet. The lease is non-cancellable, meaning that the airline has an unavoidable commitment to make payments to Boeing for the life of the contract. This is an obligating event causing an expected outflow of benefits and is thus a liability in the books of the airline that should be shown on the airlines balance sheet. In commercial substance over legal form, the aircraft will be shown as an asset of the airline, with an obligation to pay a stated sum for the use of that asset. This is more useful information to shareholders than simply recognising lease expenses as paid and not including the aircraft on the

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companys balance sheet, since to not recognise the aircraft would give investors a misleading impression of the liabilities (ie unavoidable obligations) of the airline and the assets employed by the airline.

Case study 17.2

Consider the characteristics of the following lease agreements: A contract to rent a holiday cottage for a month A contract to rent a new car from a leasing company for a period of five years. A contract to rent a photocopier for a period of ten years.

Solution to case study 17.2

Renting a cottage for a month is a short time compared to the expected life of the asset. It is unlikely that the renter would consider the cottage to be an asset belonging to the renter, but rather an asset which the renter has temporary use of. There are also unlikely to be any material liabilities to pay for the use of the cottage at the year end, unless the rent was unpaid, in which case it could be fairly described as an ordinary current payable. The useful life of cars is variable depending on the car, but five years appears to be a fairly long period of time. It is likely that the renter would consider the car to be his/ her car. A car will lose the great majority of its market value in the first five years of its life. At the inception of the lease, the renter would be very aware of the obligation to pay for the car for a period of five years and the total liability to pay would quite possibly be close to the market value of the car at the inception of the lease. In substance, this may be more similar to a hire purchase agreement for most companies than a simple rental. This is slightly borderline but may be seen to be more akin to a purchase agreement than to a simple rental agreement. A photocopier is unlikely to have a life of greater than ten years. This rental agreement will most probably be for substantially the whole useful life of the asset. It is the same in commercial substance as if the renter had borrowed money from a third party and used this money to purchase a photocopier. This will especially be true if the agreement is non-cancellable, or cancellable only on adverse terms. This would mean that the renter has an unavoidable obligation also

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to make payments for the next ten years.

TYPES OF LEASE

IAS 17 draws a distinction between two types of lease: Finance leases Operating leases.

A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incident to ownership.

An alternative working definition of an operating lease is that an operating lease is a lease that is not a finance lease! The logic of IAS 17 is that assets should be recognised in the balance sheet of the lessee if the lessee substantially has control of the asset. This places the definition of a finance lease on the definition of an asset in the Framework document. Items that suggest a lease is a finance lease include (IAS 17, paragraphs 10-11): Transfer of ownership of the asset to the lessee at the end of the lease term (commonly referred to as a hire purchase agreement) If the lessee has the option to purchase the asset at a price which is expected to be substantially less than the fair value of the asset at the date the option to purchase becomes exercisable (commonly called a bargain purchase option) The lease term is for the major part of the economic life of the asset, even if legal ownership is never transferred to the lessee If at the inception (ie start) of the lease the present value of the lease obligation (ie rental payments) amounts to substantially all of the fair value of the asset at inception If the asset is so specialised that it is unlikely to be of any use to any other business other than the lessee If the lessee guarantees that if the lessee cancels the lease, the lessee will pay the lessor any losses the lessor suffers If the lessee has the ability to continue to use the asset after the expiry of the minimum term of the lease for a rental that

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is below the market rentals that could then be charged for that asset. These are indicator only and it is very much a matter of professional judgement whether a lease is a finance lease or an operating lease. In practical terms, each company should draw up its own tests and apply them consistently.
Why is the difference important?

Fairly small differences in the commercial nature of a lease can make a great difference to the accounts as the accounting for finance leases and operating leases is very different. In summary:
Finance lease Operating lease

Asset

Capitalised as if the Not on the balance lessee owned the asset sheet of the lessee. and depreciated as normal. Obligation to pay future lease rentals recorded and discounted to net present value. Depreciation on the leased asset an expense. Interest costs on the unwinding of the discounting of the lease obligation shown as an expense. No liability to pay future rentals shown in the balance sheet. Only lease rentals as they fall due shown in the income statement.

Liability

Income statement

Disclosures

Significant

Relatively minor.

Most companies would prefer to have a lease agreement interpreted as an operating lease rather than as a finance lease, since finance leases immediately increase the reported gearing of the company. The following summary diagram should help in deciding whether a lease is an operating lease or a finance lease:

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Start

Is ownership transferred by the end of the lease term? No Does the lease contain a bargain purchase option? No Is the lease term for a major part of the assets useful life? No Is the present value of the minimum lease payments greater than or substantially equal to (eg 90% of) the assets fair value? No This is an operating lease

Yes

Yes

Yes

Yes

This is a finance lease

Accounting treatment

IAS 17 requires that, when an asset changes hands under a finance lease, lessor and lessee should account for the transaction as though it were a credit sale. In the lessee' books s therefore:

DEBIT CREDIT

Asset account Lessor (liability) account

The amount to be recorded in this way is the lower of the fair value and the present value of the minimum lease payments. A variant approach which produces the same net result is to debit the asset account with the fair value, and to debit an interest suspense account with the total amount of interest or finance charges payable under the agreement and to credit a

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lessor account with the total amount (capital and interest) payable under the agreement. We will see later how this affects the year end accounting entries. IAS 17 states that it is not appropriate to show liabilities for leased assets as deductions from the leased assets. A distinction should be made between current and non-current lease liabilities, if the entity makes this distinction for other assets. The asset should be depreciated (on the bases set out in IASs 16 and 38) over the shorter of: The lease term The asset' useful life s

If there is reasonable certainty of eventual ownership of the asset, then it should be depreciated over its useful life.

COMPREHENSIVE CASE STUDY 17.3 Summary of Terms of Agreement for Lease of a Car

Lease term: Rental: Deposit: Timing of rental:

Three years from 1 January 20x1 $600 per month None. Paid by the lessee into the lessors bank account by the last day of each month The lessor retains legal title at all times until the lessor and lessee agree that the lessee shall exercise their purchase option (see below). At the end of this lease, the lessee shall have the option to purchase the car for an amount of $5,000.

Legal title:

Purchase option:

Guarantee of residual value: The lessee does not guarantee any residual value of the car. Insurance and maintenance: The lessee is responsible for insuring the car and maintaining it to a standard agreed with the lessor. The lessee is responsible for any losses arising for example due to theft, fire or damage beyond normal wear and tear.

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Repossession by lessor: If any lease payments are more than one month, the lessor can obtain immediate repossession and still obtain all lease payments due. Cash alternative purchase: The lessee may opt to buy the car outright for its fair value at the inception of the lease of $20,000. Any payments made between inception and exercise of this option shall not be refundable by the lessor. Assume that this type of car loses 25% of its market value each year and that this is the lessees depreciation policy for cars generally. Also assume that the lessor incurs legal fees and other incremental costs of $900 to sign the lease.
Suggested solution Classification of lease

Is ownership transferred by the end of the lease term? No. Does the lease contain a bargain purchase option? Yes it does, see working 1. The expected market value of the car at the time when the option to purchase can be exercised will be substantially greater than the cost of exercising the option. It is therefore very likely that the option will be exercised. Is the lease term for a major part of the assets useful life? No, but it doesnt matter, as we already have one yes answer, so this is a finance lease. Is the present value of the minimum lease payments greater than or substantially equal to (eg 90%) of the assets fair value? Yes (see working 1). But we wouldnt have to calculate this in order to describe this as a finance lease. We would, however, have to do lots of calculations in order to determine how to include this lease in the financial statements of the business.

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Conclusion

On the basis of the information available, this is a finance lease, because it has a bargain purchase option that means that legal title is very likely to eventually be transferred. The non-current asset will be included in the balance sheet of the lessee, as will the liability to pay for it. There will be no future interest included in this initial liability, since there is no obligation to incur this liability for future interest. See working 2. Dr Cr Non-current assets Liabilities $20,000 $20,000

Asset in lessees balance sheet

The asset would be included in the balance sheet of the company and would therefore need to be depreciated as required by IAS 16 Property Plant and Equipment. The period of depreciation is the shorter of: The useful life of the asset, and The maximum lease term.

Here, the depreciation policy is given as 25% per annum on a reducing balance basis.
Working 1

Expected market value of the car at the time of the option to purchase being possible to exercise: Market value at 1 January 20x1: $20,000 $8,438

Expected market value at 31 December 20x3: (0.75 x 0.75 x 0.75 x $20,000) This is the cash that the lessee could reasonably expect to receive from selling the car in year 3 if they were to purchase it for a bargain purchase price of $5,000. They could therefore expect to buy the asset from the lessor on 31 December 20x3 for $5,000 and sell it on for $8,438. As this is almost certainly going to happen, the lease should be classified as a finance lease.

Working 2

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Net present value of the minimum lease payments at inception of the lease. To calculate the NPV of the minimum lease payments, it is first necessary to identify from the lease what the expected pre-tax cash flows of the lessor are, assuming that the bargain purchase option will not be taken. This is to determine what the interest rate implicit in the lease is. IAS 17 states that the interest rate implicit in the lease is: the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor. This is a serious practical difficulty, since the figures may not be known, for example how much the asset cost the lessor to buy. It can also be onerous. For this reason, the short-cut methods such as the sum of the digits method discussed later are often used instead in practice. Assuming that the lessor pays the cars fair value of $20,000 at the inception of the lease to buy the car, these are the cash flows and timing of the lessors cash flows: Month 0: Purchase of car and other marginal costs Month 1 35 Lease payments Month 36 Lease payment + highly probable purchase option The IRR of these cash flows is 1.1543% per month (using Excel =IRR() function or similar calculator).
Working 3 Calculation of the net present value of minimum lease payments DF @ implicit rate DCF @ implicit rate

$20,900 cash outflow $600 inflow $5,600 inflow

Cash flow

T0 T1 - T35 T36 Total

Non-refundable deposit Rentals payable Rental and purchase

0 1.1543% 600 1.1543% 5,600 1.1543%

0 17,195 3,705 20,900

The month by month liability in the balance sheet of the lessee can therefore be calculated as:

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Liab bf

Interest @ 1.1543%

Cash

Liab cf

Total interest

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

20x1 20x1 20x1 20x1 20x1 20x1 20x1 20x1 20x1 20x1 20x1 20x1 20x2 20x2 20x2 20x2 20x2 20x2 20x2 20x2 20x2 20x2 20x2 20x2 20x3 20x3 20x3 20x3 20x3 20x3 20x3 20x3 20x3 20x3 20x3 20x3

20,900 20,541 20,178 19,811 19,440 19,064 18,684 18,300 17,911 17,518 17,120 16,718 16,311 15,899 15,483 15,061 14,635 14,204 13,768 13,327 12,881 12,430 11,973 11,511 11,044 10,572 10,094 9,610 9,121 8,626 8,126 7,620 7,108 6,590 6,066 5,536

241 237 233 229 224 220 216 211 207 202 198 193 188 184 179 174 169 164 159 154 149 143 138 133 127 122 117 111 105 100 94 88 82 76 70 64

-600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -600 -5,600

20,541 20,178 19,811 19,440 19,064 18,684 18,300 17,911 17,518 17,120 16,718 16,311 15,899 15,483 15,061 14,635 14,204 13,768 13,327 12,881 12,430 11,973 11,511 11,044 10,572 10,094 9,610 9,121 8,626 8,126 7,620 7,108 6,590 6,066 5,536 0

2,611

1,933

1,156

EXTRACTS FROM THE FINANCIAL STATEMENTS Balance sheet

Non-current assets Non-current assets held under finance leases ($20,000 x 0.75) Long-term liabilities $15,000

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Finance lease liability Current liabilities Finance lease liability ($16,311 - $11,044)
Income statement (extracts)

$11,044

$5,267

Depreciation on assets held under finance leases Interest charges on finance lease liabilities Notes to the financial statements

$2,500 $2,611

Included within creditors are finance leases with the following minimum lease payments: Payable within the next year ($600 x 12) $7,200 Payable between two and five years $7,200 Payable thereafter $0 Less: Future interest included in the above not yet due($3,089) Total liability in the balance sheet $11,311 The net present value of lease payments due within the following periods is: (Note: this is the payments to be made, but excluding interest that will become payable in that period). Payable within the next year ($600 x 12) - $1,933 $5,267 Payable between two and five years $6,044 Payable thereafter $0 Total liability in the balance sheet $11,311

SHORTCUT ALTERNATIVE FOR APPORTIONMENT OF RENTAL PAYMENTS

Lease rental payments are fixed payments for the duration of the lease. They comprise two elements: An interest charge on the finance provided by the lessor to enable the lessee in substance to purchase the asset under a hire purchase agreement from the lessor. This proportion of each payment is interest payable and interest receivable in the income statements of the lessee and lessor respectively. A repayment of part of the loan provided to the lessee by the lessor. In the lessee' books this proportion of each s

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rental payment must be debited to the lessor' account to s reduce the outstanding liability. In the lessor' books, it s must be credited to the lessee' account to reduce the s amount owing (the debit of course is to cash).

At the inception of the lease, the loan is very large. This means that the large loan generates large interest charges. Towards the end of the life of the lease, the loan is smaller, as its largely been paid off, generating smaller interest charges. The fixed repayments each period therefore comprise both an interest and a capital element, as such:

Loan principal element of each payment Interest element of each payment

Time

In reality, the mathematics are a little bit more complicated than a straight line like this (a straight line split between capital and interest is prohibited by IAS 17 unless the difference between a straight line apportionment and accurate apportionment using either the actuarial or sum of digits method is immaterial). The split between the two will look more like this:

Loan principal element of each payment Interest element of each payment

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Time

The accounting problem is to decide what proportion of each instalment paid by the lessee represents interest, and what proportion represents a repayment of the capital advanced by the lessor. There are two apportionment methods you may encounter: The actuarial method, as in case study 17.3 The sum-of-the-digits method, as an approximation to the actuarial method.

The sum-of-the-digits method approximates to the actuarial method, splitting the total interest (without reference to a rate of interest) in such a way that the greater proportion falls in the earlier years. The procedure is as follows.

(a) Calculate the total cost of finance over the period of the lease as the total difference between the total amounts expected to be paid less the cash price of the asset at the inception of the lease. (b) Assign a digit to each instalment. The digit 1 should be assigned to the final instalment, 2 to the penultimate instalment and so on. (c) Add the digits. A quick method of adding the digits is to
n (n + 1) 2

use the formula

where n is the number of instalments

and if the instalments (ie payments) are made in arrears rather than in advance of each period, so that the last payment is made on the final day of the minimum lease term. If the payments are made in advance of each period, there will be one fewer interest bearing period, as the first instalment will be paid to repay the loan before any interest has accrued. This means that if payments are made in advance, the sum of digits formula is amended to

n(n 1) . 2

(d) Calculate the interest charge included in each instalment. Do this by multiplying the total interest accruing over the lease term by the fraction:
Digit applicable to the instalment Sum of the digits

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Case study 17.4

On 1 January 20x1, Visitors Co signs a contract as lessee for the use of some oil drilling machinery for a period of six years. The contract requires an initial non-returnable deposit of $20,000 and six annual payments of $45,000 to be paid at the end of each year. At the end of the lease period, Visitors Co has the right to extend the lease into a secondary period of up to another six years at a further nominal annual rental of $1 to be paid also at the end of each year. The expected useful life of the drilling machinery is ten years. The drilling machinery could be purchased for cash at 1 January 20x1 for $240,000. The lease is considered to transfer substantially all the risks and rewards incident to ownership of the drilling equipment to Visitors Co.

Required

Using the information above and the sum of the digits method of allocation of finance lease costs, produce extracts from the financial statements relating to leases at 31 December 20x1.

Solution

In this example, enough detail is given to use any of the apportionment methods. In an examination question, you would normally be directed to use one method specifically.
Total finance charges

Total amounts expected to be paid: Initial non-returnable deposit Lease payments ($45,000 x 6) Total payable Less: Cash price Total cost of finance over 6 years $20,000 $270,000 $290,000 ($240,000) $50,000

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Allocation of total finance charge to each period

Interest bearing instalment First (31.12.x1) Second (31.12.x2) Third (31.12.x3) Fourth (31.12.x4) Fifth (31.12.x5) Sixth (31.12.x6) Total sum of digits

Digit 6 5 4 3 2 1 21

Date

Payment

Accrued interest

Loan principal

1.1.x1 1.1.x1 31.12.x1 31.12.x1 31.12.x1 31.12.x2 31.12.x2 31.12.x2 31.12.x3 31.12.x3 31.12.x3 31.12.x4 31.12.x4 31.12.x4 31.12.x5 31.12.x5 31.12.x5 31.12.x6 31.12.x6 31.12.x6

Inception Deposit 20,000 Interest ($50,000 x 6/21) Payment 45,000 Year-end Interest ($50,000 x 5/21) Payment 45,000 Year-end Interest ($50,000 x 4/21) Payment 45,000 Year-end Interest ($50,000 x 3/21) Payment 45,000 Year-end Interest ($50,000 x 2/21) Payment 45,000 Year-end Interest ($50,000 x 1/21) Payment 45,000 Year-end

14,286 (14,286) 0 11,905 (11,905) 0 9,524 (9,524) 0 7,143 (7,143) 0 4,762 (4,762) 0 2,381 (2,381) 0 50,001

240,000 (20,000) (30,714) 189,286 (33,095) 156,191 (35,476) 120,715 (37,857) 82,858 (40,238) 42,620 (42,619) 1

Total interest

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EXTRACTS FROM THE FINANCIAL STATEMENTS Balance sheet

Non-current assets Non-current assets held under finance leases ($240,000 x 9/10) Long-term liabilities Finance lease liability Current liabilities Finance lease liability
Income statement (extracts)

216,000

$156,191

$33,095

Depreciation on assets held under finance leases $24,000 Interest charges on finance lease liabilities Notes to the financial statements Included within creditors are finance leases with the following minimum lease payments: Payable within the next year $45,000 Payable between two and five years $180,000 Payable thereafter $0 Less: Future interest included in the above not yet due($35,714) Total liability in the balance sheet $189,286 The net present value of lease payments due within the following periods is: (Note: this is the payments to be made, but excluding interest that will become payable in that period). Payable within the next year Payable between two and five years Payable thereafter Total liability in the balance sheet $33,095 $156,191 $0 $189,286 $14,286

Proposals for change

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The IASB has a long-term project to revise lease accounting for the following reasons: The current distinction between operating lease and finance lease is difficult to apply The distinction is seen by many as arbitrary The financial statements look very different depending on whether there is a distinction of finance or operating lease Operating leases clearly include an obligation to pay rentals during the life of the lease. This obligation is not currently recognised in the financial statements.

It is impossible to predict the likely outcome of the IASB proposals as the project is in a very early stage. The IASB aim to issue an exposure draft in the second half of 2008 but there is no target date for a new IFRS on leasing. Given the increasing focus on standards applying the principles of the Framework, it seems likely that the new standard on leasing will require that all leases over perhaps one year in duration will be accounted for similarly to finance leases.

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IAS 19: Employee Benefits

The need for the standard

Accounting for employment costs has proven over the years to be one of the most controversial areas of financial reporting. The aims of applying the matching principle and to avoid reporting transactions that may give a misleading view of sustainable profit have produced a number of accounting standards that approach the problem in different ways. For many entities, especially larger entities, post-retirement costs can be a highly material component of both staff expenses and also liabilities. In Trinidad and Tobago, many such pension schemes are showing a surplus (which will be explained later). This is less of a problem than many other companies have around the world. In some cases, such as with British Airways, the obligation to pay pensions to past and current employees is of fundamental interest to analysts as the obligation is extremely large and at the moment the pensions liabilities greatly exceed the pension assets. Consistency in recognition, valuation and reporting of staff costs is clearly needed. The latest edition of IAS 19 attempts to show the total cost of employing a staff member in the current year by giving rules on: Recognition of accruals for unclaimed holidays Recognition of constructive but not legal obligations, such as bonuses expected by staff Recognition of all post-employment costs in the period where such benefits are promised, rather than when they are paid (or even when contributions into a pension fund are paid) Reporting gains and losses arising from changes in assumptions about pension liabilities.

SHORT-TERM COSTS (IAS 19, paragraphs 10 23)

This mostly means all costs associated with employing somebody in the current period other than post-employment (ie pension) benefits. It may include: Salary

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Employers taxes on employment such as social security contributions Accrued bonuses, profit sharing and holiday leave Benefits paid on termination.

For the most part, accounting for short-term benefits is a straightforward application of the matching/ accruals concept and application of the requirements of IAS 37 Provisions.

Case study 19.1

Gahan Co employs 500 staff at an average remuneration of USD 30,000 for 260 days paid annual remuneration. Average annual leave is 15 days paid holiday per year plus five days paid sick leave. Paid sick leave can be carried forward without limits if unused. It can be taken without a requirement to prove illness. Although the firms official policy is that all annual leave not taken by 31 December each year is forfeited, it has always been Gahans practice to allow staff to carry forward up to three days unused paid annual leave each year-end. In the current year, the average number of days of unused sick leave is two days and unused holidays (limited to five for each person) is 2.5 days. Staff are also paid bonuses each year of 10% of the companys profit before tax and before bonus expense. Without the bonus, Gahans staff would be paid below market rates. The companys directors believe that they would face significant difficulties with relationships with key staff if the bonus were not to be paid. The current years profit (before bonus costs) is USD 5.2 million.

Required

Calculate how each of the above items will affect profit for the current year for Gahan Co.

Solution to case study 19.1

IAS 19 paragraph 15 requires that where sick leave is in substance part of annual leave, the cost of providing it should be accrued. Unused sick leave: ($30,000/ 260) x 2,000 x 2 = $115,385

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Unused holidays: ($30,000/ 260) x 2,000 x 2.5 = $144,231 Accrued bonus: $520,000 10% x USD 5.2 million =

Total addition to short-term staff costs $779,616

Case study 19.2

An entity has 100 employees, who are each entitled to five working days of paid sick leave for each year. Unused sick leave may be carried forward for one calendar year. Sick leave is taken first out of the current years entitlement and then out of any balance brought forward from the previous year (a LIFO basis). At 31 December 20x1, the average unused entitlement is two days per employee. The entity expects, based on past experience which is expected to continue, that 92 employees will take no more than five days of paid sick leave in 20x2 and that the remaining eight employees will take an average of six and a half days each.

Solution to case study 19.2

The entity expects that it will pay an additional 12 days of sick pay as a result of the unused entitlement that has accumulated at 31 December 20x1 (one and a half days each, for eight employees). Therefore, the entity recognises a liability equal to 12 days of sick pay.
POST-EMPLOYMENT BENEFITS (IAS 19, paragraphs 24 143)

There are a wide variety of possible post-employment benefits, such as the possible costs of guaranteeing to run a staff alumni organisation. By far the most important post-employment benefit is a contractual arrangement to pay a pension to employees after they retire. This may be included as a term in each persons employment contract, or employees may opt into a pension plan. Often, there is a qualifying period of a few years before staff are entitled to opt into a pension plan. There are two possible types of pension plan; one of which presents few commercial risks and accounting difficulty and one which presents considerable difficulty both for the company and its accountants/ auditors. The distinction depends on what is defined (ie known) from the contract with the staff member.

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Pension plans

Defined contribution (Simple)

Defined benefit (More complex)

Defined contribution plans (IAS 19, paragraphs 43 47)

In such a plan, the known factor is what level of contributions the employer will make into a pension plan on behalf of the employee. If the eventual retirement fund is too little to meet the former employees needs, the employer has no ongoing legal or constructive obligation to the employee. As such, as soon as contributions are made into the pension plan, the employer is no longer exposed to ongoing risk or involvement. For this reason, the assets and liabilities of the pension plan are not reported on the employers balance sheet, since they do not meet the recognition criteria of the IASB Framework. Accordingly, the only impact on the financial statements of the employer is to record payments made into the pension plan on behalf of the employee. The only liability is if there are payments due that have not been paid. It is unusual for there to be any significant time lag between the employee providing their work and contributions being due for payment. As a short-term liability any unpaid amounts are therefore not discounted, since the effect of the discounting would be immaterial. Paragraph 45 of IAS 19 requires that any time lag of twelve months or more would be subject to discounting to decide the net present value of the contributions liability.

Note that throughout IAS 19, all pension plans must be held in a separate fund from the sponsoring employer. This fund must be a separate entity to the employer. This is to provide employees and pensioners with protection in the event that the employer runs into financial difficulty.

Defined benefit plans

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Defined benefit plans used to be common in a number of economies, including Trinidad and Tobago. They have become significantly rarer in recent years as they have become a much greater risk to employers than they were expected to be when the obligations to employees were created, ie when the funds were established. This is as investment performance has been more variable than expected but also very largely as former employees have lived materially longer after retirement than expected when they joined the pension plan. This is referred to as reduced mortality. Also, a number of pension plans have terms which provide for care of former employees if they are unable to work due to health. This risk of creating a greater cost of expected lifetime care is referred to by actuaries as morbidity. Both reduced mortality and greater morbidity have increased total pensions payable to former employees in many companies. The result of this perceived risk is that companies have largely closed their defined benefit plans to new members, opting instead to provide defined contribution benefits to staff. In the Caribbean, rather against world trends, a number of defined benefit plans are in surplus. There is still a risk to employers of this reversing however and so we can expect defined benefit plans to become less common in the future. Existing defined benefit plans will continue to be a feature of the sponsoring employers financial obligations however until the last pensioner covered by each defined benefit plan dies. The terms of a defined benefit plan are simply agreed between employer and employee. This means that the terms can be almost anything at all, ranging from the rather mean and inadequate to the very generous. A typical defined benefit plan will pay an annual pension (actually paid monthly but revised annually for inflation) to the former employee from the date of their retirement to the date of their death equivalent to:

Annual pension = Final salary x Years service for the employer 60

Case study 19.3

Pitt Co is a mining company. One employee, Brad, has worked for the company for 25 years and is now reaching the normal retirement age for the company of 55 years. At his date of retirement, his pensionable salary (this would be defined in his employment contract) was $16,500 pa. As part of his employment contract, he has been a member of the defined benefit plan for all of his working life with the company. He has a defined benefit pension determined as 2% of his final pensionable salary for each year of service. This is payable to him or to his wife until he dies. If he dies with a surviving spouse, the pension plan rules provide that 50% of the pension benefit is payable to the surviving spouse from the date of the former employees death to their own

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death. The pension payable is adjusted each year for inflation at the previous years inflation rate. Brad is married to a 55 year old woman. In his country, male life expectancy is 65 years for men and 71 years for women. As a former miner, Brads life expectancy is expected to be two years less than the average.

Required

Calculate the annual pension in todays terms that Brad can expect to receive. Ignoring the time value of money, calculate the total expected liability to Brad and his wife.

Solution to case study 19.3

Annual pension = Final salary x 2% x Years service for the employer $16,500 x 2% x 25 = $8,250 Brad and his wife can expect to receive $687.50 per month from Pitt until the latter of them dies. Brads remaining expected life from the date of his retirement is 8 years (65 2 55). His wifes remaining life is expected to be 16 years. Pitt therefore expects to pay (in todays money) eight years of pension of $8,250 and a further eight years to Brads wife of $4,125. This makes a total liability of $99,000, ignoring the time value of money.

Discounting liabilities

In reality, the time value of money will be very significant. In order to meet the future liability above of $99,000 it will be necessary to invest a substantially smaller amount today. Each year that the employee performs further service for the sponsoring employer, this will increase the pension eventually payable to him/ her. The sponsoring employer will need to invest further assets to meet this liability, although the time value of money will be such that the extra amount needed to be invested will be substantially smaller than the extra liability itself as the funds can be prudently expected to grow at something at least as fast as a risk free rate. This extra liability each year is referred to in IAS 19 as current service cost.

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In order to provide a prudent measure of the expected eventual liability, paragraph 78 of IAS 19 requires that the liability to pay future pensions is discounted at something only slightly above a risk-free rate of return. The standard prefers the discount rate to be used to calculate the NPV of the pensions liability each year to be the yield on high quality corporate bonds. If there is no deep market in such bonds, such as in Trinidad and Tobago, the yield on government stock should be used. Paragraph 78 of IAS 19 requires that the currency of the bonds used to estimate a risk-free rate shall be the same as the currency in which the pensions are eventually payable. Sadly, this means that reference to the yield on US government bonds is not an option for a pension plan whose pensions are payable in Trinidad and Tobago dollars. It would appear that a typical real rate of return used by a number of companies for such discounting is around 2.5% per annum. This is very much a rule of thumb and should only be used for discounting liabilities for smaller pension schemes where the difference between this rule of thumb and a more precisely determined estimate would not be material. If possible, the real rate of return on long-dated bonds issued by the government of Trinidad and Tobago should be used. The discount rate used should be consistent with the basis upon which the estimates have been prepared with respect to inflation. For example, if all pensions payable have been estimated using current prices without adjusting for the effects of expected future inflation, these cash flows should be discounted at a real rate rather than a money rate. The yield on government bonds prevailing at any time is inherently a money rate, since it logically also provides a return to cover current inflation. Care must be taken to ensure that the assumptions made with cash flows and discount rate are mutually compatible (IAS 19, paragraph 72).

Case study 19.4

The pension payable to Brad in case study 19.3 was estimated without making any allowance for future inflation. They are therefore real cash flows which must be discounted at the real rate, ie stripping out the effect of inflation when calculating the current return on government bonds. If the observed yield on government bonds (ie total return on a bond bought at todays market price) is observed at 9.8% and inflation at todays date is running at 7.0%, estimate the net present value of Pitts liability to Brad at Brads retirement date.

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Solution to case study 19.4

First, it is necessary to estimate an appropriate real discount rate, using the function: (1 + m) = (1 + i) x (1 + r), where m = money rate, i = inflation rate and r = real yield on government bonds. (1.098) = (1.07) x (1 + r) => r = 2.62% This will then be used to discount the expected cash flows payable to Brad (assuming one lump sum payment at the end of each year for simplicity), with the following cash flows: End of year 1 end of year 8: $8,250 annuity (ie recurring periodic payment) End of year 9 end of year 16: $4,125 annuity The net present value of the above at 2.62% is $82,778. If the same cash flows were to be discounted at the rates below, the net present value would vary significantly: At 3.62%, the net present value would be $77,655 At 5% the net present value would be $71,367 At 9.8% (ie accidentally mixing real cash flows and money discount rates), the net present value would be $54,828.

Even relatively small changes in discount rate can therefore affect the long-term liability significantly. Oddly, IAS 19 does not require disclosure of the discount rate used to discount the liability, nor any disclosure of how the liability in the balance sheet would change if the discount rate were to move by 1%.

Interest cost

Each period, the liability comes one period closer to expected settlement. It must therefore be compounded up by one year using the discount rate used to initially discount it. This is consistent in approach with unwinding discounts on liabilities held at net present value under IAS 37. In the context of IAS 19, this is referred to as interest cost although it is the same in substance as unwinding of discounts under IAS 37.

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Expected return on plan assets

In the same way that the liability will grow each period by the effect of compounding the liability up by one period, the pension plans assets will also be expected to grow by capital growth and dividends received. IAS 19 requires that the plan assets each year are compounded up by a long-term expected rate of growth. The standard is silent on how to estimate this rate of growth, so a long-term moving average appears to be the logical choice. Any difference between the expected growth in the plans assets and the actual growth forms part of the unexpected (actuarial) gain or loss arising in the period. This is elaborated below

Case study 19.5

Assuming that there is no change to estimates of expected lives or discount rates, show the movements in the liability Pitt Co has to Brad for the first year following his retirement.

Solution to case study 19.5

Liability brought forward Add: Interest cost @ 2.62% Less: Partial payment of liability (pension paid) ($8,250) Liability carried forward

$82,778 $2,167

$76,695

Actuarial gains and losses

In a defined benefit plan, the contractual duty of the sponsoring employer is to pay future pension benefits. This creates an obligation and an outflow of benefit so therefore a liability. This is a long-term liability since virtually all of it will be paid more than one year from the balance sheet date. It must therefore be discounted at an appropriate rate, as the time value of money is certain to be material. The size of the liability is inherently uncertain, with its value varying each period as each of these items may change: What each members final salary will be How long each person (or their dependants, if covered) will live after they retire

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Any other variables, such as additional health care costs provided after retirement The appropriate discount rate to use in calculating the net present value of the expected future cash outflows.

Changes in each of these estimates will cause a change in the net present value of the liability to pay future pensions. Such changes, even for a pension fund with no new members, can be highly material. In order to meet the liability for future pensions payable, almost all pension funds (the notable exception being almost all state pension plans) will also have a separate legally protected fund to hold the pension plan assets. There may be rules either in law or in the pension plans own rules that govern what type of investments the pension plan may make. Typically, trustees of a pension plan are only allowed to invest in lower risk investments and may be prevented from investing in the sponsoring employers own shares. If all goes to plan, the assets in the pension plan will grow to exactly meet the money needed to pay the employees their future pensions between when they retire and when they die. This inevitably never happens. In reality, each year it is highly likely that the assets and the liabilities will be out of balance, producing an actuarial gain or loss (surplus or deficit). This type of gain is referred to as an actuarial gain, since it arises as a balancing items from the complex calculations made about expected future returns, life expectancy of pensioners and many other complicated matters that are best performed by a professional actuary. IAS 19 does not require that a pension plan is valued by an actuary, but it requires disclosure of who performed the valuation. In any large pension plan, it is likely that analysts would not trust figures on such a complicated discounted cash flow analysis if that is prepared by the directors.
Case study 19.6

Consider the implications for the pension plan of Pitt Co in each of the following circumstances. Would each of these changes one-by-one be likely to produce an actuarial gain (ie surplus) or loss (ie deficit)? a. A more up-to-date survey shows that both male and female life expectancy are now two years higher than previously thought b. A significant number of the employees are found to be living with HIV c. Long-term investment returns increase to be 1% higher than previously estimated

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d. It is discovered that the workforce covered by the pension plan is 40% female, where the actuary had wrongly assumed it to be 50/50 split. In each case, consider separately the effect, if any, on the net present value of the pensions liability and then the effect, if any, on the value of the pension plans assets.

Solution to case studies 19.6a 19.6d

19.6.a. This would have no effect on the pension plans assets, but would increase the period for which pensions are expected to be paid. It would therefore generate a new actuarial deficit (loss). 19.6.b. This would have no effect on the pension plan assets. The results of this on the pension plan liability are uncertain. HIV if untreated is likely to significantly reduce life expectancy. This would therefore reduce the total pension payable and produce an actuarial surplus, as the pension payable would be less than previously estimated. However, if the pension plan includes health care cover, then the cost of HIV combination therapy could be a very substantial additional morbidity cost. This would then produce a substantial actuarial deficit (loss). The precise effects of each change in actuarial assumptions can only be determined with full knowledge of the rules of the pension plan itself. 19.6.c. This would have no effect on the pensions liability, but would increase the expected return on plan assets. As the plan assets at the end of the year would be greater than expected, it would create a new actuarial surplus (gain). 19.6.d. As female life expectancy is greater than male, a lower proportion of female workers to male would reduce total pensions payable and thus reduce the pensions liability below what was previously estimated. As it would have no effect on the pension plan assets, this would generate a new actuarial surplus (gain).
Case study 19.7

Assume that at the end of Brads first year of retirement, the life expectancy of both he and his wife have both risen by two years.
Required

Estimate the new pensions liability at the real discount rate of 2.62%.

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Solution to case study 19.7

The new cash flows expected to be payable would be (remembering that this is now one year later than the first actuarial valuation of the liability to Brad): End of year 1 end of year 9: $8,250 annuity (ie recurring periodic payment) End of year 10 end of year 17: $4,125 annuity The net present value of the above at 2.62% is $88,704.

This would have an unexpected effect on the year-end liability to Brad: Liability brought forward Add: Interest cost @ 2.62% Less: Partial payment of liability (pension paid) ($8,250) Liability carried forward (expected) Add: Actuarial loss in year Liability carried forward (actual) $76,695 $12,009 $88,704 $82,778 $2,167

Variability of actuarial assumptions

Actuarial assumptions can vary year by year. For this reason, it may be distorting to a view of sustainable profit to report all actuarial gains and losses arising each year in profit. Experience suggests that this could produce large credits one year, only to be countered by large debits the year after. This is especially the case with variations in discount rates, since these vary up and down with the economic cycle. IAS 19 therefore allows companies a choice of accounting policy for dealing with cumulative actuarial gains and losses, being either: Only report gains outside a 10% corridor in each years profit. This allows a pension plan to swing into surplus or deficit by 10% of the size of the pension plan without these actuarial gains or losses being reported in profit, or

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Report all actuarial gains or losses arising each year in full but bypass the income statement and report them directly in the statement of changes in equity.

The 10% figure is somewhat arbitrary and is determined as the larger of 10% of the fair value of the pension funds assets at the start of the period and 10% of the net present value of the pension funds liabilities at the start of the year.

Profit smoothing

IFRS generally try to prohibit profit smoothing techniques that have been used in the past, such as making and releasing unnecessary provisions. IAS 19 allows, and indeed requires, a sponsoring employer to take certain profit smoothing steps. This is sensible as with a pension plan where liabilities are very longterm and where a large number of different variables can affect the snapshot value of assets and liabilities each year. The longterm nature of a pension plan means that gains and losses can be viewed as unrealised for a longer period than normal provisions could. For example, an unusually strong performance in pension fund investments in the current year is likely to become a much weaker performance in the future before the liability to pensioners is extinguished. To minimise disruption to the income statement of the sponsoring employer, IAS 19 therefore requires: Either all actuarial gains or losses to be reported in full in equity as incurred, or only gains outside the 10% corridor to be reported in income statement. If the income statement with 10% corridor approach is used, any gain or loss outside this 10% limit may be amortised over the remaining service life of staff. Current year gain in pension fund assets reported in the income statement is a long-term average expected return on plan assets rather than the actual current year increase in plan asset value. Any increases in pension plan benefits with retrospective effect (past service costs) are amortised over the remaining service life of staff. This is not possible where pension benefits are enhanced for people who have already retired, as there is no period of benefit to match this cost to.

Curtailments (IAS 19, paragraphs 109 115)

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Where a sponsoring employer is able to reduce pension benefits payable under a pension plan this will produce an immediate actuarial gain, or at least reduction in deficit. A curtailment could occur where it becomes apparent that the sponsoring employer is not a going concern with the ongoing pension liability or where a division is sold or closed down. An employer may also be able to transfer the pension obligation to a third party such as an insurance company which may generate a gain on the derecognition of all the pension plans assets and liabilities. The figures for the pension plan must be revalued immediately before the curtailment using the most up-to-date actuarial assumptions and treated in accordance with the normal rules of IAS 19. By doing this, only the effects of the curtailment itself are reported in the income statement. In the event of such a curtailment happening, the difference between the net balance sheet position before the curtailment and after the curtailment is reported in the income statement immediately as a gain or loss.

Disclosures

There are substantial disclosure requirements of IAS 19. To comply with these, it is best to read the IAS itself. Broadly, all components of the net balance sheet position and all movements in these figures are required to be shown. The comprehensive case study below provides an example of the principal disclosures.

COMPREHENSIVE CASE STUDY

Derry, a public limited company, operates a defined benefit plan. A full actuarial valuation by an independent actuary revealed that the value of the liability at 31 May 20x4 was $1,500 million. This was updated to 31 May 20x5 by the actuary and the value of the liability at that date was $2,000 million. The scheme assets comprised mainly bonds and equities and the fair value of these assets was as follows: 31 May 20x4 31 May 20x5 $m $m Fixed interest and index linked bonds 380 600 Equities 1,300 1,900 Other investments 290 450 _____ _____ 1,970 _____ 2,950 _____

The scheme had been altered during the year with improved benefits arising for the employees and this had been taken into account by the actuaries. The increase in the actuarial liability in respect of employee service in prior periods was $25 million

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(past service cost). The increase in the actuarial liability resulting from employee service in the current period was $70 million (current service cost). The company had not recognised any net actuarial gain or loss in the income statement to date. The company had paid contributions of $60 million to the scheme during the period. The company expects its return on the scheme assets at 31 May 20x5 to be $295 million and the interest on pension liabilities to be $230 million. The average expected remaining working lives of the employees is 10 years and the net cumulative unrecognised gains at 1 June 20x4 were $247 million. The company wishes to use the corridor approach but minimise impact of the pension plan each year on its reported profit.

Solution to comprehensive case study

IAS 19 Employee Benefits concentrates on a balance sheet perspective for employee benefits and focuses on the use of current values. The surplus or deficit in the fund is to be determined annually with assets being measured at their fair value at the balance sheet date. The scheme liabilities should be measured on an actuarial basis using the projected unit credit method and a corporate bond rate to discount the obligations. The net amount appears in the employers balance sheet as an asset or liability. Full actuarial valuations should occur with sufficient frequency such that financial statement amounts do not differ materially from amounts that would be determined at the balance sheet date. The balance sheet asset cannot exceed the net total of (a) unrecognised actuarial losses and past service cost, and

(b) the present value of any available refunds from the plan or reduction in future contributions to the plan Gains and losses measured at the year end are reflected in the subsequent year. The amortisation of the net gain/loss is required if it is in excess of 10% of the greater of the defined benefit obligation or the fair value of the plan assets. The period of amortisation cannot exceed the average remaining service period. Plan amendments which result in a change in the past service cost for active employees is recognised on a straight line basis over the average remaining vesting period. Companies are concerned about the volatile nature of charges in the income statement in the form of the expected return on plan assets as the higher the asset value of equities then the

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higher will be the expected return on assets figure. If the equity market is volatile, then so will be the expected return figure. IAS 19 offers a choice of possibilities of how to deal with the amount of profit/losses not recognised in the income statement. The actuarial gains/losses can be deferred if the cumulative amount remains inside the 10% corridor. Any amount outside the corridor (and optionally any amount inside) can be amortised over a shorter period than the working lives of the employees or even immediately so long as the approach is consistent. An amendment to IAS 19 issued in December 2004 allows a further option in accounting for the actuarial gains and losses. The amendment allows an entity to recognise all of the actuarial gain or loss immediately through the statement of changes in equity. If an entity wishes to adopt this policy then they must do so for all defined benefit plans and all actuarial gains and losses.
Suggested approach

Working through each of the three balance sheet asset or liability accounts in double entry is probably the best way to see each transaction. In order these are: 1. Look at the previous years unrecognised actuarial gain or loss (if using the corridor limit approach). If using this approach, calculate how much of the opening actuarial gain or loss is outside the corridor limits. Apply the companys accounting policy to this (eg amortise over remaining service life of employees). 2. Calculate interest cost and add to pensions liability (Dr income statement, Cr liability) 3. Calculate expected return on plan assets and add to plan assets (Dr pension plan assets, Cr income statement) 4. Record any contributions to the plan (Dr pension plan assets, Cr company cash) 5. Record any pensions paid to former pensioners (Dr pensions liability, Cr pension plan assets) 6. Record extra liability to staff for one more year of service: current service cost (Dr income statement, Cr pensions liability) 7. Record extra liability for pension plan members for service already given, such as enhancements to benefits: past service cost (Dr deferred past service costs and/ or income statement, Cr pensions liability) 8. Compare the theoretical balance on pensions liability and pension plan assets and compare to actual. The differences are actuarial gains arising in the year. 9. Calculate carried forward balance on deferred actuarial gains or losses.

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10. Prepare necessary disclosures, including adding total of plan assets, pensions liability and unrecognised actuarial gain or loss to show one-line presentation of net recoverable or payable to the pension plan in the sponsoring companys balance sheet.
Pension plan liability

31.5.x5 Pensions paid 31.5.x5 Carried down (advised by actuary)

0 31.5.x4 31.5.x5 2,000 31.5.x5 31.5.x5 31.5.x5 2,000

Brought down Past service costs Current service costs Interest Actuarial loss (balance)

1,500 25 70 230 175 2,000

Pension plan assets

31.5.x4 31.5.x5 31.5.x5 31.5.x5

Brought down Contributions Expected return Actuarial gain

1,970 31.5.x5 Pensions paid 60 31.5.x5 Carried down 295 625 2,950

0 2,950

2,950

Actuarial gain unrecognised in profit (deferred on balance sheet)

31.5.x5 Income statement (w) 31.5.x5 Pension liability 31.5.x5 Carried down

5 31.5.x4 Brought down 175 31.5.x5 Plan assets 692 872

247 625 872

Balance sheet note 31 May 20x5 $m 2,000 (2,950) _____

Present value of the obligation Fair value of plan assets

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Net surplus in plan Unrecognised actuarial gains Net plan asset in sponsoring employers balance sheet

950 (692) _____ 258 _____

The net plan asset is subject to a test to ensure that it does not exceed the future economic benefit that it represents for the enterprise.

Income statement note

Current service costs Interest cost Expected return on plan assets Net actuarial gain recognised in the year Past service cost Income statement expense

20x5 $ 70 230 (295) (5) 25 25

Note: As the benefits are vested immediately following an alteration to the plan, the past service cost is recognised immediately.

WORKINGS (1) Corridor limits from previous year and recognition of previous year actuarial gain or loss outside corridor limit At 1 June 20x4

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Net unrecognised gain Limits of 10% corridor (greater of 10% of 1,500 or 10% of 1,970) Excess Amortisation is therefore (50 10 years)

$m 247 (197) _____ 50 _____ 5 _____

This will be recognised as Dr unrecognised gains 5, Cr income statement 5.

(2) Actuarial (gain)/loss

20x5 $ Present value of obligation at 1 June 20x4 1,500 Interest cost 230 Current service cost 70 Past service cost 25 Expected value* 1,825 Actuarial (gain)/loss a balancing figure 175 Present value of obligation at 31 May 20x5 2,000 * this is what the valuation would show if all of the estimates made at the start of the period had been 100% accurate 20x5 $ Market value of plan assets at 1 June 20x4 1,970 Expected return on plan assets 295 Contributions 60 Expected value * 2,325 Actuarial gain/(loss) a balancing figure 625 Market value of plan assets at 31 May 20x5 2,950 * this is what the valuation would show if all of the estimates made at the start of the period had been 100% accurate Actuarial gains and losses 20x5 $ (175) 625 450 On asset

On obligation

Gain/(loss) on the obligation Gain/(loss) on the asset Net

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Amount of actuarial difference recognised

b/f Gain /(loss) in the year (see (a) above) Recognised in the period (W) Net gain unrecognised at the year end

20x5 $ 247 450 (5) 692

Corridor limits for recognition of gain in year ended 31.5.x6 $ 10% of plan obligations at the start of the year 200 10% of plan assetsat the start of the year 295 Limit is the greater of the above 295 Actuarial gain at year end 692 Amount which falls outside the corridor 397 Amount recognised next year ( 10) 40

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IAS 21: Effects of Foreign Exchange Rates

The need for the standard

Clearly, many businesses will engage in transactions denominated in foreign currencies and so some uniformity in the treatment of foreign currency transactions and exposures is essential. IAS 21 covers a number of situations where a business may become exposed to changes in foreign exchange rates: Transactions of the reporting entity in a foreign currency, eg by raising a loan in a foreign currency or by making sales to a foreign customer where the sale price is denominated in the foreign currency. Having a foreign branch or subsidiary. The entity wishing to report its results in a different currency to the currency in which it principally operates, perhaps to attract US investors.

The standard covers each of these situations and provides detailed guidance on how each situation should be presented.

Outside scope of standard

IAS 21 does not cover foreign currency derivatives, which may include relatively common foreign currency risk management techniques such as forwards. These are covered by IAS 39. IAS 21 no longer contains rules about presentation of hedged transactions. These are also covered by IAS 39.

Principal changes to the previous IAS 21

Accounting for the effects of foreign currency transactions has been revised a number of times, with the most recent version of IAS 21 taking effect from 1 January 2005. The latest version of IAS 21 makes a number of fundamental changes to the previous version, including the introduction of the critically important concept of entities having to determine, as objectively as possible, which is their functional currency. The standard no longer has any concept of a closing rate method and temporal methods of translation of foreign subsidiaries.

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It is no longer possible for a company in a hyperinflationary economy to avoid the need to restate figures under IAS 29 by instead choosing that it shall record all transactions in a stable currency, unless that stable currency can fairly be described as the entitys functional currency (see below). Anybody familiar with the previous version of IAS 21 is well advised to study the latest version assuming no prior knowledge. Much of it will be familiar but much will not be.

Critical technical terms

Foreign currency Functional currency

A currency other than the functional currency of the entity. The currency of the primary economic environment in which the entity operates. See below for further discussion of this. Units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. Examples are receivables, payables and foreign currency deposits. Non-monetary items include non-current assets and goodwill. The currency in which the financial statements are presented. The exchange rate for immediate delivery.

Monetary items

Presentation currency Spot exchange rate

Suggested approach to foreign currency

These terms will be defined later, but it may help to give an overview of a suggested approach to foreign currency transactions: 1. Decide which is the entitys functional currency. Review this annually to ensure it is still the most appropriate choice. 2. Translate any transactions in foreign currency to the entitys functional currency as they occur at the spot rate 3. At the year-end, revalue monetary items to the closing rate with the ensuing gain or loss reported in the income statement

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4. Translate the financial statements from the functional currency to a different reporting currency, if required.

Key issue: Determination of functional currency

Trinidad and Tobago law requires that the accounting records are maintained in Trinidad and Tobago dollars. This can be rather onerous for branches of foreign entities where much of the income and expenses are not in the local currency. IAS 21 requires that each entity makes a formal assessment of which is its functional currency. This is step one in dealing will all foreign currency is critical as it decides which one currency in the World is not a foreign currency! Deciding which is the functional currency is a matter of professional judgement, possibly weighing up opposing factors. In practical terms, it is probably the currency that most people working in the business use to refer to transactions. Paragraphs 9 12 of IAS 21 give a number of factors that an entity should consider in deciding which is its functional currency, given below.

Primary factors to consider (give these a high weighting):

The currency that mainly influences sales prices for goods and services, which will often be the currency in which transactions are denominated and then settled The currency of the country whose economy mainly determines the sales prices of its goods and services. The currency that mainly influences costs of inputs, such as labour and materials.

Secondary factors to consider (give these a lower weighting):

The currency in which debt is raised to fund the business The currency in which sales receipts are usually retained Whether the activities of the entity are, in substance, a direct extension of the activities of a foreign parent. This would imply that the functional currency of the branch is the same as the functional currency of the parent. Indicators of such a closely tied parent-branch relationship include:

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Commercial decisions such as pricing and arranging borrowings all done by the parent company If transactions with the parent are a high proportion of the local entitys trading If the local entity is not a going concern without transactions with the parent entity.

o o

Once an entity has determined which is its functional currency, this is not changed unless there is a clear need to do so. It is therefore possible for an entity to have to deal with foreign currency in two stages, for example with a company whose functional currency is TTD buying some goods in EUR if that company is choosing to report in USD with a view to flotation on the New York Stock Exchange.

Initial recognition and subsequent gains and losses (paragraphs 20 34 IAS 21)

Foreign currency transactions must be translated at the spot rate on the date of the transaction into the functional currency from the foreign currency. This is the date when the item would first be recognised in the IFRS accounts. For acquisition of an asset, this is normally the date from which it is possible to control the asset. For a liability, it is the date from which an obligating event exists. At the end of each reporting period, monetary assets and liabilities are retranslated at the year-end rate. Any gain or loss arising on this retranslation is reported in full in the income statement. Changes in the exchange rate after the balance sheet date do not represent an adjusting event after the balance sheet date. Non-monetary items are not retranslated if they are held at historic cost. If they are held at fair value, for example investment property, they are retranslated at the rate ruling on the date that the latest fair value was established. This includes a fair value for items that must be checked to ensure that their historic cost does not exceed net realisable value, such as inventory. Exchange differences are generally reported in the income statement, although if a gain or loss on a non-monetary item is required by another IAS/ IFRS to be shown directly in equity, then the foreign currency gain or loss is also shown in equity.

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Case study 21.1: Choice of functional currency

Leonard Co is a holiday company which owns a number of villas it purchased or constructed in Tobago. The company is owned by a private equity group in the UK. Around 75% of its principal income stream is US Dollars, with a significant but smaller element of its income in Euro. It generates little income in Trinidad Dollars and only a small proportion of its expenses are in Trinidad Dollars as most of its expenses are interest to service the US variable rate loans to purchase the property and agents fees in the USA and the Euro zone. It financed the purchase or construction of the villas it rents with variable rate interest only mortgages in US Dollars from US banks. In order to comply with Trinidad revenue law, it maintains its records in Trinidad Dollars. In order to appear locally sensitive and to avoid having to keep separate accounting records in Trinidad and Tobago dollars so as to comply with Trinidad revenue law, it has declared the Trinidad Dollar to be its functional currency. The key figures from the balance sheet and income statement of the company show the following:
20x2 20x1

Non-current assets Mortgages loans Other net assets

TDD 280 m USD 45 m

TDD 260 m USD 45 m TDD 36 m

TDD 40m

Half of the other net assets are monetary net assets and half are non-monetary net assets. The exchange rate ruling when the properties were purchased was TDD/USD = 8.2 and the rate ruling when the non-monetary other assets were incurred was TDD/USD = 6.8. You are told that the exchange rates between the US Dollar and the Trinidad and Tobago Dollar were (fictitious): 31 December 20x1: TDD/ USD 31 December 20x2: TDD/ USD Average for the year
Required

8.0 6.0 6.8

Using the Trinidad Dollar as the functional currency, produce the balance sheets of the company at 31 December 20x1 and

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31 December 20x2 and the income statement for the year ended 31 December 20x2. Calculate foreign exchange gains and losses. Reperform the above calculations using the USD as the functional currency. Comment on the results. Decide, with reasons, whether the choice of functional currency was appropriate.

Case study 21.2

This case study gives an overview of a number of requirements of IAS 21. Suppose Company A is based in Trinidad. It decides that its principal exposure is to the Trinidad economy, with some limited purchases and sales abroad. It chooses to report its results both in TDD and in USD. On 15 November 20x6, it bought some specialist raw materials from a company in Germany. These had a price of EUR 45,000, which was to be settled in Euro. The exchange rate on this date was TDD/EUR = 7.652. At the year end of 31 December 20x6, this debt had not been paid although no penalty interest was payable. The debt was eventually paid on 1 February 20x7. The exchange rates between the TDD, EUR and USD on the relevant dates were:
TDD/EUR TDD/USD

31 December 20x6 Average for 20x6 1 February 20x7

7.976 7.820 7.860

6.150 6.185 6.075

Required

Calculate the gain or loss in the entity accounts of the Trinidad business in the years to 31 December 20x6 and 31 December 20x7.

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Suggested solution

15 Nov 20x6 The purchases and the associated liability will be recorded at the spot rate between the foreign currency and the functional currency on this date, being TDD/ EUR = 7.652. Dr Purchases Cr Payables 31 Dec 20x6 The inventory is a non-monetary asset so it is not retranslated at the period-end closing rate, but rather left at its historic rate. The payable is a monetary item so must be retranslated at the period-end closing rate. This means that the payable is now valued at TDD 368,920 (EUR 45,000 x 7.976). This produces a foreign exchange loss: Dr Foreign exchange loss in income statement TDD 24,580 Cr Payables TDD 24,580. 1 Feb 20x7 When the payable is settled, it will be necessary to spend TDD 353,700 to buy EUR 45,000 (45,000 x 7.860). There is therefore a final foreign exchange gain on derecognition of the payable: Dr Payables Cr Cash 353,700 Cr Exchange gain in income statement TDD 368,920 TDD TDD 5,220. TDD 344,340 TDD 344,340.

Change in functional currency (IAS 21 paragraphs 35 37)

If the company changes its functional currency, which should be rare, then the new currency is applied only prospectively rather than retrospectively. All the figures in the old functional currency are translated into the new functional currency at the date of the change.
Translation from functional currency to presentation currency (IAS 21, paragraphs 38 47)

For most smaller and medium-sized entities, this stage will not be required. This additional step will be required for larger business that either: Have a foreign subsidiary which has a different functional currency to the parent, or

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Where the company chooses to present its financial statements in another currency to its own functional currency (eg if listed on a foreign stock exchange).

The more common situation is the former, where a parent will wish to translate the accounts of its subsidiary or associate into its own presentation currency prior to consolidation. The techniques are the same, however. Paragraph 39 of IAS 21 contains the main rules: The results and financial position of an entity whose functional currency is not he currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedure: Assets and liabilities for each balance sheet presented (ie including comparatives) shall be translated at the closing rate at the date of that balance sheet; Income and expenses for each income statement (ie including comparatives) shall be translated at exchange rates at the dates of the transactions; and All resulting exchange differences shall be recognised as a separate component of equity.

It is normal and permissible to use an average rate for translation of the income statement, so long as the exchange rate between functional currency and presentation currency has not been unusually volatile in the period.
Case study 21.3

Lime Co is a company based in Trinidad. It uses the Trinidad and Tobago dollar as its functional currency. It chooses to publish financial statements both locally and also in US Dollars, with a view to attracting investment from US companies. It performs this translation in accordance with IAS 21. You are provided with the income statement for the year ended 31 December 20x6, the balance sheet at this date and also the previous years balance sheet. You are told that the average mid-market exchange rate between the Trinidad and Tobago dollar and the US dollar recently has been: 31 December 20x6: 31 December 20x5: 6.75 7.00

Weighted average for 20x6: 6.50

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Required

Using the data above, present the financial statements in US Dollars. Calculate exchange differences that will be analysed as a separate component of equity.
Solution to case study 21.3 Income statement for the year ended 31 December 20x6 TDD' 000 Ex rate USD' 000

Revenue Cost of sales Gross profit Operating expenses Finance costs Profit before tax Tax Profit after tax

48,000 (25,000) 23,000 (12,000) (2,000) 9,000 (2,700) 6,300

6.50 6.50 6.50 6.50 6.50

7,385 (3,846) 3,538 (1,846) (308) 1,385 (415) 969

Net Assets at 31 December 20x6 TDD Ex rate USD

Freehold land Inventories Receivables Cash Total assets Trade payables Loans Net assets

17,000 8,300 10,000 15,000 50,300 (12,000) (9,000) 29,300

6.75 6.75 6.75 6.75 6.75 6.75

2,519 1,230 1,481 2,222 7,452 (1,778) (1,333) 4,341

Net Assets at 31 December 20x5 TDD Ex rate USD

Freehold land Inventories Receivables Cash Total assets Trade payables Loans

17,000 7,500 10,000 10,500 45,000 (11,500) (10,500)

7.00 7.00 7.00 7.00 7.00 7.00

2,429 1,071 1,429 1,500 6,429 (1,643) (1,500)

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Net assets
Proof of exchange difference

23,000

3,286

Closing equity Opening equity Increase in the period Explained by: Profit after tax in year Items taken directly to equity: Shares issued/ redeemed Revaluation gains Dividends Forex difference (residual item)

29,300 23,000 6,300 6,300 0 0 0 0

4,341 3,286 1,055 969 0 0 0 86

In this situation, the translation to the reporting currency has produced a credit to reserves of $86,000. As this arises only as a result of rounding errors rather than being a truly realised loss to the shareholders, it is reported directly in equity rather than being reported as an expense in the income statement. As it does not represent a true loss, it is not subsumed within retained earnings, since to do so would imply that its a true realised loss. Instead, it is reported as a separate component of equity.
Consolidation of a foreign operation/ subsidiary (IAS 21 paragraphs 44 47)

Note: If you are unfamiliar with group accounting, you should work through ICATTs notes on IFRS 3 and IAS 27 before working through the example below. This is a modification of the method used to translate into a reporting currency as given above. There are some additional matters that are likely to arise where there is a foreign entity to consolidate, including: Goodwill on the acquisition of the foreign operation Fair value adjustments made in the calculation of this goodwill Cancellation of intra-group balances between the domestic and foreign operations.

Goodwill, trading impairment and forex impairment (IAS 21, paragraph 47)

Goodwill on the acquisition of another business arises in the books of the acquiring company on consolidation (as on consolidation the historical cost of the investment is decomposed into the net assets of the subsidiary date at acquisition and goodwill at acquisition). Goodwill represents the

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premium that was paid to the previous owner of the acquired business for the right to receive all (or a controlling share) of the expected future profits of the acquired entity.
Case study 21.4

Auto GmbH is a German company whose functional and reporting currency is the Euro. On 1 January 20x1, it bought an 80% interest in Coche SARL, a Spanish company whose functional and reporting currency is also the Euro. Auto paid the previous owners of Coche EUR 125 million for this controlling interest. At the time, the net assets of Coche at fair value were EUR 120 million. This would be recorded in the entity balance sheet of Auto as a simple investment, thus: Dr Cr Investment in Coche EUR 125 million

Cash, loans, new shares, etc EUR 125 million.

Looking at what has come into and out of the group balance sheet of Auto, this cost of investment is decomposed into the individual assets and liabilities of the subsidiary, minority interest that must now be recorded and goodwill as a residual figure. The changes to the group balance sheet will therefore be: Dr Cr Cr Dr Individual assets/ liabilities EUR 120 million

Minority interest (20% above) EUR 24 million Cash, loans, new shares, etc EUR 125 million Goodwill (residual) EUR 29 million.

Goodwill never arises in the books of the subsidiary itself, but always in the books of the acquirer, as noted above. The acquirer is therefore buying a non-monetary intangible noncurrent asset when it acquires goodwill. This asset is of a highly uncertain value, especially if it is acquired in a foreign currency. The actual value of the future income stream (share of profits of the subsidiary) can be affected by both: Poorer than anticipated performance of the subsidiary, and Exchange rates moving adversely to mean that the remitted value of the profits of the subsidiary are lower than originally expected. There are therefore two stages to the impairment review of goodwill on a foreign operation. Any impairment review performed on the trading performance of the foreign entity will be treated as a realised loss and reported in the income statement of the parent, in accordance with IAS 36. This is

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because there is a reasonable degree of certainty that the ability of the subsidiary to generate income in its own functional currency has been impaired. Additionally, the parent is now required to look each period for any unrealised impairment loss due to foreign currency movements. Often an adverse movement in the exchange rate between the functional currency of the foreign operation and the functional currency of the parent will reverse in future years. Any such impairment is initially therefore considered to be an unrealised impairment (or gain) and is reported in equity of the parent company.
Fair value adjustments (IAS 21, paragraph 47)

As fair value adjustments are an integral part of the goodwill calculation and goodwill is considered to be an asset in the functional currency of the foreign entity, fair value adjustments are also considered to be a foreign currency asset or liability and retranslated each year at the closing rate. This includes fair value adjustments on non-monetary assets, as all assets and liabilities of the subsidiary are translated at the closing rate.
Intra-group balances (IAS 21, paragraph 45)

Intra-group items are payables or receivables and are thus inherently monetary items. All monetary items must be translated at the closing rate.
Case study 21.5

Parent Co is a British company whose functional currency and reporting currency is GBP. It has a subsidiary in the USA, whose functional currency is the USD. During the current year on a date when the spot rate was USD/GBP = 2.0, Parent sold inventory to Subsidiary for a sales price of GBP 100,000. These goods were not paid for by Subsidiary at the time although the intention was for Subsidiary to remit GBP 100,000 to Parent before long. This was not intended by Parent to be part of Parents long-term investment in Subsidiary. On the initial transfer, Parent correctly recorded the following: Dr Intragroup receivables Cr Intragroup sales GBP 100,000 GBP 100,000.

On the same date, Subsidiary correctly recorded the following: Dr Intragroup purchases USD 200,000

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Cr Intragroup payables

USD 200,000.

At the year-end, the exchange rate was USD/GBP = 2.5. Translating the intragroup payable of USD 200,000 at this rate produces the following balances: Intragroup receivable (in books of Parent) GBP 100,000

Intragroup payables (in books of Subsidiary) GBP 80,000. The two figures do not cancel. This is not due to items in transit since both entities have correctly recorded transactions and are up to date. The transaction requires that Subsidiary buys GBP 100,000 to pay its liability to Parent. At the year-end rate, this will cost Subsidiary USD 250,000. Applying the normal rules of translation of foreign currencies, Subsidiary will have retranslated its liability of GBP 100,000 to USD 250,000 generating a foreign currency loss in its own books of USD 50,000. At the year-end rate, this gives a foreign currency loss of GBP 20,000. This currency loss must be recognised, even if the foreign operation is consolidated using interim financial statements which have not had monetary items translated to the year-end rate. It is reported in the income statement of Subsidiary as a loss in the income statement and so also a loss in the group income statement. The only exception to this requirement to show losses on retranslation of intra-group balances is if the parent has advanced a long-term loan to the foreign operation which it does not seek recovery of in the near future. This would then form part of the cost of the foreign operation.
Case study 21.6

On 1 January 20x6, Bush Co (a US company with functional currency USD) purchased an 80% controlling interest in Williams Co when the exchange rate was 8 Trinidad dollars per US dollar. It paid USD 405,000 for this controlling interest. At this date, the capital of Williams was TDD 1.5 million and Williams had retained earnings of TDD 1.46 million. There were no recognised impairments of this goodwill on acquisition in the year to 31.12.x6. The exchange rate at 31 December 20x7 was 6.75 TDD per USD, at 31 December 20x6 it was 7 and the average rate during the year to 31 December 20x7 was 6.50. The average rate in the year to 31 December 20x6 was 7.25. Dividends were declared at the end of the year and were paid shortly after the year-end. No dividends were paid in the year to 31 December 20x6. Williams made a profit in the year to 31.12.x6 of TDD 1,827,000. On 31.12.x7 an impairment review of the subsidiary, which is considered to be a single cash generating unit under IAS 36 showed an impairment of TDD 174,400, all of which has been allocated to the goodwill on acquisition.

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Note: These figures have been calculated using a spreadsheet and so there are some small rounding errors when rounded to the nearest 1,000.
Balance sheet at 31 December 20x7 Bush Williams USD' 000 TDD' 000 Ex rate Williams Group USD' 000 USD' 000

Property, plant and equipment Cost of investment Goodwill (Working 2) Current assets Total assets Share capital Retained earnings Forex difference reserve (balance) Minority interest (Working 3) Current liabilities Total equity and liabilities

6,235 405 0 2,214 8,854 1,500 5,109 0 0 2,245 8,854

8,500 0 0 4,782 13,282 1,500 6,527 0 0 5,255 13,282

6.75

1,259

7,494 0 103 2,922 10,519 1,500 5,688 69 238

6.75

708 1,968 125 183

Below Below

6.75

779 1,968

3,024 10,519

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Income statement for year ended 31 December 20x7 Bush USD' 000 Williams TDD' 000 Ex rate Williams Group USD' 000 USD' 000

Revenue Cost of sales Gross profit Operating expenses Impairment losses Finance costs Dividend from subsidiary Profit before tax Tax Profit for the period Attributable to: Equity holders of the parent Minority interests (20% x 652)

10,200 (6,520) 3,680 (2,750) 0 (120) 118 928 (200) 728

15,850 (6,820) 9,030 (3,540) 0 (50) 0 5,440 (1,200) 4,240

6.50 6.50 6.50 6.50 6.50

2,438 (1,049) 1,389 (545) (8) 836 (185) 652

12,638 (7,569) 5,069 (3,295) (128) 0 1,646 (385) 1,261 1,131 130

Statement of changes in equity for the year ended 31 December 20x7 Bush Williams USD000 TDD000 4,799 3,287 1,410 4,240

Balance at 31 December 20x6 Profit for the period Total gains recognised in the period Dividends paid Balance at 31 December 20x7

1,410 (500) 5,709

4,240 (1,000) 6,527

(Working 1: Goodwill on acquisition)

Fair value of consideration paid USD 405,000 Fair value of net assets acquired, being: Capital of Williams TDD 1,500,000 Reserves of W at acquisition TDD 1,460,000 Equity of W at acquisition TDD 2,960,000 At spot exchange rate of 8: USD 370,000 Group share 80% (USD 296,000) Goodwill at acquisition USD 109,000 This is reported in USD, but a record maintained of its value in the functional currency of the subsidiary at acquisition: USD 109,000 x 8 = TDD 872,000.

Working 2: Carrying value of goodwill TDD

Rate

USD

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At acquisition 1.1.x6 Impairment losses 20x6 Unrealised exchange gain (balance) At 31.12.x6 Impairment losses 20x7* Unrealised exchange gain (balance) At 31.12.x7

872,000 0 0 872,000 (174,400) 0 697,600

8.00

109,000

15,571 7.00 124,571 6.75 (25,837) 6.75 4,614 103,348

* As this is a one-off material expense arising on a specific date, the year-end rate appears to show a more true and fair view than translating at an average rate.
Working 3: Minority interest

Net assets of Williams as consolidated (USD 1,968 USD 779) Minority share at 20% of above
Working 4: Retained earnings of Williams

1,189 237.8

Post-acquisition profits Dividends 20x6 Sub-total Profit 20x7 Dividends 20x7 Total Check: Pre-acquisition profit Retained earnings in balance sheet

TDD' 000 Rate USD' 000 1,827 7.25 252 0 1,827 4,240 6.50 652 (1,000) 6.75 (148) 5,067 756

1,460 6,527
USD' 000 5,109 (26)

Working 5: Group reserves Bush (parent co) Less: Goodwill impairments Add: 80% post-acquisition profit of Williams (80% x 756) Group reserves

605 5,688

DISPOSAL OF FOREIGN OPERATIONS (IAS 21, PARAGRAPHS 48 49)

On disposal of a foreign operation, any cumulative exchange difference in equity relating to that subsidiary is recycled though the income statement and so reported in the income statement as part of the gain or loss on derecognition of the foreign operation in the group financial statements.

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Interaction with deferred tax (IAS 12, paragraph 50)

Any gain or loss reported under IAS 12 but not allowed as a deductible expense or assessed as taxable income is very likely to be a temporary difference in accordance with IAS 12, requiring full provision for deferred tax.

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IAS 36 Impairment of Assets

The need for the standard

IAS 36 provides the generic rules for recognition of impairments of assets. Prior to its introduction, there were widely differing practices between companies on the recognition of impairments, including: Whether only impairments that were seen as permanent would be reported Whether impairments were reported in the income statement or taken directly to equity until the impaired asset was scrapped or sold The basis used for valuing assets in order to assess if any impairment had taken place.

Scope of the standard

The standard applies to all companies reporting under IFRS. There are a number of other standards that provide specific rules for identifying and valuing impairment losses. Where another standard provides specific rules then that standard prevails over the generic rules of IAS 36. This means that IAS 36 does not apply to: inventories (IAS 2 Inventories) assets arising from construction contracts (IAS 11 Construction Contracts) deferred tax assets (IAS 12 Income Taxes) assets arising from employee benefits (IAS 19 Employee Benefits) financial assets within the scope of IAS 39 Financial Instruments: Recognition and Measurement investment property measured at fair value (IAS 40 Investment Property) biological assets related to agricultural activity that are measured at fair value less estimated point-of-sale costs (IAS 41 Agriculture) deferred acquisition costs and intangible assets, arising from insurance contracts within the scope of IFRS 4 Insurance Contracts and non-current assets (or disposal groups) classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

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In practice, the most common use of IAS 36 is to identify impairments in: Property, plant and machinery Intangible assets other than goodwill Purchased positive goodwill.

Overview of the standards requirements

The standard requires that companies should at least annually review whether there has been any evidence that an asset is impaired. An impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount.

Framework focus The Framework describes an asset as a resource controlled by an entity which is expected to produce a flow of future economic benefits. This is the basis of the principle of determining recoverable amount. If an assets carrying value is greater than its recoverable amount (which is the value of the expected future inflow of benefits) then the excess over the recoverable amount does not meet the definition of an asset. This excess must therefore be written off as an expense immediately.

Recoverable amount

This is a critical concept in recognising impairments and then accounting for them. The recoverable amount is the maximum inflow of benefits that an entity can expect from having control of an asset. Control will normally be achieved by having ownership of an asset which therefore normally gives the entity the option to sell the asset. The maximum benefit from owning any asset is therefore:

Recoverable amount is the higher of:

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Value in use

Net realisable value

The net present value of the estimated net cash flows earned by ongoing use of the asset by its current owner

The proceeds that could be expected from selling the asset to an unconnected third party, less the costs necessarily incurred to enable that sale.

This means that if it is apparent that net realisable value exceeds the value in use, the rational thing is to dispose of the asset. This means that assets should never be recorded at an impaired value below net realisable value. In reality, it is often impossible to identify the value in use of an individual asset, since that individual asset may not generate an income stream on its own. This difficulty is solved by the concept of the cash generating unit.

Cash generating unit

A cash generating unit is the smallest identifiable group of assets that generates cash inflows that are largely (but not necessarily wholly) independent of the cash inflows from other assets or groups of assets. A working definition of a cash generating unit might be that it is the smallest group of assets that together could form a business that could be a going concern in their own right. Cash generating units may not be bigger than the segments used by the business to report its results under IAS 14 Segment Reporting. The purpose of dividing the company into cash generating units is similar to the treatment of inventory under IAS 2; ie to prevent unrealised gains in the value of one group of assets masking realised losses in another.

Case study 36.1

Canteena Co operates in two business areas of the leisure

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business, one of which has two operating divisions. A review of the value of the property, plant and equipment of each of these operating divisions reveals the following estimates for values in use and net realisable values:
Value in use NRV

Gyms and health clubs division: Cinemas division North: Cinemas division South: Totals

$115,000

$105,000 $35,000 $67,000

$40,000 $60,000 $215,000

$207,000

The current carrying values before considering impairments of the assets in each division are: Gyms and health clubs division: Cinemas division North: Cinemas division South: Totals $82,000 $38,000 $80,000 $200,000

The companys policy is to revalue all its property, plant and equipment where possible.

Required

State the accounting journals necessary to record the revaluations of the property, plant and machinery of Canteena Co assuming that: The company as a whole is considered to be a cash generating unit as no division within Canteena is capable of generating independent cash flows. The three divisions above are each considered to be a cash generating unit.

Solution to case study 36.1

If the company is considered to be one cash generating unit only then the comparison is:

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Current carrying value: Value in use:

$200,000 $215,000.

The increase in value will therefore be recorded as a net unrealised gain of $15,000 by debiting non-current assets $15,000 and crediting equity by the same amount. If the company is analysed more accurately into its component cash generating units, the picture becomes:
Recoverable Carrying amount value

VIU

NRV

Gyms and health clubs Cinemas North Cinemas South

115,000 105,000 40,000 35,000 60,000 67,000

115,000 40,000 67,000

82,000 38,000 80,000

There is an unrealised gain in gyms and health clubs of $33,000, an unrealised gain in cinemas North of $2,000 and an impairment in the value of cinemas South of $13,000. It is possible in both circumstances that cinemas South may be sold as its net realisable value is greater than its value in use, suggesting that that division has more worth to somebody else than it does to Canteena Co. It may therefore be reclassified as a disposal group and a current asset under IFRS 5. In this situation, the impairment loss of $13,000 (being $80,000 less the net realisable value of $67,000) will be written off immediately. This is even if Canteena Co intends to not dispose of cinemas South, as no non-current asset or group of noncurrent assets should be recorded at an impaired value below net realisable value.

Recognition of impairments (IAS 36 para 12 17)

At a minimum any of the indicators below should be taken to indicate that an asset or cash generating unit has been impaired, thus triggering a full impairment review and valuation: The market value of the asset has declined significantly more than expected in the period Likely obsolescence, eg through technological redundancy Long-term change to interest rates reducing the assets NRV (see below)

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Evidence that the company as a whole is worth more on a break-up basis than as a going concern, ie evidence of internally generated negative goodwill Physical damage to the asset Major plans to restructure the business suggesting that the asset is redundant to the companys needs Worse than expected output from the asset compared to when it was last valued.

This list is not exhaustive but gives indicators. Any indicator that suggests that the full carrying value of the asset may not be recovered by net income of at least as great a value should trigger a full impairment valuation.

Estimating value in use

The value in use is estimated using anticipated cash flows, discounted at an appropriate rate. Care should be taken to ensure that the assumptions made about risk in the estimated cash flows are not duplicated in the choice of discount rate. For example, if the future cash flows are estimated using very conservative assumptions, a discount rate far above a risk-free discount rate is likely to be inappropriate since this would double-count the effective write-down of the assets value.

Allocation of impairment losses and reversal of impairments

An impairment loss, being the carrying amount of an asset less its recoverable amount, is recognised immediately in profit or loss. If the asset is revalued in accordance with another IAS/ IFRS (eg an item of property, plant and equipment in accordance with IAS 16 Property, Plant and Equipment), the impairment loss is treated as a revaluation decrease in accordance with that other standard. An impairment loss for a cash-generating unit is allocated to reduce the carrying amount of the assets of the unit in the following order: 1. reduce the carrying amount of any goodwill allocated to the cash-generating unit, and then 2. reduce the other assets of the unit pro rata on the basis of the carrying amount of each asset. An impairment loss on any asset other than goodwill recognised in prior periods is reversed if there is a change in the estimates used to determine the assets recoverable amount since the last impairment loss was recognised. In this case, the carrying amount of the asset is increased to its recoverable amount, but

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not exceeding the carrying amount of the asset that would have been determined had no impairment loss been recognised in prior years.

Purchased goodwill

For the purpose of impairment testing, goodwill acquired in a business combination is allocated to each of the cashgenerating units, or groups of cash-generating units, that are expected to benefit from the synergies of the combination. Goodwill impairment must not be reversed.
COMPREHENSIVE CASE STUDY 36.2

S has identified a division that produces a specific product as a cash generating unit. The carrying value of the assets at 31 December 20x5 is shown below: Goodwill Tangible assets: Land and buildings Plant and machinery $m 100 400 140 _____ 540 _____ 640 _____ A competitor has recently introduced a superior version of the product to the market. S has to react to this competition by funding improvements and dropping the price of the product. Both of these reduce the margin on the product and the management believe that this information is an indicator of impairment. The following additional information is relevant: (i) Forecast cash inflows from the production of the product are as follows: Year ended 31 December: $m 200 170 110 $m

20x6 20x7 20x8

(ii) The directors believe that a pre tax return of 11% is appropriate to the level of risk of the manufacture of this type of product. (iii) The land and buildings are carried at a valuation. Their depreciated historical cost is $240 million at 31 December 20x5.

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(iv) The net selling price of land and buildings is estimated at $300 million and that of the plant and machinery at $68 million.
Required

Calculate the impairment loss that must be recognised at 31 December 20x5 and explain how this loss will be treated in the financial statements for the year ended 31 December 20x5.

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Suggested Solution to case study 36.2:

Cash generating unit (i) Impairment loss

Carrying amount before impairment loss Recoverable amount Impairment loss

$m 640 (398) ____ 242 ____

Recoverable amount is value in use as this is higher than fair value less costs to sell (W2).
Workings

(1)

Value in use: $m 180 138 80 ____ 398 ____

Forecast cash flows discounted at 11%: Year l (200 0.90) Year 2 (170 0.81) Year 3 (110 0.73)

(2) FV less costs to sell: $m Goodwill Land and buildings Plant and equipment 68 ____ 368 ____ Accounting for the impairment loss The credit entry The impairment loss must be allocated to the various noncurrent assets in the following order: firstly, goodwill and then to the other assets on a pro rata basis. Before Impairment After impairment loss impairment $m $m $m Goodwill 100 (100) Land and buildings 400 (100) (W) 300 Plant and machinery 140 (42) (W) 98 300

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____ 640 ____

Working

____ (242) ____

____ 398 ____

The impairment loss of $242m is first allocated to the goodwill ($100m). This leaves $142m to be allocated to the other assets on a pro-rata basis. Loss on land and buildings =
400 $142m = $105m 540

If this amount was written off the carrying amount of the land and buildings would be reduced to $295m (400105). This is less than the fair value less costs to sell of the land and buildings. IAS 36 prohibits the reduction of the carrying amount of an asset to below its fair value less costs to sell during the pro rating exercise. This means that only $100m of the impairment loss can be charged against the carrying amount of the asset. The balance of $5m must be charged elsewhere, in this case to the plant and machinery. Loss on plant and machinery = $5m (see above) = $42m. The debit entry The basic rule is that the loss is charged to the income statement. However where a loss relates to an asset that is carried at a revalued amount it must be taken to the revaluation reserve to the extent that it is covered by the surplus on that asset. The land and buildings have been revalued. The impairment loss that relates to this asset is recognised in reserves until the reserve is reduced to zero. The depreciated historical cost of the freehold land and buildings is $240 million. This implies that the revaluation surplus that relates to these assets is $160m (400 240). This is greater than the impairment loss that has been allocated to the assets ($105m). The whole of this amount can be taken to equity. The remainder of the impairment loss ($137 million) must be recognised in the income statement for the year. It must be included within operating profit and may also need to be disclosed as an exceptional item.
140 $142 = $37m + 540

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Suggested step-by-step approach to impairments

1. Identify major classes of tangible and intangible noncurrent assets 2. Set a date each period for assessment of if each class has suffered an impairment. Note that this does not have to be the year-end date, but the date that each class of assets is considered must be the same each year. 3. Allocate assets, including purchased goodwill, to cash generating units if assets do not generate an income stream in their own right. 4. Each period, formally assess if there are any internal or external factors suggesting that an asset or cash generating unit may be impaired. If there are no such factors, it is unlikely that an impairment loss needs to be recognised. 5. If there are impairment indicators, prepare (or update) the value in use and net realisable value calculations to determine the impaired value for the asset. 6. Write off any impairment loss to the income statement or to equity and/ or income statement if the newly impaired asset had previously been revalued upwards through equity. 7. Review any assets or cash generating units that had previously been impaired to assess if there can be any reversal of past impairments. This reversal cannot be shown for goodwill.

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IAS 37: Provisions, contingent liabilities and contingent assets

The need for the standard

Prior to the introduction of IAS 37, there was considerable confusion over what a provision actually was and when it should be recognised. There were also wide differences in the techniques used to evaluate what size of provision should be recorded, for example whether the most probable figure or the worst case scenario figures should be used. Much of the confusion arose from the application of prudence, since prudence on its own would suggest that the worst case scenario should always be recognised as a future outflow in the financial statements.
Abuse of provisions

Provisions were widely seen to be abused by companies wishing to smooth profits. In years when profits exceeded expectations if there were no restriction on when provisions could be recognised, it would be easy to recognise a provision, thus establishing a liability and reducing reporting profit. This provision could then be released in subsequent years when the true profit was below expectations. This fails to give a true and fair view of the true performance of the business. There was also considerable inconsistency in the recognition of provisions at the time of acquiring control of another business. A common use of creative accounting was to recognise a provision in the books of the acquired company at the time of acquisition. This has the effect of increasing goodwill asset and providing a provision that could be released to increase postacquisition group profit.
Requirements of the standard

The standard gives mandatory rules on a number of aspects relating to provisions, being: Revised definitions of provisions, contingent liabilities and contingent assets Initial recognition of provisions Methods for establishing initial value of provisions Discounting of long-term provisions Recognising changes in value of provisions Disclosure requirements to enable analysts to understand how provisions have been determined.

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Definitions (paragraph 10, IAS 37)

A provision is a liability 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. A legal obligation is an obligation that derives from: (a) a contract (through its explicit or implicit terms); (b) legislation; or (c) other operation of law. A constructive obligation is an obligation that derives from an entitys actions where: (a) 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 (b) 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: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) (ii) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability .

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

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Contingent assets

Although the definition above uses the word possible, the implementation guidance of IAS 37 uses the word probable, meaning greater than 50% estimated probability. An asset whose recovery is virtually certain such as an insurance claim that is beyond dispute where the insurer is both willing and able to pay is not subject to a contingency at all and so is outside the scope of IAS 37. It would be recognised and valued in the balance sheet as a normal asset. An asset where a right to recover is probable but not certain is a contingent asset. It is disclosed in the notes to the accounts but not recognised with any value in the balance sheet. Note that this is different to assets such as debtors, where the legal right to recover is offset by an allowance for doubtful debts. The right to recover is clear and so the debtor is recognised. A contingent asset is one where its existence itself is questionable. Contingent assets are common in the realm of insurance recoveries for losses, where there may be a legal dispute between insurance company and the person insured whether the claim itself is covered by the terms of the insurance policy.
Contingent liabilities

A contingent liability as either a liability where an obligating event might exist but the probability of an obligation to pay is below 50%. It may also be the rare situation where an obligating event exists, but the amount known is completely impossible to estimate. All contingent liabilities must be disclosed in the financial statements, but not recognised in the balance sheet. For example, where one company gives a guarantee over the borrowings of another, this would be disclosed as a contingent liability in the financial statements of the company giving the promise.
Provisions

The definition of provision effectively prohibits recognition of provisions for future outflows arising as a result of a future intention, since an intention is not an obligation as it is possible for the companys management to change their mind. This is a major change from previous common practice. Similarly, provisions for future expected operating losses are prohibited. However likely or difficult to avoid such losses might be, there is no obligation to make losses if profitable opportunities arise. There is therefore no liability.

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If a business has an obligation to transfer an uncertain amount of resources out of the business at some point in future, a provision must be recognised. If there is only an intention rather than an irreversible obligation a provision must not be recorded. Initial recognition of provision As soon as a company has an obligation, provision must be recognised. The value to be recorded is the expected value of the amount to be transferred. This amount will be an estimate and it is highly likely that the eventual amount paid will be materially different to the amount initially estimated when provision is first made.
Distinguishing between provision and contingent liability

Provisions must be recognised in the balance sheet, with a likely impact on profit. Contingent liabilities are not recognised in the financial statements themselves, but rather are disclosed in the notes to the financial statements. There are extensive disclosure requirements for provisions.
Step by step approach to recognition of provisions and contingent liabilities

The diagram below gives a practical step by step approach to recognising provisions as against recognising contingent liabilities:

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A probable outflow is one where there is estimated to be a greater than 50% probability that an outflow will occur. IAS 37 does not define what is remote. In practice, it is a matter of judgement taking into account the possible consequences of the contingent liability. For example, any contingent liability that could affect the gong concern status of the company should be disclosed. A contingent liability with an estimated 10% probability of an outflow of resources that is only just material probably does not need to be disclosed.
Methods for establishing initial value of provisions

This provides some practical difficulty since estimating the amount of the provision will rely on a probability model and an average expected value. This is an area that is highly judgemental and very difficult to audit given its inherent subjectivity.
Discounting of long-term provisions

Where an outflow is expected and provision is therefore made, an assessment must then be made of the likely timing of this outflow. If the amount is expected to be paid some years from

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the balance sheet date, the time value of money is likely to be material. IAS 37 requires that provisions must be discounted at a pre-tax discount rate that reflects the current market assessments of the time value of money and the risks specific to the liability. In practice, this often means the required return that investors would need to invest in that project (considering that higher risk projects generally require a higher return than lower risk projects).
Choice of discount rate

IAS 37 leaves a great deal of judgement in which discount rate should be selected to find a rate that the risks attaching to the type of liability to be discounted. In practice, a company should choose a methodology for finding an appropriate discount rate and then apply it consistently. In practice, it is often best to select a discount rate that is easily verified by external enquiry. For example, discounting long-term liabilities by reference to the real yield on US government bonds would provide a prudent measure of the provisions value. It is also common in practice to select fairly low discount rates. This also has a practical advantage that many short- and mediumterm liabilities are likely to have an immaterial difference between the discounted and undiscounted values. This immateriality means that many liabilities can be presented at their undiscounted value whilst still materially complying with IAS 37.
Illustration: Extract from the accounting policy note of BP

The group makes full provision for the future cost of decommissioning oil and natural gas production facilities and related pipelines on a discounted basis on the installation of those facilities. At 31 December 2005, the provision for the costs of decommissioning these production facilities and pipelines at the end of their economic lives was $6,450 million (2004 $5,572 million and 2003 $4,720 million). The provision has been estimated using existing technology, at current prices and discounted using a real discount rate of 2.0% (2004 2.0% and 2003 2.5%) ..To the extent that these liabilities are not expected to be settled within the next three years, the provisions are discounted using either a nominal discount rate of 4.5% (2004 4.5% and 2003 4.5%) or a real discount rate of 2.0% (2004 2.0% and 2003 2.5%), as appropriate.

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Case study 37.1

A company builds a nuclear power station in one year during 2000 at a cost of $1,250 million. It is expected to have a useful life of 65 years, after which it will be de-commissioned. There is some chance that the decommissioning will only occur in 2100 or 2110 however as it may be necessary to leave the station unused for some years before it can safely be decommissioned. The expected costs of decommissioning in todays money are $300 million. The power station started to produce energy that could be sold at the end of 2000. The company is required to set up a fund that will be used to pay the decommissioning costs. In order to ensure that there is only minimal chance of there not being sufficient funds to pay for the decommissioning, this fund is held in US government bonds, which have shown a yield of 5% before inflation. Inflation in the country concerned is running at an average of 3% pa. The company uses a straight line method of depreciation for the nuclear power station over 65 years.

Required:

Calculate the investment on 1 January 2000 that would be necessary to yield the $300 million expected to be needed for decommissioning if the decommissioning takes place in 2065. Suggest an accounting treatment for these transactions and draft extracts from the balance sheet and income statement: in the year 2000 in the year 2001 assuming that everything turns out as expected, in the year when the decommissioning takes place (year 2065).

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Solution

The investments are expected to produce a pre-tax real return each year of 2%. The amount required to produce the necessary $300 million in 65 years is therefore: $300 million x 1 = 1.0265 $82.82 million

If this were invested at 1.1.2000 then it would be expected to yield enough assets to pay the liability, ie the outflow expected no sooner than 65 years from the date of completion of the power station. If liabilities were not presented at their present value, the balance sheet would show the following: Assets Liabilities Net liability 82,815 (300,000) (217,185)

This would not give a true and fair view, since there are expected to be sufficient assets to pay the liabilities as the outflows are demanded. Long-term liabilities (including provisions) are therefore discounted at an appropriate discount rate, where the time value of money is material. Instead, the liability is presented at its discounted value, showing: Assets Liabilities Net liability 82,815 (82,815) 0

Over time, this discounted figure must be amortised up to the actual expected outflow of $300 million. Long-term liabilities are therefore initially discounted on their initial recognition and then compounded back up to the actual cash flow. This compounding back up is often referred to as the unwinding of the initial discount. The liability is recognised when construction starts, as: Cr Provisions 82,815

Normally, recognition of a provision causes a debit to be taken to expenses. This is since the transaction that gives rise to the need for a provision normally only benefits the current period. In this case however, taking an expense of $82,815 to the income statement in 2000 would be totally misleading, since the expected cost of decommissioning is expected to give benefits to the company for the next 65 years.

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The debit side is therefore added to the recognised value of the non-current asset and depreciated over the 65 year expected life of the asset. So the initial recognition of the provision is Dr Cr Non-current assets Provisions $82,815 $82,815

This means that the nuclear power station is initially recognised with a total value of $1,332.815m ($1,250m + $82.815m). It produces an annual depreciation charge of $20.5 million ($1,332.815m/65). In the year to 31.12.00, there will be a year of depreciation, plus a years charge to compound up the liability, as this was recognised at 1 January 2001.
$ millions Depreciation Interest expense 2001 20.5 1.66 (w1) 2000 20.5 1.69 (w2)

(w1) (w2)

$82.815m x 2% = $1.66m ($82.815 m + $1.66m) x 2%.

Recognising changes in estimates of provisions

Each balance sheet date, each provision should be reviewed and recalculated. The provision will change due to three separate effects: Being one period closer to the expected outflow of cash or other resources Changes in the underlying estimate of how much cash will be expended Changes in the appropriate discount rate.

IAS 37 gives specific guidance on the effect of the first two of these effects but is silent on the third. The notes before therefore reflect what appears to be current best practice in addition to the disclosure requirements of the standard.

Case study 37.2

During the year to 31 December 20x0, a company makes

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accidentally leaks some oil into the environment, causing considerable environmental damage and damage to the local community. At 31 December 20x0, the company estimates that it will pay $25 million to settle the cost of the damage, including estimated legal fees of $4 million. It is expected that this will be paid on 31 December 20x9. The company has an insurance policy that it believes covers such an event to a maximum recovery of $10 million, although the insurance company claim that the companys own negligence means that it does not have to pay up on the insurance policy. At 31 December 20x1, the amount expected to be paid has increased to $28 million. The company wishes at 31 December 20x0 to set aside funds to pay the expected liability. The company invests in low risk government bonds that yield a real return of 3%. By 31 December 20x1, the long-term expected yield on such bonds has risen to 3.25%.
Required

Show the effect of establishing the provision in the financial statements at 31 December 20x0 and the effect of the change in the provision in the financial statements in the year to 31 December 20x1.
Solution

The potential recovery is not virtually certain. It is therefore a contingent asset. Its existence will be disclosed in the notes to the accounts if the company believes that its recovery is probable (ie greater than 50% probability) but it must not be netted against the provision assuming no recovery. The investments are expected to produce a pre-tax real return each year of 3%. The amount required to produce the necessary $25 million in 9 years is therefore: $25 million x 1 = 1.039 $19.160 million

This is a result of activities in the current year with no purchase of a non-current asset. The full effect of establishing the provision is therefore shown as an expense in the income statement in the year to 31 December 20x0. So the initial recognition of the provision is Dr Cr Operating expenses Provisions $19.160 million $19,160 million

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The following year, the estimates have changed. The liability is also one year closer to settlement. The year-end value of the provision has therefore changed due to three factors: The effluxion of time A change in the appropriate discount rate A change in the underlying estimates of cash outflow.

IAS 37 requires that the 31 December 20x1 financial statements recognise the most up-to-date estimate of the present value of the provision. As provisions are a highly judgemental item in the financial statements that can be used to smooth profits, IAS 37 requires clear disclosure of the effects of each of these changes. This allows analysts to see which companies appear to change estimates frequently, which implies profit smoothing. If the estimates had remained the same, then there would be an increase in the provision due to the passage of one year requiring an unwinding of the discount: Dr Cr Finance cost Provision $19.160 million x 3% = $575,000 $575,000.

If the amount of the outflow and its timing remained the same but the discount rate changed, then the provision required at 31 December 20x1 would be: $25 million x 1 = 1.030258 $19.356 million

However, the amount of cash outflow has also increased. This means that the provision required in the balance sheet at 31 December 20x1 is: = $28 million x 1 1.030258 $21.679 million

The provisions history in double entry terms can therefore be shown as: Provision for cost of environmental damage 31.12.x0 Expenses 31.12.x0 Carried down 19,160 19,160 Carried down 31.12.x1 (subtotal) 1.1.x1 Brought down

19,160 19,160 19,160 575 19,735 19,735 19,735

19,735 31.12.x1 Interest @ 3% 19,735

31.12.x1 C/d provision @ 3.25% 19,356 31.12.x1 Brought down 31.12.x1 Income statement 379 19,735

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C/d provision using all 31.12.x1 new estimates

21,679 31.12.x1 Brought down Operating 31.12.x1 expenses 21,679 1.1.x2 Brought down

19,356 2,323 21,679 21,679

Disclosures

To facilitate a clear understanding of what a company is using provisions for, IAS 37 requires extensive disclosure of the existence of provisions, the uncertainties surrounding the provision and movements on the provision in the year.

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For each class of provision, an entity shall disclose: (a) the carrying amount at the beginning and end of the period; (b) additional provisions made in the period, including increases to existing provisions; (c) amounts used (ie incurred and charged against the provision) during the period ; (d) unused amounts reversed during the period ; and (e) the increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate. Comparative information is not required. An entity shall disclose the following for each class of provision: (a) a brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits; (b) an indication of the uncertainties about the amount or timing of those outflows. Where necessary to provide adequate information, an entity shall disclose the major assumptions made concerning future events, (c) the amount of any expected reimbursement, stating the amount of any asset that has been recognised for that expected reimbursement. Unless the possibility of any outflow in settlement is remote, an entity shall disclose for each class of contingent liability at the balance sheet date a brief description of the nature of the contingent liability and, where practicable: (a) an estimate of its financial effect; (b) an indication of the uncertainties relating to the amount or timing of any outflow; and (c) the possibility of any reimbursement.

Case study 37.3

World Wide Nuclear Fuels, a company listed on a recognised stock exchange, disclosed the following information in its financial statements for the year ending 30 November 2005: Provisions and long-term commitments

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(i)

Provision for decommissioning the groups radioactive facilities is made over their useful life and covers complete demolition of the facility within fifty years of it being taken out of service together with any associated waste disposal. The provision is based on future prices and is discounted using a current market rate of interest. $m 675 33 125 27 ____ ____

Provision for decommissioning costs Balance at 1 December 2004 Adjustment arising from change in price levels (charged to reserves) Charged in the year to income statement Adjustment due to change in knowledge (charged to reserves) Balance at 30 November 2005

860

There are still decommissioning costs of $1,231m (undiscounted) to be provided for in respect of the groups radioactive facilities as the companys policy is to build up the required provision over the life of the facility. The company purchased an oil company during the year. As part of the sale agreement, oil has to be supplied to the companys former holding company at an uneconomic rate for a period of five years. As a result a provision for future operating losses has been set up of $135m, which relates solely to the uneconomic supply of oil. Additionally the oil company is exposed to environmental liabilities arising out of its past obligations, principally in respect of soil and ground water restoration costs, although currently there is no legal obligation to carry out the work. Liabilities for environmental costs are provided for when the group determines a formal plan of action on the closure of an inactive site. It has been decided to provide for $120m in respect of the environmental liability on the acquisition of the oil company. World Wide Nuclear Fuels has a reputation for ensuring the preservation of the environment in its business activities.
Required

Discuss whether the provisions have been accounted for correctly under IAS 37.
Suggested solution:

Decommissioning costs IAS 37 has a significant impact on decommissioning activities. It appears that the company is building up the required provision over the useful life of the radioactive facility, often called the units of production method. However IAS 37 requires the provision to be the best estimate of the expenditure required to settle the obligation at the

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balance sheet date. The provision should be capitalised as an asset if the expenditure provides access to future economic benefits. If this is not the case, then the provision should be charged immediately to the income statement. IAS 37 does not prescribe the accounting treatment for the resulting debit but amendments have been made to IAS 16 Property, Plant and Equipment to ensure a smooth interaction between the two standards. The asset so created will be written off over the life of the facility subject to the usual impairment test in IAS 36 Impairment of Assets. Thus the decommissioning costs of $1,231m (undiscounted) not yet provided for will have to be brought onto the balance sheet at its discounted amount and a corresponding asset created. The current practice adopted by the company as regards the discounting of the provision is inconsistent. The provision is based on future cash flows but the discount rate is based upon current market rates of interest. IAS 37 suggests that the discount rate should be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. The discount rate should not reflect risks for which future cash flow estimates have been adjusted. Therefore, the provision should be based on current prices discounted by the current market rate. The company currently makes a reserve adjustment for changes in price levels. However this adjustment would have two elements, the unwinding of the discount which should be charged to the income statement, and treated as a financing cost, and changes in cash flow caused by a change in the discount rate. There was no clear consensus on how to treat this change and therefore the IASB issued IFRIC 1Changes in Existing Decommissioning and Similar Liabilities, the consensus of this interpretation being that any changes in cash flow caused by a change in discount rate should be adjusted against the carrying value of the relevant asset. The amount charged to reserves of $27m, in respect of change in knowledge, should not be charged to reserves. If the change in knowledge is in respect of the original estimate for the decommissioning costs then it could be argued that this is a change in the estimate and the new amount should be recognised as part of the cost of the asset. Again IFRIC 1 clarifies this point and requires that any change to the original estimate should be made against the carrying value of the asset.
Oil company One of the quite explicit rules of IAS 37 is that no provision should be made for future operating losses. However, if the company has entered into an onerous contract then a provision will be required. An onerous contract is one entered into with another party under which the unavoidable costs of fulfilling the contract exceed the revenues to be received and where the entity would have to pay compensation to the other party if the contract was not fulfilled. Thus it appears that the contract should be loss making by nature. Thus in this case the provision of $135m would remain in the financial statements and would affect the fair value exercise and the computation of goodwill.

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Provisions for environmental liabilities should be recognised when the entity becomes obliged (legally or constructively) to rectify environmental damage or perform restorative work on the environment. A provision should only be made where the company has no real option but to carry out remedial work. The mere existence of environmental contamination caused by the companys activities does not in itself give rise to an obligation. Thus in this case there is no current obligation. However it can be argued that there is a constructive obligation to provide for the remedial work because the conduct of the company has created a valid expectation that the company will clean up the environment. Thus there is no easy solution to the problem as it will be determined by the subjective assessment of the directors and auditors as to whether there is a constructive obligation. It is a difficult concept and one which will result in different interpretations.
Suggested step-by-step approach to provisions and contingent liabilities

1. Determine an accounting policy and apply it consistently, eg a policy never to discount provisions where the outflow is expected within three years of the balance sheet date. 2. Identify any possible obligating events at the balance sheet date 3. Work through the summary flowchart above to determine if each possible obligating event requires a provision or is a contingent liability. 4. Where an obligating event requires a provision, estimate pretax cash flows in todays money and the timing of these cash flows. 5. Calculate the closing provision required as an undiscounted figure 6. Discount this provision at an appropriate rate if its settlement is not within the short-term 7. Calculate any changes in opening provision in this order: 8. Compound discounted opening provisions at the rate used to discount them: show this as a finance cost in the income statement 9. If there is a change in the appropriate discount rate, recalculate the new provision using the latest discount rate. Show any further difference as an income statement expense 10. Recalculate each provision required using the latest estimates of cash outflow, timing of outflow and latest discount rate. Show any final difference as an operating expense.

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11. State the accounting policy, discount rates used and any reason for movement on provisions as a note to the financial statements.

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IAS 38: Intangible Assets

Scope

IAS 38 prescribes the accounting treatment for intangible assets, except: intangible assets that are within the scope of another Standard. For example, IAS 2 Inventories applies to intangible assets held for sale in the ordinary course of business; mineral rights and expenditure on exploration for, or development and extraction of non-regenerative resources.

The need for the standard

The Framework defines an asset as an asset resource controlled by an entity which is reasonably expected to produce an inflow of benefits. In the past, a number of companies have attempted to increase the perceived strength of the balance sheet and also simultaneously increase the profit figure by treating certain expenses as deferred costs. The standard is focused on establishing consistent criteria for recognition of intangible assets, for dealing with their write-off over time and for establishing when it is possible to revalue intangible assets.

Initial recognition of intangible assets

Intangible assets may be acquired by an entity in a number of different ways: By being purchased individually, or By being developed internally by the entity itself, or By being purchased as part of a new business combination, either as an intangible asset in the books of the new subsidiary or as goodwill on the new business combination.

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Framework focus

The Framework paragraphs 82 83 describe the process of recognition of any element of financial statements, with paragraph 83 giving the criteria for recognition. Recognition is the process of including an asset in the balance sheet with an appropriate monetary value and description. The recognition criteria for all elements (including assets) under IFRS are the cornerstone of accounting for intangible assets, since a fundamental issue with many intangible assets is whether they can even fairly be said to exist! The recognition criteria in the Framework are: An item that meets the definition of an element should be recognised if: It is probable that any future economic benefit associated with the item will flow to or from the entity, and The item has a cost or value that can be measured with reliability.

An asset under IFRS is a resource controlled by an entity as a result of past events which is expected to produce an inflow of future benefit to the entity controlling it.

Step-by-step approach to recognition of intangible assets

The process of enquiry for whether an intangible asset can be recognised is therefore to ask: Is it controlled by the reporting entity? Is there reasonable certainty that it will generate an inflow of benefits for the reporting entity? Can it be given a cost or a reliable fair value? Should the intangible be recognised as an intangible in its own right or simply as part of goodwill?

If the answer to any of these questions is no, then no intangible asset may be recognised. If its acquisition has involved spending some cash or other resource, this outflow must be treated as an expense.

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Case studies 38.1 38.7

Consider the above step-by-step approach to determine if the items below must be recognised as intangible assets under IAS 38, or if instead they must be recognised as an expense.
38.1 Expenditure on research leading to a prototype 38.2 Development costs improving the performance of a product that is already on the market 38.3 Costs of providing training in IFRS to staff 38.4 Market research costs 38.5 The good name earned by a company over many years of trading, where it is estimated that the companys brand earns $8 million more a year in profit than if the company did not have that brand 38.6 The publishing title of a national newspaper 38.7 The value of a companys customer list and marketing mailshot database
Suggested solutions to case studies 38.1 38.7: 38.1 38.2 38.3 38.4 38.5 38.6 38.7

Is it controlled by the reporting entity? Is there reasonable certainty that it will generate an inflow of benefits for the reporting entity? Can it be given a cost or a reliable fair value? Should the intangible be recognised as an intangible in its own right or simply as part of goodwill? A separately recognised intangible non-

Yes

Yes

Yes

Yes

Yes

Yes

Yes

No

Maybe

No, staff can leave N/A

No

Probably

Yes

Probably not

N/A

Yes

N/A

Maybe

No

Probably not

N/A

Yes

N/A

N/A

Part of goodwill

Part of internally generated goodwill

Part of internal goodwill

No

Maybe

No

No

No

No

No

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current asset?

Internally generated goodwill, brands, mastheads, publishing titles, customer lists and similar items are not recognised as assets, since there is insufficient certainty whether they will generate an inflow of benefits and/ or they have no identifiable (ie marginal) cost. Expenditure on research is recognised as an expense. There is no recognition of an intangible asset arising from research as its stream of benefits is insufficiently certain to meet the Framework definition of an asset. An intangible asset arising from development is recognised only if specified criteria are met. If an intangible item des not meet the criteria for recognition as an asset, the expenditure is recognised as an expense when incurred. Expenditure that was initially recognised as an expense is not included in the cost of an intangible asset at a later date. The initially recognised value is the marginal cost of acquiring the asset. Internal expenses such as apportionment of general overhead that would have been incurred regardless of the acquisition of the intangible asset may not be capitalised.
Goodwill or not goodwill?

On a new business combination, the acquirer is likely to have paid a premium for control of the acquired business and its future income stream. This is purchased positive goodwill, which is capitalised and tested for annual impairment under IFRS 3. Frequently, acquirers prefer to identify other intangible assets of the acquired company which can be recognised separately from goodwill, as goodwill is seen by many analysts as not being a real asset and so it is less likely to increase a companys share price than a patent for example. This does not necessarily have any impact on profit, as intangible assets and goodwill eventually are expensed to the income statement via either annual impairment testing or by systematic amortisation. The distinction between goodwill and other intangible assets depends on whether the other assets are separable from goodwill. To be separable from goodwill, it must be possible to sell the intangible asset without substantially disposing of the newly acquired business. In some cases, a group of intangible assets may not be separable from each other, but as a group they may be separated from the business without threatening the going concern status of the business. An example of this

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would be if a soft drinks manufacturer makes a number of drinks including a brand called Caribbean Spring. The intangible asset of the right to extract water and the brand name may be recognised separately from goodwill but not from each other, since one relies on the other for its ability to generate profit. IAS 38 distinguishes between brands and trademarks. A brand is seen as being similar to the trade name of the company itself and thus not separable from goodwill. Trade marks are more akin to sub-brands and could be sold separately without selling the company as a whole. It is possible to capitalise trademarks separately from goodwill but not brands. (Paragraph 37, IAS 38).
Impairments, amortisation and revaluation

Subsequent to initial recognition, an intangible asset is carried at: cost, less any accumulated amortisation and any accumulated impairment losses; or revalued amount, less any subsequent accumulated amortisation and any accumulated impairment losses. The revalued amount is fair value at the date of revaluation and is determined by reference to an active market.

An intangible asset may only be carried at a subsequently revalued amount if there is an active market for the asset. Paragraph 8 of IAS 38 defines an active market as a market where: The items traded in the market are homogenous, and Willing buyers and sellers can be found at any time, and Prices are available to the public

Case study 38.8

Discuss whether there is an active market for the following intangible assets: International football players (eg David Beckhams transfer to LA Galaxy Carbon credits to pollute under the Kyoto Protocol proposals (assume that the Protocol had been fully enacted).

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Solution to case study 38.8:

There is no active market, as the asset in question is by its nature unique. Although there may be an active market for footballer transfers, there is no active market for individual footballers until they are actually sold. So the value of David Beckham cannot be used to reliably value another footballer, such as Wayne Rooney. Footballers can only be recognised at the amortised value of what was paid to acquire them; there can be no subsequent upwards valuation because other footballers have been transferred for large sums. Carbon credits under the Kyoto Protocol could have been traded, in the same manner that other regulatory quotas such as agricultural production quotas are traded. One carbon credit is much the same as another, so a recent transaction to buy and sell a carbon credit can be used as a reliable valuation of another, identical, carbon credit. There is thus an active market in homogenous assets. Any revaluation increase is credited directly to equity as revaluation surplus, unless it reverses a revaluation decrease of the same asset previously recognised in profit or loss. Any revaluation decrease is recognised in profit or loss. However, the decrease is debited directly to the revaluation surplus in equity to the extent of any credit balance in revaluation surplus in respect of that asset. An entity assesses whether the useful life of an intangible asset is finite or indefinite; the useful life is indefinite if there is no foreseeable limit to the period over which the asset is expected to generate net cash flows. The depreciable amount of an intangible asset with a finite life is amortised on a systematic basis over its useful life. An intangible asset with an indefinite useful life is not amortised, but is tested for impairment at least annually. Impairment of intangible assets is recognised in accordance with IAS 36 Impairment of Assets. The gain or loss on derecognition of an intangible asset is the difference between the net disposal proceeds, if any, and the carrying amount of the item. The gain or loss is recognised in profit or loss.
Comprehensive case study 38.9

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On 1 July 20x4 Heywood, a company listed on a recognised stock exchange, was finally successful in acquiring the entire share capital of Fast Trak. The terms of the bid by Heywood had been improved several times as rival bidders also made offers for Fast Trak. The terms of the initial bid by Heywood were: 20 million $1 ordinary shares in Heywood. Each share had a stock market price of $350 immediately prior to the bid; a cash element of $15 million.

The final bid that was eventually accepted on 1 July 20x4 by Fast Traks shareholders. Heywood had improved the cash offer to $25million and included a redeemable loan note of a further $25 million that will be redeemed on 30 June 2008. It carried no interest, but market rates for this type of loan note were 13% per annum. There was no increase in the number of shares offered but at the date of acceptance the price of Heywoods shares on the stock market had risen to $400 each. The present value of $1 receivable in a future period where interest rates are 13% can be taken as: at end of year three at end of year four $070 $060

The fair value of Fast Traks net assets, other than its intangible long-term assets, was assessed by Heywood to be $64million. This value had not changed significantly throughout the bidding process. The details of Fast Traks intangible assets acquired were: (i) The brand name of Kleenwash a dish washing liquid. A rival brand name thought to be of a similar reputation and value to Kleenwash had recently been acquired for a disclosed figure of $12 million. (Paragraph 40, IAS 38) A government licence to extract a radioactive ore from a mine for the next ten years. The licence is difficult to value as there was no fee payable for it. However, as Fast Trak is the only company that can mine the ore, the directors of Heywood have estimated the licence to be worth $9 million. The mine itself has been included as part of Fast Traks property, plant and equipment. A fishing quota of 10,000 tonnes per annum in territorial waters. A specialist company called Quotasales actively trades in these and other quotas. The price per tonne of these fishing quotas at the date of acquisition was $1,600. The quota is for an indefinite period of time, but in order to preserve fish

(ii)

(iii)

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stocks the government has the right to vary the weight of fish that may be caught under a quota. The weights of quotas are reviewed annually.

Suggested Solution Fast Trak

Net tangible assets Intangible assets

$m fishing quota brand goodwill 16 12 28 __

$m 64 56 ___ 120 ___

Net assets/purchase consideration Notes: Purchase consideration: shares 20 million @ $4 cash loan note 25 million @ 060

80 25 15 ___ 120 ___

IFRS 3 Business Combination requires intangible assets acquired as part of a business combination to be recognised separately from goodwill. The standard requires that any intangible that is capable of separate recognition and whose fair value is identifiable at the date of acquisition will be recognised as a separate asset and not subsumed within the value of goodwill.
Kleenwash

A brand, almost by definition, is unique; however IAS 38 says that where similar assets have been bought recently this may be used as a basis for determining a reliable value.
Government licence

As there was no fee payable for this licence, Fast Trak could not carry it at a value other than zero. The licence may well be classed as a separate asset but it can only be used in conjunction with the mine and cannot be sold on to other parties. This does not necessarily mean that it would have a zero value in Heywoods consolidated balance sheet. However, the problem is that there is clearly not an active market in these licences (there is only one) and there is no information of how the directors of Heywood arrived at the figure of $9 million given in the question. If this is the discounted future cash flows attributable to the licence this may constitute a reliable measure of cost. However, given the circumstances, such cash flows

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could not be solely attributed to the licence as they involve the use of other assets. Thus, it is likely that the licence could not be separately recognised.

Fishing quota

This appears to satisfy the definition of an active market, therefore the fair value is 10,000 $1,600 = $16 million. The quota may well be classed as an intangible asset with an indefinite life as the quota is for an indefinite period of time. If this were the case the quota would be capitalised and tested annually for impairment, the quota would not be amortised. If Heywood followed the revaluation model for subsequent measurement then if the price per tonne were to increase above $1,600 the asset would be revalued with any increase in value being taken direct to equity. If the government were to impose a finite life upon the quota then from that point in time the asset would have a finite life and would be amortised over the life of the quota imposed by the government.

Goodwill

This is the excess of the purchase consideration over the net tangible and separate intangible assets. The remainder of the long-term intangible assets is attributable to the goodwill of Fast Trak.

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IAS 40 Investment Property

The need for the standard

Investment properties potentially fall into the category of financial investments (which would be covered by IAS 39) and property, which would be covered by IAS 16. This potential confusion over definition and accounting treatment therefore necessitates a separate accounting standard.
Definition (IAS 40, paragraph 5)

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: Use in the production or supply of cgoods or services or for administrative purposes, or Sale in the ordinary course of business.

It is also possible for a lessee holding property under an operating lease to classify that building as investment property, so long as the operating lease is instead treated as a finance lease and the investment property is kept at its fair value in the investors balance sheet. This is a recent change to IAS 40, which deals with the practical situation that it is common for leases of land and buildings to be long enough to allow for a probable investment return but which do not substantially transfer the risks and rewards incident to ownership. For example, a lease over some land of 50 years may be enough to make a profit on future assignment of the lease over the land, but the infinite life of land makes it difficult to fit a lease of land into IAS 17s definition of a finance lease. If a property is partly owner-occupied and partly let out as an investment property, the portions should be treated separately if they can be sold separately, if not it is treated under IAS 16 rules, unless only an insignificant portion is owner occupied. Where a property is let to a parent or other subsidiary, then in the consolidated financial statements it is treated as an owneroccupied property under IAS 16, but in the individual financial statements of the lessor it is treated as an investment property under this Standard.
Initial recognition

As with assets generally, investment property is recognised in the financial statements from the moment when it meets the definition of an asset (ie when it becomes probable that there

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will be a future inflow of benefits) and when it can be measured reliably. Investment property is initially recognised at cost. This cost includes transaction costs of acquiring the property. If an investment property has been built by the entity itself, it is recognised as a deferred cost under IAS 16 until the time when it is complete and able to generate a rental yield. Upon completion, it is reclassified as an investment property under IAS 40. The cost of constructing an investment property cannot include any abnormally high costs of construction, start-up costs nor operating losses incurred until the property reaches its full level of occupancy.
Framework focus These rules for non-recognition of abnormally high costs of construction are consistent with the Frameworks definition of an asset since these losses are unlikely to generate a stream of benefit into the future.

Investment properties held under leases are initially recognised at the lower of the present value of the lease obligation and the propertys fair value, in accordance with finance lease accounting under IAS 17. Transfers to, or from, the investment property classification are made only when there is evidence of a change in use.
Subsequent valuations

Subsequent to initial recognition, investment property is carried using either the cost model or the fair value model:
Choice of accounting policy

Cost model

Fair value model

Cost, less accumulated depreciation and any accumulated impairment losses, as prescribed by IAS

Fair value is the price at which the property could be exchanged between knowledgeable, willing parties in an arms length transaction.

Consistency requires that the same policy should be applied to all investment properties. A change from one method to another should only be made where it will result in a more appropriate

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presentation. The Standard envisages that a change from fair value to cost is unlikely to be appropriate. This suggests that the fair value model is the preferred accounting treatment for investment property under IFRS.

Cost Model

An enterprise choosing the cost model should adopt the benchmark treatment in IAS 16 (as referred to above). Note: the allowed alternative in IAS 16 (of revaluation reported as reserve movements) is not permitted for investment properties. It can however, be used for non-investment properties. Where the cost model is chosen, the fair values of the investment properties must be disclosed in the notes to the accounts in addition to the cost model figures in the balance sheet.

The measurement model is applied consistently to all investment property. However, an entity may choose either the fair value model or the cost model for investment property backing liabilities that pay a return linked directly to the fair value of specified assets including that investment property, regardless of the model chosen for all other investment property.

Fair Value Model

An enterprise that chooses the fair value model should, after initial recognition, value all its investment properties at their fair values. A gain or loss arising from a change in the fair value of an investment property should be included in the net profit or loss of the period in which it arises. Note: this differs markedly from revaluations in IAS 16, which are generally treated as movements on an unrealised revaluation reserve. IAS 40 effectively treats movements in fair values as realised. The introduction to the Standard makes it clear that the IASB prefer the fair value model, but they also recognise that this is a controversial issue about which many accountants have reservations, and this is why, for the time being, the cost model is permitted. The fair value of an investment property is usually its market value. The market value is preferably determined by an independent valuer experienced in the type of property and local

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market. It is based on an arms length transaction ie between independent unrelated parties on commercial terms. The market value is based on an informed willing buyer and an informed willing seller in an open market under normal selling conditions (eg after proper marketing of the property). Circumstances unique to a buyer or seller should be ignored (eg where a seller may be in financial difficulties and requires a quick sale or it is a forced sale.) Although current prices on an active market of similar properties represents the best evidence of fair values, other sources of information can provide evidence of fair values if there is an insufficient volume of recent similar property sales to give an objective fair value. These other sources include:

prices for dissimilar properties adjusted to reflect differences; prices on a less active market adjusted to reflect economic changes since those prices occurred; or discounted estimated future net cash flows relating to existing leases. This would only be appropriate where there is external evidence that they are similar properties in the same location and condition and the rentals are at current levels.

Fair values should not double count certain assets. For example, fair values determined from rentals for a furnished letting would include the value of the furniture, which should not then be recognised again as a separate asset. In the rare cases where it is not possible to reliably determine a fair value on a continuing basis for an individual property it should be treated under the benchmark treatment in IAS 16 (at cost less depreciation and impairments). When adopting the fair value model this only applies to the individual property, all other investment properties should be measured at fair value.

Derecogition of investment property

The gain or loss on derecognition of an item of investment property is the difference between the net disposal proceeds, if any, and the carrying amount of the item. This is consistent with the general principle that the gain or loss on derecognition of anything is the difference between the new item coming into the balance sheet (eg sales proceeds) and the item leaving the balance sheet (eg an investment property held at fair value). The gain or loss is included in profit or loss.

Obviously a disposal will occur if a property is sold, but it would also be considered as sold where it is let under a finance lease.

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The gain or loss on disposal is the difference between the carrying value and the net sale proceeds (discounting should apply to deferred consideration) and it is recognised as income or expense in the income statement. Special rules contained in IAS 17, Leases apply to sales and leasebacks.

Transfers under the cost model

Where the cost model has been adopted, all transfers between classifications are made at the carrying value (historical cost less depreciation and impairments) of the property, no gains or losses will arise. This treatment is uncontroversial and presents no difficulties.

Transfers under the fair value model

Transfers from investment properties should only occur where there is a change of use. This may be because an owner decides to occupy a property that was previously used as an investment property or there may be an intention to dispose of the property. Normally, in the latter case, an enterprise would continue to show the property as an investment property until it is sold. However, where it is intended to develop the property before it is sold, it should be transferred to inventory. For both of the above transfers the cost of the property for the purpose of the transfer is the fair value at the date of the transfer. An owner occupied property appropriately transferred to investment properties at the end of the owner occupation should be revalued to its fair value at the date of transfer. Any difference between its carrying value and fair value should be treated as a revaluation under IAS 16 (normally a reserve movement). Where a property that has been included in inventory (because it is available for sale) and is then let on an operating lease to a third party it should be transferred to investment properties at its fair value at the date of the transfer. Any gain or loss on its carrying value immediately before the transfer is included in the profit or loss for the period. This is consistent with the treatment of profits on the sale of inventories. An investment property in the course of (self) construction or development is treated under IAS 16 as property, plant and equipment. When construction is complete it is transferred to investment properties at its fair vale at the date of completion. Any difference between the fair value and the carrying value of the property is recognised in income in the period of the transfer.

Case study 40.1

Speculator owns a number of properties. An independent surveyor has

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assessed their market values as:

Property Cost 1 July 20x3 $ 41,000 76,000 80,000 197,000 Valuation 30 June 20x4 $ 52,000 82,000 70,000 204,000 Valuation 30 June 20x5 $ 73,000 66,000 90,000 229,000

A B C

All the properties had an estimated life of 50 year when they were acquired. They are all let on short leases under commercial terms, however property C is let to a fellow subsidiary of Speculator. The group policy (applied by all members of the group) is to adopt the fair value model in IAS 40 for investment properties and to treat owneroccupied properties under the benchmark treatment in IAS 16.
Required: Prepare extracts of the group financial statements of Speculator in respect of the above properties for the years to 30 June 20x4 and 20x5. How would this differ if the question asked for the entity statements of Speculator? Solution: In the consolidated financial statements property C would have to be classified as an owner-occupied property and treated under IAS 16 . This means it would be carried at deprecated historic cost.

Income statement: - year to 30 June

Depreciation property C ($80,000/50 years) Investment property surpluses - A -B Investment property deficits - B Balance sheet: as at 30 June Property, plant and equipment C Investment properties

20x4 $ (1,600) 11,000 6,000

20x5 $ (1,600) 21,000

(16,000) 20x4 20x5 78,400 76,800 134,000 139,000

In the entity financial statements of Speculator property C would be classed as an investment property. The property would not be depreciated. Instead a deficit of $10,000 in 20x4 and a surplus of $20,000 in 20x5 would be reported as well as the above surpluses and deficits on properties A and B.

Disclosure (in addition to that in IAS 17, Leases) An enterprise should disclose:

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the method of determining fair values. It should state that this was by reference to market values, or, if not, the other factors in determining the value should be disclosed; that a qualified independent valuer with appropriate experience has valued the investment properties, or, if not, this fact should be disclosed; the amounts in the income statement for: rental income from investment properties; their direct operating expenses split between those properties that generated income and those that did not. any restrictions on the realisability of investment properties or on the remittance of rental income; contractual obligations to purchase, construct or develop investment properties.

Fair value Model

a detailed reconciliation (similar to property, plant and equipment under IAS 16) of the carrying value of investment properties at the beginning and end of the period; net gains or losses from changes in fair values; net exchange gains or losses on the translation of the financial statements of a foreign entity (presumably relating to investment properties held by a subsidiary); transfers to and from inventories and owner-occupied properties.

Where the fair value of an individual property cannot be reliably measured, the above reconciliation should be disclosed separately for that property. There should be a description of the property, the reasons why its fair value cannot be measured reliably and, if possible, a range of fair values for it. Details of the gains or losses on the disposal of such properties should also be separately disclosed.

Cost Model

Similar disclosures are required to those that apply to properties classified as property, plant and equipment under IAS 16:

deprecation methods and rates, useful lives etc;

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a detailed reconciliation of the carrying value of investment properties at the beginning and end of the period; impairment losses; exchange gains and losses; transfers to and from inventories and owner-occupied properties; and the fair values of the properties.

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