Additional performance measures

For many years, regulators and standard-setters have debated how entities should best present financial

performance and not mislead the user.

 Introduction
 Common practice
 Evaluating the aims

Introduction

Many jurisdictions have enforced a standard format for performance reporting, with no additional analysis permitted
on the face of the Statement of Profit or Loss. Others have allowed entities to adopt various methods of conveying the
nature of ‘underlying’ or ‘sustainable’ earnings.

Although financial statements are prepared in accordance with applicable financial reporting standards, users are
demanding more information and issuers seem willing to give users their understanding of the financial information.
This information varies from the disclosure of additional key performance indicators of the business to providing
more information on individual items within the financial statements. These additional performance measures
(APMs) can assist users in making investment decisions, but they do have limitations.

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Common practice

It is common practice for entities to present APMs, such as normalised profit, earnings before interest and tax (EBIT)
and earnings before interest, tax, depreciation and amortisation (EBITDA). These alternative profit figures can appear
in various communications, including company media releases and analyst briefings. Alternative profit calculations
normally exclude particular income and expense items from the profit figure reported in the financial statements.
Also, there could be the exclusion of income or expenses that are considered irrelevant from the viewpoint of the
impact on this year’s performance or when considering the expected impact on future performance. 

An example of the latter has been gains or losses from changes in the fair value of financial instruments. The
exclusion of interest and tax helps to distinguish between the results of the entity’s operations and the impact of
financing and taxation. 

These APMs can help enhance users’ understanding of the company’s results and can be important in assisting users
in making investment decisions, as they allow them to gain a better understanding of an entity’s financial statements

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 and evaluate the entity through the eyes of the management. They can also be an important instrument for easier
comparison of entities in the same sector, market or economic area. 

However, they can be misleading due to bias in calculation, inconsistency in the basis of calculation from year to year,
inaccurate classification of items and, as a result, a lack of transparency. Often there is little information provided on
how the alternative profit figure has been calculated or how it reconciles with the profit reported in the financial
statements. 

The APMs are also often described in terms which are neither defined by issuers nor included in professional
literature and thus cannot be easily recognised by users. 

APMs include: 

 all measures of financial performance not specifically defined by the applicable financial reporting
framework
 all measures designed to illustrate the physical performance of the activity of an issuer’s business
 all measures disclosed to fulfil other disclosure requirements included in public documents containing
regulated information. 

An example demonstrating the use of APMs is the financial statements of Telecom Italia Group for the year ended 31
December 2011. These contained a variety of APMs as well as the conventional financial performance measures laid
down by IFRS® Standards. The non-IFRS APMs used in the Telecom Italia statements were:

EBITDA. Used by Telecom Italia as the financial target in its internal presentations (business plans) and in its
external presentations (to analysts and investors). The entity regarded EBITDA as a useful unit of measurement for
evaluating the operating performance of the group and the parent.

Organic change in revenues, EBITDA and EBIT. These measures express changes in revenues, EBITDA and EBIT,
excluding the effects of the change in the scope of consolidation, exchange differences and non-organic components
constituted by non-recurring items and other non-organic income and expenses. The organic change in revenues,
EBITDA and EBIT is also used in presentations to analysts and investors. 

Net financial debt. Telecom Italia saw net financial debt as an accurate indicator of its ability to meet its financial
obligations. It is represented by gross financial debt less cash and cash equivalents and other financial assets. The
report on operations includes two tables showing the amounts taken from the statement of financial position and
used to calculate the net financial debt of the group and parent.

Adjusted net financial debt. A new measure introduced by Telecom Italia to exclude effects that are purely
accounting in nature resulting from the fair value measurement of derivatives and related financial assets and
liabilities.

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 Evaluating the aims

The International Accounting Standards Board (IASB) is undertaking an initiative to explore how disclosures in IFRS
financial reporting can be improved. The project has started to look at possible ways to address the issues arising
from the use of APMs. This initiative is made up of a number of projects. It will consider such things as adding an
explanation in IAS® 1 that too much detail can obscure useful information and adding more explanations, with
examples, of how IAS 1 requirements are designed to shape financial statements instead of specifying precise terms
that must be used. This includes whether subtotals of IFRS numbers such as EBIT and EBITDA should be
acknowledged in IAS 1.

In the UK, the Financial Reporting Council supports the inclusion of APMs when users are provided with additional
useful, relevant information. In contrast, the Australian Financial Reporting Council feels that such measures are
outside the scope of the financial statements. In 2012, the Financial Markets Authority (FMA) in the UK issued a
guidance note on disclosing APMs and other types of non-GAAP financial information, such as underlying profits,
EBIT and EBITDA. 

APMs appear to be used by some issuers to present a confusing or optimistic picture of their performance by
removing negative aspects. There seems to be a strong demand for guidance in this area, but there needs to be a
balance between providing enough flexibility, while ensuring users have the necessary information to judge the
usefulness of the APMs.

To this end, the European Securities and Markets Authority (ESMA) has launched a consultation on APMs. The aim is
to improve the transparency and comparability of financial information while reducing information asymmetry
among the users of financial statements. ESMA also wishes to improve coherency in APM use and presentation and
restore confidence in the accuracy and usefulness of financial information. 

ESMA has therefore developed draft guidelines that address the concept and description of APMs, guidance for the
presentation of APMs and consistency in using APMs. The main requirements are:

 Issuers should define the APM used, the basis of calculation and give it a meaningful label and context.
 APMs should be reconciled to the financial statements. 
 APMs that are presented outside financial statements should be displayed with less prominence.
 An issuer should provide comparatives for APMs and the definition and calculation of the APM should be
consistent over time.
 If an APM ceases to be used, the issuer should explain its removal and the reasons for the newly defined
APM.

However, these guidelines may not be practicable when the cost of providing this information outweighs the benefit
obtained or the information provided may not be useful to users. Issuers will most likely incur both implementation
costs and ongoing costs. Most of the information required by the guidelines is already collected for internal
management purposes, but may not be in the format needed to satisfy the disclosure principles. 

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 ESMA believes that the costs will not be significant because APMs should generally not change over periods.
Therefore, ongoing costs will relate almost exclusively to updating information for every reporting period. ESMA
believes that the application of these guidelines will improve the understandability, relevance and comparability of
APMs.

Application of the guidelines will enable users to understand the adjustments made by management to figures
presented in the financial statements. ESMA believes that this information will help users to make better-grounded
projections and estimates of future cashflows and assist in equity analysis and valuations. The information provided
by issuers in complying with these guidelines will increase the level of disclosures, but should lead issuers to provide
more qualitative information. The national competent authorities will have to implement these guidelines as part of
their supervisory activities and provide a framework against which they can require issuers to provide information
about APMs.

Written by a member of the Strategic Business Reporting examining team

Bin the clutter

The effects of clutter have typically come in for little consideration by the preparers of annual reports. However, the

phenomenon is increasingly under discussion, with initiatives recently launched to combat it.

It is unusual to think about the effects of ‘clutter’ but, increasingly, this phenomenon is being discussed. One
prominent website describes clutter as follows: ‘Clutter invades your space and takes over your life. Clutter makes
you disorganised, stressed, out of control. Clutter distracts you from your priorities. Clutter can stop you achieving
your goals.’ This definition of clutter may not be completely applicable to annual reports, but it is possible to see
certain aspects, which are applicable.

The UK’s Financial Reporting Council (FRC), among other organizations, has called for reduced ’clutter’ in annual
reports. Additionally, the Institute of Chartered Accountants In Scotland (ICAS) and the New Zealand Institute of
Chartered Accountants (NZICA) were commissioned by the International Accounting Standards Board (the Board) to
make cuts to the disclosures within a certain group of International Financial Reporting Standards (IFRS ®), and
produce a report.

Clutter in annual reports is a problem, obscuring relevant information and making it more difficult for users to find
the key points about the performance of the business and its prospects for long-term success. The main observations
of the discussion paper published by the FRC were:

 there is substantial scope for segregating standing data, either to a separate section of the annual report (an
appendix) or to the company’s website
 immaterial disclosures are unhelpful and should not be provided
 the barriers to reducing clutter are mainly behavioural
 there should be continued debate about what materiality means from a disclosure perspective.

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It is important for the efficient operation of the capital markets that annual reports do not contain unnecessary
information. However, it is equally important that useful information is presented in a coherent way so that users can
find what they are looking for and gain an understanding of the company’s business and the opportunities, risks and
constraints that it faces. A company, however, must treat all of its shareholders equally in the provision of
information. It is for each shareholder to decide whether they wish to make use of that information. It is not for a
company to pre-empt a shareholder's rights in this regard by withholding the information.

A significant cause of clutter in annual reports is the vast array of requirements imposed by laws, regulations and
financial reporting standards. Regulators and standard setters have a key role to play in cutting clutter both by
cutting the requirements that they themselves already impose and by guarding against the imposition of unnecessary
new disclosures. A listed company may have to comply with listing rules, company law, international financial
reporting standards, the corporate governance codes, and if it has an overseas listing, any local requirements, such as
those of the Securities and Exchange Commission (SEC) in the US. Thus, a major source of clutter is the fact that
different parties require differing disclosures for the same matter. For example, an international bank in the UK may
have to disclose credit risk under IFRS 7, Financial Instruments: Disclosures, the Companies Acts and the Disclosure
and Transparency Rules, the SEC rules and Industry Guide 3, as well as the requirements of Basel II Pillar 3. A
problem is that different regulators have different audiences in mind for the requirements they impose on annual
reports. Regulators attempt to reach wider ranges of actual or potential users and this can lead to a loss of focus and
structure in reports.

There may a need for a proportionate approach to the disclosure requirements for small and mid-cap quoted
companies that take account of the needs of their investors, as distinct from those of larger companies. This may be
achieved by different means. For example, a principles-based approach to disclosures in IFRS standards, specific
derogations from requirements in individual IFRS standards or the creation of an appropriately adapted local version
of the IFRS for SMEs  standard. Pressures of time and cost can understandably lead to defensive reporting by smaller
entities and to choosing easy options, such as repeating material from a previous year, cutting and pasting from the
reports of other companies and including disclosures of marginal importance.

There are behavioural barriers to reducing clutter. It may be that the threat of criticism or litigation could be a
considerable limitation on the ability to cut clutter. The threat of future litigation may outweigh any benefits to be
obtained from eliminating ‘catch-all’ disclosures. Preparers of annual reports are likely to err on the side of caution
and include more detailed disclosures than are strictly necessary to avoid challenge from auditors and regulators.
Removing disclosures is perceived as creating a risk of adverse comment and regulatory challenge. Disclosure is the
safest option and is therefore often the default position. Preparers and auditors may be reluctant to change from the
current position unless the risk of regulatory challenge is reduced. Companies have a tendency to repeat disclosures
because they were there last year.

Explanatory information may not change from year to year but it nonetheless remains necessary to an understanding
of aspects of the report. There is merit in a reader of an annual report being able to find all of this information in one
place. If the reader of a hard copy report has to switch to look at a website to gain a full understanding of a point in
the report, there is a risk that the report thereby becomes less accessible rather than more. Even if the standing
information is kept in the same document but relegated to an appendix, that may not be the best place to facilitate a

5
quick understanding of a point. A new reader may be disadvantaged by having to hunt in the small print for what
remains key to a full understanding of the report.

Preparers wish to present balanced and sufficiently informative disclosures and may be unwilling to separate out
relevant information in an arbitrary manner. The suggestion of relegating all information to a website assumes that
all users of annual reports have access to the internet, which may not be the case. A single report may best serve the
investor, by having one reference document rather than having the information scattered across a number of delivery
points.

Shareholders are increasingly unhappy with the substantial increase in the length of reports that has occurred in
recent years. This has not resulted in more or better information, but more confusion as to the reason for the
disclosure. A review of companies’ published accounts will show that large sections such as ‘Statement of Directors
Responsibilities’ and ‘Audit Committee report’ are almost identical.

Materiality should be seen as the driving force of disclosure, as its very definition is based on whether an omission or
misstatement could influence the decisions made by users of the financial statements. The assessment of what is
material can be highly judgmental and can vary from user to user. A problem that seems to exist is that disclosures
are being made because a disclosure checklist suggests it may need to be made, without assessing whether the
disclosure is necessary in a company’s particular circumstances. However, it is inherent in these checklists that they
include all possible disclosures that could be material. Most users of these tools will be aware that the disclosure
requirements apply only to material items, but often this is not stated explicitly for users.

One of the most important challenges is in the changing audiences. From its origins in reporting to shareholders,
preparers now have to consider many other stakeholders including employees, unions, environmentalists, suppliers,
customers, etc. The disclosures required to meet the needs of this wider audience have contributed to the increased
volume of disclosure. The growth of previous initiatives on going concern, sustainability, risk, the business model and
others that have been identified by regulators as ‘key’ has also expanded the annual report size.

The length of the annual report is not necessarily the problem but the way in which it is organised. The inclusion of
‘immaterial’ disclosures will usually make this problem worse but, in a well organised annual report, users will often
be able to bypass much of the information they consider unimportant, especially if the report is on line. It is not the
length of the accounting policies disclosure that is itself problematic, but the fact that new or amended policies can be
obscured in a long note running over several pages. A further problem is that accounting policy disclosure is often
‘boilerplate’, providing little specific detail of how companies apply their general policies to particular transactions.

IFRS standards require disclosure of ‘significant accounting policies’. In other words, IFRS standards do not require
disclosure of insignificant or immaterial accounting policies. Omissions in financial statements are material only if
they could, individually or collectively, influence the economic decisions that users make. In many cases, it would not.
Of far greater importance is the disclosure of the judgments made in selecting the accounting policies, especially
where a choice is available.

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 A reassessment of the whole model will take time and may necessitate changes to law and other requirements. For
example, unnecessary clutter could be removed by not requiring the disclosure of IFRS standards in issue but not yet
effective. The disclosure seems to involve listing each new standard in existence and each amendment to a standard,
including separately all those included in the annual improvements project, regardless of whether there is any impact
on the entity. The note becomes a list without any apparent relevance.

The Board has recently issued a request for views regarding its forward agenda in which it acknowledges that
stakeholders have said that disclosure requirements are too voluminous and not always focused in the right areas.
The drive by the Board has very much been to increase the use of disclosure to address comparability between
companies and, in the short to medium term, a reduction in the volume of accounting disclosures does not look
feasible although this is an area to be considered by the Board for its post 2012 agenda.

Written by a member of the Strategic Business Reporting examining team

Business Combinations – IFRS 3 (Revised)

This article provides an introduction to IFRS® 3 and IAS® 27, including piecemeal acquisitions and disposals.
 Purchase consideration
 Goodwill and non-controlling interests (NCI)
 Fair valuing assets and liabilities
 IAS 27 Separate financial statements
 Disposal of controlling interest while retaining associate holding

Purchase consideration

The purchase consideration includes the fair value of all interests that the acquirer may have held previously in the
acquired business. This includes any interest in an associate or joint venture, or other equity interests of the acquired
business. Any previous stake is seen as being ‘given up’ to acquire the entity, and a gain or loss is recorded on its
disposal.

If the acquirer already held an interest in the acquired entity before acquisition, the standard requires the existing
stake to be re-measured to fair value at the date of acquisition, taking into account any movement to the statement of
profit or loss together with any gains previously recorded in equity that relate to the existing holding. If the value of
the stake has increased, there will be a gain recognised in the statement of comprehensive income of the acquirer at
the date of the business combination. A loss would only occur if the existing interest has a carrying amount in excess
of the proportion of the fair value of the business obtained and no impairment had been recorded previously. This
loss situation is not expected to occur frequently.

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Contingent consideration is also recognised at fair value even if payment is not deemed to be probable at the date of
the acquisition.

EXAMPLE 1
Josey acquires 100% of the equity of Burton on 31 December 2008. There are three elements to the purchase
consideration: an immediate payment of $5m, and two further payments of $1m if the return on capital employed
(ROCE) exceeds 10% in each of the subsequent financial years ending 31 December. All indicators have suggested
that this target will be met. Josey uses a discount rate of 7% in any present value calculations.

Requirement:
Determine the value of the investment.

Solution
The two payments that are conditional upon reaching the target ROCE are contingent consideration and the fair value
of $(1m/1.07 + 1m/1.072) ie $1.81m will be added to the immediate cash payment of $5m to give a total
consideration of $6.81m.

All subsequent changes in debt-contingent consideration are recognised in the statement of profit or loss, rather than
against goodwill, as they are deemed to be a liability recognised under IAS 32/39. An increase in the liability for good
performance by the subsidiary results in an expense in the statement of profit or loss, and under-performance against
targets will result in a reduction in the expected payment and will be recorded as a gain in the statement of profit or
loss. These changes were previously recorded against goodwill.

The nature of the contingent consideration is important as it may meet the definition of a liability or equity. If it meets
the definition of equity, then there will be no re-measurement as per IAS 32/39. The new requirement is that
contingent consideration is fair valued at acquisition and, unless it is equity, is subsequently re-measured through
earnings rather than the historic practice of re-measuring through goodwill. This change is likely to increase the focus
and attention on the opening fair value calculation and subsequent re-measurements.

The standard also requires any gain on a ‘bargain purchase’ (negative goodwill) to be recorded in the statement of
profit or loss, as in the previous standard.

Transaction costs no longer form a part of the acquisition price; they are expensed as incurred. Transaction costs are
not deemed to be part of what is paid to the seller of a business. They are also not deemed to be assets of the
purchased business that should be recognised on acquisition. The standard requires entities to disclose the amount of
transaction costs that have been incurred.

The standard clarifies accounting for employee share-based payments by providing additional guidance on valuation,
as well as on how to decide whether share awards are part of the consideration for the business combination or are
compensation for future services.

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 Goodwill and non-controlling interests (NCI)

IFRS 3 gives entities the option, on an individual transaction basis, to measure NCIs (minority interests) at the fair
value of their proportion of identifiable assets and liabilities, or at full fair value. The first method will result in the
measurement of goodwill, a process which is basically the same as in the existing IFRS. However, the second method
will record goodwill on the NCI as well as on the acquired controlling interest. Goodwill continues to be a residual but
it will be a different residual under IFRS 3 (Revised) if the full fair value method is used as compared to the previous
standard. This is partly because all of the consideration, including any previously held interest in the acquired
business, is measured at fair value, but it is also because goodwill can be measured:

 as the difference between the consideration paid and the purchaser’s share of identifiable net assets
acquired: this is a ‘partial goodwill’ method because the NCI is recognised at its share of identifiable net assets and
does not include any goodwill
 on a ‘full goodwill’ basis: this means that goodwill is recognised for the NCI in a subsidiary as well as the
controlling interest.

EXAMPLE 2
Missile acquires a subsidiary on 1 January 2008. The fair value of the identifiable net assets of the subsidiary was
$2,170m. Missile acquired 70% of the shares of the subsidiary for $2.145m. The NCI was fair valued at $683m.

Requirement:
Compare the value of goodwill under the partial and full methods.

Solution
Goodwill based on the partial and full goodwill methods under IFRS 3 (Revised) would be:

Partial goodwill $m

Purchase consideration 2,145

Fair value of identifiable net assets (2,170)

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 Partial goodwill $m

NCI (30% x 2,170) 651

Goodwill 626

Partial goodwill $m

Purchase consideration 2,145

NCI 683

  2,828

Fair value of identifiable net assets (2,170)

Goodwill 658

It can be seen that goodwill is effectively adjusted for the change in the value of the NCI, which represents the
goodwill attributable to the NCI of $32m ($658m – $626m). Choosing this method of accounting for NCI only makes a

10
difference in an acquisition where less than 100% of the acquired business is purchased. The full goodwill method
will increase reported net assets on the balance sheet, which means that any future impairment of goodwill will be
greater. Although measuring NCI at fair value may prove difficult, goodwill impairment testing is likely to be easier
under full goodwill, as there is no need to gross-up goodwill for partially owned subsidiaries.

Fair valuing assets and liabilities

IFRS 3 (Revised) requires all of the identifiable assets and liabilities of the acquiree to be included in the consolidated
statement of financial position. Most assets are recognised at fair value, with exceptions for certain items such as
deferred tax and pension obligations. The International Accounting Standards Board provided additional clarity that
has resulted in more intangible assets being recognised than previously. Acquirers are required to recognise brands,
licences and customer relationships, and other intangible assets.

Contingent assets are not recognised, and contingent liabilities are measured at fair value. After the date of the
business combination, contingent liabilities are re-measured at the higher of the original amount and the amount
under the relevant standard.

The ability of an acquirer to recognise a liability for terminating or reducing the activities of the acquiree is severely
restricted. A restructuring provision can be recognised in a business combination only when the acquiree has, at the
acquisition date, an existing liability for which there are detailed conditions in IAS 37, but these conditions are
unlikely to exist at the acquisition date in most business combinations.

An acquirer has a maximum period of 12 months from the date of acquisition to finalise the acquisition accounting.
The adjustment period ends when the acquirer has gathered all the necessary information, subject to the 12-month
maximum. There is no exemption from the 12-month rule for deferred tax assets or changes in the amount of
contingent consideration. The revised standard will only allow adjustments against goodwill within this one-year
period.

Where NCI is measured at fair value, the valuation methods used for determining that value require to be disclosed;
and, in a step acquisition, disclosure is required of the fair value of any previously held equity interest in the acquiree,
and the amount of gain or loss recognised in the statement of profit or loss resulting from re-measurement.

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IAS 27 Separate financial statements

This revised standard moves IFRS Standards toward the use of the economic entity approach. The economic entity
approach treats all providers of equity capital as shareholders of the entity, even when they are not shareholders in
the parent company.

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For example, disposal of a partial interest in a subsidiary in which the parent company retains control, does not result
in a gain or loss but in an increase or decrease in equity under the economic entity approach. Purchase of some or all
of the NCI is treated as a treasury transaction and accounted for in equity. A partial disposal of an interest in a
subsidiary in which the parent company loses control but retains an interest as an associate, creates the recognition
of gain or loss on the entire interest. A gain or loss is recognised on the part that has been disposed of, and a further
holding gain is recognised on the interest retained, being the difference between the fair value of the interest and the
book value of the interest. The gains are recognised in the statement of comprehensive income. Amendments to IAS
28, Investments in Associates, and IAS 31, Interests in Joint Ventures, extend this treatment to associates and joint
ventures.

EXAMPLE 3

Step acquisition
On 1 January 2008, A acquired a 50% interest in B for $60m. A already held a 20% interest which had been acquired
for $20m but which was valued at $24m at 1 January 2008. The fair value of the NCI at 1 January 2008 was $40m, and
the fair value of the identifiable net assets of B was $110m. The goodwill calculation would be as follows, using the
full goodwill method: 

  $m $m

1 January 2008 consideration 60  

Fair value of interest held  24  

    84

NCI   40

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   $m $m

    124

Fair value of identifiable net assets    (110)

Goodwill   14

A gain of $4m would be recorded on the increase in the value of the previous holding in B.

EXAMPLE 4

Acquisition of part of an NCI

On 1 January 2008, Rage acquired 70% of the equity interests of Pin, a public limited company. The purchase
consideration comprised cash of $360m. The fair value of the identifiable net assets was $480m. The fair value of the
NCI in Pin was $210m on 1 January 2008. Rage wishes to use the full goodwill method for all acquisitions. Rage
acquired a further 10% interest from the NCIs in Pin on 31 December 2008 for a cash consideration of $85m. The
carrying value of the net assets of Pin was $535m at 31 December 2008.

  $m $m

Fair value of consideration for 70% interest 360  

Fair value of NCI 210  

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   $m $m

    570

Fair value of identifiable net assets    (480)

Goodwill   90

Acquisition of further interest

The net assets of Pin have increased by $(535 – 480)m – ie $55m and therefore the NCI has increased by 30% of
$55m – ie $16.5m. However, Rage has purchased an additional 10% of the shares and this is treated as a treasury
transaction. There is no adjustment to goodwill on the further acquisition.

  $m

Pin NCI, 1 January 2008 210

Share of increase in net assets in post-acquisition 16.5

period

Net assets, 31 December 2008 226.5

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   $m

Transfer to equity of Rage (10/30 x 226.5) (75.5)

Balance at 31 December 2008 – NCI 151

Fair value of consideration 85

Charge to NCI (75.5)

Negative movement in equity 9.5

Rage has effectively purchased a further share of the NCI, with the premium paid for that share naturally being
charged to equity. The situation is comparable when a parent company sells part of its holding but retains control.

EXAMPLE 5

Disposal of part of holding to NCI

Using Example 4, instead of acquiring a further 10%, Rage disposes of a 10% interest to the NCIs in Pin on 31
December 2008 for a cash consideration of $65m. The carrying value of the net assets of Pin is $535m at 31
December 2008.

15
   $m  

Pin net assets at 1 January 2008 480  

Increase in net assets 55  

Net assets at 31 December 2008 535  

Fair value of consideration 65  

Transfer to NCI (10% x (535 net assets + 90 (62.5)  

goodwill))

Positive movement in equity 2.5  

The parent has effectively sold 10% of the carrying value of the net assets (including goodwill) of the subsidiary
($62.5m) at 31 December 2008 for a consideration of $65m, giving a profit of $2.5m, which is taken to equity.

Disposal of controlling interest while retaining associate holding

IAS 27 sets out the adjustments to be made when a parent loses control of a subsidiary:

 Derecognise the carrying amount of assets (including goodwill), liabilities and NCIs

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 Recognise the fair value of consideration received
 Recognise any distribution of shares to owners
 Reclassify to profit or loss any amounts (the entire amount, not a proportion) relating to the subsidiary’s
assets and liabilities previously recognised in other comprehensive income, as if the assets and liabilities had been
disposed of directly
 Recognise any resulting difference as a gain or loss in profit or loss attributable to the parent
 Recognise the fair value of any residual interest.

EXAMPLE 6

Disposal of controlling interest

On 1 January 2008, Rage acquired a 90% interest in Machine, a public limited company, for a cash consideration of
$80m. Machine’s identifiable net assets had a fair value of £74m and the NCI had a fair value of $6m. Rage uses the full
goodwill method. On 31 December 2008, Grange disposed of 65% of the equity of Machine (no other investor
obtained control as a result of the disposal) when its identifiable net assets were $83m. Of the increase in net assets,
$6m had been reported in profit or loss, and $3m had been reported in comprehensive income. The sale proceeds
were $65m, and the remaining equity interest was fair valued at $25m. After the disposal, Machine is classified as an
associate under IAS 28, Investments in Associates. The gain recognised in profit or loss would be as follows:

  $m  

Fair value of consideration 65  

Fair value of residual interest to be recognised as an associate 25  

Gain reported in comprehensive income 3  

  93  

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   $m  

Less net assets and goodwill derecognised:     

net assets (83  

goodwill (80 + 6 – 74) (12  

Loss on disposal to profit or loss (2)  

After the sale of the interest, the holding in the associate will be fair valued at $25m.

Issues associated with both IFRS 3 and IAS 27 will be tested regularly in SBR and candidates should be comfortable
with the numerical examples provided above. Candidates should also be able to provide an explanation of the
principles that support these calculations.

Written by a member of the Strategic Business Reportingexamining team

Using the business model of a company to help analyse its performance

Understanding the business model of an entity is helpful in analysing and communicating the essence of a business

and for predicting the implications of a change in circumstance on a business. Strategic Business Reporting (SBR)

candidates should use this technique to improve their answers to SBR questions and this article should help them to

do this.

18
The business model in the context of Integrated Reporting is a company’s system of ‘transforming inputs, through its
business activities, into outputs and outcomes that aim to fulfil the organization’s strategic purposes and create value
over the short, medium and long term’. The definition may seem quite theoretical but there are a number of entities
who use this definition to disclose the resources (also known as capital) that the organisation draws on as inputs to
its business activities, and how these are converted to outputs (products, services, by-products, and waste), which
then have a further impact on the various capitals and stakeholders. The business model describes the entity’s
activities, asset configuration, and the way in which the business adds value including the generation of its cash flows
and its customers, products and services. The aim is to provide users with insight on the ability of the business to
adapt to changes, for example, in the availability, quality, and affordability of inputs, and how these changes can affect
the organisation’s longer-term viability.

Business model information can be fundamental to investor analysis. It provides context and understanding to the
other information in the annual report. The provision of business model information can demonstrate an entity’s
understanding of its business and key drivers which can create investor trust and reduce risk. Additionally, investors
need to understand the business, how the business has performed, and how this performance has been affected by
various factors. There is an argument that the information regarding the business model should be presented outside
the financial statements, such as in the management commentary. Investors will need to know how the business
model is responding to market trends and how the strategy supports the key components of the business model.
They will wish to know how management considers the risks and opportunities across the business model and how
money is made and value generated and re-distributed. Investors will look at the Key Performance Indicators (KPIs)
and how they reflect the key components of the business model. Having the business model play a role in financial
reporting presumes that investors have a good understanding of it prior to assessing the entity’s financial position
and performance.

There has been discussion as to whether the business model should be considered in standard setting and in
particular whether the term should be defined in the Conceptual Framework for Financial Reporting (the Conceptual
Framework). The International Accounting Standards Board (the Board) has decided not to define the business
model in the Conceptual Framework even though there was reference to the business model in an early Exposure
Draft. However, the term has been implicit in International Financial Reporting Standards (IFRS®) for a while. For
example, International Accounting Standard (IAS®) 2 Inventories generally requires inventories to be measured at
the lower of cost and net realisable value. However, IAS 2 includes an exception that allows commodity traders to
measure their inventories at fair value less cost of sale with changes in fair value less cost to sell recognised in profit
or loss. The justification for this different treatment is that the inventory of commodity traders is principally acquired
with the purpose of selling in the near future and generating a profit from the fluctuation in prices.

IFRS 9 requires classification and measurement of financial assets based on an entity’s business model. Although IFRS
9 does not contain a definition of the term ‘business model’, it does include some implicit assumptions about its
meaning. IFRS 9 views the business as based upon how the entity’s assets and liabilities are managed.

It states that an entity should classify financial assets as subsequently measured at either amortised cost or fair value
on the basis of both:

19
(a) The entity’s business model for managing the financial assets and

(b) The contractual cash flow characteristics of the financial asset.

To qualify for an amortised cost classification, the financial asset must be held  to collect contractual cash flows rather
than be held with a view to selling the asset to realise a profit or loss. For example, trade receivables held by a
manufacturing entity are likely to fall within the 'hold to collect' business model if the trade receivables do not
contain a significant financing component in accordance with IFRS 15 Revenue from Contracts with Customers.

 A debt instrument is classified as subsequently measured at fair value through other comprehensive income (FVOCI)
under IFRS 9 if it meets the 'hold to collect' and the 'sell' business model test. The asset is held within a business
model whose objective is achieved by both holding the financial asset in order to collect contractual cash flows and
selling the financial asset. This business model typically involves greater frequency and volume of sales than the hold
to collect business model. Integral to this business model is an intention to sell the instrument before the investment
matures.

Fair value through profit or loss (FVTPL) is the residual category in IFRS 9. If the business model is to hold the
financial asset for trading, then it is classified and measured at FVTPL. Some stakeholders have suggested that the
requirements for equity investments in IFRS 9 could discourage long-term investment. Their view is that the default
requirement to measure those investments at fair value with value changes recognised in profit or loss  may not
reflect the business model of long-term investors.

The term ‘business model’ has also been used in other standards. IFRS 8 Operating Segments defines an operating
segment as a ‘component of an entity that engages in business activities from which it can earn revenue and incur
expenses’. An entity with more than one business model is likely to also have different segments. If an entity has a
business model, it would have internal reporting information which measure the performance of the business model
which may in fact be the business segments.

IAS 40 Investment property distinguishes a property that is held by entities for investment purposes from the one
that is intended to be occupied by the owner. An investment property differs from an owner-occupied property
because the investment property generates cash flows largely independently of the other assets. IAS 40 sets out the
two main uses of property (owner occupied and investment) which implicitly correspond to different business
models. An owner-occupied property should be measured at depreciated cost less any impairment loss, which is an
appropriate way of reflecting the use of the property. Whereas, investment property is measured at either fair value
with fair value changes recognised in the statement of profit or loss, or on the same cost basis as for an owner-
occupied property. These different accounting treatments reflect the different uses of these assets.

If the business model continues to play a significant role in standard-setting, it could give insight into how the entity’s
business activities are managed and help users assess the resources and liabilities of the entity. Alternatively, it can
be argued that this approach may reduce comparability as it could result in different classification, measurement or
disclosure of the same transaction. This may introduce bias in the way the financial statements of an entity are
reported, and therefore make comparisons between entities difficult. It could encourage less neutral reporting as

20
 preparers may present the most favourable outcome which creates a conflict with faithful representation. This
approach can make financial statements of entities with similar business models and in the same industry, more
comparable. Thus, the difficulties with the definition of the business model and its consistent application should not
constitute a reason for excluding it because it has relevance in terms of the financial decision-making needs of the
users of the accounting information. It has always been the case that different businesses will account for the same
asset in different ways depending on what its role is within the firm’s business model. A change in the entity’s
business model is a significant event, because it implies a change in how assets and liabilities are used in the cash -
flow generation process, that is when and how gains and losses are recognised

So, although the ‘business model’ concept first appeared in IFRS 9, there had been an implicit use of the concept in
IFRS for a long time. The business model is not discussed in the latest Conceptual Framework and, as a result, it may
be argued that there is no consistency of its use in IFRS. The United Kingdom’s decision to leave the European Union
highlights the unpredictability and disruptive nature of the business environment. However, it also illustrates the
need for business models to be resilient and flexible to what is happening inside and outside an organisation and to
help stakeholders better understand how a company will adapt to significant change. SBR candidates should be
aware of these issues and be able to provide examples of these inconsistencies in an exam context.

Written by a member of the Strategic Business Reporting examining team

Concepts of profit or loss and other comprehensive income

This article explains the current rules and the conceptual debate as to where in the statement of comprehensive

income, profits and losses should be recognised – ie when should they be recognised in profit or loss and when in the

other comprehensive income. Further, it explores the debate as to whether it is appropriate to recognise profits or

losses twice.
 Recycling (the reclassification from equity to P&L)
 Double entry
 The future of reclassification
 No OCI and no reclassification
 Narrow approach to the OCI
 Broad approach to the OCI
 Conclusion

The performance of a company is reported in the statement of profit or loss and other comprehensive income.
IAS® 1, Presentation of Financial Statements, defines profit or loss as ‘the total of income less expenses, excluding the
components of other comprehensive income’. Other comprehensive income (OCI) is defined as comprising ‘items of
income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or
permitted by other International Financial Reporting Standards (IFRS ®). Total comprehensive income is defined as

21
‘the change in equity during a period resulting from transactions and other events, other than those changes resulting
from transactions with owners in their capacity as owners’.

It is a myth, and simply incorrect, to state that only realised gains are included in profit or loss (P/L) and that only
unrealised gains and losses are included in the OCI. For example, gains on the revaluation of land and buildings
accounted for in accordance with IAS 16, Property Plant and Equipment (IAS 16 PPE), are recognised in OCI and
accumulate in equity in Other Components of Equity (OCE). On the other hand, gains on the revaluation of land and
buildings accounted for in accordance with IAS 40, Investment Properties, are recognised in P/L and are part of the
Retained Earnings (RE). Both such gains are unrealised. The same point could be made with regard to the gains and
losses on the financial asset of equity investments. If such financial assets are designated in accordance with IFRS
9, Financial Instruments (IFRS 9), at inception as Fair Value Through Other Comprehensive Income (FVTOCI) then the
gains and losses are recognised in OCI and accumulated in equity in OCE. Whereas if management decides not to
make this election, then the investment will by default be designated and accounted for as Fair Value Through Profit
or Loss (FVTP&L) and the gains and losses are recognised in P/L and become part of RE.

There is at present no overarching accounting theory that justifies or explains in which part of the statement gains
and losses should be reported. The International Accounting Standards Board (the Board)’s Conceptual Framework
for Financial Reporting® is silent on the matter. So rather than have a clear principles based approach what we
currently have is a rules based approach to this issue. It is down to individual accounting standards to direct when
gains and losses are to be reported in OCI. This is clearly an unsatisfactory approach. It is confusing for users.

In July 2013 the Board published a discussion paper on its Conceptual Framework for Financial Reporting. This
addressed the issue of where to recognise gains and losses. It suggests that the P/L should provide the primary
source of information about the return an entity has made on its economic resources in a period. Accordingly the P/L
should recognise the results of transactions, consumption and impairments of assets and fulfilment of liabilities in the
period in which they occur. In addition the P/L would also recognise changes in the cost of assets and liabilities as
well as any gains or losses resulting from their initial recognition. The role of the OCI would then be to support the
P/L. Gains and losses would only be recognised in OCI if it made the P&L more relevant. In my view whilst this may
be an improvement on the current absence of any guidance it does not provide the clarity and certainty users crave.

Recycling (the reclassification from equity to P&L)

Now let us consider the issue of recycling. This is where gains or losses are reclassified from equity to P/L as a
reclassification adjustment. In other words gains or losses are first recognised in the OCI and then in a later
accounting period also recognised in the P/L. In this way the gain or loss is reported in the total comprehensive
income of two accounting periods and in colloquial terms is said to be recycled as it is recognised twice. At present it
is down to individual accounting standards to direct when gains and losses are to be reclassified from equity to P/L
as a reclassification adjustment. So rather than have a clear principles based approach on recycling what we currently
have is a rules based approach to this issue. This is clearly, again, an unsatisfactory approach but also as we shall see
one addressed by the Board’s July 2013 discussion paper on its Conceptual Framework for Financial Reporting

22
IAS 21, The Effects of Changes in Foreign Exchange Rates (IAS 21), is one example of a standard that requires gains
and losses to be reclassified from equity to P/L as a reclassification adjustment. When a group has an overseas
subsidiary a group exchange difference will arise on the re-translation of the subsidiary’s goodwill and net assets. In
accordance with IAS 21 such exchange differences are recognised in OCI and so accumulate in OCE. On the disposal of
the subsidiary, IAS 21 requires that the net cumulative balance of group exchange differences be reclassified from
equity to P&L as a reclassification adjustment – ie the balance of the group exchange differences in OCE is transferred
to P/L to form part of the profit on disposal.

IAS 16 PPE is one example of a standard that prohibits gains and losses to be reclassified from equity to P/L as a
reclassification adjustment. If we consider land that cost $10m which is treated in accordance with IAS 16 PPE. If the
land is subsequently revalued to $12m, then the gain of $2m is recognised in OCI and will be taken to OCE. When in a
later period the asset is sold for $13m, IAS 16 PPE specifically requires that the profit on disposal recognised in the
P/L is $1m – ie the difference between the sale proceeds of $13m and the carrying value of $12m. The previously
recognised gain of $2m is not recycled/reclassified back to P/L as part of the gain on disposal. However the $2m
balance in the OCE reserve is now redundant as the asset has been sold and the profit is realised. Accordingly, there
will be a transfer in the Statement of Changes in Equity, from the OCE of $2m into RE.

Back to top 

Double entry

For those who love the double entry let me show you the purchase, the revaluation, the disposal and the transfer to
RE in this way.

On purchase $m $m

Dr     Land PPE 10  

Cr     Cash   10

On revaluation    

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Dr     Land PPE 2  

Cr     OCE and recognised in OCI   2

On disposal    

Dr     Cash 13  

Cr     Land PPE   12

Cr     P/L   1

On transfer      

Dr     OCE 2  

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 Cr     Retained earnings   2

If IAS 16 PPE allowed the reclassification from equity to P&L as a reclassification adjustment,
the profit on
disposal recognised in P&L would be $3m including the $2m reclassified from equity to P&L
and the last two double entries above replaced with the following.

On reclassification from equity to P/L  $m  $m  

     

Dr     Cash 13  

Cr     Land PPE   12

Cr     P/L   3

Dr     OCE 2  

IFRS 9 also prohibits the recycling of the gains and losses on FVTOCI investments to P/L on
disposal. The no reclassification rule in both IAS 16 PPE and IFRS 9 means that such gains
on those assets are only ever reported once in the statement of profit or loss and other
comprehensive income – ie are only included once in total comprehensive income. However
many users, it appears, rather ignore the total comprehensive income and the OCI and just
base their evaluation of a company’s performance on the P/L. These users then find it

25
strange that gains that have become realised from transactions in the accounting period are
not fully reported in the P/L of the accounting period. As such we can see the argument in
favour of reclassification. With no reclassification the earnings per share will never fully
include the gains on the sale of PPE and FVTOCI investments.

The following extract from the statement of comprehensive income summarises the current
accounting treatment for which gains and losses are required to be included in OCI and, as
required, discloses which gains and losses can and cannot be reclassified back to profit and
loss.

Extract from the statement of profit or loss and other comprehensive income

  $m

Profit for the year XX

Other comprehensive income  

Gains and losses that cannot be reclassified back to profit or loss  

Changes in revaluation surplus where the revaluation method is used in XX / (XX)

accordance with IAS 16

Remeasurements of a net defined benefit liability or asset recognised in XX / (XX)

accordance with  IAS 19

26
 Gains and losses on remeasuring FVTOCI financial assets in accordance with XX / (XX)
IFRS 9

Gains and losses that can be reclassified back to profit or loss  

Group exchange differences from translating functional currencies into XX / (XX)

presentation currency in accordance with IAS 21

The effective portion of gains and losses on hedging instruments in a cash flow XX / (XX)
hedge under IFRS 9

Total comprehensive income XX / (XX)

The future of reclassification

In the July 2013 discussion paper on the Conceptual Framework for Financial Reporting the
role of the OCI and the reclassification from equity to P/L is debated.

Back to top 

No OCI and no reclassification

It can be argued that reclassification should simply be prohibited. This would free the
statement of profit or loss and other comprehensive income from the need to formally to
classify gains and losses between P/L and OCI. This would reduce complexity and gains
and losses could only ever be recognised once. There would still remain the issue of how to

27
define the earnings in earnings per share, a ratio loved by investors, as clearly total
comprehensive income would contain too many gains and losses that were non-operational,
unrealised, outside the control of management and not relating to the accounting period.

Back to top 

Narrow approach to the OCI

Another suggestion is that the OCI should be restricted, should adopt a narrow approach.
On this basis only bridging and mismatch gains and losses should be included in OCI and be
reclassified from equity to P/L.

A revaluation surplus on a financial asset classified as FVTOCI is a good example of a

bridging gain. The asset is accounted for at fair value on the statement of financial position
but effectively at cost in P/L. As such, by recognising the revaluation surplus in OCI, the OCI
is acting as a bridge between the statement of financial position and the P/L. On disposal
reclassification ensures that the amount recognised in P/L will be consistent with the
amounts that would be recognised in P/L if the financial asset had been measured at
amortised cost.

The effective gain or loss on a cash flow hedge of a future transaction is an example of a
mismatch gain or loss as it relates to a transaction in a future accounting period so needs to
be carried forward so that it can be matched in the P/L of a future accounting period. Only by
recognising the effective gain or loss in OCI and allowing it to be reclassified from equity to
P/L can users to see the results of the hedging relationship.

Back to top 

Broad approach to the OCI

A third proposition is for the OCI to adopt a broad approach, by also including transitory
gains and losses. The Board would decide in each IFRS whether a transitory
remeasurement should be subsequently recycled.

Examples of transitory gains and losses are those that arise on the remeasurement of
defined benefit pension funds and revaluation surpluses on PPE.

Back to top 

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 Conclusion

Whilst the Board has not yet determined which approach will be adopted, its chairman Hans
Hoogervorst has gone on the record as saying ‘It is absolutely vital that the P/L contains all
information that can be relevant to investors and that nothing of importance gets left out…
and… the Board should be very disciplined in its use of OCI as resorting to OCI too easily
would undermine the credibility of net income so the OCI should only be used as an
instrument of last resort’. Now that sounds like a personal endorsement of the narrow
approach to me!

Tom Clendon is a lecturer at FTMS based in Singapore and is the author of the
second edition of A Student's Guide to Group Accounts (published by Kaplan
Publishing)

The Conceptual Framework

In March 2018, the International Accounting Standards Board (the

Board) finished its revision of The Framework for Financial
Reporting (the Framework).
The primary purpose of financial information is to be useful to existing and potential
investors, lenders and other creditors (users) when making decisions about the financing of
the entity and exercising rights to vote on, or otherwise influence, management’s actions that
affect the use of the entity’s economic resources. The Framework sets out the information
needed to assess management’s stewardship, and separates this from the information that
users need to assess the prospects of the entity’s future net cash flows.

Chapter 1 – The objective of general-purpose financial reporting

The purpose of the Framework is to:

 assist the IASB to develop and revise its standards

 assist entities to develop consistent accounting policies when no standard applies to
a particular transaction or other event, or when a standard allows a choice of accounting
policy, and
 assist all stakeholders to understand and interpret the standards

IFRSs take precedence over the Framework. However, should new IFRSs depart from the
Framework, the IASB will explain the reasons in the Basis for Conclusions on that standard.

29
 When considering the objective of general-purpose financial reporting, the Board
reintroduced the concept of ‘stewardship’. This is a relatively minor change and, as many of
the respondents to the Discussion Paper highlighted, stewardship is not a new concept. The
importance of stewardship by management is inherent within the existing Framework and
within financial reporting, so this statement largely reinforces what already exists.

Users base their expectations of returns on their assessment of:

 the amount, timing and uncertainty of future net cash inflows to the entity, and
 management’s stewardship of the entity’s resources.

Chapter 2 – Qualitative characteristics of useful financial

information
The Framework sets out the qualitative characteristics of useful financial information.
However, these characteristics are subject to cost constraints, and it is therefore important to
determine whether the benefits to users of the information justify the cost incurred by the
entity providing it. The Framework clarifies what makes financial information useful, that is,
information must be relevant and must faithfully represent the substance of financial
information.

Relevance and faithful representation remain as the two fundamental qualitative

characteristics. The four enhancing qualitative characteristics continue to be timeliness,
understandability, verifiability and comparability.

Whilst the qualitative characteristics remain unchanged, the Board decided to reinstate
explicit references to prudence and substance over form.

Prudence is introduced in support of the principle of neutrality for the purposes of faithful
representation. Prudence is understood here as the exercise of caution when making
judgements under conditions of uncertainty. Users find this concept important as they feel
that it should help counteract the natural optimistic bias of management. By acknowledging
neutrality and prudence, the Framework includes all conceptual underpinnings for the
development of IFRSs.

The Board concluded that substance over form was not a separate component of faithful
representation. The Board also decided that, if financial statements represented a legal form
that differed from the economic substance, then they could not result in a faithful
representation.

Whilst that statement is true, the Board felt that the importance of the concept needed to be
reinforced and so a statement has now been included in Chapter 2 that states that faithful

30
representation provides information about the substance of an economic phenomenon rather
than its legal form.

Many standards, such as International Accounting Standard (IAS®) 37 Provisions,

Contingent Liabilities and Contingent Assets, apply a system of asymmetric prudence. In IAS
37, a probable outflow of economic benefits would be recognised as a provision, whereas a
probable inflow would only be shown as a contingent asset and merely disclosed in the
financial statements. Therefore, two sides in the same court case could have differing
accounting treatments despite the likelihood of the pay-out being identical for either party.
Many respondents highlighted this asymmetric prudence as necessary under some
accounting standards and felt that a discussion of the term was required. Whilst this is true,
the Board believes that the Framework should not identify asymmetric prudence as a
necessary characteristic of useful financial reporting.

The Framework states that the concept of prudence does not imply a need for asymmetry,
such as the need for more persuasive evidence to support the recognition of assets than
liabilities. It has included a statement that, in financial reporting standards, such asymmetry
may sometimes arise as a consequence of requiring the most useful information.

Many users would prefer the concept of measurement reliability, but the Framework provides
clarification concerning measurement uncertainties which are defined in terms of faithful
representation. Faithful representation of information does not mean that that information
must be accurate in all respects. As the use of estimates are an essential part of the
preparation of financial information and this does not necessarily weaken the usefulness of
the information. The Framework strikes a balance between relevance and faithful
representation in order to provide useful information to the users of financial statements.
Information with a very high degree of uncertainty should be replaced by information whose
estimation involves less uncertainty as long as explanations are provided. The IASB states
that a faithful representation provides information about the substance of an economic
phenomenon instead of merely providing information about its legal form.

Chapter 3 – Financial statements and the reporting entity

This addition relates to the description and boundary of a reporting entity. The Board has
proposed the description of a reporting entity as: an entity that chooses or is required to
prepare general purpose financial statements.

It is useful to users to understand that the general purpose financial statements are prepared
on the assumption that the reporting entity is a going concern. If this assumption is not
appropriate, they are prepared in accordance with a basis other than IFRSs. The Framework
explains that this assumption means that the entity has neither the intention nor the need to
enter liquidation or cease trading in the foreseeable future. The Framework also states that

31
the financial statements are prepared from the perspective of the reporting entity as a whole,
not from the perspective of some or all of the entity’s users. This is a useful clarification for
users, because in practice the perspective taken in drafting the various standards is not
always clear.

Chapter 4 – The elements of financial statements

The Board has changed the definitions of assets and liabilities. The changes to the
definitions of assets and liabilities can be seen below.

  2010  2018  Supporting concept

definition definition

Asset (of an A resource controlled A present economic  

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

Economic   A right that has  

resource the potential to
produceeconomic
benefits

Liability (of an A present obligation A present obligation An entity’s obligation

entity) of the entity arising of the entity to transfer to transfer and
from past events, the an economic resource economic resource
settlement of which as a result of past must have

32
 is expected to result events. the potential to
in an outflow from the require the entity to
entity of resources transfer an economic
embodying economic resource to another
benefits. party.

Obligation   A duty of  
responsibility that an
entity has no practical
ability to avoid.

The Board has therefore changed the definitions of assets and liabilities. Whilst the concept
of ‘control’ remains for assets and ‘present obligation’ for liabilities, the key change is that the
term ‘expected’ has been replaced. For assets, ‘expected economic benefits’ has been
replaced with ‘the potential to produce economic benefits’. For liabilities, the ‘expected
outflow of economic benefits’ has been replaced with the ‘potential to require the entity to
transfer economic resources’.

The reason for this change is that some people interpret the term ‘expected’ to mean that an
item can only be an asset or liability if some minimum threshold were exceeded. As no such
interpretation has been applied by the Board in setting recent IFRS Standards, this definition
has been altered in an attempt to bring clarity.

The Board has acknowledged that some IFRS Standards do include a probability criterion
for recognising assets and liabilities. For example, IAS 37 Provisions, Contingent Liabilities
and Contingent Assets states that a provision can only be recorded if there is a probable
outflow of economic benefits, while IAS 38 Intangible Assetshighlights that for development
costs to be recognised there must be a probability that economic benefits will arise from the
development.

The proposed change to the definition of assets and liabilities will leave these unaffected.
The Board has explained that these standards don’t rely on an argument that items fail to
meet the definition of an asset or liability. Instead, these standards include probable inflows
or outflows as a criterion for recognition. The Board believes that this uncertainty is best
dealt with in the recognition or measurement of items, rather than in the definition of
assets or liabilities.

33
 Chapter 5 – Recognition and derecognition
The Board has confirmed a new approach to recognition, which requires decisions to be
made by reference to the qualitative characteristics of financial information. The Board has
confirmed that an entity should recognise an asset or a liability (and any related income,
expense or changes in equity) if such recognition provides users of financial statements with:

 relevant information about the asset or the liability and about any income, expense or
changes in equity
 a faithful representation of the asset or liability and of any income, expenses or
changes in equity, and
 information that results in benefits exceeding the cost of providing that information.

A key change to this is the removal of a ‘probability criterion’. This has been removed as
different financial reporting standards apply different criterion; for example, some apply
probable, some virtually certain and some reasonably possible. This also means that it will
not specifically prohibit the recognition of assets or liabilities with a low probability of an
inflow or outflow of economic resources.

This is potentially controversial, and the Framework addresses this specifically as chapter 5;
paragraph 15 states that ‘an asset or liability can exist even if the probability of an inflow or
outflow of economic benefits is low’.

The key point here relates to relevance. If the probability of the event is low, this may not be
the most relevant information. The most relevant information may be about the potential
magnitude of the item, the possible timing and the factors affecting the probability.

Even stating all of this, the Framework acknowledges that the most likely location for items
such as this is to be included within the notes to the financial statements.

Finally, a major change in chapter 5 relates to derecognition. This is an area not previously
addressed by the Framework but the Framework states that derecognition should aim to
represent faithfully both:

(a) the assets and liabilities retained after the transaction or other event that led to the
derecognition (including any asset or liability acquired, incurred or created as part of the
transaction or other event), and

(b) the change in the entity’s assets and liabilities as a result of that transaction or other
event.

Chapter 6 – Measurement
34
The selection of a measurement basis must take into account the key characteristics of
useful financial information (relevance and faithful representation) and more particularly the
characteristics of the element, the contribution to cash flows due to economic activities, and
measurement uncertainty and the cost constraint.

A balance is needed between giving entities the flexibility to provide relevant information that
faithfully represents the entity’s assets, liabilities, equity, income and expenses; and
requiring information that is comparable, both from period to period and across entities.

Effective communication in financial statements is also supported by considering that entity-

specific information is more useful than standardised descriptions and duplication of
information in different parts of the financial statements is usually unnecessary and can
make financial statements less understandable.

The first of the measurement bases discussed is historical cost. The accounting treatment of
this is unchanged, but the Framework now explains that the carrying amount of non-financial
items held at historical cost should be adjusted over time to reflect the usage (in the form of
depreciation or amortisation). Alternatively, the carrying amount can be adjusted to reflect
that the historical cost is no longer recoverable (impairment). Financial items held at
historical cost should reflect subsequent changes such as interest and payments, following
the principle often referred to as amortised cost.

The Framework also describes three measurements of current value: fair value, value in use
(or fulfilment value for liabilities) and current cost.

Fair value continues to be defined as the price in an orderly transaction between market
participants. Value in use (or fulfilment value) is defined as an entity-specific value, and
remains as the present value of the cash flows that an entity expects to derive from the
continuing use of an asset and its ultimate disposal.

Current cost is different from fair value and value in use, as current cost is an entry value.
This looks at the value in which the entity would acquire the asset (or incur the liability) at
current market prices, whereas fair value and value in use are exit values, focusing on the
values which will be gained from the item.

Relevance is a key issue. The Framework says that historical cost may not provide relevant
information about assets held for a long period of time, and are certainly unlikely to provide
relevant information about derivatives. In both cases, it is likely that some variation of current
value will be used to provide more predictive information to users.

Conversely, the Framework suggests that fair value may not be relevant if items are held
solely for use or to collect contractual cash flows. Alongside this, the Framework specifically

35
mentions items used in a combination to generate cash flows by producing goods or
services to customers. As these items are unlikely to be able to be sold separately without
penalising the activities, a cost-based measure is likely to provide more relevant information,
as the cost is compared to the margin made on sales.

Chapter 7 – Presentation and disclosure

This is a new section, containing the principles relating to how items should be presented
and disclosed.

The first of these principles is that income and expenses should be included in the statement
of profit or loss unless relevance or faithful representation would be enhanced by including a
change in the current value of an asset or a liability in OCI.

The second of these relates to the recycling of items in OCI into profit or loss. IAS
1 Presentation of Financial Statements suggests that these should be disclosed as items to
be reclassified into profit or loss, or not reclassified.

The recycling of OCI is contentious and some commenters argue that all OCI items should
be recycled. Others argue that OCI items should never be recycled, whilst some argue that
only some items should be recycled.

The Framework contains a statement that income and expenses included in OCI are
recycled when doing so would enhance the relevance or faithful representation of the
information. OCI may not be recycled if there is no clear basis for identifying the period in
which recycling should occur.

Written by a member of the Strategic Business Reportingexamining team

Accounting for cryptocurrencies

There are many issues that accountants may encounter in practice

for which no accounting standard currently exists; one example is
cryptocurrencies. For example, as no accounting standard currently
exists to explain how cryptocurrency should be accounted for,
accountants have no alternative but to refer to existing accounting
standards. This article demonstrates to Strategic Business

36
Reporting (SBR) candidates how this can be done using
cryptocurrencies as an example.
In any exam situation, it is expected that candidates will take a few minutes to reflect on
each question/scenario and plan their answer – ie in this case, think about what accounting
standards might be applicable. This plan will then provide a structure for your answer. SBR
candidates should note that it is perfectly acceptable to suggest a reasonable accounting
standard and then explain why that standard is not applicable; indeed, this article adopts a
similar approach with International Accounting Standard (IAS®) 7, Statement of Cash Flows,
IAS 32, Financial Instruments: Presentation and International Financial Reporting Standard
(IFRS®) 9, Financial Instruments

What is cryptocurrency?

Cryptocurrency is an intangible digital token that is recorded using a distributed ledger

infrastructure, often referred to as a blockchain. These tokens provide various rights of use.
For example, cryptocurrency is designed as a medium of exchange. Other digital tokens
provide rights to the use other assets or services, or can represent ownership interests.

These tokens are owned by an entity that owns the key that lets it create a new entry in the
ledger. Access to the ledger allows the re-assignment of the ownership of the token. These
tokens are not stored on an entity’s IT system as the entity only stores the keys to the
Blockchain (as opposed to the token itself). They represent specific amounts of digital
resources which the entity has the right to control, and whose control can be reassigned to
third parties.

What accounting standards might be used to account for

cryptocurrency?

At first, it might appear that cryptocurrency should be accounted for as cash because it is a
form of digital money. However, cryptocurrencies cannot be considered equivalent to cash
(currency) as defined in IAS 7 and IAS 32 because they cannot readily be exchanged for any
good or service. Although an increasing number of entities are accepting digital currencies
as payment, digital currencies are not yet widely accepted as a medium of exchange and do
not represent legal tender. Entities may choose to accept digital currencies as a form of
payment, but there is no requirement to do so.

IAS 7 defines cash equivalents as ‘short-term, highly liquid investments that are readily
convertible to known amounts of cash and which are subject to an insignificant risk of

37
changes in value’. Thus, cryptocurrencies cannot be classified as cash equivalents because
they are subject to significant price volatility. Therefore, it does not appear that digital
currencies represent cash or cash equivalents that can be accounted for in accordance with
IAS 7.

Intuitively, it might appear that cryptocurrency should be accounted for as a financial asset at
fair value through profit or loss (FVTPL) in accordance with IFRS 9. However, it does not
seem to meet the definition of a financial instrument either because it does not represent
cash, an equity interest in an entity, or a contract establishing a right or obligation to deliver
or receive cash or another financial instrument. Cryptocurrency is not a debt security, nor an
equity security (although a digital asset could be in the form of an equity security) because it
does not represent an ownership interest in an entity. Therefore, it appears cryptocurrency
should not be accounted for as a financial asset.

However, digital currencies do appear to meet the definition of an intangible asset in

accordance with IAS 38, Intangible Assets. This standard defines an intangible asset as an
identifiable non-monetary asset without physical substance. IAS 38 states that an asset is
identifiable if it is separable or arises from contractual or other legal rights. An asset is
separable if it is capable of being separated or divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract,
identifiable asset or liability. This also corresponds  with IAS 21, The Effects of Changes in
Foreign Exchange Rates, which states that an essential feature of a non-monetary asset is
the absence of a right to receive (or an obligation to deliver) a fixed or determinable number
of units of currency. Thus, it appears that cryptocurrency meets the definition of an intangible
asset in IAS 38 as it is capable of being separated from the holder and sold or transferred
individually and, in accordance with IAS 21, it does not give the holder a right to receive a
fixed or determinable number of units of currency.

Cryptocurrency holdings can be traded on an exchange and therefore, there is an

expectation that the entity will receive an inflow of economic benefits. However,
cryptocurrency is subject to major variations in value and therefore it is non-monetary in
nature. Cryptocurrencies are a form of digital money and do not have physical substance.
Therefore, the most appropriate classification is as an intangible asset.

IAS 38 allows intangible assets to be measured at cost or revaluation. Using the cost model,
intangible assets are measured at cost on initial recognition and are subsequently measured
at cost less accumulated amortisation and impairment losses. Using the revaluation model,
intangible assets can be carried at a revalued amount if there is an active market for them;
however, this may not be the case for all cryptocurrencies. The same measurement model
should be used for all assets in a particular asset class. If there are assets for which there is
not an active market in a class of assets measured using the revaluation model, then these
assets should be measured using the cost model.

38
 IAS 38 states that a revaluation increase should be recognised in other comprehensive
income and accumulated in equity. However, a revaluation increase should be recognised in
profit or loss to the extent that it reverses a revaluation decrease of the same asset that was
previously recognised in profit or loss. A revaluation loss should be recognised in profit or
loss. However, the decrease shall be recognised in other comprehensive income to the
extent of any credit balance in the revaluation surplus in respect of that asset. It is unusual
for intangible assets to have active markets. However, cryptocurrencies are often traded on
an exchange and therefore it may be possible to apply the revaluation model.

Where the revaluation model can be applied, IFRS 13, Fair Value Measurement, should be
used to determine the fair value of the cryptocurrency. IFRS 13 defines an active market,
and judgement should be applied to determine whether an active market exists for particular
cryptocurrencies. As there is daily trading of Bitcoin, it is easy to demonstrate that such a
market exists. A quoted market price in an active market provides the most reliable evidence
of fair value and is used without adjustment to measure fair value whenever available. In
addition, the entity should determine the principal or most advantageous market for the
cryptocurrencies.

An entity will also need to assess whether the cryptocurrency’s useful life is finite or
indefinite. An indefinite useful life is where there is no foreseeable limit to the period over
which the asset is expected to generate net cash inflows for the entity. It appears that
cryptocurrencies should be considered as having an indefinite life for the purposes of IAS
38. An intangible asset with an indefinite useful life is not amortised but must be tested
annually for impairment.

In certain circumstances, and depending on an entity’s business model, it might be

appropriate to account for cryptocurrencies in accordance with IAS 2, Inventories, because
IAS 2 applies to inventories of intangible assets. IAS 2 defines inventories as assets:

 held for sale in the ordinary course of business

 in the process of production for such sale, or
 in the form of materials or supplies to be consumed in the production process or in
the rendering of services.

For example, an entity may hold cryptocurrencies for sale in the ordinary course of business
and, if that is the case, then cryptocurrency could be treated as inventory. Normally, this
would mean the recognition of inventories at the lower of cost and net realisable value.
However, if the entity acts as a broker-trader of cryptocurrencies, then IAS 2 states that their
inventories should be valued at fair value less costs to sell. This type of inventory is
principally acquired with the purpose of selling in the near future and generating a profit from
fluctuations in price or broker-traders’ margin. Thus, this measurement method could only be

39
 applied in very narrow circumstances where the business model is to sell cryptocurrency in
the near future with the purpose of generating a profit from fluctuations in price.

As there is so much judgement and uncertainty involved in the recognition and measurement
of crypotocurrencies, a certain amount of disclosure is required to inform users in their
economic decision-making. IAS 1, Presentation of Financial Statements, requires an entity to
disclose judgements that its management has made regarding its accounting for holdings of
assets, in this case cryptocurrencies, if those are part of the judgements that had the most
significant effect on the amounts recognised in the financial statements. Also IAS 10, Events
after the Reporting Period requires an entity to disclose any material non-adjusting events.
This would include whether changes in the fair value of cryptocurrency after the reporting
period are of such significance that non-disclosure could influence the economic decisions
that users of financial statements make on the basis of the financial statements.

So, accounting for cryptocurrencies is not as simple as it might first appear. As no IFRS
standard currently exists, reference must be made to existing accounting standards (and
perhaps even the Conceptual Framework of Financial Reporting). SBR candidates should be
prepared to adopt this approach in an exam situation because it allows them to substantiate
their conclusion which is an approach that will be expected by employers in practice.

Written by a member of the Strategic Business Reportingexamining team

Deferred tax

Deferred tax is a topic that is consistently tested in Financial

Reporting (FR) and is often tested in further detail in Strategic
Business Reporting (SBR). This article will start by considering
aspects of deferred tax that are relevant to FR before moving on to
the more complicated situations that may be tested in SBR.
 The basics
 The FR exam
 The SBR exam

The basics

Deferred tax is accounted for in accordance with IAS® 12, Income Taxes. In FR, deferred tax
normally results in a liability being recognised within the Statement of Financial Position. IAS

40
12 defines a deferred tax liability as being the amount of income tax payable in future
periods in respect of taxable temporary differences. So, in simple terms, deferred tax is tax
that is payable in the future. However, to understand this definition more fully, it is necessary
to explain the term ‘taxable temporary differences’.

Temporary differences are defined as being differences between the carrying amount of an
asset (or liability) within the Statement of Financial Position and its tax base ie the amount at
which the asset (or liability) is valued for tax purposes by the relevant tax authority.

Taxable temporary differences are those on which tax will be charged in the future when the
asset (or liability) is recovered (or settled).

IAS 12 requires that a deferred tax liability is recorded in respect of all taxable temporary
differences that exist at the year-end – this is sometimes known as the full provision method.

All of this terminology can be rather overwhelming and difficult to understand, so consider it
alongside an example. Depreciable non-current assets are the typical deferred tax example
used in FR.

Within financial statements, non-current assets with a limited useful life are subject to
depreciation. However, within tax computations, non-current assets are subject to capital
allowances (also known as tax depreciation) at rates set within the relevant tax legislation.
Where at the year-end the cumulative depreciation charged and the cumulative capital
allowances claimed are different, the carrying amount of the asset (cost less accumulated
depreciation) will then be different to its tax base (cost less accumulated capital allowances)
and hence a taxable temporary difference arises.

EXAMPLE 1
A non-current asset costing $2,000 was acquired at the start of year 1. It is being
depreciated straight line over four years, resulting in annual depreciation charges of $500.
Thus a total of $2,000 of depreciation is being charged. The capital allowances granted on
this asset are:

  $

Year 1 800

41
   $

Year 2 600

Year 3 360

Year 4 240

Total capital allowances  2,000

Table 1 shows the carrying amount of the asset, the tax base of the asset and therefore the
temporary difference at the end of each year.

As stated above, deferred tax liabilities arise on taxable temporary differences, ie those
temporary differences that result in tax being payable in the future as the temporary
difference reverses. So, how does the above example result in tax being payable in the
future?

Entities pay income tax on their taxable profits. When determining taxable profits, the tax
authorities start by taking the profit before tax (accounting profits) of an entity from their
financial statements and then make various adjustments. For example, depreciation is
considered a disallowable expense for taxation purposes but instead tax relief on capital
expenditure is granted in the form of capital allowances. Therefore, taxable profits are
arrived at by adding back depreciation and deducting capital allowances from the accounting
profits. Entities are then charged tax at the appropriate tax rate on these taxable profits.

42
In the above example, when the capital allowances are greater than the depreciation
expense in years 1 and 2, the entity has received tax relief early. This is good for cash flow
in that it delays (ie defers) the payment of tax. However, the difference is only a temporary
difference and so the tax will have to be paid in the future. In years 3 and 4, when the capital
allowances for the year are less than the depreciation charged, the entity is being charged
additional tax and the temporary difference is reversing. Hence the temporary differences
can be said to be taxable temporary differences.

Notice that overall, the accumulated depreciation and accumulated capital allowances both
equal $2,000 – the cost of the asset – so over the four-year period, there is no difference
between the taxable profits and the profits per the financial statements.

At the end of year 1, the entity has a temporary difference of $300, which will result in tax
being payable in the future (in years 3 and 4). In accordance with the concept of prudence, a
liability is therefore recorded equal to the expected tax payable.

Assuming that the tax rate applicable to the company is 25%, the deferred tax liability that
will be recognised at the end of year 1 is 25% x $300 = $75. This will be recorded by
crediting (increasing) a deferred tax liability in the Statement of Financial Position and
debiting (increasing) the tax expense in the Statement of Profit or Loss.

By the end of year 2, the entity has a taxable temporary difference of $400, ie the $300
bought forward from year 1, plus the additional difference of $100 arising in year 2. A liability
is therefore now recorded equal to 25% x $400 = $100. Since there was a liability of $75
recorded at the end of year 1, the double entry that is recorded in year 2 is to credit
(increase) the liability and debit (increase) the tax expense by $25.

At the end of year 3, the entity’s taxable temporary differences have decreased to $260
(since the company has now been charged tax on the difference of $140). Therefore in the
future, the tax payable will be 25% x $260 = $65. The deferred tax liability now needs
reducing from $100 to $65 and so is debited (a decrease) by $35. Consequently, there is
now a credit (a decrease) to the tax expense of $35.

At the end of year 4, there are no taxable temporary differences since now the carrying
amount of the asset is equal to its tax base. Therefore the opening liability of $65 needs to

43
 be removed by a debit entry (a decrease) and hence there is a credit entry (a decrease) of
$65 to the tax expense. This can all be summarised in the following working.

The movements in the liability are recorded in the Statement of Profit or Loss as part of the
taxation charge

Year 1 2 3 4
  $ $ $ $

Opening deferred tax liability 0 75 100 65

Increase/(decrease) in the year 75 25 (35) (65)

Closing deferred tax liability   75 10 65 0

0

The closing figures are reported in the Statement of Financial Position as part of the
deferred tax liability.

Proforma
Example 1 provides a proforma, which may be a useful format to deal with deferred tax
within a published financial statements question. The movement in the deferred tax liability in
the year is recorded in the Statement of Profit or Loss where:

 an increase in the liability, increases the tax expense

 a decrease in the liability, decreases the tax expense.

The closing figures are reported in the Statement of Financial Position as the deferred tax
liability.

The Statement of Profit or Loss

As IAS 12 considers deferred tax from the perspective of temporary differences between the

44
carrying amount and tax base of assets and liabilities, the standard can be said to take a
‘balance sheet approach’. However, it will be helpful to consider the effect on the Statement
of Profit or Loss.

Continuing with the previous example, suppose that the profit before tax of the entity for
each of years 1 to 4 is $10,000 (after charging depreciation). Since the tax rate is 25%, it
would then be logical to expect the tax expense for each year to be $2,500. However,
income tax is based on taxable profits not on the accounting profits.

The taxable profits and so the actual tax liability for each year could be calculated as in
Table 2.

The income tax liability is then recorded as a tax expense. As we have seen in the example,
accounting for deferred tax then results in a further increase or decrease in the tax expense.
Therefore, the final tax expense for each year reported in the Statement of Profit or Loss
would be as in Table 3.

It can therefore be said that accounting for deferred tax is ensuring that the matching
principle is applied. The tax expense reported in each period is the tax consequences (ie tax
charges less tax relief) of the items reported within profit in that period.

45
 The FR exam

Deferred tax is consistently tested in the published financial statementsfinancial statements

question in the FR exam. Here are some hints on how to deal with the information in the
question.

 The deferred tax liability given within the trial balance or draft financial statements will
be the opening liability balance.
 In the notes to the question there will be information to enable you to calculate the
closing liability for the SFP or the increase/decrease in the liability.

It is important that you read the information carefully. You will need to ascertain exactly what
you are being told within the notes to the question and therefore how this relates to the
working that you can use to calculate the figures for the answer.

Consider the following sets of information – all of which will achieve the same ultimate
answer in the published financial statements.

EXAMPLE 2
The trial balance shows a credit balance of $1,500 in respect of a deferred tax liability.

The notes to the question could contain one of the following sets of information:

1. At the year-end, the required deferred tax liability is $2,500.

2. At the year-end, it was determined that an increase in the deferred tax liability of
$1,000 was required.
3. At the year-end, there are taxable temporary differences of $10,000. Tax is charged
at a rate of 25%.
4. During the year, taxable temporary differences increased by $4,000. Tax is charged
at a rate of 25%.

46
Situations 1 and 2 are both giving a figure that can be slotted straight into the deferred tax
working. In situations 3 and 4 however, the temporary differences are being given. These
are then used to calculate a figure which can be slotted into the working. In all situations, the
missing figure is calculated as a balancing figure. Table 4 shows the completed workings.

Revaluations of non-current assets

Revaluations of non-current assets (NCA) are a further example of a taxable temporary
difference. When an NCA is revalued to its current value within the financial statements, the
revaluation surplus is recorded in equity (in a revaluation reserve) and reported as other
comprehensive income. While the carrying amount of the asset has increased, the tax base
of the asset remains the same and so a temporary difference arises.

Tax will become payable on the surplus when the asset is sold and so the temporary
difference is taxable. Since the revaluation surplus has been recognised within equity, to
comply with matching, the tax charge on the surplus is also charged to equity. Suppose that
in Example 1, the asset is revalued to $2,500 at the end of year 2, as shown in Table 5.

47
The carrying amount will now be $2,500 while the tax base remains at $600. There is,
therefore, a temporary difference of $1,900, of which $1,500 relates to the revaluation
surplus. This gives rise to a deferred tax liability of 25% x $1,900 = $475 at the year-end to
report in the Statement of Financial Position. The liability was $75 at the start of the year
( Example 1) and thus there is an increase of $400 to record.

However, the increase in relation to the revaluation surplus of 25% x $1,500 = $375 will be
charged to the revaluation reserve and reported within other comprehensive income. The
remaining increase of $25 will be charged to the Statement of Profit or Loss as before.

The overall double entry is:

D Tax expense in Statement of Profit or $25

r Loss

D Revaluation reserve in equity $375

r

Cr Deferred tax liability in SFP $400

The SBR exam

It is important to appreciate that deferred tax can arise in respect of many different types of
asset or liability and not just non-current assets as discussed above. Therefore, for SBR it is
more important that candidates understand the principles behind deferred tax so that they
can be applied to any given situation. Some of the situations that may be seen are discussed
below. In all of the following situations, assume that the applicable tax rate is 25%.

Deferred tax assets

It is important to be aware that temporary differences can result in needing to record a
deferred tax asset instead of a liability. Temporary differences affect the timing of when tax is
paid or when tax relief is received. While normally they result in the payment being deferred
until the future or relief being received in advance (and hence a deferred tax liability) they

48
can result in the payment being accelerated or relief being due in the future.

In these latter situations the temporary differences result in a deferred tax asset arising (or
where the entity has other larger temporary differences that create deferred tax liabilities, a
reduced deferred tax liability).

Whether an individual temporary difference gives rise to a deferred tax asset or liability can
be ascertained by applying the following rule:

Carrying amount of Tax base of asset / Temporary difference

asset / (Liability) =
(Liability)

If the temporary difference is positive, a deferred tax liability will arise. If the temporary
difference is negative, a deferred tax asset will arise.

EXAMPLE 3
Suppose that at the reporting date the carrying amount of a non-current asset is $2,800
while its tax base is $3,500, as shown in Table 6 above.

In this scenario, the carrying amount of the asset has been written down to below the tax
base. This might be because an impairment loss has been recorded on the asset which is
not allowable for tax purposes until the asset is sold. The entity will therefore receive tax
relief on the impairment loss in the future when the asset is sold.

The deferred tax asset at the reporting date will be 25% x $700 = $175.

49
It is worth noting here that revaluation gains, which increase the carrying amount of the
asset and leave the tax base unchanged, result in a deferred tax liability. Conversely,
impairment losses, which decrease the carrying amount of the asset and leave the tax base
unchanged, result in a deferred tax asset.

EXAMPLE 4
At the reporting date, inventory which cost $10,000 has been written down to its net
realisable value of $9,000. The write down is ignored for tax purposes until the goods are
sold.

The write off of inventory will generate tax relief, but only in the future when the goods are
sold. Hence the tax base of the inventory is not reduced by the write off. Consequently, a
deferred tax asset of 25% x $1,000 = $250 as shown in Table 8 should be recorded at the
reporting date.

EXAMPLE 5
At the reporting date, an entity has recorded a liability of $25,000 in respect of pension
contributions due. Tax relief is available on pension contributions only when they are paid.

The contributions will only be recognised for tax purposes when they are paid in the future.
Hence the pension expense is currently ignored within the tax computations and so the
liability has a nil tax base, as shown in Table 8. The entity will receive tax relief in the future
and so a deferred tax asset of 25% x $25,000 = $6,250 should be recorded at the reporting
date.

Group financial statements

When dealing with deferred tax in group financial statements, it is important to remember
that a group does not legally exist and so is not subject to tax. Instead, tax is levied on the
individual legal entities within the group and their individual tax assets and liabilities are
cross-cast in the consolidation process. To calculate the deferred tax implications on
consolidation adjustments when preparing the group financial statements, the carrying
amount refers to the carrying amount within the group financial statements while the tax
base will be the tax base in the entities’ individual financial statements.

Fair value adjustments

At the date of acquisition, a subsidiary’s net assets are measured at fair value. The fair value
adjustments may not alter the tax base of the net assets and hence a temporary difference
may arise. Any deferred tax asset/liability arising as a result is included within the fair value
of the subsidiary’s net assets at acquisition for the purposes of calculating goodwill.

Goodwill

50
Goodwill only arises on consolidation – it is not recognised as an asset within the individual
financial statements. Theoretically, goodwill gives rise to a temporary difference that would
result in a deferred tax liability as it is an asset with a carrying amount within the group
financial statements but will have a nil tax base. However, IAS 12 specifically excludes a
deferred tax liability being recognised in respect of goodwill.

Provisions for unrealised profits (PUPs)

When goods are sold between group companies and remain in the inventory of the buying
company at the year-end, an adjustment is made to remove the unrealised profit from the
consolidated financial statements. This adjustment also reduces the inventory to the original
cost when a group company first purchased it. However, the tax base of the inventory will be
based on individual financial statements and so will be at the higher transfer price.
Consequently, a deferred tax asset will arise. Recognition of the asset and the consequent
decrease in the tax expense will ensure that the tax already charged to the individual selling
company is not reflected in the current year’s consolidated Statement of Profit or Loss but
will be matched against the future period when the profit is recognised by the group.

EXAMPLE 6
P owns 100% of the equity share capital of S. P sold goods to S for $1,000 recording a profit
of $200. All of the goods remain in the inventory of S at the year-end. Table 9 shows that a
deferred tax asset of 25% x $200 = $50 should be recorded within the group financial
statements.

Measurement of deferred tax

IAS 12 states that deferred tax assets and liabilities should be measured based on the tax
rates that are expected to apply when the asset/liability will be realised/settled. Normally,
current tax rates are used to calculate deferred tax on the basis that they are a reasonable
approximation of future tax rates and that it would be too unreliable to estimate future tax
rates.

Deferred tax assets and liabilities represent future taxes that will be recovered or that will be
payable. It may therefore be expected that they should be discounted to reflect the time
value of money, which would be consistent with the way in which other liabilities are
measured. IAS 12, however, does not permit or allow the discounting of deferred tax assets
or liabilities on practical grounds.

51
The primary reason behind this is that it would be necessary for entities to determine when
the future tax would be recovered or paid. In practice this is highly complex and subjective.
Therefore, to require discounting of deferred tax liabilities would result in a high degree of
unreliability. Furthermore, to allow but not require discounting would result in inconsistency
and so a lack of comparability between entities.

Deferred tax and the framework

As we have seen, IAS 12 considers deferred tax by taking a “balance sheet” approach to the
accounting problem by considering temporary differences in terms of the difference between
the carrying amounts and the tax values of assets and liabilities – also known as the
valuation approach. This can be said to be consistent with the approach taken to recognition
in the International Accounting Standards Board’s Conceptual Framework for Financial
Reporting®(the Conceptual Framework). However, the valuation approach is applied
regardless of whether the resulting deferred tax will meet the definition of an asset or liability
in its own right.

Thus, IAS 12 considers the overriding accounting issue behind deferred tax to be the
application of matching – ensuring that the tax consequences of an item reported within the
financial statements are reported in the same accounting period as the item itself.

For example, in the case of a revaluation surplus, since the gain has been recognised in the
financial statements, the tax consequences of this gain should also be recognised – that is to
say, a tax charge. In order to recognise a tax charge, it is necessary to complete the double
entry by also recording a corresponding deferred tax liability.

However, part of the Conceptual Framework’s definition of a liability is that there is a ‘present
obligation’. Therefore, the deferred tax liability arising on the revaluation gain should
represent the current obligation to pay tax in the future when the asset is sold. However,
since there is no present obligation to sell the asset, there is no present obligation to pay the
tax.

Therefore, it is also acknowledged that IAS 12 is inconsistent with the Conceptual

Framework to the extent that a deferred tax asset or liability does not necessarily meet the
definition of an asset or liability.

Sally Baker and Tom Clendon are tutors at Kaplan Financial

Giving investors what they need

52
 This article looks at how reporting capital structure is challenging,
but markets are keen for the information.
 Introduction
 What is it?
 Investor needs
 IAS 1 Disclosures
 Examples
 Companies Act
 Capitalisation table
 Debt and equity
 Diversity and difficulty

Introduction

Often the advice to investors is to focus upon cash and cash flow when analysing corporate
reports. However insufficient financial capital can cause liquidity problems and sufficiency of
financial capital is essential for growth. Discussion of the management of financial capital is
normally linked with entities that are subject to external capital requirements but it is equally
important to those entities which do not have regulatory obligations.

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What is it?

Financial capital is defined in various ways. The term has no accepted definition having been
interpreted as equity held by shareholders or equity plus debt capital including finance
leases. This can obviously affect the way in which ‘capital’ is measured which has an impact
on return on capital employed (ROCE).

An understanding of what an entity views as capital and its strategy for capital management
is important to all companies and not just banks and insurance companies. Users have
diverse views of what is important in their analysis of capital. Some focus on historical
invested capital, others on accounting capital and others on market capitalisation.

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Investor needs

Investors have specific but different needs for information about capital depending upon their
approach to the valuation of a business. If the valuation approach is based upon a dividend
model, then shortage of capital may have an impact upon future dividends. If ROCE is used
for comparing the performance of entities, then investors need to know the nature and
quantity of the historical capital employed in the business. There is diversity in practice as to
what different companies see as capital and how it is managed.

There are various requirements for entities to disclose information about ‘capital’. In drafting
IFRS® 7, Financial Instruments: Disclosures, the International Accounting Standards Board
(the Board) considered whether it should require disclosures about capital. In assessing the
risk profile of an entity, the management and level of an entity’s capital is an important
consideration.

The Board believes that disclosures about capital are useful for all entities, but they are not
intended to replace disclosures required by regulators as their reasons for disclosure may
differ from those of the Board. As an entity’s capital does not relate solely to financial
instruments, the Board has included these disclosures in IAS® 1, Presentation of Financial
Statements rather than IFRS 7. IFRS 7 requires some specific disclosures about financial
liabilities, it does not have similar requirements for equity instruments.

The Board considered whether the definition of ‘capital’ is different from the definition of
equity in IAS 32, Financial Instruments; Presentation. In most cases disclosure capital would
be the same as equity but it might also include or exclude some elements. The disclosure of
capital is intended to give entities the ability to describe their view of the elements of capital if
this is different from equity.

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IAS 1 Disclosures

As a result, IAS 1 requires an entity to disclose information that enables users to evaluate
the entity’s objectives, policies and processes for managing capital. This objective is
obtained by disclosing qualitative and quantitative data. The former should include narrative
information such as what the company manages as capital, whether there are any external
capital requirements and how those requirements are incorporated into the management of
capital.

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Some entities regard some financial liabilities as part of capital whilst other entities regard
capital as excluding some components of equity for example those arising from cash flow
hedges. The Board decided not to require quantitative disclosure of externally imposed
capital requirements but rather decided that there should be disclosure of whether the entity
has complied with any external capital requirements and, if not, the consequences of non-
compliance. Further there is no requirement to disclose the capital targets set by
management and whether the entity has complied with those targets, or the consequences
of any non-compliance.

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Examples

Examples of some of the disclosures made by entities include information as to how gearing
is managed, how capital is managed to sustain future product development and how ratios
are used to evaluate the appropriateness of its capital structure. An entity bases these
disclosures on the information provided internally to key management personnel.

If the entity operates in several jurisdictions with different external capital requirements such
that an aggregate disclosure of capital would not provide useful information, the entity may
disclose separate information for each separate capital requirement.

Besides the requirements of IAS 1, the IFRS Practice Statement Management Commentary
suggests that management should include forward-looking information in the commentary
when it is aware of trends, uncertainties or other factors that could affect the entity’s capital
resources.

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Companies Act

Additionally, some jurisdictions refer to capital disclosures as part of their legal requirements.
In the UK, Section 414 of the Companies Act 2006 deals with the contents of the Strategic
Report and requires a ‘balanced and comprehensive analysis’ of the development and
performance of the business during the period and the position of the company at the end of
the period.

The section further requires that to the extent necessary for an understanding of the
development, performance or position of the business, the strategic report should include an
analysis using key performance indicators. It makes sense that any analysis of a company’s

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financial position should include consideration of how much capital it has and its sufficiency
for the company’s needs.

The Financial Reporting Council Guidance on the Strategic Report suggests that comments
should appear in the report on the entity’s financing arrangements such as changes in net
debt or the financing of long-term liabilities.

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Capitalisation table

In addition to the annual report, an investor may find details of the entity’s capital structure
where the entity is involved in a transaction, such as a sale of bonds or equities.

It is normal for an entity to produce a capitalisation table in a prospectus showing the effects
of the transactions on the capital structure. The table shows the ownership and debt
interests in the entity but may show potential funding sources, and the effect of any public
offerings.

The capitalisation table may present the pro forma impact of events that will occur as a result
of an offering such as the automatic conversion of preferred stock, the issuance of common
stock, or the use of the offering proceeds for the repayment of debt or other purposes. The
Board does not require such a table to be disclosed but it is often required by securities
regulators.

For example, in the US, the table is used to calculate key operational metrics. Amedica
Corporation announced in February 2016 that it had ‘made significant advancements in its
ongoing initiative toward improving its capitalisation table, capitalisation, and operational
structure’.

It can be seen that information regarding an entity’s capital structure is spread across
several documents including the management commentary, the notes to financial
statements, interim accounts and any document required by securities regulators.

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Debt and equity

Essentially there are two classes of capital reported in financial statements, namely debt and
equity. However, debt and equity instruments can have different levels of benefits and risks.

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When an entity issues a financial instrument, it has to determine its classification either as
debt or as equity. The result of the classification can have a significant effect on the entity’s
reported results and financial position. Liability classification impacts upon an entity’s gearing
ratios and results in any payments being treated as interest and charged to earnings. Equity
classification may be seen as diluting existing equity interests.

IAS 32 sets out the nature of the classification process but the standard is principle based
and sometimes the outcomes are surprising to users. IAS 32 does not look to the legal form
of an instrument but focuses on the contractual obligations of the instrument.

IAS 32 considers the substance of the financial instrument, applying the definitions to the
instrument’s contractual rights and obligations. The variety of instruments issued by entities
makes this classification difficult with the application of the principles occasionally resulting in
instruments that seem like equity being accounted for as liabilities. Recent developments in
the types of financial instruments issued have added more complexity to capital structures
with the resultant difficulties in interpretation and understanding.

The Board has undertaken a research project with the aim of improving accounting for
financial instruments that have characteristics of both liabilities and equity. The Board has a
major challenge in determining the best way to report the effects of recent innovations in
capital structure.

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Diversity and difficulty

There is a diversity of thinking about capital, which is not surprising given the issues with
defining equity, the difficulty in locating sources of information about capital and the diversity
of business models in an economy.

Capital needs are very specific to the business and are influenced by many factors such as
debt covenants, and preservation of debt ratings. The variety and inconsistency of capital
disclosures does not help the decision making process of investors. Therefore the details
underlying a company’s capital structure are essential to the assessment of any potential
change in an entity’s financial flexibility and value.

Written by a member of the Strategic Business Reporting examining team

IAS 21 – does it need amending?

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 This article examines the issues raised by IASB research that referred to a
KASB study into whether IAS 21 needs amending.
 Long-term liabilities
 Average exchange rate

The International Accounting Standards Board (IASB) initiated a research project that examined the
previous research conducted by the Korean Accounting Standards Board (KASB). This research
considered whether any work on IAS 21, The Effects of Changes in Foreign Exchange Rates, was
appropriate. This article looks at some of the issues raised by the project in the context of IAS 21®.

The foreign exchange market is affected by many factors, and in countries with a floating exchange
rate, their foreign exchange rates are inevitably exposed to volatility due to the effects of the different
factors influencing the market. For example, the ongoing problem of Greece repaying its enormous
debts has significantly affected the value of the euro. 

As the barriers to international flows of capital are further relaxed, the volatility of the foreign
exchange market is likely to continue. This volatility affects entities that engage in foreign currency
transactions and there has been a resultant call in some quarters to amend IAS 21.

IFRS® 7, Financial Instruments: Disclosure requires disclosure of market risk, which is the risk that
the fair value or cashflows of a financial instrument will fluctuate due to changes in market prices.
Market risk reflects, in part, currency risk. In IFRS 7, the definition of foreign currency risk relates
only to financial instruments. IFRS 7 and IAS 21 have a different conceptual basis. IFRS 7 is based
upon the distinction between financial/non-financial elements, whereas IAS 21 utilises the
monetary/non-monetary distinction. 

The financial/non-financial distinction determines whether an item is subject to foreign currency risk
under IFRS 7, whereas translation in IAS 21 uses monetary/non-monetary distinction, thereby
possibly causing potential conceptual confusion. Foreign currency risk is little mentioned in IAS 21
and on applying the definition in IFRS 7 to IAS 21, non-financial instruments could be interpreted as
carrying no foreign currency risk. Under IAS 21, certain monetary items include executory contracts,
which do not meet the definition of a financial instrument. These items would be translated at the
closing rate, but as such items are not financial instruments, they could be deemed not to carry foreign
currency risk under IFRS 7.

Foreign currency translation should be conceptually consistent with the conceptual framework. IAS
21 was issued in 1983 with the objective of prescribing how to include foreign currency transactions
and foreign operations in the financial statements of an entity and how to translate financial
statements into a presentation currency. 

There is little conceptual clarification of the translation requirements in IAS 21. The requirements of
IAS 21 can be divided into two main areas: the reporting of foreign currency transactions in the

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functional currency; and the translation to the presentation currency. Exchange differences arising
from monetary items are reported in profit or loss in the period, with one exception which is that
exchange differences arising on monetary items that form part of the reporting entity’s net investment
in a foreign operation are recognised initially in other comprehensive income, and in profit or loss on
disposal of the net investment. 

However, it would be useful to re-examine whether it is more appropriate to recognise a gain or loss
on a monetary item in other comprehensive income instead of profit or loss in the period and to define
the objective of translation. Due to the apparent lack of principles in IAS 21, difficulty could arise in
determining the nature of the information to be provided on translation.

There is an argument that the current accounting standards might not reflect the true economic
substance of long-term monetary assets and liabilities denominated in foreign currency because
foreign exchange rates at the end of the reporting period are used to translate amounts that are to be
repaid in the future. IAS 21 states that foreign currency monetary amounts should be reported using
the closing rate with gains or losses recognised in profit or loss in the period in which they arise, even
when the rate is abnormally high or low. 

There are cases where an exchange rate change is likely to be reversed, and thus it may not be
appropriate to recognise foreign exchange gains or losses of all monetary items as realised gains or
losses. Thus there is an argument that consideration should be given as to whether foreign exchange
gains or losses should be recognised in profit or loss or in other comprehensive income (OCI) based
on the distinction between current items and non-current items. 

Any potential fluctuation in profit or loss account would be reduced by recognising in OCI those
foreign exchange gains or losses of non-current items with a high possibility of reversal. Furthermore,
the question would arise as to whether these items recognised in OCI could be reclassified.

However, the IASB is currently determining via its conceptual framework project the purpose and
nature of OCI, as there is no obvious principle that drives gains and losses out of profit or loss and
into OCI, and there is no shared view among the IASB’s constituents about what should be in profit
or loss and what should be in OCI.

IAS 21 does provide some guidance on non-monetary items by stating that when a gain or loss on a
non-monetary item is recognised in OCI, any exchange component of that gain or loss shall be
recognised in OCI. 

Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange
component of that gain or loss shall be recognised in profit or loss. 

Long-term liabilities

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In the case of long-term liabilities, although any translation gains must be recognised in profit or loss,
and treated as part of reported profit, in some jurisdictions, these gains are treated as unrealised for the
purpose of computing distributable profit. 

The reasoning is that there is a greater likelihood in the case of long-term liabilities that the favourable
fluctuation in the exchange rate will reverse before repayment of the liability falls due.

As stated already, IAS 21 requires all foreign currency monetary amounts to be reported using the
closing rate; non-monetary items carried at historical cost are reported using the exchange rate at the
date of the transaction and non-monetary items carried at fair value are reported at the rate that existed
when the fair values were determined. As monetary items are translated at the closing rate, although
the items are not stated at fair value, the use of the closing rate does provide some fair value
information. However, this principle is not applied to non-monetary items as, unless an item is
measured at fair value, the recognition of a change in the exchange rate appears not to provide useful
information.

A foreign operation is defined in IAS 21 as a subsidiary, associate, joint venture, or branch whose
activities are based in a country or currency other than that of the reporting entity. Thus the definition
of a foreign operation is quite restrictive. It is possible to conduct operations in other ways; for
example, using a foreign broker. Therefore, the definition of a foreign operation needs to be based
upon the substance of the relationship and not the legal form.

Although the exchange rate at the transaction date is required to be used for foreign currency
transactions at initial recognition, an average exchange rate may also be used. The date of a
transaction is the date on which the transaction first qualifies for recognition in accordance with IFRS.
For practical reasons, a rate that approximates to the actual rate at the date of the transaction is often
used. For example, an average rate for a week or a month might be used for all transactions in each
foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the
use of the average rate for a period is inappropriate.

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Average exchange rate

A question arises as to which exchange rate to use and therefore it would be useful to have
more specific guidance on the use of the average exchange rate. IAS 21 allows a certain
amount of flexibility in calculating the average rate. The determination of the average rate
depends upon factors such as the frequency and value of transactions, the period over
which the rate will apply and the nature of the entity’s systems. There are a large number of
methods that can be used to calculate the average rate, but no guidance is given in IAS 21
as to how such a rate is determined.

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 The IASB has completed its initial assessments on this project and decided that narrow
scope amendments were unnecessary. In May 2015, it had no plans to undertake any
additional work and is to remove this project from the research programme, subject to
feedback in the next agenda consultation.

Written by a member of the Strategic Business Reporting examining team

IFRS 2, Share-based payment

International Financial Reporting Standard (IFRS®) 2, Share-based

Payment, applies when a company acquires or receives goods and
services for equity-based payment.
 Recognition of share-based payment
 Equity settled transactions
 Performance conditions
 Cash settled transactions
 Deferred tax implications
 Disclosure

These goods can include inventories, property, plant and equipment, intangible assets, and
other non-financial assets. There are two notable exceptions: shares issued in a business
combination, which are dealt with under IFRS 3, Business Combinations; and contracts for
the purchase of goods that are within the scope of International Accounting Standard (IAS®)
32 and IAS 39. In addition, a purchase of treasury shares would not fall within the scope of
IFRS 2, nor would a rights issue where some of the employees are shareholders.

Examples of some of the arrangements that would be accounted for under IFRS 2 include
call options, share appreciation rights, share ownership schemes, and payments for services
made to external consultants based on the company’s equity capital.

Recognition of share-based payment

IFRS 2 requires an expense to be recognised for the goods or services received by a

company. The corresponding entry in the accounting records will either be a liability or an
increase in the equity of the company, depending on whether the transaction is to be settled
in cash or in equity shares. Goods or services acquired in a share-based payment
transaction should be recognised when they are received. In the case of goods, this is
obviously the date when this occurs. However, it is often more difficult to determine when

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 services are received. If shares are issued that vest immediately, then it can be assumed
that these are in consideration of past services. As a result, the expense should be
recognised immediately.

Alternatively, if the share options vest in the future, then it is assumed that the equity
instruments relate to future services and recognition is therefore spread over that period.

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Equity settled transactions

Equity-settled transactions with employees and directors would normally be expensed and
would be based on their fair value at the grant date. Fair value should be based on market
price wherever this is possible. Many shares and share options will not be traded on an
active market. If this is the case then valuation techniques, such as the option pricing model,
would be used. IFRS 2 does not set out which pricing model should be used, but describes
the factors that should be taken into account. It says that ‘intrinsic value’ should only be used
where the fair value cannot be reliably estimated. Intrinsic value is the difference between
the fair value of the shares and the price that is to be paid for the shares by the counterparty.

The objective of IFRS 2 is to determine and recognise the compensation costs over the
period in which the services are rendered. For example, if a company grants share options
to employees that vest in the future only if they are still employed, then the accounting
process is as follows:

 The fair value of the options will be calculated at the date the options are granted.
 This fair value will be charged to profit or loss equally over the vesting period, with
adjustments made at each accounting date to reflect the best estimate of the number of
options that will eventually vest.
 Shareholders’ equity will be increased by an amount equal to the charge in profit or
loss. The charge in the income statement reflects the number of options vested. If
employees decide not to exercise their options, because the share price is lower than the
exercise price, then no adjustment is made to profit or loss. On early settlement of an award
without replacement, a company should charge the balance that would have been charged
over the remaining period.

EXAMPLE 1
A company issued share options on 1 June 20X6 to pay for the purchase of inventory. The
inventory is eventually sold on 31 December 20X8. The value of the inventory on 1 June
20X6 was $6m and this value was unchanged up to the date of sale. The sale proceeds
were $8m. The shares issued have a market value of $6.3m.

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How will this transaction be dealt with in the financial statements?

Answer
IFRS 2 states that the fair value of the goods and services received should be used to value
the share options unless the fair value of the goods cannot be measured reliably. Thus
equity would be increased by $6m and inventory increased by $6m. The inventory value will
be expensed on sale.

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Performance conditions

Schemes often contain conditions which must be met before there is entitlement to the
shares. These are called vesting conditions. If the conditions are specifically related to the
market price of the company’s shares then such conditions are ignored for the purposes of
estimating the number of equity shares that will vest. The thinking behind this is that these
conditions have already been taken into account when fair valuing the shares. If the vesting
or performance conditions are based on, for example, the growth in profit or earnings per
share, then it will have to be taken into account in estimating the fair value of the option at
the grant date.

EXAMPLE 2
A company grants 2,000 share options to each of its three directors on 1 January 20X6,
subject to the directors being employed on 31 December 20X8. The options vest on 31
December 20X8. The fair value of each option on 1 January 20X6 is $10, and it is
anticipated that on 1 January 20X6 all of the share options will vest on 30 December 20X8.
The options will only vest if the company’s share price reaches $14 per share.

The share price at 31 December 20X6 is $8 and it is not anticipated that it will rise over the
next two years. It is anticipated that on 31 December 20X6 only two directors will be
employed on 31 December 20X8.

How will the share options be treated in the financial statements for the year ended 31
December 20X6?

Answer
The market-based condition (ie the increase in the share price) can be ignored for the
purpose of the calculation. However the employment condition must be taken into account.
The options will be treated as follows:

2,000 options x 2 directors x $10 x 1 year / 3 years = $13,333

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Equity will be increased by this amount and an expense shown in profit or loss for the year
ended 31 December 20X6.

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Cash settled transactions

Cash settled share-based payment transactions occur where goods or services are paid for
at amounts that are based on the price of the company’s equity instruments. The expense
for cash settled transactions is the cash paid by the company.

As an example, share appreciation rights entitle employees to cash payments equal to the
increase in the share price of a given number of the company’s shares over a given period.
This creates a liability, and the recognised cost is based on the fair value of the instrument at
the reporting date. The fair value of the liability is re-measured at each reporting date until
settlement.

EXAMPLE 3
Jay, a public limited company, has granted 300 share appreciation rights to each of its 500
employees on 1 July 20X5. The management feel that as at 31 July 20X6, the year end of
Jay, 80% of the awards will vest on 31 July 20X7. The fair value of each share appreciation
right on 31 July 20X6 is $15.

What is the fair value of the liability to be recorded in the financial statements for the year
ended 31 July 20X6?

Answer
300 rights x 500 employees x 80% x $15 x 1 year / 2 years = $900,000

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Deferred tax implications

In some jurisdictions, a tax allowance is often available for share-based transactions. It is

unlikely that the amount of tax deducted will equal the amount charged to profit or loss under
the standard. Often, the tax deduction is based on the option’s intrinsic value, which is the
difference between the fair value and exercise price of the share. A deferred tax asset will
therefore arise which represents the difference between a tax base of the employee’s
services received to date and the carrying amount, which will effectively normally be zero. A

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 deferred tax asset will be recognised if the company has sufficient future taxable profits
against which it can be offset.

For cash settled share-based payment transactions, the standard requires the estimated tax
deduction to be based on the current share price. As a result, all tax benefits received (or
expected to be received) are recognised in the profit or loss.

EXAMPLE 4
A company operates in a country where it receives a tax deduction equal to the intrinsic
value of the share options at the exercise date. The company grants share options to its
employees with a fair value of $4.8m at the grant date. The company receives a tax
allowance based on the intrinsic value of the options which is $4.2m. The tax rate applicable
to the company is 30% and the share options vest in three-years’ time.

Answer
A deferred tax asset would be recognised of:

$4.2m @ 30% tax rate x 1 year / 3 years = $420,000

The deferred tax will only be recognised if there are sufficient future taxable profits available.

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Disclosure

IFRS 2 requires extensive disclosures under three main headings:

 Information that enables users of financial statements to understand the nature and
extent of the share-based payment transactions that existed during the period.
 Information that allows users of financial statements to understand how the fair value
of the goods or services received, or the fair value of the equity instruments which have
been granted during the period, was determined.
 Information that allows users of financial statements to understand the effect of
expenses, which have arisen from share-based payment transactions, on the entity’s profit
or loss in the period.

The standard is applicable to equity instruments granted after 7 November 2002 but not yet
vested on the effective date of the standard, which is 1 January 2005. IFRS 2 applies to
liabilities arising from cash-settled transactions that existed at 1 January 2005.

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 SBR candidates need to be comfortable with the above accounting principles and be able to
explain them in the context of some accounting numbers.

Written by a member of the Strategic Business Reportingexamining team 

IFRS 9, Financial Instruments

The issue of IFRS® 9, Financial Instrumentsis part of the project to

replace IAS® 39, Financial Instruments – Recognition and
Measurement.
 Classification of financial assets
 Impairment of financial assets
 Classification of financial liabilities
 Summary

It was issued in November 2009 and initially dealt with classification and measurement of
financial assets. IFRS 9 was subsequently updated in October 2010 to include accounting
for financial liabilities.

IFRS 9 is effective for accounting periods commencing on or after 1 January 2013, with
earlier application possible. Note that further developments are in progress dealing with
impairment, derivatives and hedging. To the extent that IFRS 9 does not yet deal with a
particular issue, the requirements of IAS 39 continue to apply.

This article focuses on the accounting requirements relating to financial assets and financial
liabilities only. Other aspects of accounting for financial instruments, such as hedging
arrangements, will be considered in a separate article.

Arguably, IFRS 9 has simplified and improved accounting for financial assets in comparison
with its predecessor, IAS 39. The number of classifications has been reduced from four to
three, as the available-for-sale classification has not been retained within IFRS 9. This has
consequently resulted in elimination of the requirement to recycle gains and losses
previously taken to equity upon derecognition of the financial asset, bringing the benefit of
reduced complexity of financial reporting information.

There is increased emphasis on fair value accounting and reporting, which is regarded as
both relevant and reliable information to those interested in financial reports. IFRS 9 has also
reduced the degree of discretion for classification and accounting treatment of financial
assets, which should support consistent reporting of financial information relating to financial
assets and enhance understanding and comparability of that information.

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 If we begin with the classification of financial assets, IFRS 9 now classifies financial assets
under three headings as follows:

Classification of financial assets

(1) Financial assets at fair value through profit or loss (FVTPL)

This is the normal default classification for financial assets and will apply to all financial
assets unless they are designated to be measured and accounted for in any other way. This
classification includes any financial assets held for trading purposes and also derivatives,
unless they are part of a properly designated hedging arrangement. Debt instruments will be
classified to be measured and accounted for at FVTPL unless they have been correctly
designated to be measured at amortised cost (see later). Initial recognition at fair value is
normally cost incurred and this will exclude transactions costs, which are charged to profit or
loss as incurred. Remeasurement to fair value takes place at each reporting date, with any
movement in fair value taken to profit or loss for the year, which effectively incorporates an
annual impairment review.

(2) Financial assets at fair value through other comprehensive income (FVTOCI)
This classification applies to equity instruments only and must be designated upon initial
recognition. It will typically be applicable for equity interests that an entity intends to retain
ownership of on a continuing basis. Initial recognition at fair value would normally include the
associated transaction costs of purchase. The accounting treatment automatically
incorporates an impairment review, with any change in fair value taken to other
comprehensive income in the year.

Upon derecognition, any gain or loss is based upon the carrying amount at the date of
disposal. One important point is that there is no recycling of any amounts previously taken to
equity in earlier accounting periods. Instead, at derecognition, an entity may choose to make
an equity transfer from other components of equity to retained earnings as any amounts
previously taken to equity can now be regarded as having been realised.

(3) Financial assets measured at amortised cost

This classification can apply only to debt instruments and must be designated upon initial
recognition. For the designation to be effective, the financial asset must pass two tests as
follows:

 The business model test – to pass this test, the entity must be holding the financial
asset to collect in the contractual cash flows associated with that financial asset. If this is not
the case, such as the financial asset being held and then traded to take advantage of

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 changes in fair value, then the test is failed and the financial asset reverts to the default
classification to be measured at FVTPL.
 The cash flow characteristics test – to pass this test, the contractual cash flows
collected must consist solely of payment of interest and capital. If this is not the case, the
test is failed and the financial asset reverts to the default classification to be measured at
FVTPL.

One example of a financial asset that would fail this test is a convertible bond. While there is
receipt of the nominal rate of interest payable by the bond issuer, and the bond will be
converted into shares or cash at a later date, the cash flows are affected by the fact that the
bond holder has a choice to make at some later date – either to receive shares or cash at
the time the bond is redeemed. The nominal rate of interest received will be lower than for
an equivalent financial asset without conversion rights to reflect the right of choice the
bondholder will make at some later date.

This classification of financial asset requires annual review for evidence of possible
impairment and, if there is evidence, there must be an impairment review. Any impairment
identified must be charged to profit or loss in full immediately.

One problem that may arise in relation to financial assets measured at fair value is whether a
reliable fair value can be determined at the reporting date. For exchange-traded financial
assets, such as equity shares in a listed entity, this may be a relatively straightforward
process. If, however, the financial assets in question are not traded on an exchange, there
may be no definitive method to determine fair value at a particular date. This could result in
the exercise of judgment or discretion, which could undermine the reliability or relevance of
any amounts accounted for as a fair value.

Illustration 1 – classification and measurement of financial assets

An entity, Suarez, purchased a five-year bond on 1 January 2010 at a cost of $5m with
annual interest of 5%, which is also the effective rate, payable on 31 December annually. At
the reporting date of 31 December 2010 interest has been received as expected and the
market rate of interest is now 6%.

Required:
Account for the financial asset at 31 December 2010 on the basis that:
(i) it is classified as FVTPL, and
(ii) it is classified to be measured at amortised cost, on the assumption it passes the
necessary tests and has been properly designated at initial recognition.

Answer:
(i) If classified as FVTPL

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This requires that the fair value of the bond is measured based upon expected future cash
flows discounted at the current market rate of interest of 6% as follows:

Expected cash
Year 6% discount factor Present value $m
flows

31 December $5m x 5% = $0.25m 0.9434 0.2358

2011

31 December $0.25m 0.8900 0.2225

2012

31 December $0.25m 0.8396 0.2099

2013

31 December $0.25m + $5m 0.7921 4.1585

2014

      4.8267

Therefore, at the reporting date of 31 December 2010, the financial asset will be stated at a
fair value of $4.8267m, with the fall in fair value amounting to $0.1733m taken to profit or
loss in the year. Interest received will be taken to profit or loss for the year amounting to
$0.25m.

(ii) If classified to be measured at amortised cost

This requires that the fair value of the bond is measured based upon expected future cash

69
flows discounted at the original effective rate of 5%. This will continue to be at $5m as the
following calculation confirms:

Expected cash
Year 5% discount factor Present value $m
flows

31 December $5m x 5% = $0.25m 0.9524 0.2381

2011

31 December $0.25m 0.9070 0.2267

2012

31 December $0.25m 0.8638 0.2160

2013

31 December $0.25m + $5m 0.8227 4.3192

2014

      5,0000

In addition, interest received during the year of $0.25m will be taken to profit or loss for the
year.

Impairment of financial assets

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IFRS 9 effectively incorporates an impairment review for financial assets that are measured
at fair value, as any fall in fair value is taken to profit or loss or other comprehensive income
for the year, depending upon the classification of the financial asset (see earlier).

For financial assets designated to be measured at amortised cost, an entity must make an
assessment at each reporting date whether there is evidence of possible impairment; if there
is, then an impairment review should be performed. If impairment is identified, it is charged
to profit or loss immediately. Quantification of the recoverable amount would normally be
based upon the present value of the expected future cash flows estimated at the date of the
impairment review and discounted to their present value based on the original effective rate
of return at the date the financial asset was issued.

Illustration 2 – impairment of financial assets measured at amortised cost

Using the information contained within Illustration 1, where the carrying amount of the
financial asset at 31 December 2010 was $5m. If, in early 2011, it was identified the bond
issuer was beginning to experience financial difficulties, and there was doubt regarding full
recovery of the amounts due to Suarez, an impairment review would be required. The
expected future cash flows now expected by Suarez from the bond issuer are as follows:

Year   Expected cash flows

31 December   $0.20m
2011

31 December   $0.20m
2012

31 December   $0.20m
2013

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 Year   Expected cash flows

31 December   $0.20m + $4.4m

2014

Required: Calculate the extent of impairment of the financial asset to be included in the
financial statements of Suarez for the year ending 31 December 2011.

Answer: The future cash flows now expected are discounted to present value based on the
original effective rate associated with the financial asset of 5% as follows:

Expected cash
Year 5% discount factor Present value $m
flows

31 December $0.20m 0.9524 0.1905

2011

31 December $0.20m 0.9070 0.1814

2012

31 December $0.20m 0.8638 0.1727

2013

31 December $0.20m + $4.4m 0.8227 3,7844

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 Expected cash
Year 5% discount factor Present value $m
flows

2014

      4,3290

Therefore, impairment amounting to the change in carrying value of ($5.0m – $4.329m)

$0.671m will be recognised as an impairment charge in the year to 31 December 2011.
Additionally, there will also be recognition of interest receivable in the statement of
comprehensive income for the year amounting to (4.329m x 5%) $0.2165m.

Both the Board and FASB in the US continue their work on accounting for impairment of
financial assets, with a reporting standard expected before the end of 2011.

Classification of financial liabilities

IFRS 9 was updated in October 2010 to include recognition and measurement of financial
liabilities. Essentially, the requirements of IAS 39 in relation to financial liabilities are now
contained in IFRS 9 and require that financial liabilities should be accounted for as follows:

1. Financial liabilities at fair value through profit or loss (FVTPL): like the equivalent
classification for financial assets, this will include financial liabilities incurred for trading
purposes and also derivatives that are not part of a hedging arrangement.
2. Other financial liabilities measured at amortised cost: if financial liabilities are not
measured at FVTPL, they are measured at amortised cost.

IFRS 9 also retains the option for some liabilities, which would normally be measured at
amortised cost to be measured at FVTPL if, in doing so, it eliminates or reduces an
accounting mismatch, sometimes referred to as ‘the fair value option’. Where this is the
case, to the extent that part of the change in fair value of the financial liability is due to a
change in the entity’s own credit risk, this should be taken to other comprehensive income in
the year, with the balance of any change in fair value taken to profit or loss. If this accounting

73
treatment for the credit risk creates or enlarges an accounting mismatch in profit or loss then
the gain or loss relating to credit risk should also be taken to profit or loss.

Back to top 

Summary

The overall impact of IFRS 9 is that there is likely to be increased emphasis on fair value
accounting for financial assets, rather than the use of other forms of measurement such as
amortised cost or historical cost. In addition, accounting for impairment of financial assets
has become less complex.

There have been no significant changes to accounting for financial liabilities.

Tony Sweetman is a content specialist and tutor at Kaplan Publishing and Kaplan
Financial

IFRS 13, Fair Value Measurement

IFRS 13 has required a significant amount of work by entities to

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

The guidance in IFRS 13 does not apply to transactions dealt with by certain standards. For
example share based payment transactions in IFRS 2, Share-based Payment, leasing
transactions in IFRS 16, Leases, or to measurements that are similar to fair value but are not
fair value – for example, net realisable value calculations in IAS®2, Inventories or value in
use calculations in IAS 36, Impairment of Assets. Therefore, IFRS 13 applies to fair value
measurements that are required or permitted by those standards not scoped out by IFRS 13.
It replaces the inconsistent guidance found in various IFRS standards with a single source of
guidance on measurement of fair value.

74
Historically, fair value has had a different meaning depending on the context and usage. The
Board’s definition of fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement
date. Basically it is an exit price. Consequently, fair value is focused on the assumptions of
the market place, is not entity specific and so takes into account any assumptions about risk.
This means that fair value is measured using the same assumptions used by market
participants and takes into account the same characteristics of the asset or liability. Such
conditions would include the condition and location of the asset and any restrictions on its
sale or use.

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

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

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

The most advantageous market is the one, which maximises the amount that would be
received for the asset or paid to extinguish the liability after transport and transaction costs.
Often these markets would be the same.

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 Sensibly an entity does not have to carry out an exhaustive search to identify either market
but should take into account all available information. Although transaction costs are taken
into account when identifying the most advantageous market, the fair value is calculated
before adjustment for transaction costs because these costs are characteristics of the
transaction and not the asset or liability. However, if location is a factor, then the market
price is adjusted for the costs incurred to transport the asset to that market. Market
participants must be independent of each other and knowledgeable, and able and willing to
enter into transactions.

This is a complex process and so IFRS 13 sets out a valuation approach, which refers to a
broad range of techniques, which can be used. There are three approaches based on the
market, income and cost. When measuring fair value, the entity is required to maximise the
use of observable inputs and minimise the use of unobservable inputs. To this end, the
standard introduces a fair value hierarchy, which prioritises the inputs into the fair value
measurement process

Fair value measurements are categorised into a three-level hierarchy, based on the type of
inputs to the valuation techniques used, as follows:

 Level 1 inputs are unadjusted quoted prices in active markets for items identical to
the asset or liability being measured. As with current IFRS standards, if there is a quoted
price in an active market, an entity uses that price without adjustment when measuring fair
value. An example of this would be prices quoted on a stock exchange. The entity needs to
be able to access the market at the measurement date. Active markets are ones where
transactions take place with sufficient frequency and volume for pricing information to be
provided. An alternative method may be used where it is expedient. The standard sets out
certain criteria where this may be applicable. For example where the price quoted in an
active market does not represent fair value at the measurement date. An example of this
may be where a significant event takes place after the close of the market such as a
business reorganisation or combination.
The determination of whether a fair value measurement is based on level 2 or level 3 inputs
depends on (i) whether the inputs are observable inputs or unobservable and (ii) their
significance.

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

76
 Finally, level 3 inputs are unobservable inputs. These inputs should be used only
when it is not possible to use Level 1 or 2 inputs. The entity should maximise the use of
relevant observable inputs and minimise the use of unobservable inputs. However, situations
may occur where relevant inputs are not observable and therefore these inputs must be
developed to reflect the assumptions that market participants would use when determining
an appropriate price for the asset or liability. The general principle of using an exit price
remains and IFRS 13 does not preclude an entity from using its own data. For example cash
flow forecasts may be used to value an entity that is not listed. Each fair value measurement
is categorised based on the lowest level input that is significant to it.

IFRS 13 also sets out certain valuation concepts to assist in the determination of fair value.
For non-financial assets only, fair value is determined based on the highest and best use of
the asset as determined by a market participant. Highest and best use is a valuation concept
that considers how market participants would use a non-financial asset to maximise its
benefit or value. The maximum value of a non-financial asset to market participants may
come from its use in combination with other assets and liabilities or on a standalone basis. In
determining the highest and best use of a non-financial asset, IFRS 13 indicates that all uses
that are physically possible, legally permissible and financially feasible should be
considered. As such, when assessing alternative uses, entities should consider the physical
characteristics of the asset, any legal restrictions on its use and whether the value generated
provides an adequate investment return for market participants.

The fair value measurement of a liability, or the entity’s own equity, assumes that it is
transferred to a market participant at the measurement date. In many cases there is no
observable market to provide pricing information and the highest and best use is not
applicable. In this case, the fair value is based on the perspective of a market participant
who holds the identical instrument as an asset. If there is no corresponding asset, then a
corresponding valuation technique may be used. This would be the case with a
decommissioning activity. The fair value of a liability reflects the non performance risk based
on the entity’s own credit standing plus any compensation for risk and profit margin that a
market participant might require to undertake the activity. Transaction price is not always the
best indicator of fair value at recognition because entry and exit prices are conceptually
different.

The guidance includes enhanced disclosure requirements that include:

 information about the hierarchy level into which fair value measurements fall
 transfers between levels 1 and 2
 methods and inputs to the fair value measurements and changes in valuation
techniques, and

77
 additional disclosures for level 3 measurements that include a reconciliation of
opening and closing balances, and quantitative information about unobservable inputs and
assumptions used.

The above is a snapshot of a standard, which has required a significant amount of work by
entities to simply understand the nature of the principles and concepts involved.

Written by a member of the Strategic Business Reporting examining team

IFRS for SMEs

A focus on the International Financial Reporting Standard for small

to medium-sized entities.
The principal aim when developing accounting standards for small to medium-sized
enterprises (SMEs) is to provide a framework that generates relevant, reliable and useful
information which should provide a high quality and understandable set of accounting
standards suitable for SMEs.

In July 2009, the International Accounting Standards Board (the Board) issued the IFRS for
SMEs Standard (the SMEs Standard). This standard provides an alternative framework that
can be applied by eligible entities in place of the full set of International Financial Reporting
Standards (IFRS®).

The SMEs Standard is self-contained, incorporating accounting principles based on extant

IFRS Standards which have been simplified to suit the entities that fall within its scope.
There are a number of accounting standards and disclosures that may not be relevant for
the users of SME financial statements. As a result the standard does not address the
following topics:

 earnings per share

 interim financial reporting
 segment reporting
 insurance (because entities that issue insurance contracts are not eligible to use the
standard), and
 assets held for sale.

In addition, there are certain accounting treatments that are not allowable under the SMEs
Standard. Examples of these disallowable treatments are the revaluation model for property,
plant and equipment and intangible assets, and proportionate consolidation for investments

78
in jointly controlled entities. Generally, there are simpler methods of accounting available to
SMEs than those accounting practices, which have been disallowed.

Additionally the standard eliminates the 'available-for-sale' and 'held-to maturity'

classifications of International Accounting Standard (IAS®) 39, Financial instruments:
recognition and measurement. All financial instruments are measured at amortised cost
using the effective interest method except that investments in non-convertible and non-
puttable ordinary and preference shares that are publicly traded or whose fair value can
otherwise be measured reliably are measured at fair value through profit or loss. All
amortised cost instruments must be tested for impairment. At the same time the standard
simplifies the hedge accounting and derecognition requirements. However, SMEs can
choose to apply IAS 39 in full if they so wish.

The standard also contains a section on transition, which allows all of the exemptions in
IFRS 1, First-time Adoption of International Financial Reporting Standards. It also contains
'impracticability' exemptions for comparative information and the restatement of the opening
statement of financial position.

As a result of the above, the SMEs Standard requires SMEs to comply with less than 10% of
the volume of accounting requirements applicable to listed companies complying with the full
set of IFRS Standards.

There is no universally agreed definition of an SME. No single definition can capture all the
dimensions of a small or medium-sized business, or cannot be expected to reflect the
differences between firms, sectors, or countries at different levels of development.

Most definitions based on size use measures such as number of employees, net assets
total, or annual turnover. However, none of these measures apply well across national
borders. The SMEs Standard is intended for use by entities that have no public
accountability (ie its debt or equity instruments are not publicly traded).

Ultimately, the decision regarding which entities should use the SMEs Standard stays with
national regulatory authorities and standard setters. These bodies will often specify more
detailed eligibility criteria. If an entity opts to use the SMEs Standard, it must follow the
standard in its entirety - it cannot cherry pick between the requirements of the SMEs
Standard and those of full IFRS Standards.

The Board makes it clear that the prime users of IFRS Standards are the capital markets.
This means that IFRS Standards are primarily designed for quoted companies and not
SMEs. The vast majority of the world's companies are small and privately owned, and it
could be argued that IFRS Standards are not relevant to their needs or to the needs of their

79
 users. It is often thought that small business managers perceive the cost of compliance with
accounting standards to be greater than their benefit.

To this end, the SMEs Standard makes numerous simplifications to the recognition,
measurement and disclosure requirements in full IFRS Standards. Examples of these
simplifications are:

 goodwill and other indefinite-life intangibles are amortised over their useful lives, but
if useful life cannot be reliably estimated, then 10 years
 a simplified calculation is allowed if measurement of defined benefit pension plan
obligations (under the projected unit credit method) involves undue cost or effort
 the cost model is permitted for investments in associates and joint ventures.

The main argument for the SMEs  Standard is the undue cost burden of reporting, which is
proportionately heavier for smaller firms. The cost burden of applying the full set of IFRS
Standards may not be justified on the basis of user needs. Further, much of the current
reporting framework is based on the needs of large business, so SMEs perceive that the full
statutory financial statements are less relevant to the users of SME accounts. SMEs also
use financial statements for a narrower range of decisions, as they have less complex
transactions and therefore less need for a sophisticated analysis of financial statements.
Thus, the disclosure requirements in the SMEs Standard are also substantially reduced
when compared with those in full IFRS Standards partly because they are not considered
appropriate for users' needs and for cost-benefit considerations. Many disclosures in full
IFRS Standards are more relevant to investment decisions in capital markets than to the
transactions undertaken by SMEs.

There are arguments against different reporting requirements for SMEs in that it may lead to
a two-tier system of reporting. Entities should not be subject to different rules, which could
give rise to different 'true and fair views'.

One course of action could have been for GAAP for SMEs to be developed on a national
basis, with IFRSs focusing on accounting for listed company activities. The main issue here
would be that the practices developed for SMEs may not have been consistent and may
have lacked comparability across national boundaries. Also, if a SME wished to list its
shares on a capital market, the transition to IFRSs may be more difficult.

There were a number of approaches that could have been taken to developing the SMEs
Standard. Under one approach, the exemptions given to smaller entities would be prescribed
in the mainstream accounting standard. For example, an appendix could have been included
within the standard detailing those exemptions given to smaller enterprises. Another
approach would have been to introduce a separate standard comprising all the issues
addressed in IFRS Standards, which are relevant to SMEs.

80
The SMEs Standard is a self-contained set of accounting principles that are based on full
IFRS Standards, but that have been simplified so that they are suitable for SMEs. The
standard has been organised by topic with the intention that the standard would be user-
friendly for preparers and users of SME financial statements.

The SMEs Standard and full IFRS Standards are separate and distinct frameworks. Entities
that are eligible to apply the SMEs Standard, and that choose to do so, must apply that
standard in full and cannot chose the most suitable accounting policy from full IFRS
Standards or the SMEs Standard.

However, the SMEs Standard is naturally a modified version of full IFRS Standards, and not
an independently developed set of standards. They are based on recognised concepts and
pervasive principles and they will allow easier transition to full IFRS Standards if the SME
decides to become a public listed entity. In deciding on the modifications to make to IFRS
Standards, the needs of the users have been taken into account, as well as the costs and
other burdens imposed upon SMEs. Relaxation of some of the measurement and
recognition criteria in IFRS Standards had to be made in order to achieve the reduction in
these costs and burdens. Some disclosure requirements are intended to meet the needs of
listed entities, or to assist users in making forecasts of the future. Users of financial
statements of SMEs often do not make such kinds of forecasts. Small companies pursue
different strategies, and their goals are more likely to be survival and stability rather than
growth and profit maximisation.

The stewardship function is often absent in small companies, with the financial statements
play an agency role between the owner-manager and the bank.

Where financial statements are prepared using the SMEs Standard, the basis of
presentation note and the auditor's report will refer to compliance with the SMEs Standard.
This reference may improve access to capital. The standard also contains simplified
language and explanations of the standards.

The Board did not set an effective date for the standard because the decision as to whether
to adopt the SMEs Standard is a matter for each jurisdiction.

In the absence of specific guidance on a particular subject. An SME may, but is not required
to, consider the requirements and guidance in full IFRS Standards dealing with similar
issues. The Board has produced full implementation guidance for SMEs.

There may be some important tax issues arising for SMEs that adopt the SMEs Standard
andand this has been cited as one of the main reasons why some SMEs have not adopted
the SME Standard. Since 2005, listed groups in the UK have been required to prepare their

81
 consolidated financial statements in accordance with IFRS. Almost all other groups and
companies have had a choice to follow IFRS Standards or UK GAAP.

The SMEs Standard is a response to international demand from developed and emerging
economies for a rigorous and common set of accounting standards for smaller and medium-
sized businesses that is much simpler than full IFRS Standards. The SMEs Standard should
provide improved comparability for users of financial statements while enhancing the overall
confidence in the financial statements of SMEs, and reducing the significant costs involved
of maintaining standards on a national basis.

Written by a member of the Strategic Business Reportingexamining team

Impairment of financial assets

The International Accounting Standards Board (the Board) is proposing

new regulations for the impairment of financial assets.
 Current regulation on the impairment of financial assets – the incurred loss approach
 Proposed regulation on the impairment of financial assets – the expected loss approach
 Example of the expected loss approach
 Background to the proposals
 Two stage approach
 Simplified approach
 Conclusion

Current regulation on the impairment of financial assets – the

incurred loss approach

IAS® 39, Financial Instruments: Recognition and Measurement (IAS 39), does not require financial
assets classified at fair value through profit or loss (FVTP&L) and fair value through other
comprehensive income (FVTOCI) to be subject to impairment reviews. Therefore impairment reviews
are only required in respect of financial assets that are classified as amortised cost – for example,
loans, debt securities and trade receivables. Please see 'Related links' for the articles that I have
previously written explaining these terms and the basic principles of accounting for financial
instruments.

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IAS 39 states that a financial asset is impaired and impairment losses are incurred only if a loss event
has occurred and this loss event had a reliably measurable impact on the future cash flows. This is
often called the 'incurred loss' approach.

The incurred loss approach has the advantage of being fairly objective – there has to have been a past
event – for example, an actual default or a breach of a debt covenant. This objectivity reduces the risk
of profit smoothing by companies are they are unable to estimate anticipated future losses. However,
the incurred loss model has attracted criticism because it can result in the overstatement of both assets
and profits. Arguably the incurred loss approach was a contributory factor in the credit crunch.

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Proposed regulation on the impairment of financial assets – the

expected loss approach

The Board has proposed a model where credit losses on financial assets are no longer recognised
when incurred but rather, are recognised on the basis of expected credit losses. This is often called the
'expected loss' approach.

The expected loss approach is likely to result in earlier recognition of credit losses, which includes not
only losses that have already been incurred but also expected future losses. Arguably this method will
be more prudent as both assets and profits will be reduced. It is however open to the criticism that
allowing the judgment of what future losses might be incurred it will allow some companies to engage
in profit smoothing.

Expected credit losses are defined as the expected shortfall in contractual cash flows. The estimation
of expected credit losses should consider past events, current conditions and reasonable and
supportable forecasts.

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Example of the expected loss approach

The Bale company has a portfolio of $50,000 financial assets (debt instruments) that have two years
to maturity and are correctly accounted for at amortised cost. Each asset has a coupon rate of 10% as
well as an effective rate of 10%. No previous impairment loss has been recognised. At the year-end
information has emerged that the sector in which the borrowers operate is experiencing tough
economic conditions. It is now felt that a proportion of loans will default over the remaining loan

83
period. After considering a range of possible outcomes, the overall rate of return from the portfolio is
expected to be approximately 6% per annum for each of the next two years.

Required:
Calculate the expected credit losses on a life time basis.

Answer
The lender was expecting an annual return of $5,000 a year ($50,000 × 10%) but is now only
expecting an annual return of $3,000 a year ($50,000 × 6%). There is therefore a shortfall – ie an
expected credit loss shortfall of $2,000 per year. An allowance should be calculated at the present
value of the shortfalls over the remaining life of the asset.

The discount rate used should be between the risk-free rate and the effective rate of the asset. In the
absence of further information, the effective rate of 10% has been used in the calculations below:

  Contractual cash flow shortfall Discount  Present value  

$ rate $
$

Yea 2,000 0.909 1,818

r1

Yea 2,000 0.8264 1,653

r2

      3,471

Thus, the expected credit loss is $3,471. This is recognised as the impairment loss thus creating an
expense to be charged to profit or loss and offset against the carrying value of the financial asset on
the statement of financial position.

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Background to the proposals

In 2009, the Board published an exposure draft (ED) that proposed adjusting for expected impairment
losses through adjusting the effective interest rate of a financial instrument. The basis for this model
was that expected credit losses are usually priced into the interest rate to be charged and should be
reflected in the yield on the financial asset. Changes in credit loss expectations were to be recognised
as incurred as these changes would not have been priced into the asset. This works conceptually but is
a little impracticable. In 2011, the Board proposed removing interest adjustment from the recognition
of impairment losses and adopting expected credit losses and this is the basis of the current ED issued
in March 2013.

The ED applies to financial assets measured at amortised cost and at fair value through other
comprehensive income. This includes debt instruments such as loans, debt securities and trade
receivables. Additionally it applies to irrevocable loan commitments and financial guarantee contracts
that are not accounted for at fair value through profit or loss under IFRS® 9 and also lease receivables.
This is a wider scope than at present.

The principle behind the ED is that financial statements should reflect the general pattern of
deterioration or improvement in the credit quality of financial assets within the scope of the ED. The
Board’s new proposals require the recognition of expected credit losses for certain financial assets by
creating an allowance/provision based on either 12-month or lifetime expected credit losses. For
financial assets, entities would recognise a loss allowance whereas for commitments to extend credit,
a provision would be set up to recognise expected credit losses.

On initial recognition, an entity would create a credit loss allowance/provision equal to 12-months'
expected credit losses. In subsequent years, if the credit risk increased significantly since initial
recognition, this amount would be replaced by an estimate of the lifetime expected credit losses.
Financial assets with a low credit risk would not meet the lifetime expected credit losses criterion. An
entity does not recognise lifetime expected credit losses for financial assets that are equivalent to
'investment grade', which means that the asset has a low risk of default. Under the proposed model,
there is a rebuttable presumption that lifetime expected losses should be provided for if contractual
cash flows are 30 days overdue. If the credit quality subsequently improves and the lifetime expected
credit losses criterion is no longer met, the credit loss reverts back to a 12-month expected credit loss
basis. The entity can apply the ED on a collective basis, rather than on an individual basis, if the
financial instruments share the same risk characteristics.

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Two stage approach

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On initial recognition
On the initial recognition of a financial asset an entity would recognise an impairment loss based on
the 12-months' expected credit losses.

On subsequent review
Financial assets whose credit quality has not significantly deteriorated since their initial recognition;
then the impairment loss is based on 12 months of expected credit losses.

Financial assets whose credit quality has significantly deteriorated since their initial recognition, then
the impairment loss is based on a lifetime of expected credit losses.

Financial assets for which there is objective evidence of an impairment as at the reporting date, then
the impairment loss is based on a lifetime of expected credit losses.

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Simplified approach

For trade receivables there is a simplified procedure in that no credit loss allowance is recognised on
initial recognition. Any impairment loss will be the present value of the expected cash flow shortfalls
over the remaining life of the receivables.

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Conclusion

The proposed change from the incurred loss model to an expected credit loss model will
require more judgment as the carrying value of financial assets will be dependent on
considering more forward-looking information which means that any losses would be
accounted for earlier than happens under the current rules.

Tom Clendon is a lecturer at FTMS based in Singapore and is the author of the
second edition of A Student's Guide to Group Accounts (published by Kaplan
Publishing)

Impairment of goodwill

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 According to IFRS® 3, Business Combinations, there are two ways
to measure the goodwill that arises on the acquisition of a
subsidiary and each has a slightly different impairment process.
 How to calculate goodwill
 Consider calculating goodwill
 Basic principles of impairment
 Consider an impairment review
 Goodwill and impairment
 Proportionate goodwill and the impairment review
 Consider an impairment review of proportionate goodwill
 Gross goodwill and the impairment review
 Consider an impairment review of gross goodwill
 Observation

This article discusses and shows both ways of measuring goodwill following the acquisition
of a subsidiary, and how each measurement of goodwill is subject to an impairment review.

How to calculate goodwill

The traditional measurement of goodwill on the acquisition of a subsidiary is the excess of

the fair value of the consideration given by the parent over the parent’s share of the fair
value of the net assets acquired. This method can be referred to as the proportionate
method. It determines only the goodwill that is attributable to the parent company.

Another method of measuring goodwill on the acquisition of the subsidiary is to compare the
fair value of the whole of the subsidiary (as represented by the fair value of the consideration
given by the parent and the fair value of the non controlling interest) with all of the fair value
of the net assets of the subsidiary acquired. This method can be referred to as the gross or
full goodwill method. It determines the goodwill that relates to the whole of the subsidiary, ie
goodwill that is both attributable to the parent’s interest and the non-controlling interest
(NCI).

Back to top 

Consider calculating goodwill

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Borough acquires an 80% interest in the equity shares of High for consideration of $500. The
fair value of the net assets of High at that date is $400. The fair value of the NCI at that date
(ie the fair value of High’s shares not acquired by Borough) is $100.

Required

(1) Calculate the goodwill arising on the acquisition of High on a proportionate basis.

(2) Calculate the gross goodwill arising on the acquisition of High, ie using the fair value of
the NCI.

Solution

(1) The proportionate goodwill arising is calculated by matching the consideration that the
parent has given, with the interest that the parent acquires in the net assets of the
subsidiary, to give the goodwill of the subsidiary that is attributable to the parent.

Parent’s cost of investment at the $500

fair value of consideration given

Less the parent’s share of the fair  

value of the net assets of the subsidiary
acquired (80% x ($320
$400) )

Goodwill attributable to the parent   $180  

(2) The gross goodwill arising is calculated by matching the fair value of the whole business
with the whole fair value of the net assets of the subsidiary to give the whole goodwill of the
subsidiary, attributable to both the parent and to the NCI.

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 Parent’s cost of investment at the $500
fair value of consideration given

Fair value of the NCI $100

Less the fair value of the net

assets of the subsidiary acquired (100% x $400) ($400)

Gross goodwill $200

Given a gross goodwill of $200 and a goodwill attributable to the parent of $180, the goodwill
attributable to the NCI is the difference of $20.

In these examples, goodwill is said to be a premium arising on acquisition. Such goodwill is

positive goodwill and accounted for as an intangible asset in the group financial statements,
and as we shall see be subject to an annual impairment review.

In the event that there is a bargain purchase, ie negative goodwill arises, then this is
regarded as a profit and immediately recognised in income.

Basic principles of impairment

An asset is impaired when its carrying amount exceeds the recoverable amount. The
recoverable amount is, in turn, defined as the higher of the fair value less cost to sell and the
value in use; where the value in use is the present value of the future cash flows.

An impairment review calculation looks like this.

This is the carrying amount, ie the figure that the asset is currently recorded at in the
financial statements.

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Consider an impairment review

A company has an asset that has a carrying amount of $800. The asset has not been
revalued. The asset is subject to an impairment review. If the asset was sold then it would
sell for $610 and there would be associated selling costs of $10. (The fair value less costs to
sell of the asset is therefore $600.) The estimate of the present value of the future cash flows
to be generated by the asset if it were kept is $750. (This is the value in use of the asset.)

Required
Determine the outcome of the impairment review.

Solution
An asset is impaired when its carrying amount exceeds the recoverable amount, where the
recoverable amount is the higher of the fair value less costs to sell and the value in use. In
this case, with a fair value less cost to sell of only $600 and a value in use of $750 it both
follows the rules, and makes common sense to minimise losses, that the recoverable

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 amount will be the higher of the two, ie $750.
 

Impairment review

Carrying amount of the asset $800  

Carrying amount of the asset $800  

Recoverable amount ($750)  

Impairment loss $50  

The impairment loss must be recorded so that the asset is written down. There is no
accounting policy or choice about this. In the event that the recoverable amount had
exceeded the carrying amount then there would be no impairment loss to recognise and as
there is no such thing as an impairment gain, no accounting entry would arise.

As the asset has never been revalued, the loss has to be charged to income. Impairment
losses are non-cash expenses, like depreciation, so in the cash flow statement they will be
added back when reconciling operating profit to cash generated from operating activities,
just like depreciation again.

Assets are generally subject to an impairment review only if there are indicators of
impairment. IAS® 36, Impairment of Assets lists examples of circumstances that would
trigger an impairment review.

External sources

 market value declines

 negative changes in technology, markets, economy, or laws
 increases in market interest rates
 company share price is below the carrying amount 

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 Internal sources

 obsolescence or physical damage

 asset is part of a restructuring or held for disposal
 worse economic performance than expected

Goodwill and impairment

The asset of goodwill does not exist in a vacuum; rather, it arises in the group financial
statements because it is not separable from the net assets of the subsidiary that have just
been acquired.

The impairment review of goodwill therefore takes place at the level of a cash-generating
unit, that is to say a collection of assets that together create an independent stream of cash.
The cash-generating unit will normally be assumed to be the subsidiary. In this way, when
conducting the impairment review, the carrying amount will be that of the net assets and the
goodwill of the subsidiary compared with the recoverable amount of the subsidiary.

When looking to assign the impairment loss to particular assets within the cash generating
unit, unless there is an asset that is specifically impaired, it is goodwill that is written off first,
with any further balance being assigned on a pro rata basis.

The goodwill arising on the acquisition of a subsidiary is subject to an annual impairment

review. This requirement ensures that the asset of goodwill is not being overstated in the
group financial statements. Goodwill is a peculiar asset in that it cannot be revalued so any
impairment loss will automatically be charged against income. Goodwill is not deemed to be
systematically consumed or worn out thus there is no requirement for a systematic
amortisation.

Back to top 

Proportionate goodwill and the impairment review

When goodwill has been calculated on a proportionate basis then for the purposes of
conducting the impairment review it is necessary to gross up goodwill so that in the
impairment review goodwill will include an unrecognised notional goodwill attributable to the
NCI.

Any impairment loss that arises is first allocated against the total of recognised and

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unrecognised goodwill in the normal proportions that the parent and NCI share profits and
losses.

Any amounts written off against the notional goodwill will not affect the consolidated financial
statements and NCI. Any amounts written off against the recognised goodwill will be
attributable to the parent only, without affecting the NCI.

If the total amount of impairment loss exceeds the amount allocated against recognised and
notional goodwill, the excess will be allocated against the other assets on a pro rata basis.
This further loss will be shared between the parent and the NCI in the normal proportion that
they share profits and losses.

Back to top 

Consider an impairment review of proportionate goodwill

At the year-end, an impairment review is being conducted on a 60%-owned subsidiary. At

the date of the impairment review the carrying amount of the subsidiary’s net assets were
$250 and the goodwill attributable to the parent $300 and the recoverable amount of the
subsidiary $700.

Required
Determine the outcome of the impairment review.

Solution
In conducting the impairment review of proportionate goodwill, it is first necessary to gross it
up.

Proportionate Goodwill including the 

Grossed up
goodwill notional unrecognised NCI

$300 x 100/60 = $500

Now, for the purposes of the impairment review, the goodwill of $500 together with the net
assets of $250 form the carrying amount of the cash-generating unit.

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Impairment review

Carrying amount  

Net assets $250

Goodwill $500

  $750

Recoverable amount ($700)

Impairment loss $50

The impairment loss does not exceed the total of the recognised and unrecognised goodwill
so therefore it is only goodwill that has been impaired. The other assets are not impaired. As
proportionate goodwill is only attributable to the parent, the impairment loss will not impact
NCI.

Only the parent’s share of the goodwill impairment loss will actually be recorded, ie 60% x
$50 = $30.

The impairment loss will be applied to write down the goodwill, so that the intangible asset of
goodwill that will appear on the group statement of financial position will be $270 ($300 –
$30).

In the group statement of financial position, the accumulated profits will be reduced $30.

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There is no impact on the NCI.

In the group statement of profit or loss, the impairment loss of $30 will be charged as an
extra operating expense. There is no impact on the NCI.

Gross goodwill and the impairment review

Where goodwill has been calculated gross, then all the ingredients in the impairment review
process are already consistently recorded in full. Any impairment loss (whether it relates to
the gross goodwill or the other assets) will be allocated between the parent and the NCI in
the normal proportion that they share profits and losses.

Back to top 

Consider an impairment review of gross goodwill

At the year-end, an impairment review is being conducted on an 80%-owned subsidiary. At

the date of the impairment review the carrying amount of the net assets were $400 and the
gross goodwill $300 (of which $40 is attributable to the NCI) and the recoverable amount of
the subsidiary $500.

Required
Determine the outcome of the impairment review.

Solution
The impairment review of goodwill is really the impairment review of the net asset’s
subsidiary and its goodwill, as together they form a cash generating unit for which it is
possible to ascertain a recoverable amount.

Carrying amount  

Net assets $400

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 Carrying amount  

Goodwill $300

  $700

Recoverable amount $500

Impairment loss $200

The impairment loss will be applied to write down the goodwill, so that the intangible asset of
goodwill that will appear on the group statement of financial position, will be $100 ($300 –
$200).

In the equity of the group statement of financial position, the accumulated profits will be
reduced by the parent’s share of the impairment loss on the gross goodwill, ie $160 (80% x
$200) and the NCI reduced by the NCI’s share, ie $40 (20% x $200).

In the statement of profit or loss, the impairment loss of $200 will be charged as an extra
operating expense. As the impairment loss relates to the gross goodwill of the subsidiary, so
it will reduce the NCI in the subsidiary’s profit for the year by $40 (20% x $200).

Observation

In passing, you may wish to note an apparent anomaly with regards to the accounting
treatment of gross goodwill and the impairment losses attributable to the NCI. The goodwill
attributable to the NCI in this example is stated as $40. This means that goodwill is $40
greater than it would have been if it had been measured on a proportionate basis; likewise,

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the NCI is also $40 greater for having been measured at fair value at acquisition.

The split of the gross goodwill between what is attributable to the parent and what is
attributable to the NCI is determined by the relative values of the NCI at acquisition to the
parent’s cost of investment. However, when it comes to the allocation of impairment losses
attributable to the write off of goodwill then these losses are shared in the normal proportions
that the parent and the NCI share profits and losses, ie in this case 80%/20%.

This explains the strange phenomena that while the NCI are attributed with only $40 out of
the $300 of the gross goodwill, when the gross goodwill was impaired by $200 (ie two thirds
of its value), the NCI are charged $40 of that loss, representing all of the goodwill attributable
to the NCI.

Tom Clendon and Sally Baker are tutors at Kaplan Financial

Measurement

This article considers the relevance of information provided by

different measurement methods and explains the effect that they
may have on the financial statements.
The relevance of information provided by a particular measurement method depends on how
it affects the financial statements. The cost should be justified by the benefits of reporting
that information to existing and potential users. The different measures used should be the
minimum necessary to provide relevant information and there should be infrequent changes
with any necessary changes clearly explained. Further it makes sense for comparability and
consistency purposes, to use the same method for initial and subsequent measurement
unless there is a good reason from not doing so.

The existing Conceptual Framework for Financial Reporting® (the framework) provides very

little guidance on measurement, which constitutes a serious gap in the Framework. A single
measurement basis may not provide the most relevant information to users and therefore
IFRS® standards adopt a mixed measurement basis, which includes fair value, historical
cost, and net realisable value. Different information from different measurement bases may
be relevant in different circumstances. A particular measurement bases may be easier to
understand, more verifiable and less costly to implement. However, if different measurement
bases are used, it can be argued that the totals in financial statements have little meaning.
Those that prefer a single measurement method favour the use of current values to provide
the most relevant information. 

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A business that is profit orientated has processes to transform market input values (inventory
for example) into market output values.(sales of finished products).Thus it makes sense that
current values should play a key role in measurement. Current market value would appear to
be the most relevant measure of assets and liabilities for financial reporting purposes.

The International Accounting Standards Board favour a mixed measurement approach

whereby the most relevant measurement method is selected. It appears that investors feel
that this approach is consistent with how they analyse financial statements and that the
problems of mixed measurement are outweighed by the greater relevance achieved. In
recent standards, it seems that the Board felt that fair value would not provide the most
relevant information in all circumstances. For example, IFRS 9 requires the use of cost in
some cases and fair value in other cases, while IFRS 15 essentially applies cost allocation.

A factor to be considered when selecting a measurement basis is the degree of

measurement uncertainty. The Exposure Draft on the Conceptual Framework states that for
some estimates, a high level of measurement uncertainty may outweigh other factors to
such an extent that the resulting information may have little relevance. Most measurement is
uncertain and requires estimation. For example, recoverable value for impairment,
depreciation estimates and fair value measures at level 2 and 3 under IFRS
13.Consequently, the Board believes that the level of uncertainty associated with the
measurement of an item should be considered when assessing whether a particular
measurement basis provides relevant information.

Measurement uncertainty could be considered too great with the result that the entity may
not recognise the asset or liability. An example of this would be research activities. However,
sometimes a measure with a high degree of uncertainty provides the most relevant
information about an item. For example, financial instruments for which prices are not
observable. The Board thinks that the level of measurement uncertainty that makes
information lack relevance depends on the circumstances and can only be decided when
developing particular standards.

It would be easier if measurement bases were categorised as either historical cost or current
value. The Exposure Draft on the Conceptual Framework describes these two categories but
also states that cash-flow-based measurement techniques are generally used to estimate
the measure of an asset or a liability as part of a prescribed measurement basis. Cash-flow-
based measurement can be used to customise measurement bases, which can result in
more relevant information but it may also be more difficult for users to understand. As a
result the Exposure Draft does not identify those techniques as a separate category.

There are several areas of debate about measurement. For example,should any discussion
of measurement bases include the use of entry and exit values, entity-specific values and
the role of deprival value. Again should an entity’s business model affect the measurement

98
 of its assets and liabilities. Many would advocate that different measurement methods
should be applied that are dependent both on the nature of assets and liabilities and also,
importantly, on how these are used in the business. For example, property can be measured
at historical cost or fair value depending upon the business model.

In order to meet the objective of financial reporting, information provided by a particular

measurement basis must be useful to users of financial statements. A measurement basis
achieves this if the information is relevant and faithfully represents what it essentially is
supposed to represent. In addition, the measurement basis needs to provide information that
is comparable, verifiable, timely and understandable. The Board believes that when
selecting a measurement basis, the amount is more relevant if the way in which an asset or
a liability contributes to future cash flows is considered. The Board considers that the way in
which an asset or a liability contributes to future cash flows depends, in part, on the nature of
the business activities.

There are many different ways in which an asset or liability can be measured. Historical cost
seems to be the easiest of these measures but even here, complexity can arise where there
is a deferred payment or a payment, which involves an asset exchange. Subsequent
accounting after initial recognition is not necessarily straightforward with historical cost as
such matters as impairment of assets have to be taken into account and the latter is
dependent upon rules, which can be sometimes subjective.

Current values have a variety of alternative valuation methods. These include market value,
value-in-use and fulfilment value. Of these various methods, there is less ambiguity around
current market prices as with any other measure of current value, there is likely to be specific
rules in place to avoid inconsistency. In the main, the details of how these different
measurement methods are applied, are set out in each accounting standard.

Written by a member of the Strategic Business Reporting examining team

Profit, loss and other comprehensive income

This article looks at what differentiates profit or loss from other

comprehensive income and where items should be presented.
 Reclassification: for and against

The purpose of the statement of profit or loss and other comprehensive income (OCI) is to show an
entity’s financial performance in a way that is useful to a wide range of users so that they may attempt
to assess the future net cash inflows of an entity. The statement should be classified and aggregated in
a manner that makes it understandable and comparable. International Financial Reporting Standards
(IFRS®) currently require the statement to be presented as either one statement, being a combined

99
statement of profit or loss and other comprehensive income or two statements, being the statement of
profit or loss and the statement of profit or loss and other comprehensive income. An entity has to
show separately in OCI, those items which would be reclassified (recycled) to profit or loss and those
items which would never be reclassified (recycled) to profit or loss. The related tax effects have to be
allocated to these sections.

Profit or loss includes all items of income or expense (including reclassification adjustments) except
those items of income or expense that are recognised in OCI as required or permitted by IFRS
standards. Reclassification adjustments are amounts recycled to profit or loss in the current period that
were recognised in OCI in the current or previous periods. An example of items recognised in OCI
that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign
operation and realised gains or losses on cash flow hedges. Those items that may not be reclassified
are changes in a revaluation surplus under IAS® 16, Property, Plant and Equipment, and actuarial
gains and losses on a defined benefit plan under IAS 19, Employee Benefits.

However, there is a general lack of agreement about which items should be presented in profit or loss
and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of
reclassification and when or which OCI items should be reclassified. A common misunderstanding is
that the distinction is based upon realised versus unrealised gains. This lack of a consistent basis for
determining how items should be presented has led to an inconsistent use of OCI in IFRS standards. It
may be difficult to deal with OCI on a conceptual level since the International Accounting Standards
Board (the Board) are finding it difficult to find a sound conceptual basis. However, there is urgent
need for some guidance around this issue.

Opinions vary but there is a feeling that OCI has become a ‘dumping ground’ for anything
controversial because of a lack of clear definition of what should be included in the statement. Many
users are thought to ignore OCI as the changes reported are not caused by the operating flows used for
predictive purposes. Financial performance is not defined in the Conceptual Framework for Financial
Reporting®but could be viewed as reflecting the value the entity has generated in the period and this
can be assessed from other elements of the financial statements and not just the statement of profit or
loss and other comprehensive income. Examples would be the statement of cash flows and disclosures
relating to operating segments. The presentation in profit or loss and OCI should allow a user to
depict financial performance including the amount, timing and uncertainty of the entity’s future net
cash inflows and how efficiently and effectively the entity’s management have discharged their duties
regarding the resources of the entity.

Reclassification: for and against

There are several arguments for and against reclassification. If reclassification ceased, then
there would be no need to define profit or loss, or any other total or subtotal in profit or loss,
and any presentation decisions can be left to specific IFRS standards. It is argued that

100
reclassification protects the integrity of profit or loss and provides users with relevant
information about a transaction that occurred in the period. Additionally, it can improve
comparability where IFRS standards permit similar items to be recognised in either profit or
loss or OCI.

Those against reclassification argue that the recycled amounts add to the complexity of
financial reporting, may lead to earnings management and the reclassification adjustments
may not meet the definitions of income or expense in the period as the change in the asset
or liability may have occurred in a previous period.

The original logic for OCI was that it kept income-relevant items that possessed low reliability
from contaminating the earnings number. Markets rely on profit or loss and it is widely used.
The OCI figure is crucial because it can distort common valuation techniques used by
investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all
information relevant to investors. Misuse of OCI would undermine the credibility of net
income. The use of OCI as a temporary holding for cash flow hedging instruments and
foreign currency translation is non-controversial.

However, other treatments such the policy of IFRS 9 to allow value changes in equity
investments to go through OCI, are not accepted universally.

US GAAP will require value changes in all equity investments to go through profit or loss.
Accounting for actuarial gains and losses on defined benefit schemes are presented through
OCI and certain large US corporations have been hit hard with the losses incurred on these
schemes. The presentation of these items in OCI would have made no difference to the
ultimate settled liability but if they had been presented in profit or loss, the problem may have
been dealt with earlier. An assumption that an unrealised loss has little effect on the
business is an incorrect one.

The Discussion Paper on the Conceptual Framework for Financial Reporting considers three
approaches to profit or loss and reclassification. The first approach prohibits reclassification.
The other approaches, the narrow and broad approaches, require or permit reclassification.
The narrow approach allows recognition in OCI for bridging items or mismatched
remeasurements. While the broad approach has an additional category of ‘transitory
measurements’ (for example, remeasurement of a defined benefit obligation) which would
allow the Board greater flexibility. The narrow approach significantly restricts the types of
items that would be eligible to be presented in OCI and gives the Board little discretion when
developing or amending IFRS standards.

A bridging item arises where the Board determines that the statement of comprehensive
income would communicate more relevant information about financial performance if profit or
loss reflected a different measurement basis from that reflected in the statement of financial

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position For example, if a debt instrument is measured at fair value in the statement of
financial position, but is recognised in profit or loss using amortised cost, then amounts
previously reported in OCI should be reclassified into profit or loss on impairment or disposal
of the debt instrument. The Board argues that this is consistent with the amounts that would
be recognised in profit or loss if the debt instrument were to be measured at amortised cost.

A mismatched remeasurement arises where an item of income or expense represents an

economic phenomenon so incompletely that, in the opinion of the Board, presenting that
item in profit or loss would provide information that has little relevance in assessing the
entity’s financial performance. An example of this is when a derivative is used to hedge a
forecast transaction; changes in the fair value of the derivative may arise before the income
or expense resulting from the forecast transaction. The argument is that before the results of
the derivative and the hedged item can be matched together, any gains or losses resulting
from the remeasurement of the derivative, to the extent that the hedge is effective and
qualifies for hedge accounting, should be reported in OCI. Subsequently, those gains or
losses are reclassified into profit or loss when the forecast transaction affects profit or loss.
This allows users to see the results of the hedging relationship.

The Board’s preliminary view is that any requirement to present a profit or loss total or
subtotal could also result in some items being reclassified. The commonly suggested
attributes for differentiation between profit or loss and OCI (realised/unrealised, frequency of
occurrence, operating/non-operating, measurement certainty/uncertainty, realisation in the
short/long-term or outside management control) are difficult to distil into a set of principles.

Therefore, the Board is suggesting two broad principles, namely:

(a) Profit or loss provides the primary source of information about the return an entity has
made on its economic resources in a period.

(b) To support profit or loss, OCI should only be used if it makes profit or loss more relevant.

The Board feels that changes in cost-based measures and gains or losses resulting from
initial recognition should not be presented in OCI and that the results of transactions,
consumption and impairments of assets and fulfilment of liabilities should be recognised in
profit or loss in the period in which they occur. As a performance measure, profit or loss is
more used although there are a number of other performance measures derived from the
statement of profit or loss and OCI.

Written by a member of the Strategic Business Reporting examining team

Revenue revisited

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 This two-part article considers the application of IFRS 15, Revenue from
Contracts with Customers using the five-step model.
 Using the five-step model

On 28 May 2014, the International Accounting Standards Board (the Board), as a result of the joint
project with the US Financial Accounting Standards Board (FASB), issued IFRS® 15, Revenue from
Contracts with Customers. Application of the standard is mandatory for annual reporting periods
starting from 1 January 2017 onward (though there is currently a proposal to defer this date to 1
January 2018) and earlier application is permitted.

This article considers the application of IFRS 15, Revenue from Contracts with Customers using the
five-step model. The new standard introduces some significant changes so you should ensure that you
have the latest editions of all study materials.

Historically, there has been a significant divergence in practice over the recognition of revenue,
mainly because IFRS standards have contained limited guidance in certain areas. The original
standard, IAS® 18, Revenue, was issued in 1982 with a significant revision in 1993, however, IAS 18
was not fit for purpose in today’s corporate world as the guidance available was difficult to apply to
many transactions. The result was that some companies applied US GAAP when it suited their needs.

Users often found it difficult to understand the judgments and estimates made by an entity in
recognising revenue, partly because of the ‘boilerplate’ nature of the disclosures. As a result of the
varying recognition practices, the nature and extent of the impact of the new standard will vary
between entities and industries. For many transactions, such as those in retail, the new standard will
have little effect but there could be significant change to current practice in accounting for long-term
and multiple-element contracts.

IFRS 15 replaces the following standards and interpretations:

 IAS 11, Construction Contracts

 IAS 18, Revenue
 IFRIC 13, Customer Loyalty Programmes
 IFRIC 15, Agreements for the Construction of Real Estate
 IFRIC 18, Transfer of Assets from Customers
 SIC-31, Revenue – Barter Transactions Involving Advertising Services

The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of promised
good or services to customers at an amount that reflects the consideration to which the entity expects
to be entitled in exchange for those goods and services. The standard introduces a five-step model for
the recognition of revenue.

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Using the five-step model

The five-step model applies to revenue earned from a contract with a customer with limited
exceptions, regardless of the type of revenue transaction or the industry. 

Step one in the five-step model requires the identification of the contract with the
customer. Contracts may be in different forms (written, verbal or implied), but must be
enforceable, have commercial substance and be approved by the parties to the contract.
The model applies once the payment terms for the goods or services are identified and it is
probable that the entity will collect the consideration. Each party’s rights in relation to the
goods or services have to be capable of identification. If a contract with a customer does not
meet these criteria, the entity can continually reassess the contract to determine whether it
subsequently meets the criteria.

Two or more contracts that are entered into around the same time with the same customer
may be combined and accounted for as a single contract, if they meet the specified criteria.
The standard provides detailed requirements for contract modifications. A modification may
be accounted for as a separate contract or as a modification of the original contract,
depending upon the circumstances of the case.

Step two requires the identification of the separate performance obligations in the

contract. This is often referred to as ‘unbundling’, and is done at the beginning of a contract.
The key factor in identifying a separate performance obligation is the distinctiveness of the
good or service, or a bundle of goods or services. A good or service is distinct if the
customer can benefit from the good or service on its own or together with other readily
available resources and it is separately identifiable from other elements of the contract.

IFRS 15 requires that a series of distinct goods or services that are substantially the same
with the same pattern of transfer, to be regarded as a single performance obligation. A good
or service which has been delivered may not be distinct if it cannot be used without another
good or service that has not yet been delivered. Similarly, goods or services that are not
distinct should be combined with other goods or services until the entity identifies a bundle of
goods or services that is distinct. IFRS 15 provides indicators rather than criteria to
determine when a good or service is distinct within the context of the contract. This allows
management to apply judgment to determine the separate performance obligations that best
reflect the economic substance of a transaction.

Step three requires the entity to determine the transaction price, which is the amount of
consideration that an entity expects to be entitled to in exchange for the promised goods or
services. This amount excludes amounts collected on behalf of a third party – for example,

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government taxes. An entity must determine the amount of consideration to which it expects
to be entitled in order to recognise revenue.

The transaction price might include variable or contingent consideration. Variable

consideration should be estimated as either the expected value or the most likely amount.
The expected value approach represents the sum of probability-weighted amounts for
various possible outcomes. The most likely amount represents the most likely amount in a
range of possible amounts.

Management should use the approach that it expects will best predict the amount of
consideration and it should be applied consistently throughout the contract. An entity can
only include variable consideration in the transaction price to the extent that it is highly
probable that a subsequent change in the estimated variable consideration will not result in a
significant revenue reversal. If it is not appropriate to include all of the variable consideration
in the transaction price, the entity should assess whether it should include part of the
variable consideration. However, this latter amount still has to pass the ‘revenue reversal’
test.

Variable consideration is wider than simply contingent consideration as it includes any

amount that is variable under a contract, such as performance bonuses or penalties.

Additionally, an entity should estimate the transaction price, taking into account non-cash
consideration, consideration payable to the customer and the time value of money if a
significant financing component is present. The latter is not required if the time period
between the transfer of goods or services and payment is less than one year. In some
cases, it will be clear that a significant financing component exists due to the terms of the
arrangement.

In other cases, it could be difficult to determine whether a significant financing component

exists. This is likely to be the case where there are long-term arrangements with multiple
performance obligations such that goods or services are delivered and cash payments
received throughout the arrangement. For example, if an advance payment is required for
business purposes to obtain a longer-term contract, then the entity may conclude that a
significant financing obligation does not exist.

If an entity anticipates that it may ultimately accept an amount lower than that initially
promised in the contract due to, for example, past experience of discounts given, then
revenue would be estimated at the lower amount with the collectability of that lower amount
being assessed. Subsequently, if revenue already recognised is not collectable, impairment
losses should be taken to profit or loss.

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 Step four requires the allocation of the transaction price to the separate performance
obligations. The allocation is based on the relative standalone selling prices of the goods or
services promised and is made at the inception of the contract. It is not adjusted to reflect
subsequent changes in the standalone selling prices of those goods or services.

The best evidence of standalone selling price is the observable price of a good or service
when the entity sells that good or service separately. If that is not available, an estimate is
made by using an approach that maximises the use of observable inputs – for example,
expected cost plus an appropriate margin or the assessment of market prices for similar
goods or services adjusted for entity-specific costs and margins or in limited circumstances a
residual approach. The residual approach is different from the residual method that is used
currently by some entities, such as software companies.

When a contract contains more than one distinct performance obligation, an entity should
allocate the transaction price to each distinct performance obligation on the basis of the
standalone selling price.

Where the transaction price includes a variable amount and discounts, it is necessary to
establish whether these amounts relate to all or only some of the performance obligations in
the contract. Discounts and variable consideration will typically be allocated proportionately
to all of the performance obligations in the contract. However, if certain conditions are met,
they can be allocated to one or more separate performance obligations.

This will be a major practical issue as it may require a separate calculation and allocation
exercise to be performed for each contract. For example, a mobile telephone contract
typically bundles together the handset and network connection and IFRS 15 will require their
separation.

Step five requires revenue to be recognised as each performance obligation is

satisfied. This differs from IAS 18 where, for example, revenue in respect of goods is
recognised when the significant risks and rewards of ownership of the goods are transferred
to the customer. An entity satisfies a performance obligation by transferring control of a
promised good or service to the customer, which could occur over time or at a point in time.
The definition of control includes the ability to prevent others from directing the use of and
obtaining the benefits from the asset. A performance obligation is satisfied at a point in time
unless it meets one of the following criteria, in which case, it is deemed to be satisfied over
time:

 The customer simultaneously receives and consumes the benefits provided by the
entity’s performance as the entity performs.
 The entity’s performance creates or enhances an asset that the customer controls as
the asset is created or enhanced.

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

Revenue is recognised in line with the pattern of transfer. Whether an entity recognises
revenue over the period during which it manufactures a product or on delivery to the
customer will depend on the specific terms of the contract.

If an entity does not satisfy its performance obligation over time, it satisfies it at a point in
time and revenue will be recognised when control is passed at that point in time. Factors that
may indicate the passing of control include the present right to payment for the asset or the
customer has legal title to the asset or the entity has transferred physical possession of the
asset.

As a consequence of the above, the timing of revenue recognition may change for some
point-in-time transactions when the new standard is adopted.

In addition to the five-step model, IFRS 15 sets out how to account for the incremental costs
of obtaining a contract and the costs directly related to fulfilling a contract and provides
guidance to assist entities in applying the model to licences, warranties, rights of return,
principal-versus-agent considerations, options for additional goods or services and
breakage.

IFRS 15 is a significant change from IAS 18 and even though it provides more detailed
application guidance, judgment will be required in applying it because the use of estimates is
more prevalent.

For exam purposes, you should focus on understanding the principles of the five-step model
so that you can apply them to practical questions.

Read part 2

Written by a member of the Strategic Business Reporting examining team

The Sustainable Development Goals

The Sustainable Development Goals (SDGs) are 17 goals tackling

major world issues agreed by 193 UN member states to be
achieved by 2030. These goals include zero hunger, decent work
and economic growth, and reduced inequalities.

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 The SDGs apply to all countries and set the priorities for governments. Demographic and
social change, shifts in global economic power, urbanisation, climate change, resource
scarcity, inequality and technological breakthroughs demand a corporate response. The
SDGs can provide insights for companies on how they can create economic, social and
environmental value for their investors and other stakeholders. The goals will allow business
to understand and better respond to the risks and opportunities created by rapid change
across the various sectors.

There is increasing interest by the investors in understanding how businesses are

developing SDGs. Investors seek information on the relevance of the SDGs to overall
strategies, and thus entities providing relevant SDG data will help investors make informed
decisions which can lead to capital being channelled to responsible businesses. Companies
are developing business strategies that embrace the growth potential of responsible
environmental and societal policies.

There are several reasons why companies should focus on sustainable business practices,
and they include:

 the increased future government focus on sustainable business

 such business practices often improve performance as they lower operational,
reputational and regulatory risk
 there are significant business growth opportunities in products and services that
address the SDG challenges
 the fact that short term, profit based models are reducing in relevance. Companies
and their stakeholders are changing how they measure success and this is becoming more
than just about profit.

Investors realise that the SDGs will not all be equally relevant to all companies, with
boilerplate disclosures having little relevance at all. Good disclosure will qualitatively show
how the company’s SDG related activities affect the primary value drivers of the business. It
would be natural to assume that SDG reporting should be based around the disclosure of
information to mitigate business risk and the drive for improved predictability of investment
decisions. However, if there is to be fair presentation, then there should also be disclosure of
any negative and positive impacts on society and the environment.

Investors’ expectations will still be focused on companies realising their core business
activities with financial sustainability as a prerequisite for attracting investment. However,
institutional investors have a fiduciary duty to act in the best interests of their beneficiaries,
and thus have to take into account environmental, social and governance (ESG) factors,
which can be financially significant. Companies utilising more sustainable business practices
provide new investment opportunities.

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Investors screen companies as regards their ESG policies and integrate these factors into
their valuation models. Additionally there is an increased practice of themed investing,
whereby investors select a company for investment based upon specific ESG policy criteria
such as clean technology, green real estate, education and health. Investors are increasingly
factoring impact goals into their decision making whereby they evaluate how successful the
company has been in a particular area for example, the reduction of educational inequality.
This approach can help optimise financial returns and demonstrate their contribution to the
SDGs through their portfolios. Investors are increasingly incentivised to promote sustainable
economies and markets to improve their long-term financial performance.

Institutional investors realise that environmental events can create costs for their portfolio in
the form of insurance premiums, taxes, and the physical cost related with disasters. Social
issues can lead to unrest and instability, which carries business risks which may reduce
future cash flows and financial returns.

Investors seek SDG information produced in line with widely-accepted recommendations.

The Global Reporting Initiative (GRI) and the UN Global Compact amongst others, have
developed guidance documents that mutually complement each other and create a
reference point for companies.

Companies should disclose to investors how they have decided on their SDG strategy,
philosophy and approach. The approach should be capable of measurable impacts and have
a clear description of the material issues and a narrative that links the sustainability issues
back to the business model and future outlook of the entity.

For investors, it is important that SDG-related reporting is presented in the context of the
strategy, governance, performance and prospects of the entity. Stakeholders should be
engaged from the beginning in order to identify any potential impact with some investors
expecting companies to have a stakeholder dialogue that goes beyond financial matters.
Investors often require an understanding of how the entity feels about the relevance of the
SGDs to the overall corporate strategy, and this will include a discussion of any risks and
opportunities identified and changes that have occurred in the business model as a result.

The SDGs and targets are likely to present some of the greatest business risks and
opportunities for companies who should publish material SDG contributions, both positive
and negative, as part of their report. For example, an inability to address negative social and
environmental impacts may also be directly detrimental to short-term financial value for a
business. Investors are increasingly seeking investment opportunities that can make a
credible contribution to the realisation of the SDGs.

However, if an investor wants to have a positive impact on working conditions for example,
they cannot assume that any investment in this area is relevant. The investor would need to

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 be provided with additional information such as data on the lowest income workers, any
potential income increase and how confident the company is that an increase in income will
occur.

Investors can choose not to invest in, or to favour, certain investments. Alternatively, they
can actively engage in new or previously overlooked opportunities that offer an attractive
impact and financial opportunity, even though these may involve additional risk.

There is an assumption that the disclosure of ESG factors will ultimately affect the cost of
capital; lowering it for sustainable businesses and increasing it for non-sustainable ones. It
may also affect cash flow forecasts, business valuations and growth rates. Investors employ
screening strategies, which may involve eliminating companies that have specific features,
for example, low pay rates for employees and eliminating them on a ranking basis. They
may also be eliminated on the basis of companies who are contributing or not, to a range of
SDGs and targets. Investors will use SDG-related disclosures to identify risks and
opportunities on which they will, or will not, engage with companies. Investors will see
potential business opportunities in those companies that address the risks to people and the
environment and those companies that develop new beneficial products, services and
investments that may mitigate the business risks related to the SDGs.

Written by a member of the Strategic Business Reportingexamining team

The definition and disclosure of capital

This article is structured in two parts – first, it considers what might be

included as the capital of a company and, second, why this distinction is
important for the analysis of financial information.
 More complexity
 Trends

This article is useful to those candidates studying for Strategic Business Reporting. It is structured in
two parts: first, it considers what might be included as the capital of a company and, second, why this
distinction is important for the analysis of financial information.

Essentially, there are two classes of capital reported in financial statements: debt and equity.
However, debt and equity instruments can have different levels of right, benefit and risks. When an
entity issues a financial instrument, it has to determine its classification either as debt or as equity.
The result of the classification can have a significant effect on the entity’s reported results and
financial position. Liability classification impacts upon an entity’s gearing ratios and results in any

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payments being treated as interest and charged to earnings. Equity classification may be seen as
diluting existing equity interests.

IAS® 32, Financial Instruments: Presentation sets out the nature of the classification process but the
standard is principle-based and sometimes the outcomes that result from its application are surprising
to users. IAS 32 does not look to the legal form of an instrument but focuses on the contractual
obligations of the instrument. IAS 32 considers the substance of the financial instrument, applying the
definitions to the instrument’s contractual rights and obligations.

More complexity

The variety of instruments issued by entities makes this classification difficult with the application of
the principles occasionally resulting in instruments that seem like equity being accounted for as
liabilities. Recent developments in the types of financial instruments issued have added more
complexity to capital structures with the resultant difficulties in interpretation and understanding.
Consequently, the classification of capital is subjective which has implications for the analysis of
financial statements.

To avoid this subjectivity, investors are often advised to focus upon cash and cash flow when
analysing corporate reports. However, insufficient financial capital can cause liquidity problems and
sufficiency of financial capital is essential for growth. Discussion of the management of financial
capital is normally linked with entities that are subject to external capital requirements, but it is
equally important to those entities that do not have regulatory obligations.

Financial capital is defined in various ways but has no widely accepted definition having been
interpreted as equity held by shareholders or equity plus debt capital including finance leases. This
can obviously affect the way in which capital is measured, which has an impact on return on capital
employed (ROCE). An understanding of what an entity views as capital and its strategy for capital
management is important to all companies and not just banks and insurance companies. Users have
diverse views of what is important in their analysis of capital. Some focus on historical invested
capital, others on accounting capital and others on market capitalisation.

Investors have specific but different needs for information about capital depending upon their
approach to the valuation of a business. If the valuation approach is based upon a dividend model,
then shortage of capital may have an impact upon future dividends. If ROCE is used for comparing
the performance of entities, then investors need to know the nature and quantity of the historical
capital employed in the business. There is diversity in practice as to what different companies see as
capital and how it is managed.

There are various requirements for entities to disclose information about ‘capital’. In drafting
IFRS® 7, Financial Instruments: Disclosures, the International Accounting Standards Board (the

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Board) considered whether it should require disclosures about capital. In assessing the risk profile of
an entity, the management and level of an entity’s capital is an important consideration. The Board
believes that disclosures about capital are useful for all entities, but they are not intended to replace
disclosures required by regulators as their reasons for disclosure may differ from those of the Board.
As an entity’s capital does not relate solely to financial instruments, the Board has included these
disclosures in IAS 1, Presentation of Financial Statements rather than IFRS 7. IFRS 7 requires some
specific disclosures about financial liabilities; it does not have similar requirements for equity
instruments.

The Board considered whether the definition of capital is different from the definition of equity in
IAS 32. In most cases, capital would be the same as equity but it might also include or exclude some
other elements. The disclosure of capital is intended to give entities the ability to describe their view
of the elements of capital if this is different from equity.

As a result, IAS 1 requires an entity to disclose information that enables users to evaluate the entity’s
objectives, policies and processes for managing capital. This objective is obtained by disclosing
qualitative and quantitative data. The former should include narrative information such as what the
company manages as capital, whether there are any external capital requirements and how those
requirements are incorporated into the management of capital. Some entities regard some financial
liabilities as part of capital, while other entities regard capital as excluding some components of
equity – for example, those arising from cash flow hedges.

The Board decided not to require quantitative disclosure of externally imposed capital requirements
but rather decided that there should be disclosure of whether the entity has complied with any external
capital requirements and, if not, the consequences of non-compliance. Further, there is no requirement
to disclose the capital targets set by management and whether the entity has complied with those
targets, or the consequences of any non-compliance.

Examples of some of the disclosures made by entities include information as to how gearing is
managed, how capital is managed to sustain future product development and how ratios are used to
evaluate the appropriateness of its capital structure. An entity bases these disclosures on the
information provided internally to key management personnel. If the entity operates in several
jurisdictions with different external capital requirements, such that an aggregate disclosure of capital
would not provide useful information, the entity may disclose separate information for each separate
capital requirement.

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Trends

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Besides the requirements of IAS 1, the IFRS Practice Statement Management Commentary
suggests that management should include forward-looking information in the commentary
when it is aware of trends, uncertainties or other factors that could affect the entity’s capital
resources. Additionally, some jurisdictions refer to capital disclosures as part of their legal
requirements.

In the UK, Section 414 of the Companies Act 2006 deals with the contents of the Strategic
Report and requires a ‘balanced and comprehensive analysis’ of the development and
performance of the business during the period and the position of the company at the end of
the period. The section further requires that to the extent necessary for an understanding of
the development, performance or position of the business, the strategic report should include
an analysis using key performance indicators. It makes sense that any analysis of a
company’s financial position should include consideration of how much capital it has and its
sufficiency for the company’s needs. The Financial Reporting Council Guidance on the
Strategic Report suggests that comments should appear in the report on the entity’s
financing arrangements such as changes in net debt or the financing of long-term liabilities.

In addition to the annual report, an investor may find details of the entity’s capital structure
where the entity is involved in a transaction, such as a sale of bonds or equities. It is normal
for an entity to produce a capitalisation table in a prospectus showing the effects of the
transactions on the capital structure. The table shows the ownership and debt interests in
the entity but may show potential funding sources and the effect of any public offerings. The
capitalisation table may present the pro forma impact of events that will occur as a result of
an offering such as the automatic conversion of preferred stock, the issuance of common
stock, or the use of the offering proceeds for the repayment of debt or other purposes.

The Board does not require such a table to be disclosed but it is often required by securities
regulators. For example, in the USA, the table is used to calculate key operational metrics.
America Corporation announced in February 2016 that it had ‘made significant
advancements in its ongoing initiative toward improving its capitalization table, capitalization,
and operational structure’.

It can be seen that information regarding an entity’s capital structure is spread across
several documents including the management commentary, the notes to financial
statements, interim accounts and any document required by securities regulators.

The Board has undertaken a research project with the aim of improving the accounting for
financial instruments that have characteristics of both liabilities and equity. This is likely to be
a major challenge in determining the best way to report the effects of recent innovations in
capital structure.

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 There is a diversity of thinking about capital that is not surprising given the issues with
defining equity, the difficulty in locating sources of information about capital and the diversity
of business models in an economy. Capital needs are very specific to the business and are
influenced by many factors, such as debt covenants and preservation of debt ratings. The
variety and inconsistency of capital disclosures does not help the decision making process of
investors.

Therefore, the details underlying a company’s capital structure are essential to the
assessment of any potential change in an entity’s financial flexibility and value. An
appreciation of these issues and their significance is important to candidates studying
for Strategic Business Reporting.

Written by a member of the Strategic Business Reporting examining team

The integrated report framework

In 2013, the International Integrated Reporting Council (IIRC) released a

framework for integrated reporting. The framework establishes principles
and concepts that govern the overall content of an integrated report.
 Principle-based framework
 Relationship with stakeholders

In 2013, the International Integrated Reporting Council (IIRC) released a framework for integrated
reporting. This followed a three-month global consultation and trials in 25 countries.

The framework establishes principles and concepts that govern the overall content of an integrated
report. An integrated report sets out how the organisation’s strategy, governance, performance and
prospects, which lead to the creation of value. There is no benchmarking for the above matters and the
report is aimed primarily at the private sector but it could be adapted for public sector and not-for-
profit organisations.

The primary purpose of an integrated report is to explain to providers of financial capital how an
organisation creates value over time. An integrated report benefits all stakeholders interested in a
company’s ability to create value, including employees, customers, suppliers, business partners, local
communities, legislators, regulators and policymakers, although it is not directly aimed at all
stakeholders. Providers of financial capital can have a significant effect on the capital allocation and
attempting to aim the report at all stakeholders would be an impossible task and would reduce the
focus and increase the length of the report. This would be contrary to the objectives of the report,
which is value creation.

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Historical financial statements are essential in corporate reporting, particularly for compliance
purposes, but do not provide meaningful information regarding business value. Users need a more
forward-looking focus without the necessity of companies providing their own forecasts and
projections. Companies have recognised the benefits of showing a fuller picture of company value and
a more holistic view of the organisation.

The International Integrated Reporting Framework will encourage the preparation of a report that
shows their performance against strategy, explains the various capitals used and affected, and gives a
longer-term view of the organisation. The integrated report is creating the next generation of the
annual report as it enables stakeholders to make a more informed assessment of the organisation and
its prospects.

Principle-based framework

The IIRC has set out a principle-based framework rather than specifying a detailed disclosure and
measurement standard. This enables each company to set out its own report rather than adopting a
checklist approach. The culture change should enable companies to communicate their value creation
better than the often boilerplate disclosures under International Financial Reporting Standards
(IFRS®). The report acts as a platform to explain what creates the underlying value in the business and
how management protects this value. This gives the report more business relevance rather than the
compliance led approach currently used.

Integrated reporting will not replace other forms of reporting but the vision is that preparers will pull
together relevant information already produced to explain the key drivers of their business’s value.
Information will only be included in the report where it is material to the stakeholder’s assessment of
the business. There were concerns that the term ‘materiality’ had a certain legal connotation, with the
result that some entities may feel that they should include regulatory information in the integrated
report. However, the IIRC concluded that the term should continue to be used in this context as it is
well understood.

The integrated report aims to provide an insight into the company’s resources and relationships that
are known as the capitals and how the company interacts with the external environment and the
capitals to create value. These capitals can be financial, manufactured, intellectual, human, social and
relationship, and natural capital, but companies need not adopt these classifications. The purpose of
this framework is to establish principles and content that governs the report, and to explain
the fundamental concepts that underpin them. The report should be concise, reliable and complete,
including all material matters, both positive and negative in a balanced way and without material
error.

Integrated reporting is built around the following key components:

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1. Organisational overview and the external environment under which it operates
2. Governance structure and how this supports its ability to create value
3. Business model
4. Risks and opportunities and how they are dealing with them and how they affect the
company’s ability to create value
5. Strategy and resource allocation
6. Performance and achievement of strategic objectives for the period and outcomes
7. Outlook and challenges facing the company and their implications
8. The basis of presentation needs to be determined, including what matters are to be included in
the integrated report and how the elements are quantified or evaluated.

The framework does not require discrete sections to be compiled in the report but there should be a
high level review to ensure that all relevant aspects are included. The linkage across the above content
can create a key storyline and can determine the major elements of the report such that the
information relevant to each company would be different.

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Relationship with stakeholders

An integrated report should provide insight into the nature and quality of the organisation’s
relationships with its key stakeholders, including how and to what extent the organisation
understands, takes into account and responds to their needs and interests. Further, the
report should be consistent over time to enable comparison with other entities.

South African organisations have been acknowledged as among the leaders in this area of
corporate reporting with many listed companies and large state-owned companies having
issued integrated reports. An integrated report may be prepared in response to existing
compliance requirements – for example, a management commentary. Where that report is
also prepared according to the framework, or even beyond the framework, it can be
considered an integrated report. An integrated report may be either a standalone report or
be included as a distinguishable part of another report or communication. For example, it
can be included in the company’s financial statements.

The IIRC considered the nature of value and value creation. These terms can include the
total of all the capitals, the benefit captured by the company, the market value or cash flows
of the organisation and the successful achievement of the company’s objectives. However,
the conclusion reached was that the framework should not define value from any one
particular perspective because value depends upon the individual company’s own
perspective. It can be shown through movement of capital and can be defined as value

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created for the company or for others. An integrated report should not attempt to quantify
value as assessments of value are left to those using the report.

Many respondents felt that there should be a requirement for a statement from those
‘charged with governance’ acknowledging their responsibility for the integrated report in
order to ensure the reliability and credibility of the integrated report. Additionally, it would
increase the accountability for the content of the report.

The IIRC feels the inclusion of such a statement may result in additional liability concerns,
such as inconsistency with regulatory requirements in certain jurisdictions, and could lead to
a higher level of legal liability. The IIRC also felt that the above issues might result in a
slower take-up of the report and decided that those ‘charged with governance’ should, in
time, be required to acknowledge their responsibility for the integrated report while, at the
same time, recognising that reports in which they were not involved would lack credibility.

There has been discussion about whether the framework constitutes suitable criteria for
report preparation and for assurance. The questions asked concerned measurement
standards to be used for the information reported and how a preparer can ascertain the
completeness of the report.

There were concerns over the ability to assess future disclosures, and recommendations
were made that specific criteria should be used for measurement, the range of outcomes
and the need for any confidence intervals be disclosed. The preparation of an integrated
report requires judgment but there is a requirement for the report to describe its basis of
preparation and presentation, including the significant frameworks and methods used to
quantify or evaluate material matters. Also included is the disclosure of a summary of how
the company determined the materiality limits and a description of the reporting boundaries.

The IIRC has stated that the prescription of specific KPIs and measurement methods is
beyond the scope of a principles-based framework. The framework contains information on
the principle-based approach and indicates that there is a need to include quantitative
indicators whenever practicable and possible. Additionally, consistency of measurement
methods across different reports is of paramount importance. There is outline guidance on
the selection of suitable quantitative indicators.

A company should consider how to describe the disclosures without causing a significant
loss of competitive advantage. The entity will consider what advantage a competitor could
actually gain from information in the integrated report, and will balance this against the need
for disclosure.

Companies struggle to communicate value through traditional reporting. The framework can
prove an effective tool for businesses looking to shift their reporting focus from annual

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financial performance to long-term shareholder value creation. The framework will be
attractive to companies who wish to develop their narrative reporting around the business
model to explain how the business has been developed.

Written by a member of the Strategic Business Reporting examining team

When does debt seem to be equity?

The difference between debt and equity in an entity’s statement of

financial position is not easy to distinguish for preparers of financial
statements. Many financial instruments have both features with the
result that this can lead to inconsistency of reporting.
The International Accounting Standards Board (the Board) agreed with respondents from its
public consultation on its agenda (December 2012 report) that it needs greater clarity in its
definitions of assets and liabilities for debt instruments. This should therefore help eliminate
some uncertainty when accounting for assets and financial liabilities or non-financial
liabilities. The respondents felt that defining the nature of liabilities would advance the
Board’s thinking on distinguishing between financial instruments that should be classified as
equity and those instruments that should be classified as liabilities.

The objective of IAS® 32, Presentation is to establish principles for presenting financial

instruments as liabilities or equity and for offsetting financial assets and liabilities. The
classification of a financial instrument by the issuer as either debt or equity can have a
significant impact on the entity’s gearing ratio, reported earnings, and debt covenants. Equity
classification can avoid such impact but may be perceived negatively if it is seen as diluting
existing equity interests. The distinction between debt and equity is also relevant where an
entity issues financial instruments to raise funds to settle a business combination using cash
or as part consideration in a business combination.

Understanding the nature of the classification rules and potential effects is critical for
management and must be borne in mind when evaluating alternative financing options.
Liability classification normally results in any payments being treated as interest and charged
to earnings, which may affect the entity's ability to pay dividends on its equity shares.

The key feature of debt is that the issuer is obliged to deliver either cash or another financial
asset to the holder. The contractual obligation may arise from a requirement to repay
principal or interest or dividends. Such a contractual obligation may be established explicitly
or indirectly but through the terms of the agreement. For example, a bond that requires the
issuer to make interest payments and redeem the bond for cash is classified as debt. In

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 contrast, equity is any contract that evidences a residual interest in the entity’s assets after
deducting all of its liabilities. A financial instrument is an equity instrument only if the
instrument includes no contractual obligation to deliver cash or another financial asset to
another entity, and if the instrument will or may be settled in the issuer's own equity
instruments.

For instance, ordinary shares, where all the payments are at the discretion of the issuer, are
classified as equity of the issuer. The classification is not quite as simple as it seems. For
example, preference shares required to be converted into a fixed number of ordinary shares
on a fixed date, or on the occurrence of an event that is certain to occur, should be classified
as equity.

A contract is not an equity instrument solely because it may result in the receipt or delivery of
the entity’s own equity instruments. The classification of this type of contract is dependent on
whether there is variability in either the number of equity shares delivered or variability in the
amount of cash or financial assets received. A contract that will be settled by the entity
receiving or delivering a fixed number of its own equity instruments in exchange for a fixed
amount of cash, or another financial asset, is an equity instrument. This has been called the
‘fixed for fixed’ requirement. However, if there is any variability in the amount of cash or own
equity instruments that will be delivered or received, then such a contract is a financial asset
or liability as applicable.

For example, where a contract requires the entity to deliver as many of the entity’s own
equity instruments as are equal in value to a certain amount, the holder of the contract would
be indifferent whether it received cash or shares to the value of that amount. Thus, this
contract would be treated as debt.

Other factors that may result in an instrument being classified as debt are:

 is redemption at the option of the instrument holder?

 is there a limited life to the instrument?
 is redemption triggered by a future uncertain event that is beyond the control of both
the holder and issuer of the instrument?
 are dividends non-discretionary?

Similarly, other factors that may result in the instrument being classified as equity are
whether the shares are non-redeemable, whether there is no liquidation date or where the
dividends are discretionary.

The classification of the financial instrument as either a liability or as equity is based on the
principle of substance over form. Two exceptions from this principle are certain puttable
instruments meeting specific criteria and certain obligations arising on liquidation. Some

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instruments have been structured with the intention of achieving particular tax, accounting or
regulatory outcomes, with the effect that their substance can be difficult to evaluate.

The entity must make the decision as to the classification of the instrument at the time that
the instrument is initially recognised. The classification is not subsequently changed based
on changed circumstances. For example, this means that a redeemable preference share,
where the holder can request redemption, is accounted for as debt even though legally it
may be a share of the issuer.

In determining whether a mandatorily redeemable preference share is a financial liability or

an equity instrument, it is necessary to examine the particular contractual rights attached to
the instrument's principal and return elements. The critical feature that distinguishes a
liability from an equity instrument is the fact that the issuer does not have an unconditional
right to avoid delivering cash or another financial asset to settle a contractual obligation.
Such a contractual obligation could be established explicitly or indirectly. However, the
obligation must be established through the terms and conditions of the financial instrument.
Economic necessity does not result in a financial liability being classified as a liability.
Similarly, a restriction on the ability of an entity to satisfy a contractual obligation, such as the
company not having sufficient distributable profits or reserves, does not negate the entity's
contractual obligation.

Some instruments are structured to contain elements of both a liability and equity in a single
instrument. Such instruments – for example, bonds that are convertible into a fixed number
of equity shares and carry interest – are accounted for as separate liability and equity
components. 'Split accounting' is used to measure the liability and the equity components
upon initial recognition of the instrument. This method allocates the fair value of the
consideration for the compound instrument into its liability and equity components. The fair
value of the consideration in respect of the liability component is measured at the fair value
of a similar liability that does not have any associated equity conversion option. The equity
component is assigned the residual amount.
 
IAS 32 requires an entity to offset a financial asset and financial liability in the statement of
financial position only when the entity currently has a legally enforceable right of set-off and
intends either to settle the asset and liability on a net basis or to realise the asset and settle
the liability simultaneously. An amendment to IAS 32 has clarified that the right of set-off
must not be contingent on a future event and must be immediately available. It also must be
legally enforceable for all the parties in the normal course of business, as well as in the
event of default, insolvency or bankruptcy. Netting agreements, where the legal right of
offset is only enforceable on the occurrence of some future event – such as default of a party
– do not meet the offsetting requirements.

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Rights issues can still be classified as equity when the price is denominated in a currency
other than the entity’s functional currency. The price of the right is denominated in currencies
other than the issuer’s functional currency, when the entity is listed in more than one
jurisdiction or is required to do so by law or regulation. A fixed price in a non-functional
currency would normally fail the fixed number of shares for a fixed amount of cash
requirement in IAS 32 to be treated as an equity instrument. As a result, it is treated as an
exception in IAS 32 and therefore treated as equity.

Two measurement categories exist for financial liabilities: fair value through profit or loss
(FVTPL) and amortised cost. Financial liabilities held for trading are measured at FVTPL,
and all other financial liabilities are measured at amortised cost unless the fair value option is
applied.

The Board and FASB have been working on a project to replace IAS 32 and converge
International Financial Reporting Standards (IFRS®) and US GAAP for a number of
years. The ‘Financial instruments with characteristics of equity’ project (‘FICE’) resulted in a
discussion paper in 2008, but has been put on hold.

Written by a member of the Strategic Business Reportingexamining team

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