Corporate Reporting

The Institute of Chartered Accountants in England and Wales
CORPORATE REPORTING
Advanced Stage Technical Integration Level
For exams in 2014 – July 2015
Study Manual
www.icaew.com
Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-0-85760-907-6
Previous ISBN: 978-0-85760-477-4
First edition 2007
Seventh edition 2013
All rights reserved. No part of this publication may be reproduced or

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© The Institute of Chartered Accountants in England and Wales

Welcome to ICAEW
I am delighted to welcome you as a student studying our chartered accountancy qualification, the ACA.
The ACA will open doors to a highly rewarding career as a financial expert or business leader. Once you
are an ICAEW member, you will join over 138,000 others around the world who work at the highest
levels across all industry sectors, providing valuable financial and business advice. Some of our earlier
members formed today's global Big Four firms, and you can find an ICAEW Chartered Accountant on
the boards of 80% of the UK FTSE 100 companies.
We are here to help you every step of the way. As part of a worldwide network of over 19,000 students,
you will have access to a range of resources including the online student community, where you can
interact with fellow students, and our student support team. Take a look at the key resources on page ix.
I wish you the very best of luck with your studies and look forward to supporting you throughout your
career.
Michael Izza
Chief Executive
ICAEW
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Contents
 Introduction vii
 Corporate Reporting viii
 Key resources ix
 Skills assessment guide x
 Faculties and Special Interest Groups xvi
 ICAEW publications for further reading xvi
Financial statements
1 Presentation of financial statements 1
Assets, liabilities and provisions
2 Reporting of assets 27
3 Events after the reporting period, provisions and contingencies 81
Financing
4 Leases, government grants and borrowing costs 103
5 Financial instruments – presentation and disclosure 135
6 Financial instruments – recognition and measurement 155
7 Financial instruments – hedge accounting 219
Remuneration
8 Employee benefits 259
9 Share-based payment 299
Business combinations
10 Groups – revision 351
Reporting overseas activities
11 Foreign currency translation and hyperinflationary economies 419
Taxation and industry specific standards
12 Income taxes 469
13 Industry specific Standards 511
Reporting performance
14 Earnings per share 545
15 Reporting performance 583
Financial analysis
16 Financial statement analysis 625
 Index 685
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1 Introduction
1.1 What is Corporate Reporting and how does it fit within the ACA Advanced
Stage?
Structure
The ACA syllabus has been designed to develop core technical, commercial, and ethical skills and
knowledge in a structured and rigorous manner.
The diagram below shows the twelve modules at the ACA Professional Stage, where the focus is on the
acquisition and application of technical skills and knowledge, and the ACA Advanced Stage which
comprises two technical integration modules and the Case Study.
The knowledge level

In the Accounting paper you will have been introduced to the double entry system of recording
transactions and the preparation of non-complex financial statements.
Progression to ACA application level
The knowledge base that is put into place here will be taken further in two application stage modules.
The Financial Accounting module develops these basic principles covered in Accounting, looking at the
preparation of single entity financial statements in more complex situations and also introduces the issue
of group financial statements.
The Financial Reporting paper then takes these issues a step further enabling students to prepare
extracts from financial statements for entities undertaking a wide range of accounting transactions. The
emphasis is also on understanding financial information as well as preparation with analysis and
interpretation a key feature.
Progression to ACA Advanced Stage
The Advanced Stage papers – Business Reporting (BR) and Business Change (BC) – then take things
further again. The aims of BR are to ensure that students can apply analysis techniques, technical
knowledge and professional skills to resolve real-life compliance issues faced by businesses. In the BC
paper the aim is to ensure that students can provide technical advice in respect of issues arising in
business transformations eg mergers and acquisitions.
The above illustrates how the knowledge base of accounting gives a platform from which a progression
of skills and technical expertise is developed.
Introduction vii
2 Corporate Reporting
2.1 Module aim
The aim of the Business Reporting paper is:
To ensure that candidates can apply analysis techniques, technical knowledge and professional
skills to resolve real-life compliance issues faced by businesses.
Candidates may be put, for example, in the role of a preparer of financial statements, or other corporate
reports such as on sustainability and corporate responsibility, an advisor or in an assurance role facing
business issues where there are reporting implications. Compliance issues relating to taxation will also
feature in this module.
Candidates will be required to use professional judgement to identify and evaluate alternatives and
determine the appropriate solution(s) to compliance issues, giving due consideration to the commercial
impact of their recommendations.
The aim of the Business Change paper is:
To ensure that candidates can provide technical advice in respect of issues arising in business
transformations, mergers, acquisitions, alliances and disposals.
Candidates will be required to analyse and interpret both external and internal financial and non-
financial data in order to plan for change and provide advice. In undertaking this analysis students will
be expected to evaluate the impact of stakeholder influences on the data, including the impact of
choice of reporting policies.
Taxation and practical business techniques are particularly important in this module, where business
techniques include aspects of business strategy, business finance, performance management and
costing. There will also be assurance, ethical and legal implications to be considered when developing
and assessing strategic and business plans.
2.2 Specification grid

This grid shows the relative weightings of subjects within each module and should guide the relative
study time spent on each. Over time the marks available in the assessment will equate to the weightings
below, while slight variations may occur in individual assessments to enable suitably rigorous questions
to be set.
BR BC
Weighting (%) Weighting (%)
Ethics and law 5 – 10 5 – 10
Taxation 20 – 30 25 – 35
Audit and assurance 30 – 40 10 – 20
Corporate reporting 30 – 40 15 – 25
Business analysis 0 30 – 35
viii Corporate Reporting

3 Key resources
STUDENT SUPPORT TEAM
T +44 (0)1908 248 250
E studentsupport@icaew.com
STUDENT WEBSITE
icaew.com/students student homepage
icaew.com/exams exam applications, deadlines, regulations and more
icaew.com/cpl credit for prior learning/exemptions
icaew.com/examresources examiners comments, syllabus, past papers, study guides and more
icaew.com/examresults exam results
TUITION
If you are receiving structured tuition, make sure you know how and when you can contact your tutors
for extra help.
If you aren't receiving structured tuition and are interested in classroom, online or distance learning
tuition, take a look at our tuition providers in your area on icaew.com/exams
ONLINE STUDENT COMMUNITY
The online student community allows you to ask questions, gain study and exam advice from fellow
ACA and CFAB students and access our free webinars. There are also regular Ask an Expert and Ask a
Tutor sessions to help you with key technical topics and exam papers. Access the community at
icaew.com/studentcommunity
THE LIBRARY & INFORMATION SERVICES (LIS)
The Library and Information Service (LIS) is ICAEW's world-leading accountancy and business library.
You have access to a range of resources free of charge via the library website, including the catalogue,
LibCat. icaew.com/library
Introduction ix
4 Skills assessment guide
4.1 Introduction
As a Chartered Accountant in the business world, you will require the knowledge and skills to interpret
financial and other numerical and business data, and communicate the underlying issues to your clients.
In a similar way to the required knowledge, the ACA syllabus has been designed to develop your
professional skills in a progressive manner. These skills are broadly categorised as:
 Assimilating and using information
 Structuring problems and solutions
 Applying judgement
 Drawing conclusions and making recommendations
4.2 Assessing your professional skills
Initial Professional Development
BR
BC
Advance Stage
TAX FR technical integration
FA A&A
Professional Stage
application level
ETHICS Case Study
FM
Technical
Professional Stage BS
knowledge level
Skills
The work experience requirements for students provide a framework to develop appropriate work
experience, completion of which is essential in order to qualify for membership. Work experience is also
an essential component for examination preparation.
The work experience framework is built around five key skills:
 Business awareness – being aware of the internal and external issues and pressure for change facing
an organisation and assessing an organisation's performance.
 Technical and functional expertise – applying syllabus learning outcomes and where appropriate,
further technical knowledge to real situations.
 Ethics and professionalism – recognising issues, using knowledge and experience to assess
implications, making confident decisions and recommendations.
 Professional judgement – making recommendations and adding value with appropriate, targeted
and relevant solutions.
 Personal effectiveness – developing, maintaining and exercising skills and personal attributes
necessary for the role and responsibilities.
x Corporate Reporting
The examinations, and in particular the Advanced Stage, embrace all of these skills.
The link between work experience and the examinations is demonstrated by the skills development
grids produced by the examiners.
This will help students see that their practical knowledge and skills gained in the workplace feed back
into the exam room and vice-versa.
4.3 Assessment grids

The following pages set out the learning outcomes for Corporate Reporting that are addressed under
each of the four skills areas. In addition, for each skills area, there is a description of:
 The specific skills that are assessed
 How these skills are assessed
Using these grids will enable you to determine how the examination paper will be structured and to
consider whether your knowledge of Corporate Reporting is sufficiently strong to enable you to apply it
in the required manner.
Introduction xi
xii Corporate Reporting
4.4 Technical knowledge
The table contained in this section shows the technical knowledge covered in the ACA Syllabus by
module.
For each individual standard the level of knowledge required in the relevant Professional Stage module
and at the Advanced Stage is shown.
The knowledge levels are defined as follows:
Level D
An awareness of the scope of the standard.
Level C
A general knowledge with a basic understanding of the subject matter and training in its application
sufficient to identify significant issues and evaluate their potential implications or impact.
Level B
A working knowledge with a broad understanding of the subject matter and a level of experience in the
application thereof sufficient to apply the subject matter in straightforward circumstances.
Level A
A thorough knowledge with a solid understanding of the subject matter and experience in the
application thereof sufficient to exercise reasonable professional judgement in the application of the
subject matter in those circumstances generally encountered by Chartered Accountants.
Key to other symbols:
→ The knowledge level reached is assumed to be continued
Introduction xiii
Corporate Reporting
Professional Stage
Advanced Stage
Accounting
Accounting
Reporting
Financial
Financial
Title
Preface to International Financial Reporting Standards A  

Conceptual Framework for Financial Reporting C A  
IAS 1 Presentation of Financial Statements B A  
IAS 2 Inventories C A  
IAS 7 Statement of Cash Flows B B  
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors A  
IAS 10 Events after the Reporting Period A  
IAS 11 Construction Contracts A 
IAS 12 Income Taxes C A
IAS 16 Property, Plant and Equipment C A  
IAS 17 Leases A  
IAS 18 Revenue A  
IAS 19 Employee Benefits A
IAS 20 Accounting for Government Grants and Disclosure of A 
Government Assistance
IAS 21 The Effects of Changes in Foreign Exchange Rates A
IAS 23 Borrowing Costs A 
IAS 24 Related Party Disclosures A 
IAS 26 Accounting and Reporting by Retirement Benefit Plans D
IAS 27 Consolidated and Separate Financial Statements B A 
IAS 28 Investments in Associates B A 
IAS 29 Financial Reporting in Hyperinflationary Economies D
IAS 31 Interests in Joint Ventures A 
IAS 32 Financial Instruments: Presentation C A 
IAS 33 Earnings per Share B A
IAS 34 Interim Financial Reporting A
IAS 36 Impairment of Assets B A 
IAS 37 Provisions, Contingent Liabilities and Contingent Assets A  
IAS 38 Intangible Assets C B A 
IAS 39 Financial Instruments: Recognition and Measurement C B A
IAS 40 Investment Property A 
IAS 41 Agriculture D
IFRS 1 First-Time Adoption of IFRS A
IFRS 2 Share-based Payment A
IFRS 3 Business Combinations B B A
IFRS 4 Insurance Contracts D
IFRS 5 Non-current Assets Held for Sale and Discontinued B A 
Operations
IFRS 6 Exploration for and Evaluation of Mineral Resources D
IFRS 7 Financial Instruments: Disclosures B A
IFRS 8 Operating Segments A 
IFRS 9 Financial Instruments C
IFRS for SMEs C
xiv Corporate Reporting

Current issues
A number of the Chapters in this Study Manual cover current developments in the relevant financial
reporting area. For example, IAS 39 is being replaced by IFRS 9, and there are proposals for changes to
the rules on revenue recognition.
These areas are not examinable because they were not in force at the April 2013 cut-off date for
examinations in 2014. However, as a professional you need to be aware of what these issues are, and of
the problems with current accounting treatments.
Introduction xv
5 Faculties and Special Interest Groups
The faculties and special interest groups are specialist bodies within the ICAEW which offer members
networking opportunities, influence and recognition within clearly defined areas of technical expertise.
As well as providing accurate and timely technical analysis, they lead the way in many professional and
wider business issues through stimulating debate, shaping policy and encouraging good practice. Their
value is endorsed by over 40,000 members of ICAEW who currently belong to one or more of the seven
faculties:
 Audit and Assurance
 Corporate Finance
 Finance and Management
 Financial Reporting
 Financial Services
 Information Technology
 Tax
The special interest groups provide practical support, information and representation for chartered
accountants working within a range of industry sectors, including:
 Charity and Voluntary sector
 Entertainment and Media
 Farming and Rural Business
 Forensic
 Healthcare
 Interim Management
 Non-Executive Directors
 Public Sector
 Solicitors
 Tourism and Hospitality
 Valuation
Students can register free of charge for provisional membership of one special interest group and
receive a monthly complimentary e-newsletter from one faculty of your choice. To find out more and to
access a range of free resources, visit icaew.com/facultiesandsigs
6 ICAEW publications for further reading

ICAEW produces publications and guidance for its students and members on a variety of technical and
business topics. This list of publications has been prepared for students who wish to undertake further
reading in a particular subject area and is by no means exhaustive. You are not required to study these
publications for your exams. For a full list of publications, or to access any of the publications listed
below, visit the Technical Resources section of the ICAEW website at icaew.com
ICAEW no longer prints a Members Handbook. ICAEW regulations, standards and guidance are
available at icaew.com/regulations This area includes regulations and guidance relevant to the regulated
areas of audit, investment business and insolvency as well as materials that were previously in the
handbook.
The TECH and AUDIT series of technical releases are another source of guidance available to members
and students. Visit icaew.com/technicalreleases for the most up-to-date releases.
xvi Corporate Reporting

Audit and Assurance Faculty – icaew.com/aaf
 Right First Time with the Clarified ISAs, ICAEW 2010, ISBN 978-0-85760-063-9
Clarified ISAs provide many opportunities for practitioners in terms of potential efficiencies, better
documentation, better reporting to clients, and enhanced audit quality overall.
This modular guide has been developed by ICAEW's ISA implementation sub-group to help
medium-sized and smaller firms implement the clarified ISAs and take advantage of these
opportunities. This modular guide is designed to give users the choice of either downloading the
publication in its entirety, or downloading specific modules on which they want to focus.
An international edition is also available.
• Quality Control in the Audit Environment, ICAEW 2010, ISBN 0-497-80857-605-5
The publication identifies seven key areas for firms to consider. Illustrative policies and procedures
are provided for selected aspects of each key area, including some examples for sole practitioners.
The guide also includes an appendix with answers to a number of frequently asked questions on
the standard.
 The Audit of Related Parties in Practice, ICAEW 2010, ISBN 978-1-84125-565-6
This practical guide to the audit of related party relationships and transactions is set in the context
of the significant change in approach that is required under the revised ISA and highlights the
importance of planning, the need to involve the entire audit team in this, to assign staff with the
appropriate level of experience to audit this area and upfront discussions with the client to identify
related parties.
 Alternatives to Audit ICAEW, 2009, ISBN 978-1-84152-819-9
In August 2006, the ICAEW Audit and Assurance Faculty began a two-year consultation on a new
assurance services (the ICAEW Assurance Service), an alternative to audit based on the idea of
limited assurance introduced by the International Auditing and Assurance Standards Board (IAASB).
This report presents findings from the practical experience of providing the ICAEW Assurance
Service over the subsequent two years and views of users of financial information that help in
assessing the relevance of the service to their needs.
 Companies Act 2006 – Auditor related requirements and regulations third edition – March
2012 ICAEW, 2012, ISBN 978-0-85760-442-2
This third edition of the guide provides a brief summary of the key sections in the Companies Act
2006 (the Act) which relate directly to the rights and duties of auditors. It covers the various types
of reports issued by auditors in accordance with the Act. It is designed to be a signposting tool for
practitioners and identifies the other pieces of guidance issued by ICAEW, APB, FRC, POB and
others to support implementation of the Act.
 Auditing in a group context: practical considerations for auditors ICAEW, 2008, ISBN 978-1-
84152-628-7
The guide describes special considerations for auditors at each stage of the group audit's cycle.
While no decisions have been taken on UK adoption of the IAASB's clarity ISAs, the publication also
covers matters in the IAASB's revised and redrafted 'ISA 600 Special Considerations – Audits of
Group Financial Statements (Including the Work of Component Auditors)'. The revised publication
contains suggestions for both group auditors and component auditors.
Introduction xvii
Corporate Finance Faculty – icaew.com/corpfinfac
 Private equity demystified – an explanatory guide Second Edition, Financing Change Initiative,
ICAEW, March 2010, John Gilligan and Mike Wright
This guide summarises the findings of academic work on private equity transactions from around
the world. Hard copies of the abstract and full report are free and are also available by download
from icaew.com/thoughtleadership
 Best Practice Guidelines
The Corporate Finance Faculty publishes a series of guidelines on best-practice, regulatory trends
and technical issues. Authored by leading practitioners in corporate finance, they are succinct and
clear overviews of emerging issues in UK corporate finance. icaew.com/corpfinfac
• Corporate Financier magazine, ISSN 1367-4544

The award-winning Corporate Financier magazine is published ten times a year for members,
stakeholders and key associates of ICAEW's Corporate Finance Faculty.
Aimed at professionals, investors and company directors involved in corporate finance, it covers a
wide range of emerging regulatory, commercial and professional development issues.
The magazine includes features, news, analysis and research, written by experts, experienced editors
and professional journalists.
In 2011, three major themes were introduced: Innovation & Corporate Finance; Financing
Entrepreneurship; and Deal Leadership.
Corporate governance – icaew.com/corporategovernance

 The UK Corporate Governance Code 2010
The UK Corporate Governance Code (formerly the Combined Code) sets out standards of good
practice in relation to board leadership and effectiveness, remuneration, accountability and
relations with shareholders. All companies with a Premium Listing of equity shares in the UK are
required under the Listing Rules to report on how they have applied the UK Corporate
Governance Code in their annual report and accounts.
The first version of the UK Corporate Governance Code was produced in 1992 by the
Cadbury Committee. In May 2010 the Financial Reporting Council issued a new edition of
the Code which applies to financial years beginning on or after 29 June 2010.
The UK Corporate Governance Code contains broad principles and more specific provisions.
Listed companies are required to report on how they have applied the main principles of the
Code, and either to confirm that they have complied with the Code's provisions or – where they
have not – to provide an explanation.
 Internal Control: Revised Guidance on Internal Control for Directors on the Combined Code
(now the UK Corporate Governance Code)
Originally published in 1999, the Turnbull guidance was revised and updated in October 2005,
following a review by the Financial Reporting Council. The updated guidance applies to listed
companies for financial years beginning on or after 1 January 2006.
 The FRC Guidance on Audit Committees (formerly known as The Smith Guidance)
First published by the Financial Reporting Council in January 2003, and most recently updated in
2010. It is intended to assist company boards when implementing the sections of the UK
Corporate Governance Code dealing with audit committees and to assist directors serving on audit
committees in carrying out their role. Companies are encouraged to use the 2010 edition of the
guidance with effect from 30 April 2011.
xviii Corporate Reporting

 The UK Stewardship Code
The UK Stewardship Code was published in July 2010. It aims to enhance the quality of
engagement between institutional investors and companies to help improve long-term
returns to shareholders and the efficient exercise of governance responsibilities by setting out
good practice on engagement with investee companies to which the Financial Reporting
Council believes institutional investors should aspire.
A report summarising the actions being taken by the Financial Reporting Council and
explaining how the UK Stewardship Code is intended to operate was also published in
July 2010.
Corporate responsibility – icaew.com/corporateresponsibility

 Sustainable Business January 2009
The new thought leadership prospectus acts as a framework for the work that ICAEW do in
sustainability/corporate responsibility. It argues that any system that is sustainable needs accurate
and reliable information to help it learn and adapt, which is where the accounting profession plays
an important role. A downloadable pdf is available at icaew.com/sustainablebusiness
 Environmental issues in annual financial statements ICAEW, May 2009, ISBN 978-1-84152-610-2
This report is a joint initiative with the Environment Agency. It is aimed at business accountants
who prepare, use or audit the financial statements in statutory annual reports and accounts, or
who advise or sit on the boards of the UK companies and public sector organisations. It offers
practical advice on measuring and disclosing environmental performance. A downloadable pdf is
available at icaew.com/sustainablebusiness
 ESRC seminar series – When worlds collide: contested paradigms of corporate responsibility
ICAEW, in conjunction with the British Academy of Management, won an Economic and Social
Research Council grant to run a seminar series which aims to bring academics and the business
community together to tackle some of the big challenges in corporate responsibility.
icaew.com/corporateresponsibility
 The Business Sustainability Programme (BSP)
The Business Sustainability Programme is an e-learning package for accountants and business
professionals who want to learn about the business case for sustainability. The course is spread
across five modules taking users from definitions of sustainability and corporate responsibility,
through case studies and finally towards developing an individually tailored sustainability strategy
for their business. The first two modules are free to everyone. For more information and to
download a brochure visit icaew.com/bsp
Ethics – icaew.com/ethics
 Code of Ethics
The Code of Ethics helps ICAEW members meet these obligations by providing them with ethical
guidance. The Code applies to all members, students, affiliates, employees of member firms and,
where applicable, member firms, in all of their professional and business activities, whether
remunerated or voluntary.
 Instilling integrity in organisations ICAEW June 2009
Practical guidance aimed at directors and management to assist them in instilling integrity in their
organisations. This document may also be helpful to audit firms discussing this topic with clients
and individuals seeking to address issues in this area with their employers.
 Reporting with Integrity ICAEW May 2007, ISBN 978-1-84152-455-9
This publication brings ideas from a variety of disciplines, in order to obtain a more comprehensive
understanding of what is meant by integrity, both as a concept and in practice. Moreover, because
this report sees reporting with integrity as a joint endeavour of individuals, organisations and
professions, including the accounting profession, the concept of integrity is considered in all these
contexts.
Introduction xix
Finance and Management Faculty – icaew.com/fmfac
 Finance's role in the organisation November 2009, ISBN 978-1-84152-855-7
This considers the challenges of designing successful organisations, written by Rick Payne, who
leads the faculty's finance direction programme.
 Investment appraisal SR27: December 2009, ISBN 978-1-84152-854-4
This special report looks at the key issues and advises managers on how they can contribute
effectively to decision making and control during the process of investment appraisal.
 Starting a business SR28: March 2010, ISBN 978-1-84152-984-2
This report provides accountants with a realistic and motivational overview of what to consider
when starting a business.
 Developing a vision for your business SR30: September 2010, ISBN 978-0-85760-054-7
This special report looks at what makes a good vision, the benefits of having one, the role of the FD
in the process, leadership, storytelling and the use of visions in medium-sized businesses.
 Finance transformation – the outsourcing perspective SR31: December 2010, ISBN 978-0-
85760-079-0
The authors of this outsourcing special report share their expertise on topics including service level
agreements, people management, and innovation and technology.
 The Finance Function: A Framework for Analysis September 2011, ISBN 978-0-85760-285-5
This report is a source of reference for those analyzing or researching the role of the finance
function and provides a foundation for considering the key challenges involved, written by Rick
Payne, who leads the faculty's finance direction programme.
Financial Reporting Faculty – icaew.com/frfac

 EU Implementation of IFRS and the Fair Value Directive ICAEW, October 2007, ISBN 978-1-
84152-519-8
The most comprehensive assessment to date of compliance with the requirements of IFRS and the
overall quality of IFRS financial reporting.
The Financial Reporting Faculty makes available to students copies of its highly-regarded factsheets
on UK GAAP and IFRS issues, as well as its journal, By All Accounts, at icaew.com/frfac
Financial Services Faculty – icaew.com/fsf

 Audit of banks: lessons from the crisis, (Inspiring Confidence in Financial Services initiative)
ICAEW, June 2010 ISBN 978-0-85760-051-6
This research has looked into the role played by bank auditors and examined improvements that
can be made in light of lessons learned from the financial crisis. The project has included the
publication of stakeholder feedback and development of a final report.
 Measurement in financial services, (Inspiring Confidence in Financial Services initiative) ICAEW,
March 2008, ISBN 978-1-84152-546-4
This report suggests that more work is required on matching measurement practices in the
financial services industry to the needs of different users of financial information, despite the fact
that the financial services industry has the greatest concentration of measurement and modelling
skills of any industry. A downloadable pdf is available at icaew.com/thoughtleadership
 Skilled Persons' Guidance – Reporting Under s166 Financial Services and Markets Act 2000
(Interim Technical Release FSF 01/08)
This interim guidance was issued by ICAEW in April 2008 as a revision to TECH 20/30 to assist
chartered accountants and other professionals who are requested to report under s166 Financial
Services and Markets Act 2000. A downloadable pdf is available at icaew.com/technicalreleases
xx Corporate Reporting
Information Technology Faculty – icaew.com/itfac
The IT Faculty provides ongoing advice and guidance that will help students in their studies and their
work. The online community (ion.icaew.com/itcountshome) provides regular free updates as well as a
link to the faculty's Twitter feed which provides helpful updates and links to relevant articles. The
following publications should also be of interest to students:
 Make the move to cloud computing ICAEW, 2012, ISBN 978-0-85760-617-4
Cloud computing in its purest form is pay-as-you-go IT, online and on demand. The IT capabilities
provided as a service to businesses include: single software applications or software suites; online
software development platforms; and virtual computing infrastructure, ranging from data storage to
computer grids.
 Bringing employee personal devices into the business - a guide to IT consumerisation ICAEW,
2012, ISBN 978-0-85760-443-9
The gap between business and consumer technology has been growing over the last few years,
with the consumer market now leading in terms of ease of use and portability.
 Making the most of social media - a practical guide for your business ICAEW, 2011, ISBN 978-0-
85760-286-2
This guide will enable the business manager to develop a philosophy that allies social media's
potential with the business's objectives and capabilities, to set objectives and protect against pitfalls,
and then to take the first practical steps in a mass communications medium very different from any
that British business has encountered before.
Tax Faculty – icaew.com/taxfac

The Tax Faculty runs a Younger Members Tax Club which provides informal presentations, discussions
and socialising. All young professionals interested in tax are welcome to attend. See the website for
more details icaew.com/taxfac
 Tax news service
You can keep up with the tax news as it develops on the Tax Faculty's news site
icaew.com/taxnews. And you can subscribe to the free newswire which gives you a weekly round
up. For more details visit icaew.com/taxfac
 Demystifying XBRL
This booklet, produced jointly by KPMG, the Tax Faculty and the Information Technology Faculty,
explains exactly what iXBRL is all about and what must be done in order to e-file corporation tax
returns using the new standard.
 Implementing XBRL
This booklet, produced jointly by Thompson Reuters, the Tax Faculty and the Information
Technology Faculty, is a practical guide for accountants in business and practice, and follows on
from Demystifying XBRL.
 TAXline Tax Practice series of detailed briefings on current topics:
TAXline Tax Practice 27
Let property – a brief guide by Rebecca Cave (published November 2011)
The new pension rules by Anne Redston (published July 2011)
Tax Credits by Robin Williamson (published April 2011)
TAXline Tax Practice No 23
HMRC Powers – an overview of the new powers and penalties regime by Paula Clemett (published
October 2010)
Introduction xxi
xxii Corporate Reporting
CHAPTER 1
Presentation of financial
statements
Introduction
Topic List
1 IAS 1 Presentation of Financial Statements
2 IAS 34 Interim Financial Reporting
3 Future of UK GAAP
Summary and Self-test
Technical reference
Answers to Self-test
Answer to Interactive question
1
Introduction
Learning objectives Tick off
 Understand and apply the requirements of IAS 1Presentation of Financial Statements
 Demonstrate an understanding of the requirements of IAS 34 Interim Financial Reporting
 Apply recognition and measurement principles to the preparation of interim financial

statements as required by IAS 34 Interim Financial Reporting
1 IAS 1 Presentation of Financial Statements C
H
A
Section overview P
T
 IAS 1 Presentation of Financial Statements sets down the format of financial statements, containing E
requirements as to their presentation, structure and content. R
IAS 1 was amended in 2011, changing the presentation of items contained in other comprehensive
income (OCI) and their classification within OCI. 1
1.1 Main features

Titles of financial statements
The three main financial statements under IAS 1 are:
 Statement of financial position
 Statement of profit or loss and other comprehensive income
 Statement of cash flows
You may still see the old names (balance sheet, etc), as these new titles are not mandatory.
Reporting owner changes in equity and comprehensive income
IAS 1 classifies changes in equity in a period as either:
 Owner changes in equity, or
 Non-owner changes in equity.
Owner changes in equity arise from transactions with owners in their capacity as owners, eg dividends
paid and issues of share capital. These are presented in the statement of changes in equity.
Non-owner changes in equity (known as 'comprehensive income') include:
1 The profit or loss for the period
2 Income or expenditure recognised directly in equity (known as 'other comprehensive income').
These are presented in the statement of profit or loss and other comprehensive income.
Summary
IAS 1
Profit or loss for period

Statement of profit or loss and other
Non-owner transactions recognised directly in equity comprehensive income
Owner transactions Statement of changes in equity
Presentation of comparatives
IAS 1 requires disclosure of comparative information in respect of the previous period. It also requires
inclusion of a statement of financial position as at the beginning of the earliest comparative period when
an entity:
 Retrospectively applies an accounting policy
 Retrospectively restates items in the financial statements, or
 Reclassifies items in the financial statements.
In effect this will result in the presentation of three statements of financial position when there is a prior
period adjustment.
1.2 Statement of financial position

Note that reserves other than share capital and retained earnings may be grouped as 'other components
of equity'.
Presentation of financial statements 3

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7
31 Dec 20X7 31 Dec 20X6
$m $m
ASSETS
Non-current assets
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
Investments in associates X X
Available-for-sale financial assets X X
X X
Current assets
Inventories X X
Trade receivables X X
Other current assets X X
Cash and cash equivalents X X
X X
Total assets X X
EQUITY AND LIABILITIES
Equity attributable to owners of the parent
Share capital X X
Retained earnings X X
Other components of equity X X
X X
Non-controlling interests X X
Total equity X X
Non-current liabilities
Long-term borrowings X X
Deferred tax X X
Long-term provisions X X
Total non-current liabilities X X
Current liabilities
Trade and other payables X X
Short-term borrowings X X
Current portion of long-term borrowings X X
Current tax payable X X
Short-term provisions X X
Total current liabilities X X
Total liabilities X X
Total equity and liabilities X X
1.3 Statement of profit or loss and other comprehensive income

The statement of profit or loss and other comprehensive income presents the total comprehensive
income of an entity for a period.
Total comprehensive income is 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 includes all components of profit or loss and of 'other comprehensive income'.
Other comprehensive income includes income and expenses that are not recognised in profit or loss,
but instead recognised directly in equity. It includes:
 Changes in the revaluation surplus
 Remeasurements (actuarial gains and losses on defined benefit plans recognised in accordance with
IAS 19 Employee Benefits (revised 2011) (Chapter 8)
 Gains and losses arising from translating the financial statements of a foreign operation (Chapter
11)
 Gains and losses on remeasuring available-for-sale financial assets (Chapter 6)
 The effective portion of gains and losses on hedging instruments in a cash flow hedge (Chapter 7)
1.3.1 2011 Revision of IAS 1
C
In June 2011, the IASB published an amendment to IAS 1 called Presentation of items of other H
comprehensive income, changing the presentation of items contained in Other Comprehensive Income A
(OCI) and their classification within OCI. P
T
Background E
R
The blurring of distinctions between different items in OCI is the result of an underlying general lack
of agreement among users and preparers about which items should be presented in OCI and which
should be part of the profit or loss section. For instance, a common misunderstanding is that the split 1
between profit or loss and OCI is on the basis of realised versus unrealised gains. This is not, and has
never been, the case.
This lack of a consistent basis for determining how items should be presented has led to the somewhat
inconsistent use of OCI in financial statements.
Change
Entities are required to group items presented in other comprehensive income (OCI) on the basis of
whether they would be reclassified to (recycled through) profit or loss at a later date, when specified
conditions are met.
The amendment does not address which items are presented in other comprehensive income or which
items need to be reclassified.
Income tax
IAS 1 requires an entity to disclose income tax relating to each component of other comprehensive
income. This is because these items often have tax rates different from those applied to profit or loss.
This may be achieved by either
 Presenting individual components of other comprehensive income net of the related tax, or
 Presenting individual components of other comprehensive income before tax, with one amount
shown for the aggregate amount of income tax relating to those components.
Presentation
IAS 1 allows comprehensive income to be presented in two ways:
1 A single statement of profit or loss and other comprehensive income, or
2 A statement displaying components of profit or loss plus a second statement beginning with profit
or loss and displaying components of other comprehensive income (statement of profit or loss and
other comprehensive income).
The recommended format of a single statement of profit or loss and other comprehensive income is as
follows:
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X7
20X7 20X6
$m $m
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year from continuing operations X X
Loss for the year from discontinued operations (X)

20X7 20X6
$m $m
PROFIT FOR THE YEAR X X
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluation X X
Investment in equity instruments (available-for-sale financial
assets) (X) X
Actuarial gains (losses) on defined benefit pension plans (X) X
Share of gain (loss) on property revaluation of associates X (X)
Income tax relating to items that will not be reclassified X (X)
(X) X
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations X X
Cash flow hedges (X) (X)
Income tax relating to items that may be reclassified (X) (X)
X X
Other comprehensive income for the year, net of tax (X) X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X X
Profit attributable to:
Owners of the parent X X
X X
Total comprehensive income attributable to:
Owners of the parent X X
X X
Earnings per share ($)

Basic and diluted X X
Alternatively, components of OCI could be presented in the statement of profit or loss and other
comprehensive income net of tax.
Tutorial note:
Throughout this text, income and expense items which are included in the 'top half' of the statement of
profit or loss and other comprehensive income are referred to as recognised in profit or loss, or
recognised in the income statement.
Income and expense items included in the 'bottom half' of the statement of profit or loss and other
comprehensive income are referred to as recognised in other comprehensive income.
For exam purposes, you must ensure that you clarify where in the statement of profit or loss and other
comprehensive income an item is recorded, by referring to recognition:
 In profit or loss, or
 In other comprehensive income
1.4 Statement of changes in equity

All changes in equity arising from transactions with owners in their capacity as owners are shown in the
statement of changes in equity.
Non-owner transactions are not permitted to be shown in the statement of changes in equity other than
in aggregate.
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X7
C
Available
H
Translation -for-sale Non-
A
Share Retained of foreign financial Cash flow Revaluation controlling Total
capital earnings operations assets hedges surplus Total interest equity P
Balance at £'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000 T
1 Jan 20X7 X X (X) X X – X X X E
Changes in R
accounting
policy – X – – – – X – X
Restated 1
balance X X (X) X X – X X X
Changes
in equity
during 20X7
Issue of share
capital X – – – – – X – X
Dividends – (X) – – – – (X) (X) (X)
Total
comprehensive
income for the
year – X X X X X X X X
Transfer to
retained
earnings – X – – – (X) – – –
Balance at
31 Dec 20X7 X X X X X X X X X
A comparative statement for the prior period is also required.

Here is an example of a statement of changes in equity with some real figures in, to give you a better
idea of what it looks like:
OLIVE GROUP: STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 JUNE 20X9
AFS Revalua- Non-
Share Retained financial tion controlling Total
capital earnings assets surplus Total interest equity
£m £m £m £m £m £m £m
Balance at
1 July 20X8 14,280 10,896 384 96 25,656 1,272 26,928
Share capital issued 1,320 1,320 1,320
Dividends (216) (216) (120) (336)
Total comprehensive
income for the year (1,296) 72 48 (1,176) 528 (648)
Balance at
30 June 20X9 15,600 9,384 456 144 25,584 1,680 27,264
2 IAS 34 Interim Financial Reporting

Section overview
 IAS 34 recommends that entities should produce interim financial reports, and for entities that
do publish such reports, it lays down principles and guidelines for their production.
The following definitions are used in IAS 34.
Definitions
Interim period: A financial reporting period shorter than a full financial year.
Interim financial report: A financial report containing either a complete set of financial statements (as
described in IAS 1) or a set of condensed financial statements (as described in this Standard) for an
interim period.

2.1 Scope of IAS 34
IAS 34 does not make the preparation of interim financial reports mandatory, taking the view that this
is a matter for governments, securities regulators, stock exchanges or professional accountancy bodies
to decide within each country. The IASB does, however, strongly recommend to governments, and
regulators, that interim financial reporting should be a requirement for companies whose equity or debt
securities are publicly traded.
IAS 34 encourages publicity traded entities:
 To provide an interim financial report for at least the first six months of their financial year (ie a
half year financial report).
 To make the report available no later than 60 days after the end of the interim period.
Thus, a company with a year ending 31 December would be required as a minimum to prepare an
interim report for the half year to 30 June and this report should be available before the end of August.
2.2 Minimum components

IAS 34 specifies the minimum component elements of an interim financial report as follows:
 Condensed statement of financial position
 Condensed statement of profit or loss and other comprehensive income, presented either as a
single condensed statement or a condensed income statement and a condensed statement of
profit or loss and other comprehensive income
 Condensed statement of changes in equity
 Condensed statement of cash flows
 Selected note disclosures
IAS 34 applies where an entity is required to or chooses to publish an interim financial report in
accordance with International Financial Reporting Standards (IFRSs).
An interim report complying with IFRSs may be:
 A complete set of financial statements at the interim reporting date complying in full with IFRSs, or
 A condensed interim financial report prepared in compliance with IAS 34.
The rationale for requiring only condensed statements and selected note disclosures is that entities need
not duplicate information in their interim report that is contained in their report for the previous
financial year. Interim statements should focus more on new events, activities and circumstances.
2.3 Form and content

Where full financial statements are given as interim financial statements, IAS 1 should be used as a
guide, otherwise IAS 34 specifies minimum contents.
The condensed statement of financial position should include, as a minimum, each of the major
components of assets, liabilities and equity as were in the statement of financial position at the end of
the previous financial year, thus providing a summary of the economic resources of the entity and its
financial structure.
The condensed statement of profit or loss and other comprehensive income should include, as a
minimum, each of the component items of total comprehensive income as were shown in the
statement of profit or loss and other comprehensive income for the previous financial year, together
with the earnings per share and diluted earnings per share.
The condensed statement of cash flows should show, as a minimum, the three major sub-totals of
cash flow as required in statements of cash flows by IAS 7, namely: cash flows from operating activities,
cash flows from investing activities and cash flows from financing activities.
The condensed statement of changes in equity should include, as a minimum, each of the major
components of equity as were contained in the statement of changes in equity for the previous financial
year of the entity.
2.3.1 Selected explanatory notes
C
IAS 34 states that relatively minor changes from the most recent annual financial statements need not H
be included in an interim report. However, the notes to an interim report should include the following A
(unless the information is contained elsewhere in the report). P
T
 A statement that the same accounting policies and methods of computation have been used for E
the interim statements as were used for the most recent annual financial statements. If not, the R
nature of the differences and their effect should be described. (The accounting policies for
preparing the interim report should only differ from those used for the previous annual accounts in
a situation where there has been a change in accounting policy since the end of the previous 1
financial year, and the new policy will be applied for the annual accounts of the current financial
period.)
 Explanatory comments on the seasonality or 'cyclicality' of operations in the interim period. For
example, if a company earns most of its annual profits in the first half of the year, because sales are
much higher in the first six months, the interim report for the first half of the year should explain
this fact.
 The nature and amount of items during the interim period affecting assets, liabilities, capital, net
income or cash flows, that are unusual, due to their nature, incidence or size.
 The issue or repurchase of equity or debt securities.
 Nature and amount of any changes in estimates of amounts reported in an earlier interim report
during the financial year, or in prior financial years if these affect the current interim period.
 Dividends paid on ordinary shares and the dividends paid on other shares.
 Segmental results for entities that are required by IFRS 8 Operating Segments to disclose segment
information in their annual financial statements.
 Any significant events since the end of the interim period.
 Effect of changes in the composition of the entity during the interim period including the
acquisition or disposal of subsidiaries and long-term investments, restructurings and discontinued
operations.
 Any significant change in a contingent liability or a contingent asset since the date of the last
annual statement of financial position.
The standard requires the entity to provide explanatory comments about seasonality or cyclicality
relating to the interim financial statements.
Changes in the business environment such as changes in price, costs, demand, market share and
prospects for the full year should be discussed in the management discussion and analysis of the
financial review.
The entity should also disclose the fact that the interim report has been produced in compliance with
IAS 34 on interim financial reporting.
Worked example: Disclosure

Requirement
Give some examples of the type of disclosures required according to the above list of explanatory notes.
Solution
The following are examples:
 Write-down of inventories to net realisable value and the reversal of such a write-down
 Recognition of a loss from the impairment of property, plant and equipment, intangible assets, or
other assets, and the reversal of such an impairment loss
 Reversal of any provisions for the costs of restructuring
 Acquisitions and disposals of items of property, plant and equipment

 Commitments for the purchase of property, plant and equipment
 Litigation settlements
 Corrections of fundamental errors in previously reported financial data
 Any debt default or any breach of a debt covenant that has not been corrected subsequently
 Related party transactions
2.4 Periods covered

The Standard requires that interim financial reports should provide financial information for the
following periods or as at the following dates.
 Statement of financial position data as at the end of the current interim period, and comparative
data as at the end of the most recent financial year.
 Statement of profit or loss and other comprehensive income data for the current interim
period and cumulative data for the current year to date, together with comparative data for the
corresponding interim period and cumulative figures for the previous financial year.
 Statement of cash flows data should be cumulative for the current year to date, with comparative
cumulative data for the corresponding interim period in the previous financial year.
 Data for the statement of changes in equity should be for both the current interim period and
for the year to date, together with comparative data for the corresponding interim period, and
cumulative figures, for the previous financial year.
2.5 Materiality
Materiality should be assessed in relation to the interim period financial data. It should be recognised
that interim measurements rely to a greater extent on estimates than annual financial data.
2.6 Recognition and measurement principles

A large part of IAS 34 deals with recognition and measurement principles, and guidelines as to their
practical application. The guiding principle is that an entity should use the same recognition and
measurement principles in its interim statements as it does in its annual financial statements.
This means, for example, that a cost that would not be regarded as an asset in the year-end statement
of financial position should not be regarded as an asset in the statement of financial position for an
interim period. Similarly, an accrual for an item of income or expense for a transaction that has not yet
occurred (or a deferral of an item of income or expense for a transaction that has already occurred) is
inappropriate for interim reporting, just as it is for year-end reporting.
Applying this principle of recognition and measurement may result, in a subsequent interim period or at
the year-end, in a remeasurement of amounts that were reported in a financial statement for a previous
interim period. The nature and amount of any significant remeasurements should be disclosed.
Revenues received occasionally, seasonally or cyclically

Revenue that is received as an occasional item, or within a seasonal or cyclical pattern, should not be
anticipated or deferred in interim financial statements, if it would be inappropriate to anticipate or defer
the revenue for the annual financial statements. In other words, the principles of revenue recognition
should be applied consistently to the interim reports and year-end reports.
Costs incurred unevenly during the financial year

These should only be anticipated or deferred (ie treated as accruals or prepayments) if it would be
appropriate to anticipate or defer the expense in the annual financial statements. For example, it would
be appropriate to anticipate a cost for property rental where the rental is paid in arrears, but it would be
inappropriate to anticipate part of the cost of a major advertising campaign later in the year, for which
no expenses have yet been incurred. C
H
The standard goes on, in an appendix, to deal with specific applications of the recognition and A
measurement principle. Some of these examples are explained below, by way of explanation and P
illustration. T
E
R
Payroll taxes or insurance contributions paid by employers
In some countries these are assessed on an annual basis, but paid at an uneven rate during the course of
1
the year, with a large proportion of the taxes being paid in the early part of the year, and a much
smaller proportion paid later on in the year. In this situation, it would be appropriate to use an
estimated average annual tax rate for the year in an interim statement, not the actual tax paid. This
treatment is appropriate because it reflects the fact that the taxes are assessed on an annual basis, even
though the payment pattern is uneven.
Cost of a planned major periodic maintenance or overhaul

The cost of such an event later in the year must not be anticipated in an interim financial statement
unless there is a legal or constructive obligation to carry out this work. The fact that a maintenance or
overhaul is planned and is carried out annually is not of itself sufficient to justify anticipating the cost in
an interim financial report.
Other planned but irregularly-occurring costs

Similarly, these costs such as charitable donations or employee training costs, should not be accrued in
an interim report. These costs, even if they occur regularly and are planned, are nevertheless
discretionary.
Year-end bonus
A year-end bonus should not be provided for in an interim financial statement unless there is a
constructive obligation to pay a year-end bonus (eg a contractual obligation, or a regular past practice)
and the size of the bonus can be reliably measured.
Worked example: Bonus

An entity's accounting year ends on 31 December each year and it is currently preparing interim
financial statements for the half year to 30 June 20X4. It has a contractual agreement with its staff that
it will pay them an annual bonus equal to 10% of their annual salary if the full year's output exceeds one
million units. Budgeted output is 1.4 million units and the entity has achieved budgeted output during
the first six months of the year. Annual salaries are estimated to be £100 million, with the cost in the
first half year to 30 June being £45 million.
Requirement
How should the bonus be reflected in the interim financial statements?
Solution
It is probable that the bonus will be paid, given that the actual output already achieved in the year is in
line with budgeted figures, which exceed the required level of output. So a bonus of £4.5 million should
be recognised in the interim financial statements at 30 June 20X4.
Holiday pay
The same principle applies here. If holiday pay is an enforceable obligation on the employer, then any
unpaid accumulated holiday pay may be accrued in the interim financial report.

Non-monetary intangible assets
The entity might incur expenses during an interim period on items that might or will generate non-
monetary intangible assets. IAS 38 Intangible Assets requires that costs to generate non-monetary
intangible assets (eg development expenses) should be recognised as an expense when incurred unless
the costs form part of an identifiable intangible asset. Costs that were initially recognised as an expense
cannot subsequently be treated instead as part of the cost of an intangible asset. IAS 34 states that
interim financial statements should adopt the same approach. This means that it would be inappropriate
in an interim financial statement to 'defer' a cost in the expectation that it will eventually be part of a
non-monetary intangible asset that has not yet been recognised: such costs should be treated as an
expense in the interim statement.
Depreciation
Depreciation should only be charged in an interim statement on non-current assets that have been
acquired, not on non-current assets that will be acquired later in the financial year.
Foreign currency translation gains and losses

These should be calculated by the same principles as at the financial year end, in accordance with IAS
21.
Tax on income
An entity will include an expense for income tax (tax on profits) in its interim statements. The tax rate
to use should be the estimated average annual tax rate for the year. For example, suppose that in a
particular jurisdiction, the rate of tax on company profits is 30% on the first £200,000 of profit and 40%
on profits above £200,000. Now suppose that a company makes a profit of £200,000 in its first half
year, and expects to make £200,000 in the second half year. The rate of tax to be applied in the interim
financial report should be 35%, not 30%, ie the expected average rate of tax for the year as a whole.
This approach is appropriate because income tax on company profits is charged on an annual basis, and
an effective annual rate should therefore be applied to each interim period.
As another illustration, suppose a company earns pre-tax income in the first quarter of the year of £30,000,
but expects to make a loss of £10,000 in each of the next three quarters, so that net income before tax for
the year is zero. Suppose also that the rate of tax is 30%. In this case, it would be inappropriate to anticipate
the losses, and the tax charge should be £9,000 for the first quarter of the year (30% of £30,000) and a
negative tax charge of £3,000 for each of the next three quarters, if actual losses are the same as anticipated.
Where the tax year for a company does not coincide with its financial year, a separate estimated
weighted average tax rate should be applied for each tax year, to the interim periods that fall within
that tax year.
Some countries give entities tax credits against the tax payable, based on amounts of capital
expenditure or research and development, etc. Under most tax regimes, these credits are calculated and
granted on an annual basis; therefore it is appropriate to include anticipated tax credits within the
calculation of the estimated average tax rate for the year, and apply this rate to calculate the tax on
income for the interim period.
Worked example: Taxation charge

An entity's accounting year ends on 31 December 20X4, and it is currently preparing interim financial
statements for the half year to 30 June 20X4. Its profit before tax for the six month period to 30 June
20X4 is £6 million. The business is seasonal and the profit before tax for the six months to 31
December 20X4 is almost certain to be £10 million. Income tax is calculated as 25% of reported annual
profit before tax if it does not exceed £10 million. If annual profit before tax exceeds £10 million the tax
rate on the whole amount is 30%.
Requirement
Under IAS 34 what should the taxation charge be in the interim financial statements?
Solution
C
The taxation charge in the interim financial statements is based upon the weighted average rate for the H
year. In this case the entity's tax rate for the year is expected to be 30%. The taxation charge in the A
interim financial statements will be £1.8 million. P
T
E
R
Interactive question 1: Interim financial statement [Difficulty level: Intermediate]

The Alshain Company's profit before tax for the six months to 30 September 20X6 was £4 million. 1
However, the business is seasonal and profit before tax for the six months to 31 March 20X7 is almost
certain to be £8 million. Profit before tax equals taxable profit for this company.
Alshain operates in a country where income tax on companies is at a rate of 25% if annual profits are
below £11 million and a rate of 30% where annual profits exceed £11 million. These tax rates apply to
the entire profit for the year.
Under IAS 34 Interim Financial Reporting, what should be the income tax expense in Alshain's interim
financial statements for the half year to 30 September 20X6?
See Answer at the end of this chapter.
Inventory valuations
Within interim reports, inventories should be valued in the same way as for year-end accounts. It is
recognised, however, that it will be necessary to rely more heavily on estimates for interim reporting
than for year-end reporting.
In addition, it will normally be the case that the net realisable value of inventories should be estimated
from selling prices and related costs to complete and dispose at interim dates.
Worked example: Inventory valuations

An entity's accounting year ends on 31 December 20X4, and it is currently preparing interim financial
statements for the half year to 30 June 20X4. The price of its products tends to vary. At 30 June 20X4, it
has inventories of 100,000 units, at a cost per unit of £1.40. The net realisable value of the inventories is
£1.20 per unit at 30 June 20X4. The expected net realisable value of the inventories at 31 December
20X4 is £1.55 per unit.
Requirement
How should the value of the inventories be reflected in the interim financial statements?
Solution
The value of the inventories in the interim financial statements at 30 June 20X4 is the lower of cost and
NRV at 30 June 20X4. This is:
100,000  £1.20 = £120,000
2.7 Use of estimates

Although accounting information must be reliable and free from material error, it may be necessary to
sacrifice some accuracy and reliability for the sake of timeliness and cost-benefits. This is particularly the
case with interim financial reporting, where there will be much less time to produce reports than at the
financial year end. The standard therefore recognises that estimates will have to be used to a greater
extent in interim reporting, to assess values or even some costs, than in year-end reporting.
An appendix to IAS 34 gives some examples of the use of estimates.
 Inventories. An entity might not need to carry out a full inventory count at the end of each interim
period. Instead, it may be sufficient to estimate inventory values using sales margins.

 Provisions. An entity might employ outside experts or consultants to advise on the appropriate
amount of a provision, as at the year end. It will probably be inappropriate to employ an expert to
make a similar assessment at each interim date. Similarly, an entity might employ a professional
valuer to revalue non-current assets at the year end, whereas at the interim date(s) the entity will
not rely on such experts.
 Income taxes. The rate of income tax (tax on profits) will be calculated at the year end by
applying the tax rate in each country/jurisdiction to the profits earned there. At the interim stage, it
may be sufficient to estimate the rate of income tax by applying the same 'blended' estimated
weighted average tax rate to the income earned in all countries/jurisdictions.
 Classification of current and non-current assets and liabilities. The investigation for classifying
assets and liabilities as current and non-current may be more thorough at annual reporting dates
than at interim ones.
 Pensions. IAS 19 Employee Benefits encourages the use of a professionally qualified actuary in the
measurement of the plan's defined benefit obligations. For interim reporting purposes reliable
estimates may be obtained by extrapolation of the latest actuarial valuation.
 Contingencies. Normally the measurement of contingencies may involve formal reports giving the
opinions of experts. Expert opinions about contingencies and uncertainties relating to litigation or
assessments may or may not be needed at interim dates.
 Revaluations and fair value accounting. Where an entity carries assets at fair value such as non-
current assets in accordance with IAS 16 Property, Plant and Equipment or investment properties in
accordance with IAS 40 Investment Property, it may rely on independent professional valuations at
annual reporting dates, though not at interim reporting dates.
 Intercompany reconciliations. Intercompany balances that are reconciled at a detailed level at the
year end may be reconciled at a less detailed level at the interim reporting date.
 Specialised industries. Interim period measurement in specialised industries may be less precise
than at year end due to their complexity, and the cost and time investment that is required.
The principle of materiality applies to interim financial reporting, as it does to year-end reporting. In
assessing materiality, it needs to be recognised that interim financial reports will rely more heavily on
estimates than year-end reports. Materiality should be assessed in relation to the interim financial
statements themselves, and should be independent of 'annual materiality' considerations.
2.8 IFRIC 10 Interim Financial Reporting and Impairment

This IFRIC, issued in 2006, addresses the apparent conflict between IAS 34 and the requirement in other
standards on the recognition and reversal in financial statements of impairment losses on goodwill and
certain financial assets.
IFRIC 10 states that any such impairment losses recognised in an interim financial statement must not be
reversed in subsequent interim or annual financial statements.
2.9 IAS 34 Interim Financial Reporting and UK GAAP

IFRS UK GAAP
There is no requirement under IFRS The Financial Services Authority (FSA) has published the rules
to publish an interim financial report. which implement the EU Transparency Directive in the UK.
However, entities that do so These rules apply to listed companies with financial reporting
voluntarily or are required to do so by periods starting on or after 20 January 2007.
local regulators must apply IAS 34.
Listed companies are required to publish a half yearly report
(ie interim financial statements) within two months of the
end of the first six months of the financial year. The half
yearly report must include a condensed set of financial
statements prepared in accordance with IFRS, an interim
management report and a responsibility statement made by
persons responsible to the company for the report.
IFRS UK GAAP
C
Unless a company publishes quarterly financial reports, it will H
A
be required to publish an Interim Management Statement
P
(IMS) during each six month period of any financial year. The T
IMS must be published in the period between ten weeks E
after the beginning, and six weeks before the end of, the R
relevant six month period.
The IMS must explain material events and transactions that
1
have taken place during the relevant period and their impact
on the company's financial position and describe the
financial position and performance of the company during
that time. According to the FSA, companies may be able to
meet IMS requirements based on the content of their usual
performance reports, trading statements or other similar
reporting formats.
The FSA rules are supplemented by the ASB's Statement of
Best Practice.
The requirements of IAS 34 are
broadly in line with the UK
requirements with some minor
differences such as:
 IAS 34 requires detailed  The ASB's interim statement requires only narrative
disclosures in accordance with commentary.
the requirements of IFRS 3
Business Combinations relating to
business combinations in the
period.
 Comparatives for the statement  The FSA Rules require statement of financial position
of financial position are required comparatives for the corresponding interim date of the
for the previous financial year. previous year.
3 Future of UK GAAP
Section overview
 The regulatory shift away from current UK GAAP will require all entities (except those small
enough to use the FRSSE) to report in accordance with FRSUKI with an option to use IFRS.
If adopted, the ASB's proposals will mean the end of current UK GAAP.
3.1 Background
The UK and Ireland Accounting Standards Board (ASB) has been a close partner of the International
Accounting Standards Board for many years and has had enormous input into the development of
IFRSs.
Examples of standards which were developed jointly with the International Accounting Standards Board
in the past are FRS 11 Impairment of assets and FRS 12 Provisions, contingent liabilities and contingent
assets, the former being very similar to the IFRS equivalent (IAS 36) admittedly with a difference of
opinion over the allocation of impairment losses, and the latter being almost identical to IFRSs (IAS 37)
other than terminology differences.

Recently the ASB has been harmonising standards with their international counterparts in the interest of
international convergence. Recent standards issued which are a copy of the international equivalent
include:
 FRS 22 Earnings per share (IAS 33)
 FRS 23 The effects of changes in foreign exchange rates (IAS 21)
 FRS 25 Financial instruments: presentation (IAS 32)
 FRS 26 Financial instruments: recognition and measurement (IAS 39)
 FRS 29 Financial instruments: disclosures (IFRS 7)
Harmonisation with IFRS by adopting the international version as a Financial Reporting Standard is
not without its issues: the IASB is continually revising its IFRSs to improve them, which means that
the corresponding changes to the UK/Irish equivalent need to be approved before changes can be
made to the UK/Irish standard. This is time-consuming and can lead to 'cut-off' differences between
the version of the IFRS applied in the UK and Ireland versus other IFRS jurisdictions (and indeed
versus the IFRSs applied by quoted companies in the UK and Ireland). This has particularly been
the case with the financial instruments standards which have seen many changes since they were
originally issued.
3.2 Recent developments

In 2009 a decision was made to no longer converge standards with IFRSs, but rather consult on the use
of IFRSs generally by companies in the UK and Ireland. In January 2012 the ASB issued FREDs 46 to 48,
setting out revised proposals for the future of financial reporting in the UK and Republic of Ireland.
FREDs 46 and 47 became FRS 100 and 101 respectively in November 2012, which is before the cut-off
date for your exam.
 FRS 100 sets out the application of financial reporting requirements in the UK and Republic of
Ireland.
 FRS 101 or IFRS with reduced disclosures outlines the reduced disclosure framework available for use
by 'qualifying entities' choosing to report under IFRS.
 FRED 48 (FRS 102 or FRSUKI) is the Financial Reporting Standard applicable in the UK and Republic
of Ireland, including the reduced disclosures available for 'qualifying entities' reporting under this
FRS. This proposed FRS is based upon the IASB's IFRS for SMEs but has been further amended from
earlier versions.
3.3 More detail on the FRSUKI

For all entities choosing not to apply IFRS or IFRS with reduced disclosures, the ASB is proposing the
use of a new standard based on the IASB's IFRS for SMEs. The ASB's proposed standard, FRS 102 or
FRSUKI, runs to less than 300 pages and has been adapted to comply with UK and EU law,
extended and amended to address the needs of a broader group of preparers in response to
feedback on FRED 44.
3.4 Implications
The implications of the above are:
(a) All entities currently reporting under UK GAAP will be required to report under FRSUKI but may
voluntarily adopt IFRS. The three tier system previously proposed is eliminated, so that the
application of EU-adopted IFRS will not be extended beyond that required by regulation.
(b) Accounting treatments permitted under current accounting standards are introduced. Previously
the ASB had proposed keeping changes to the IFRS for SMEs to a minimum. It now proposes that
where an accounting treatment is permitted currently in UK and Irish accounting standards and in
international accounting standards it should be retained. This means that the options to revalue
land and buildings, capitalise borrowing costs or carry forward certain development expenses have
been incorporated into the FRSUKI.
(c) The requirements are aligned more closely to company law, with the majority of the presentation
requirements for the balance sheet and income statement being replaced by the formats in
company law rather than in the IFRS for SMEs.
(d) There are amendments to accounting for deferred taxation, updates to consolidation requirements
and accounting for pension plans, and the introduction of an option to recognise grant income C
over the life of a grant. H
A
(e) Qualifying entities will be able to take advantage of reduced disclosure requirements that include P
exemption from disclosure of a cash flow statement, certain financial instruments, related party and T
E
share based payments disclosures. The reliefs available are different between IFRS and FRSUKI.
R
(f) Small entities currently eligible to apply FRSSE will continue to be able to do so. Should a new
framework for micro entities be introduced as a result of EU consultation processes, the ASB would
then review the status of the FRSSE and consult again on how to amend the FRSSE to 1
accommodate any change.
(g) Guidance for public benefit entities is to be incorporated into the FRSUKI (FRED 48).
3.5 Timescale
These proposals would apply to accounting periods beginning on or after 1 January 2015, with earlier
adoption encouraged.

Summary
Presentation of
Financial Statements
IAS 1
Statement of Present SFP at start of previous period

financial position where prior period adjustment
Statement of Profit for period

comprehensive income Other comprehensive income
Statement of
cash flows
Statement of
changes in equity Transactions with owners
Interim Financial Reporting C
IAS 34 H
A
P
T
E
Minimum Minimum R
requirements disclosure
1
Condensed Where relevant Impact of any
statement of how performance is changes in
financial position affected by seasonality accounting policies
Condensed Changes in debt or Statement that

statement of equity from new accounting policies
comprehensive issues, repurchases or followed are
income repayments consistent with
latest full financial
statements
Nature and effect
Condensed statement
of any material
showing changes in
changes in estimates
equity arising from Changes in contingent
capital transactions with liabilities or contingent
owners and distributions assets since last
An update of segmental
to owners reporting date
information
Condensed Any changes in the

statement composition of the Dividends paid
of cash flows entity for each class of share
Material events after

the reporting period Any unusual items
Future of UK GAAP
Entities undder
All other entities
EU1606/2002
Apply EU-adopted FRS 102 - FRSUKI

Small entities
IFRS
FRSSE
Qualifying entities Qualifying entities
FRS 101 - FRSUKI FRS 102 - FRSUKI

with reduced with reduced
disclosures disclosed
UK company law will require either AIS accounts or Companies Act accounts

Self-test
IAS 34 Interim Financial Reporting
1 Anteater
The Anteater Company operates a saleroom in a city centre from premises which it leases from the
Moreno Company under an operating lease according to IAS 17 Leases. Anteater's accounting year
end is 31 December each year and it is currently preparing half-yearly interim financial statements
for the six months to 30 June 20X7.
The lease agreement on the store premises contains a clause for contingent lease payments as
follows:
"If the revenue of Anteater in any year to 31 December exceeds £123 million then an additional
lease rental of £4.2 million becomes payable in respect of that year to Moreno on 31 March of the
following year."
Anteater's business is seasonal due to high sales around the Christmas period. Only about one third
of annual sales are normally earned in the first six months of the year. In January 20X7 a
refurbishment of the premises was carried out and this is attracting more customers than had been
budgeted for.
Relevant information is as follows:
£m
Budgeted sales for the six months to 30 June 20X7 39
Budgeted sales for the year to 31 December 20X7 117
Actual sales for the six months to 30 June 20X7 49
The budgets were set in December 20X6 and have not been changed.
Requirement
According to IAS 34 Interim Financial Reporting, what amount should be recognised in profit or loss
for Anteater for the six months to 30 June 20X7 in respect of the contingent lease payment clause?
2 Marmoset
The Marmoset Company offers the service of transport consultations. Its accounting year ends on
31 December each year and it is currently preparing half-yearly interim financial statements for the
six months to 30 June 20X7.
During 20X7 the directors drew up a plan to introduce a new bonus scheme for all junior
consultants in order to provide incentives and improve retention. The details of the scheme were
announced to employees the day before the interim financial statements were released on 15
August 20X7. Under the planned scheme any bonus would be paid on 31 March 20X8.
The bonus will be equal to 1% of profit before tax (calculated prior to recognising the bonus) of
the year ended 31 December 20X7.
The business is seasonal such that 60% of the annual profit before tax is earned in the first 6
months of the year. The profit before tax in the interim financial statement for the six months to 30
June 20X7 is £6 million.
Requirement
What amount should be recognised in profit or loss for Marmoset for the six months to 30 June
20X7 in respect of the bonus, according to IAS 34 Interim Financial Reporting?
3 Aconcagua
The Aconcagua Company sells fashion shoes, the price of which varies during the year. Its
accounting year ends on 31 December and it prepares half-yearly interim financial statements.
At 30 June 20X7 it has inventories of 2,000 units which cost £30 each. The net realisable value of
the inventories at 30 June, when the shoes are out of season, is £20 each. No sales are expected in
the period to 31 December 20X7, but the expected net realisable value of the shoes at that date
(when they are about to come back into season) is £28 each.
Requirement
C
Should any changes in inventory values be reflected in the interim financial statements of H
Aconcagua for the six months ending 30 June 20X7 and for the six months ending 31 December A
20X7, according to IAS 34 Interim Financial Reporting? P
T
E
R

Technical reference
IAS 1 Presentation of Financial Statements

 Applies to all general purpose financial statements
 Links back to much in the IASB Framework
IAS 1.31 and IAS
 Presentation and disclosure rules apply only to material items
1.7
IAS 1.54, 56, 60,

 Statement of financial position
66, 69, 79
 Statement of profit or loss and other comprehensive income IAS 1.81-90
 Statement of changes in equity IAS 1.106-107

 Minimum components of an interim financial report IAS 34.8
 Form and content of interim financial statements IAS 34.9-11
 Selected explanatory notes IAS 34.16
 Disclosure of compliance with IFRSs IAS 34.19
 Periods for which interim financial statements are required to be presented IAS 34.20
 Materiality IAS 34.23
Disclosure in annual financial statements

 If an estimate of an amount reported in an interim period is changed IAS 34.26
significantly during the final interim period of the financial year but a separate
financial report is not published for that final interim period, the nature and
amount of that change in estimate shall be disclosed in a note to the annual
financial statements for that financial year.
Recognition and measurement

 An entity should apply the same accounting policies in its interim financial IAS 34.28
statements as are applied in its annual financial statements, except for
accounting policy changes made after the date of the most recent annual
financial statements that are to be reflected in the next annual financial
statements. However, the frequency of an entity's reporting (annual, half-yearly,
or quarterly) should not affect the measurement of its annual results. To achieve
that objective, measurements for interim reporting purposes should be made
on a year-to-date basis.
Revenues received seasonally, cyclically, or occasionally

 Revenues that are received seasonally, cyclically, or occasionally within a IAS 34.37
financial year shall not be anticipated or deferred as of an interim date if
anticipation or deferral would not be appropriate at the end of the entity's
financial year.
Costs incurred unevenly during the financial year
C
 Costs that are incurred unevenly during an entity's financial year shall be IAS 34.39 H
anticipated or deferred for interim reporting purposes if, and only if, it is also A
P
appropriate to anticipate or defer that type of cost at the end of the financial T
year. E
R
 Applying the recognition and measurement principles IAS 34.40
 Use of estimates IAS 34.41

1
 Restatement of previously reported interim periods IAS 34.43


1 Anteater
£2.1 million
Interim reports should apply the normal recognition and measurement criteria, using appropriate
estimates under IAS 34.41.
There is a constructive obligation in relation to the contingent lease payments, which should be
measured by reference to all the evidence available. As the trigger level of sales is expected to be
achieved, then under IAS 34 App.B B7 the amount to be recognised is £4.2m  6/12.
2 Marmoset
Nil
estimates under IAS 34.41.
There is no legal or constructive obligation at the interim reporting date to pay the bonus as no
announcement had been made at this date. Under IAS 34 App B B6 no expense is required.
3 Aconcagua
Six months ending 30 June 20X7 £20,000 profit decrease
Six months ending 31 December 20X7 £16,000 profit increase
estimates under IAS 34.41. IAS 34 App B B25-B26 link these general principles to inventories by
requiring them to be written down to net realisable value at the interim date; the write-down is
then reversed at the year end, if appropriate.
So the profit decrease in the six months to 30 June 20X7 is 2,000  (£30 - £20) = £20,000, while
the profit increase in the six months to 31 December 20X7 is 2,000  (£28 - £20) = £16,000.
Answer to Interactive question C
H
A
P
T
E
Answer to Interactive question 1 R
30% × £4 million = £1.2 million

The tax rate for the entire year is applied to the profits for the interim period. 1

CHAPTER 2
Reporting of assets
Introduction
Topic List
1 Review of material from earlier studies
2 IFRS 13 Fair Value Measurement
3 IAS 18 Revenue
Technical reference
Answers to Interactive questions
27
Introduction
 Apply and discuss the principles of valuing inventory, goods for resale, work-in-progress,
raw materials, inventory held by a service provider and construction contracts
 Apply and discuss the timing of the recognition of non-current assets and the
determination of their carrying amounts, including impairment and revaluations
 Apply and discuss the accounting treatment of intangible assets including the criteria for
recognition and measurement subsequent to acquisition and classification
1 Review of material from earlier studies
Section overview
 You should already be familiar with the Standards relating to current and non-current assets from
earlier studies. If not, go back to your earlier study material.
– IAS 2 Inventories
– IAS 11 Construction Contracts
– IAS 16 Property, Plant and Equipment
– IAS 38 Intangible Assets
– IAS 36 Impairment of Assets
C
H
Read the summary of knowledge brought forward and try the relevant questions. If you have any
A
difficulty, go back to your earlier study material and revise it. P
T
Assets have been defined in many different ways and for many purposes. The definition of an asset is E
important because it directly affects the treatment of such items. A good definition will prevent abuse R
or error in the accounting treatment: otherwise some assets might be treated as expenses, and some
expenses might be treated as assets.
2
In the current accounting climate, where complex transactions are carried out daily a definition that
covers ownership and value is not sufficient, leaving key questions unanswered.
 What determines ownership?
 What determines value?
The definition of an asset in the IASB's Framework from earlier studies is given below.
Definition
Asset: A resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity. (Framework)
This definition ties in closely with the definitions produced by other Standard-setters, particularly the
FASB (USA) and the ASB (UK).
A general consensus seems to exist in the standard setting bodies as to the definition of an asset which
encompasses three important characteristics.
 Future economic benefit
 Control
 The transaction to acquire control has already taken place
1.1 Property, plant and equipment

 Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration
given to acquire an asset at the time of its acquisition or construction.
 Residual value is the estimated amount that an entity would currently obtain from disposal of the
asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the
condition expected at the end of its useful life.
 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. (Note that this
definition changed when IFRS 13 Fair Value Measurement came into force in January 2013 – see
Section 2.)
 Carrying amount is the amount at which an asset is recognised after deducting any accumulated
depreciation and accumulated impairment losses.
Reporting of assets 29
Accounting treatment
 As with all assets, recognition depends on two criteria.
– It is probable that future economic benefits associated with the item will flow to the entity
– The cost of the item can be measured reliably
 These recognition criteria apply to subsequent expenditure as well as costs incurred initially (ie,
there are no longer separate criteria for recognising subsequent expenditure).
 Once recognised as an asset, items should initially be measured at cost.
 Purchase price, less trade discount/rebate plus
– Directly attributable costs of bringing the asset to working condition for intended use
– Initial estimate of the cost of dismantling and removing the item and restoring the site
on which it is located
IAS 16 also:
 Provides additional guidance on directly attributable costs including the cost of an item of
property, plant and equipment.
 States that income and related expenses of operations that are incidental to the construction or
development of an item of property, plant and equipment should be recognised in profit or loss for
the period.
 Specifies that exchanges of items of property, plant and equipment, regardless of whether the
assets are similar, are measured at fair value, unless the exchange transaction lacks commercial
substance or the fair value of neither of the assets exchanged can be measured reliably. If the
acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset
given up.
 Measurement subsequent to initial recognition
– Cost model: carrying asset at cost less depreciation and any accumulated impairment losses
– Revaluation model: carrying asset at revalued amount, ie fair value less subsequent
accumulated depreciation and any accumulated impairment losses. (IAS 16 makes clear that
the revaluation model is available only if the fair value of the item can be measured reliably.)
Asset is
revalued
upwards downwards
Has the asset Has the asset

previously suffered previously had
a downward a upward
valuation? valuation?
C
NO NO H
A
P
T
E
Recognise the increase Recognise the
R
as a revaluation surplus. decrease
YES (Other comprehensive directly in profit YES
income) or loss.
2
Recognise the increase in

Recognise the decrease
profit or loss up to the
against the revaluation
value of the downward
surplus up to the value of
valuation. Any excess should
the upward valuation. Any
be recognised as a revaluation
excess should be recognised
surplus. (Other comprehensive
directly in profit or loss.
income)
Interactive question 1: Revaluations [Difficulty level: Intermediate]

(a) Binkie Co has an item of land carried in its books at £13,000. Two years ago a slump in land values
led the company to reduce the carrying amount from £15,000. This was recorded as an expense.
There has been a surge in land prices in the current year, however, and the land is now worth
£20,000.
(b) In the example given above assume that the original cost was £15,000, revalued upwards to
£20,000 two years ago. The value has now fallen to £13,000.
(c) Crinkle Co bought an asset for £10,000 at the beginning of 20X6. It had a useful life of five years.
On 1 January 20X8 the asset was revalued to £12,000. The expected useful life has remained
unchanged (ie three years remain).
Requirements
(a) Account for the revaluation in the current year
(b) Account for the decrease in value
(c) Account for the revaluation and state the treatment for depreciation from 20X8 onwards
1.2 Inventories
Valuation
Lower of:
 Cost
 Net realisable value
Each item/group/category considered separately
Allowable costs
Allowable costs
include:
 Cost of purchase
exclude:
 Cost of storage
 Cost of selling
Determining cost
 FIFO
 Weighted average cost
Net realisable value
 Estimated cost of completion
 Estimated costs necessary to make the sale (eg marketing, selling and distribution)
Interactive question 2: Attributable cost [Difficulty level: Intermediate]

A production line results in two outputs, Product 1 and Product 2. Parts of the production process give
rise to indirect costs specifically identifiable with only one of these products, although other costs are
not separately identifiable.
Budgeted cost information for the most recent month is as follows.
Total Product 1 Product 2
£ £ £
Direct cost 300,000 140,000 160,000
Indirect production overheads
Identifiable 82,000 37,000 45,000
Other 50,000
432,000
Budgeted output – units 690 900
The entity has a policy which allocates indirect costs which are not specifically identifiable to an
individual product by reference to relative selling prices. This results in 60% being allocated to Product 1
and 40% to Product 2.
During the month, costs were incurred in line with the budget, but due to a failure of calibration to a
vital part of the process, only 675 units of Product 2 could be taken into inventory. The remainder
produced had to be scrapped, for zero proceeds.
Requirement
Calculate the cost attributable to Products 1 and 2.
Interactive question 3: Reclassification of asset [Difficulty level: Intermediate]
An entity manufactures a particular type of machine tool, each of which costs £36,000 to produce and
has a net realisable value of £45,000.
The entity takes one of the tools out of inventories to use for demonstration purposes over the next
three years. This item will be reclassified as a non-current asset and recognised in accordance with IAS
16 Property, Plant and Equipment.
Requirement
Assuming the tool has a nil residual value at the end of the three years, find its carrying amount to be
recognised as part of non-current assets one year later.
C
H
A
P
1.3 Construction contracts T
E
 Contract revenue should be recognised according to the stage of completion of the contract. R
 Contract costs are those directly related to the specific contract plus an allocation of costs incurred
in contract activity in general.
2
Interactive question 4: Contract [Difficulty level: Intermediate]

An entity assesses the stage of completion of its contracts by reference to costs incurred as a percentage
of total costs. Contract A has a fixed price of £500,000, recorded costs are £330,000, and expected
future costs are £70,000.
Requirement
What is the profit earned to date?
Interactive question 5: Three-year contract [Difficulty level: Intermediate]

Revenues and costs relating to a three-year contract commencing 1 January 20X5 are as follows.
20X5 20X6 20X7
£ £ £
Revenue per contract 800 800 800
Agreed variation 100
Total contract revenue 800 800 900
Contract costs incurred to date 150 400 752
Contract costs to completion 502 351 –
Total contract costs 652 751 752
Overall profit 148 49 148
% complete, using costs basis 23% 53% 100%
The 20X6 contract costs incurred to date include £100 which relates to additional work required for
unforeseen extras. In 20X6 the contractor negotiated with the customer to recover the cost of this
additional work, but it was not until 20X7 that it became probable that the customer would accept this
contract variation.
Requirement
How much profit should be recognised in each of the three years?
For current issues in this area see Section 3.
1.4 IAS 38 Intangible Assets
 An intangible asset is an identifiable non-monetary asset without physical substance, such as a
licence, patent or trademark.
 An intangible asset is identifiable if it is separable (ie it can be sold, transferred, exchanged,
licensed or rented to another party on its own rather than as part of a business) or it arises from
contractual or other legal rights.
 An intangible asset should be recognised if it is probable that future economic benefits
attributable to the asset will flow to the entity and the cost of the asset can be measured
reliably.
 At recognition the intangible should be recognised at cost (purchase price plus directly attributable
costs). After initial recognition an entity can choose between the cost model and the revaluation
model. The revaluation model can only be adopted if an active market (as defined) exists for that
type of asset.
 An intangible asset (other than goodwill recognised in the acquiree's financial statements)
acquired as part of a business combination should initially be recognised at fair value.
 Internally generated goodwill should not be recognised.
 Expenditure incurred in the research phase of an internally generated intangible asset should be
expensed as incurred.
 Expenditure incurred in the development phase of an internally generated intangible asset must
be capitalised provided certain tightly defined criteria are met.
– Expenditure incurred prior to the criteria being met may not be capitalised retrospectively
 An intangible asset with a finite useful life should be amortised over its expected useful life,
commencing when the asset is available for use in the manner intended by management.
 Residual values should be assumed to be nil, except in the rare circumstances when an active
market exists or there is a commitment by a third party to purchase the asset at the end of its
useful life.
 An intangible asset with an indefinite life should not be amortised, but should be reviewed for
impairment on an annual basis.
– There must also be an annual review of whether the indefinite life assessment is still
appropriate
 On disposal of an intangible asset the gain or loss is recognised in profit or loss.
Interactive question 6: Intangible assets [Difficulty level: Easy]

Requirements
(a) Give some common examples of intangible assets.
(b) Can employees be recognised as intangible assets?
1.5 IAS 36 Impairment of Assets

Scope
IAS 36 applies to impairment of all assets other than:
 Inventories
 Deferred tax assets
 Employee benefit assets
 Financial assets
 Investment property held under the fair value model
 Biological assets held at fair value less estimated point-of-sale costs
 Non-current assets held for sale
IAS 36 most commonly applies to:
 Property, plant and equipment accounted for in accordance with IAS 16 Property, Plant and
Equipment
 Intangible assets accounted for in accordance with IAS 38 Intangible Assets
 Some financial assets, namely subsidiaries, associates and joint ventures. Impairments of all other
financial assets are accounted for in accordance with IAS 39 Financial Instruments: Recognition and
Measurement
Issue
C
Assets should be carried at no more than their recoverable amount. H
A
Recoverable Amount P
= Higher of T
E
R
2
Fair value less costs Value in use
to sell
Fair value less costs to sell

Fair value less costs to sell is the price that would be received to sell the asset in an orderly transaction
between market participants at the measurement date (IFRS 13 definition of fair value, see Section 2),
less the direct incremental costs attributable to the disposal of the asset.
Examples of costs of disposal are legal costs, stamp duty and similar transaction taxes, costs of removing
the asset, and direct incremental costs to bring an asset into condition for its sale. They exclude finance
costs and income tax expense.
Value in use
Cash flow projections are based on the most recent management-approved budgets/forecasts. They
should cover a maximum period of five years, unless a longer period can be justified.
The cash flows should include:
 Projections of cash inflows from continuing use of the asset
 Projections of cash outflows necessarily incurred to generate the cash inflows from continuing use
of the asset
 Net cash flows, if any, for the disposal of the asset at the end of its useful life
 Future overheads that can be directly attributed, or allocated on a reasonable and consistent basis
They should exclude:
 Cash outflows relating to obligations already recognised as liabilities (to avoid double counting)
 The effects of any future restructuring to which the entity is not yet committed
 Cash flows from financing activities or income tax receipts and payments
Discount rate
The discount rate (or rates) should be a pre-tax rate (or rates) that reflect(s) current market assessments
of:
 The time value of money; and
 The risks specific to the asset for which future cash flow estimates have not been adjusted.
Interactive question 7: Impairment loss [Difficulty level: Exam standard]
An entity has a single manufacturing plant which has a carrying value of £749,000. A new government
elected in the country passes legislation significantly restricting exports of the product produced by the
plant. As a result, and for the foreseeable future, the entity's production will be cut by 40%. Cash flow
forecasts have been prepared derived from the most recent financial budgets/forecasts for the next five
years approved by management (excluding the effects of general price inflation).
Year 1 234 5
£'000 £'000 £'000 £'000 £'000
Future cash flows 230 211 157 104 233
(including
disposal
proceeds)
If the plant was sold now it would realise £550,000, net of selling costs.
The entity estimates the pre-tax discount rate specific to the plant to be 15%, after taking into account
the effects of general price inflation.
Requirement
Calculate the recoverable amount of the plant and any impairment loss.
Note: PV factors at 15% are as follows.
Year @
PV factor 15%
1 0.86957
2 0.75614
3 0.65752
4 0.57175
5 0.49718
Impairment indicators
The entity should look for evidence of impairment at the end of each period and conduct an
impairment review on any asset where there is evidence of impairment. The following are indicators
of impairment.
External
 Significant decline in market value of the asset below that expected due to normal passage of time
or normal use
 Significant changes with an adverse effect on the entity in the
– Technological or market environment
– Economic or legal environment
 Increased market interest rates or other market rates of return affecting discount rates and thus
reducing value in use
 Carrying amount of net assets of the entity exceeds market capitalisation
Internal
 Evidence of obsolescence or physical damage
 Significant changes with an adverse effect on the entity*:
– The asset becomes idle
– Plans to discontinue/restructure the operation to which the asset belongs
– Plans to dispose of an asset before the previously expected date
– Reassessing an asset's useful life as finite rather than indefinite
 Internal evidence available that asset performance will be worse than expected.
* Once the asset meets the criteria to be classified as 'held for sale', it is excluded from the scope of IAS
36 and accounted for under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
Annual impairment tests, irrespective of whether there are indications of impairment, are required for:
 Intangible assets with an indefinite useful life/not yet available for use
 Goodwill acquired in a business combination
Cash-generating units (CGUs)
Where it is not possible to estimate the recoverable amount of an individual asset, the entity estimates
the recoverable amount of the cash-generating unit to which it belongs.
Definition
C
Cash-generating unit: A cash-generating unit is the smallest identifiable group of assets that generates H
cash inflows that are largely independent of the cash inflows from other assets or groups of assets. A
P
T
E
If an active market exists for the output produced by an asset or a group of assets, this group of assets R
should be identified as a CGU even if some or all of the output is used internally. If the cash inflows are
affected by internal transfer pricing, management's best estimates of future prices that could be
achieved in an orderly transaction between market participants at the measurement date are used in 2
estimating the CGU's value in use.
Interactive question 8: Cash-generating units [Difficulty level: Intermediate]

Requirement
Discuss whether the following items would be cash-generating units in their own right, or part of a
larger cash-generating unit.
(a) A pizza oven in a pizza restaurant.
(b) A branch of a pizza restaurant in Warsaw.
(c) A monorail that takes fee paying visitors to a theme park from its car park.
(d) A monorail that transports fee paying commuters from a suburban part of town to the centre of
town.
(e) The internal large telephone network of a country's railway system, although its use is currently not
permitted to anybody other than railway workers.
Corporate assets
 Corporate assets are treated in a similar way to goodwill.
The CGU includes corporate assets (or a portion of them) that can be allocated to it on a
'reasonable and consistent basis'. Where not possible, the assets (or unallocated portion) are tested
for impairment as part of the group of CGUs to which they can be allocated on a reasonable and
consistent basis.
Recognition of impairment losses in financial statements
 Assets carried at historical cost – in profit or loss
 Revalued assets
The impairment loss should be treated under the appropriate rules of the applicable IFRS.
For example, property, plant and equipment first against any revaluation surplus relating to the
asset and then in profit or loss in accordance with IAS 16.
Allocation of impairment losses in a CGU
General rule
The impairment should be allocated in the following order:
 Goodwill allocated to the CGU
 Other assets on a pro-rata basis based on carrying value
The carrying amount of an asset should not be reduced below the higher of its recoverable amount (if
determinable) and zero.
The amount of the impairment loss that would otherwise have been allocated to the asset should be
allocated to the other assets on a pro-rata basis.
Allocation of loss with unallocated corporate assets or goodwill
Where not all assets or goodwill have been allocated to an individual CGU then different levels of
impairment tests are performed to ensure the unallocated assets are tested.
Test of individual CGUs
 Test the individual CGUs (including allocated goodwill and any portion of the carrying amount of
corporate assets that can be allocated on a reasonable and consistent basis).
Test of group of CGUs
 Test the smallest group of CGUs that includes the CGU under review and to which the goodwill
can be allocated/a portion of the carrying amount of corporate assets can be allocated on a
reasonable and consistent basis.
After the impairment review
The depreciation/amortisation should be adjusted in future periods to allocate the asset's revised
carrying amount less its residual value on a systematic basis over its remaining useful life.
Treatment of the non-controlling interest element of goodwill
The revision to IFRS 3 allows two methods of initially valuing the non-controlling (minority) interest in
an entity:
 As a share of the net assets of the entity at the acquisition date, or
 At fair value.
The non-controlling interest is then taken into account in the goodwill calculation per the revised
standard:
Purchase consideration X
Non-controlling interest X
X
Total fair value of net assets of acquiree (X)
Goodwill X
This means that the resulting goodwill will represent

 Only the parent's share of total goodwill when valuing the non-controlling interest using the
proportion of net assets method
 Full goodwill (ie the parent's share plus the non-controlling interest share) when using the fair value
method
Where the share of net assets method is used to value the non-controlling interest, the carrying amount
of a CGU therefore comprises:
 The parent and non-controlling share of the identifiable net assets of the unit
 Only the parent's share of the goodwill
Part of the calculation of the recoverable amount of the CGU relates to the unrecognised share in the
goodwill.
For the purpose of calculating the impairment loss, the carrying amount of the CGU is therefore
notionally adjusted to include the non-controlling share in the goodwill by grossing it up.
The consequent impairment loss calculated is only recognised to the extent of the parent's share.
Where the fair value method is used to value the non-controlling interest, no adjustment is required.
Interactive question 9: Allocation of impairment loss [Difficulty level: Exam standard]

Peter acquired 60% of Stewart on 1.1.20X1 for £450m recognising net assets of £600m, a non-
controlling interest (valued as a proportion of total net assets) of £240m and goodwill of £90m. Stewart
consists of a single cash-generating unit.
Due to adverse publicity, the recoverable amount of Stewart had fallen by 31.12.20X1. The depreciated
value of the net assets at that date was £550m (excluding goodwill). No impairment losses have yet
been recognised relating to the goodwill.
Requirement C
H
Show the allocation of the impairment losses: A
P
(a) If the recoverable amount was £510m at 31.12.20X1
T
(b) If the recoverable amount was £570m at 31.12.20X1 E
R
2
Reversal of past impairments
A reversal for a CGU is allocated to the assets of the CGU, except for goodwill, pro rata with the carrying
amounts of those assets.
However, the carrying amount of an asset is not increased above the lower of:
 Its recoverable amount (if determinable); and
 Its depreciated carrying amount had no impairment loss originally been recognised.
Any amounts left unallocated are allocated to the other assets (except goodwill) pro-rata.
The reversal is recognised in profit or loss, except where reversing a loss recognised on assets carried at
revalued amounts, which are treated in accordance with the applicable IFRS.
For example, an impairment loss reversal on property, plant and equipment first reverses the loss
recorded in profit or loss and any remainder is credited to the revaluation surplus (IAS 16).
Goodwill
Once recognised, impairment losses on goodwill are not reversed.
Impairment and IFRS 5
IFRS 5 is covered in detail in Chapter 15. Regarding impairment, note the following:
 Immediately before initial classification as held for sale, the asset (or disposal group) is measured in
accordance with the applicable IFRS (eg property, plant and equipment held under the IAS 16
revaluation model is revalued).
 On classification of the non-current asset (or disposal group) as held for sale, it is written down to
fair value less costs to sell (if less than carrying amount).
 Any impairment loss arising under IFRS 5 is charged to profit or loss (and the credit allocated to
assets of a disposal group using the IAS 36 rules, ie first to goodwill then to other assets pro-rata
based on carrying value).
 Non-current assets/disposal groups classified as held for sale are not depreciated/amortised.
 Subsequent changes in fair value less costs to sell: any subsequent changes in fair value less costs to
sell are recognised as a further impairment loss (or reversal of an impairment loss).
 However, gains recognised cannot exceed cumulative impairment losses to date (whether under
IAS 36 or IFRS 5).
2 IFRS 13 Fair Value Measurement
Section overview
 IFRS 13 Fair Value Measurement gives extensive guidance on how the fair value of assets and
liabilities should be established.
 IFRS 13 sets out to:
(a) Define fair value
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosures about fair value measurements
 IFRS 13 defines fair value as 'the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement
date'.
 Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets
and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date.
 IFRS 13 states that valuation techniques must be those which are appropriate and for which
sufficient data are available. Entities should maximise the use of relevant observable inputs and
minimise the use of unobservable inputs.
2.1 Background
In May 2011 the IASB published IFRS 13 Fair Value Measurement. The project arose as a result of the
Memorandum of Understanding between the IASB and FASB (2006) reaffirming their commitment to
the convergence of IFRSs and US GAAP. With the publication of IFRS 13, IFRS and US GAAP now have
the same definition of fair value and the measurement and disclosure requirements are now aligned.
2.2 Objective
IFRS 13 sets out to:
(a) Define fair value
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosures about fair value measurements
Definition
Fair value: 'the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date'.
The previous definition used in IFRS was 'the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm's length transaction'.
The price which would be received to sell the asset or paid to transfer (not settle) the liability is
described as the 'exit price' and this is the definition used in US GAAP. Although the concept of the
'arm's length transaction' has now gone, the market-based current exit price retains the notion of an
exchange between unrelated, knowledgeable and willing parties.
2.3 Scope
IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures. The
measurement and disclosure requirements do not apply in the case of:
(a) Share-based payment transactions within the scope of IFRS 2 Share-based Payment
(b) Leasing transactions within the scope of IAS 17 Leases; and
(c) Net realisable value as in IAS 2 Inventories or value in use as in IAS 36 Impairment of Assets.
Disclosures are not required for:
(a) Plan assets measured at fair value in accordance with IAS 19 Employee Benefits
(b) Plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by
Retirement Benefit Plans; and
(c) Assets for which the recoverable amount is fair value less disposal costs under IAS 36 Impairment
of Assets.
2.4 Measurement
Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets and
liabilities and on exit (selling) prices. It also takes into account market conditions at the measurement
date. In other words, it looks at the amount for which the holder of an asset could sell it and the C
amount which the holder of a liability would have to pay to transfer it. It can also be used to value an H
A
entity's own equity instruments.
P
Because it is a market-based measurement, fair value is measured using the assumptions that market T
E
participants would use when pricing the asset, taking into account any relevant characteristics of the
R
asset.
It is assumed that the transaction to sell the asset or transfer the liability takes place either:
2
(a) In the principal market for the asset or liability; or
(b) In the absence of a principal at market, in the most advantageous market for the asset or liability.
The principal market is the market which is the most liquid (has the greatest volume and level of
activity) for that asset or liability. In most cases the principal market and the most advantageous market
will be the same.
IFRS 13 acknowledges that when market activity declines an entity must use a valuation technique to
measure fair value. In this case the emphasis must be on whether a transaction price is based on an
orderly transaction, rather than a forced sale.
Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of the asset or
liability, but may be taken into account when determining the most advantageous market.
Fair value measurements are based on an asset or a liability's unit of account, which is specified by each
IFRS where a fair value measurement is required. For most assets and liabilities, the unit of account is the
individual asset or liability, but in some instances may be a group of assets or liabilities.
Illustration: Unit of account

A premium or discount on a large holding of the same shares (because the market's normal daily trading
volume is not sufficient to absorb the quantity held by the entity) is not considered when measuring fair
value: the quoted price per share in an active market is used.
However, a control premium is considered when measuring the fair value of a controlling interest,
because the unit of account is the controlling interest. Similarly, any non-controlling interest discount is
considered where measuring a non-controlling interest.
Worked example: principal or most advantageous market

An asset is sold in two active markets, Market X and Market Y, at £58 and £57, respectively. Valor Co
does business in both markets and can access the price in those markets for the asset at the
measurement date as follows.
Market X Market Y
£ £
Price 58 57
Transaction costs (4) (3)
Transport costs (to transport the asset to that market) (4) (2)
50 52
Remember that fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of
the asset or liability, but may be taken into account when determining the most advantageous market.
If Market X is the principal market for the asset (ie the market with the greatest volume and level of
activity for the asset), the fair value of the asset would be £54, measured as the price that would be
received in that market (£58) less transport costs (£4) and ignoring transaction costs.
If neither Market X nor Market Y is the principal market for the asset, Valor must measure the fair value
of the asset using the price in the most advantageous market. The most advantageous market is the
market that maximises the amount that would be received to sell the asset, after taking into account
both transaction costs and transport costs (ie the net amount that would be received in the respective
markets).
The maximum net amount (after deducting both transaction and transport costs) is obtainable in
Market Y (£52, as opposed to £50). But this is not the fair value of the asset. The fair value of the asset is
obtained by deducting transport costs but not transaction costs from the price received for the asset in
Market Y: £57 less £2 = £55.
2.4.1 Non-financial assets

For non-financial assets the fair value measurement looks at the use to which the asset can be put. It
takes into account the ability of a market participant to generate economic benefits by using the asset in
its highest and best use.
2.5 Valuation techniques

IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient
data are available. Entities should maximise the use of relevant observable inputs and minimise the use
of unobservable inputs.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use to measure
fair value:
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting
entity can access at the measurement date
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly, eg quoted prices for similar assets in active markets or for
identical or similar assets in non active markets or use of quoted interest rates for valuation
purposes
Level 3 Unobservable inputs for the asset or liability, ie using the entity's own assumptions about
market exit value.
2.5.1 Valuation approaches

The IFRS identifies three valuation approaches.
(a) Income approach. Valuation techniques that convert future amounts (eg cash flows or income
and expenses) to a single current (ie discounted) amount. The fair value measurement is
determined on the basis of the value indicated by current market expectations about those future
amounts.
(b) Market approach. A valuation technique that uses prices and other relevant information generated
by market transactions involving identical or comparable (ie similar) assets, liabilities or a group of
assets and liabilities, such as a business.
(c) Cost approach. A valuation technique that reflects the amount that would be required currently to
replace the service capacity of an asset (often referred to as current replacement cost).
Entities may use more than one valuation technique to measure fair value in a given situation. A change
of valuation technique is considered to be a change of accounting estimate in accordance with IAS 8,
and must be disclosed in the financial statements.
Examples of inputs used to measure fair value
Asset or liability Input
Level 1 Equity shares in a listed Unadjusted quoted prices in an
company active market
Level 2 Licensing arrangement arising Royalty rate in the contract
from a business combination with the unrelated party at
inception of the arrangement
Cash generating unit Valuation multiple (eg a
multiple of earnings or revenue
or a similar performance
measure) derived from
C
observable market data, eg
H
from prices in observed A
transactions involving P
comparable businesses T
E
Finished goods inventory at a Price to customers adjusted for R
retail outlet differences between the
condition and location of the
inventory item and the 2
comparable (ie similar)
inventory items
Building held and used Price per square metre derived
from observable market data,
eg prices in observed
transactions involving
comparable buildings in similar
locations
Level 3 Cash generating unit Financial forecast (eg of cash
flows or profit or loss)
developed using the entity's
own data
Three-year option on Historical volatility, ie the
exchange-traded shares volatility for the shares derived
from the shares' historical
prices
Interest save swap Adjustment to a mid-market
consensus (non-binding) price
for the swap developed using
data not directly observable or
otherwise corroborated by
observable market data
2.6 Measuring liabilities

Fair value measurement of a liability assumes that the liability is transferred at the measurement date to
a market participant, who is then obliged to fulfil the obligation. The obligation is not settled or
otherwise extinguished on the measurement date.
2.6.1 Entity's own credit risk

The fair value of a liability reflects the effect of non-performance risk, which includes but is not limited
to the entity's own credit risk. This may be different for different types of liabilities.
Illustration: Entity's own credit risk
Black Co and Blue Co both enter into a legal obligation to pay £20,000 cash to Green Co in seven years.
Black Co has a top credit rating and can borrow at 4%. Blue Co's credit rating is lower and it can borrow
at 8%.
Black Co will receive approximately £15,200 in exchange for its promise. This is the present value of
£20,000 in seven years at 4%.
Blue Co will receive approximately £11,700 in exchange for its promise. This is the present value of
£20,000 in seven years at 8%.
2.7 IFRS 13 and business combinations

Fair value generally applies on a business combination. This topic is covered in Chapter 10, together
with some further examples.
2.8 Disclosure
An entity must disclose information that helps users of its financial statements assess both of the
following:
(a) For assets and liabilities that are measured at fair value on a recurring or non-recurring basis, the
valuation techniques and inputs used to develop those measurements.
(b) For recurring fair value measurements using significant unobservable inputs (Level 3), the effect
of the measurements on profit or loss or other comprehensive income for the period. Disclosure
requirements will include:
(i) Reconciliation from opening to closing balances
(ii) Quantitative information regarding the inputs used
(iii) Valuation processes used by the entity
(iv) Sensitivity to changes in inputs
2.9 Was the project necessary?

The IASB is already considering the matter of the measurement basis for assets and liabilities in financial
reporting as part of its Conceptual Framework project. It could therefore be argued that it was not
necessary to have a separate project on fair value. The Conceptual Framework might have been the more
appropriate forum for discussing when fair value should be used as well as how to define and
measure it.
However, it has been argued that a concise definition and clear measurement framework is needed
because there is so much inconsistency in this area, and this may form the basis for discussions in the
Conceptual Framework project.
The IASB has also pointed out that the global financial crisis has highlighted the need for:
 Clarifying how to measure fair value when the market for an asset becomes less active; and
 Improving the transparency of fair value measurements through disclosures about measurement
uncertainty.
2.9.1 Advantages and disadvantages of fair value (versus historical cost)
Fair value
Advantages Disadvantages
 Relevant to users' decisions  Subjective (not reliable)
 Consistency between companies  Hard to calculate if no active market
C
 Predicts future cash flows  Time and cost H
A
 Lack of practical experience/familiarity P
T
 Less useful for ratio analysis (bias) E
R
 Misleading in a volatile market
Historical cost
 Reliable  Less relevant to users' decisions
 Less open to manipulation  Need for additional measure of
recoverable amounts (impairment test)
 Quick and easy to ascertain
 Does not predict future cash flows
 Matching (cost and revenue)
 Practical experience & familiarity
3 IAS 18 Revenue
Section overview
 IAS 18 governs the recognition of revenue in general and in specific (common) types of
transaction. Generally, recognition should be when it is probable that future economic benefits
will flow to the entity and when these benefits can be measured reliably.
 Income, as defined by the IASB's Framework, includes both revenues and gains. Revenue is income
arising in the ordinary course of an entity's activities and it may be called different names, such as
sales, fees, interest, dividends or royalties.
 There are problems associated with revenue recognition, and proposals to remedy those problems
are being considered.
3.1 Measurement of revenue

The amount of revenue is usually decided by the agreement of the buyer and seller. Revenue is
measured as the fair value of the consideration received.
3.2 Sale of goods
Revenue from the sale of goods should only be recognised when:
 The entity has transferred the significant risks and rewards of ownership of the goods to the
buyer
 The entity has no continuing managerial involvement to the degree usually associated with
ownership, and no longer has effective control over the goods sold
 The amount of revenue can be measured reliably
 It is probable that the economic benefits associated with the transaction will flow to the entity
 The costs incurred in respect of the transaction can be measured reliably
If significant risks and rewards remain with the seller the transaction is not a sale and revenue cannot be
recognised.
Rendering of services
When the outcome of a transaction involving the rendering of services can be estimated reliably, the
associated revenue should be recognised by reference to the stage of completion of the transaction at
the reporting date.
The outcome of a transaction can be estimated reliably when:
 The amount of revenue can be measured reliably
 It is probable that the economic benefits associated with the transaction will flow to the entity
 The stage of completion of the transaction at the reporting date can be measured reliably
 The costs incurred for the transaction and the costs to complete the transaction can be measured
reliably
When services are performed by an indeterminate number of acts over a period of time, revenue should
normally be recognised on a straight-line basis. If one act is of more significance than the others, then
the significant act should be carried out before revenue is recognised.
When the outcome of the transaction involving the rendering of services cannot be estimated reliably,
revenue is recognised only to the extent of the expenses recognised that are recoverable.
Interest, royalties and dividends
Revenue should be recognised when:
 It is probable that the economic benefits associated with the transaction will flow to the entity; and
 The amount of the revenue can be measured reliably.
3.3 Disclosure
 Accounting policies
 Amount of each significant category of revenue recognised during the period
 Amount of revenue from exchanges of goods or services included in each significant category of
revenue
IAS 18 is generally agreed to be out of date. It does not address the relatively complex transactions that
now take place, for example, barter transactions, transactions involving options, sales of licences for the
use of computer software. This lack of specific guidance has led to aggressive earnings management:
creative accounting techniques whereby revenue is recognised before it has been earned.
The IASB has a current project to develop a new standard, but this is at an early stage. In the meantime
the general principles of IAS 18 and of the IASB Framework should be applied.
At Advanced level, revenue recognition may relate to issues of off-balance sheet finance, substance over
form or creative accounting.
Interactive question 10: Recognition [Difficulty level: Intermediate]
Given that prudence is the main consideration, discuss under what circumstances, if any, revenue might
be recognised at the following stages of a sale.
(a) Goods are acquired by the business which it confidently expects to resell very quickly.
(b) A customer places a firm order for goods.
(c) Goods are delivered to the customer.
(d) The customer is invoiced for goods.
(e) The customer pays for the goods.
(f) The customer's cheque in payment for the goods has been cleared by the bank.
C
H
A
Interactive question 11: More revenue recognition [Difficulty level: Intermediate] P
T
Caravans Deluxe is a retailer of caravans, dormer vans and mobile homes, with a year end of 30 June. It E
is having trouble selling one model – the £30,000 Mini-Lux, and so is offering incentives for customers R
who buy this model before 31 May 20X7:
(a) Customers buying this model before 31 May 20X7 will receive a period of interest free credit,
2
provided they pay a non-refundable deposit of £3,000, an instalment of £15,000 on 1 August
20X7 and the balance of £12,000 on 1 August 20X9.
(b) A three-year service plan, normally worth £1,500, is included free in the price of the caravan.
On 1 May 20X7, a customer agrees to buy a Mini-Lux caravan, paying the deposit of £3,000. Delivery is
arranged for 1 August 20X7.
As the sale has now been made, the sales director of Caravans Deluxe wishes to recognise the full sale
price of the caravan, £30,000, in the financial statements for the year ended 30 June 20X7.
Requirement
Advise the director of the correct accounting treatment for this transaction. Assume a 10% discount
rate. Show the journal entries for this treatment.
3.4 IFRIC 12 Service concession arrangements

3.4.1 What is a service concession arrangement?
Service concession arrangements are arrangements whereby a government or other body grants
contracts for the supply of public services – such as roads, energy distribution, prisons or hospitals – to
private operators. The objective of IFRIC 12 is to clarify how certain aspects of existing IASB literature are
to be applied to service concession arrangements.
3.4.2 The two types of arrangement

IFRIC 12 draws a distinction between two types of service concession arrangement.
(a) In one, the operator receives a financial asset, specifically an unconditional contractual right to
receive cash or another financial asset from the government in return for constructing or upgrading
the public sector asset.
(b) In the other, the operator receives an intangible asset – a right to charge for use of the public
sector asset that it constructs or upgrades. A right to charge users is not an unconditional right to
receive cash because the amounts are contingent on the extent to which the public uses the
service.
IFRIC 12 allows for the possibility that both types of arrangement may exist within a single contract: to
the extent that the government has given an unconditional guarantee of payment for the construction
of the public sector asset, the operator has a financial asset; to the extent that the operator has to rely
on the public using the service in order to obtain payment, the operator has an intangible asset.
3.4.3 Accounting – Financial asset model

The operator recognises a financial asset to the extent that it has an unconditional contractual right to
receive cash or another financial asset from or at the direction of the grantor for the construction
services. The operator has an unconditional right to receive cash if the grantor contractually guarantees
to pay the operator
(a) Specified or determinable amounts or
(b) The shortfall, if any, between amounts received from users of the public service and specified or
determinable amounts, even if payment is contingent on the operator ensuring that the
infrastructure meets specified quality or efficiency requirements.
The operator measures the financial asset at fair value.
3.4.4 Accounting – Intangible asset model

The operator recognises an intangible asset to the extent that it receives a right (a licence) to charge
users of the public service. A right to charge users of the public service is not an unconditional right to
receive cash because the amounts are contingent on the extent that the public uses the service.
The operator measures the intangible asset at fair value.
3.4.5 Operating revenue

The operator of a service concession arrangement recognises and measures revenue in accordance with
IASs 11 and 18 for the services it performs.
3.5 IFRIC 13 Customer loyalty programmes

The issue
IFRIC 13 Customer loyalty programmes addresses accounting by entities that grant loyalty award credits
(such as 'points' or travel miles) to customers who buy other goods or services. Specifically, it explains
how such entities should account for their obligations to provide free or discounted goods or services
('awards') to customers who redeem award credits.
Key provisions
(a) An entity that grants loyalty award credits shall allocate some of the proceeds of the initial sale to
the award credits as a liability (its obligation to provide the awards). In effect, the award is
accounted for as a separate component of the sale transaction.
(b) The amount of proceeds allocated to the award credits is measured by reference to their fair value,
that is, the amount for which the award credits could have been sold separately.
(c) The entity shall recognise the deferred portion of the proceeds as revenue only when it has fulfilled
its obligations. It may fulfil its obligations either by supplying the awards itself or by engaging (and
paying) a third party to do so.
(d) If at any time the expected costs of meeting the obligation exceed the consideration received, the
entity has an onerous contract for which IAS 37 would require recognition of a liability.
(e) If IFRIC 13 causes an entity to change its accounting policy for customer loyalty awards, IAS 8
applies.
Illustration: Customer loyalty programmes

During July and August 20X8 Sagefoot introduced a customer loyalty programme on a trial basis.
Customers were granted points when they spent a certain amount in the company's stores. Once a
customer has collected a certain number of points, these can be exchanged for further goods, provided
that this is done before 31 December 20X8. The scheme did not appear to increase revenue
significantly, and so it was discontinued after the end of August 20X8. During the period covered by the
scheme, customers were granted 650,000 points. Each point has a fair value of £20 and at 30
September 20X8 125,000 points had been redeemed. Management has no previous experience of
customer loyalty schemes of this type. Through research it has established that where retailers operate
ongoing loyalty schemes, approximately 20% of points are never redeemed.
What is the correct treatment for the customer loyalty programme?
Solution
The total fair value of the points issued is £13,000,000 (650,000 × £20) and the best estimate would
appear to be that 520,000 (80% × 650,000) of these will be redeemed.
To recognise revenue in line with IFRIC 13, this should be apportioned by taking the number of points
redeemed in the period over the total number of points expected to be redeemed. The revenue to be
recognised in the year is £3,125,000 (125,000/520,000), leaving £9,875,000 (£13,000,000 – C
£3,125,000) as a deferred revenue liability at the year end. H
A
P
T
E
3.6 Principal or agent? R
Previously IAS 18 covered the accounting treatment for amounts collected by an agent on behalf of a
principal, which is: recognise only the commission as revenue (not the amounts collected on behalf of
the principal). However, it did not give guidance on determining whether an entity is acting as agent or 2
principal.
In 2009, the IASB issued some improvements to various IFRS, most of which are minor. The change
which is relevant here is the additional guidance in the appendix to IAS 18 Revenue on determining
whether an entity is acting as an agent or principal. The new guidance is as follows:
Acting as principal
An entity is acting as a principal when it is exposed to the significant risks and rewards associated with
the sale of goods or rendering of services. Features that indicate that an entity is acting as a principal
include (individually or in combination):
(a) Primary responsibility for providing goods or services to the customer or for fulfilling the order
(b) The entity having the inventory risk before or after the customer order, during shipping or on
return
(c) Discretion in establishing prices (directly or indirectly) eg providing additional goods or services
(d) The entity bearing the customer's credit risk.
Acting as agent
An entity is acting as an agent when it is not exposed to the significant risks and rewards associated with
the sale of goods or rendering of services. One feature that indicates that an entity is an agent is that the
amount the entity earns is predetermined eg fixed fee per transaction or percentage of amount billed to
the customer.
3.7 Current developments: Exposure Draft: Revenue recognition in contracts

with customers
Note. You will not be tested in detail on the material in this Section, but you need to be aware of the
issues involved.
3.7.1 Reasons for the ED

The IASB and US Financial Accounting Standards Board (FASB) are undertaking a joint project to
develop a new revenue recognition standard.
In US GAAP, there are more than 100 revenue recognition standards which produce results for different
industries which are sometimes inconsistent with each other. In International GAAP, there are only two
standards (IAS 11 and IAS 18), but they are inconsistent and vague.
The ED was issued in June 2010, following a 2008 Discussion Paper and re-exposed with some
modifications in November 2011.
3.7.2 Proposed approach
 Step 1. Identify the contract with the customer. Identifying a contract is usually straightforward,
as there will be a written agreement or an alternative according to normal business practice. The
entity would normally treat each contract separately, but there are cases where they might
combine them. The key point is price interdependence. Usually a company would apply the
proposals to a single contract. However, in some cases the company would account for two or
more contracts together if the prices of those contracts are interdependent. Conversely, a company
would segment a single contract and account for it as two or more contracts if some goods or
services are priced independently of other goods and services.
 Step 2. Identify the separate performance obligations. The key point is distinct goods or
services. A contract includes promises to provide goods or services to a customer. Those promises
are called performance obligations. A company would account for a performance obligation
separately only if the promised good or service is distinct. A good or service is distinct if it is sold
separately or if it could be sold separately because it has a distinct function and a distinct profit
margin.
 Step 3. Determine the transaction price. The key proposal is a probability weighted expected
amount. The transaction price is the amount of consideration a company expects to be entitled to
from the customer in exchange for transferring goods or services. The transaction price would
reflect the company's probability-weighted estimate of variable consideration (including reasonable
estimates of contingent amounts) in addition to the effects of the customer's credit risk and the
time value of money (if material).
 Step 4. Allocate the transaction price to the performance obligations. The key proposal is
relative selling price allocation. A company would allocate the transaction price to all separate
performance obligations in proportion to the stand-alone selling price of the good or service
underlying each performance obligation. If the good or service is not sold separately, the company
would estimate its stand-alone selling price.
 Step 5. Recognise revenue when a performance obligation is satisfied. A company would
recognise revenue when it satisfies a performance obligation by transferring the promised good or
service to the customer. The good or service is transferred when the customer obtains control of
the promised good or service. An indicator of this is when the customer has the risks and rewards
of ownership.
The amount of revenue recognised is the amount allocated to that performance obligation in Step 4.
3.7.3 Additional guidance

The proposed standard gives guidance on cost:
A company would recognise the costs of obtaining a contract (eg selling and marketing costs) as
expenses when incurred. If the costs incurred in fulfilling a contract are not eligible for recognition as an
asset in accordance with other standards (eg inventory), the company would recognise an asset only if
those costs:
(a) Relate directly to a contract
(b) Relate to future performance under the contract and
(c) Are expected to be recovered.
The proposed standard would also contain enhanced disclosure requirements to help users of financial
statements better understand the amount, timing and uncertainty of revenue and cash flows from
contracts with customers. Those proposals would require a company to disclose qualitative and
quantitative information about:
(a) its contracts with customers, including a maturity analysis for contracts extending beyond one year
(b) the significant judgements, and changes in judgements, made in applying the proposed standard
to those contracts.
3.7.4 Key effects of the proposed approach

(a) Revenue would be recognised only in the transfer of goods or services to a customer. This
proposal would affect some long-term contracts currently accounted for using a percentage of
completion method when the customer does not receive goods or services continuously (eg some
construction and some software development contracts). Under the proposal, a company would
apply the percentage of completion method of revenue recognition only if the company transfers
services to the customer throughout the contract – ie if the customer owns the work in progress as
it is built or developed.
(b) Separate performance obligations would be recognised for distinct goods or services. This
proposal could result in some revenue being attributed to goods or services that are now
considered incidental to the contract – for instance, to mobile phones that are provided free of
charge with airtime contracts and to some post-delivery services, such as maintenance and
installation.
(c) Probability weighted estimates would be required of the consideration to be received. This
could result in a company recognising some revenue on the transfer of a good or service, even if
the consideration amount is contingent on a future event – for example, an agent that provides
C
brokerage services in one period in exchange for an amount of consideration to be determined in H
future periods, depending on the customer's behaviour. A
P
(d) A customer's credit risk would be reflected in the measurement of revenue. This could result in T
a company recognising some revenue when it transfers a good or service to a customer even if E
there is uncertainty about the collectability of the consideration, rather than deferring revenue R
recognition until the consideration is collected.
(e) The transaction price will be allocated in proportion to the stand-alone selling price. This will
2
affect some existing practices, particularly in the software sector, that currently result in the deferral
of revenue if a company does not have objective evidence of the selling price of a good or service
to be provided.
(f) Contract acquisition costs are to be expensed. This proposal would affect companies that
currently capitalise such costs – for example, commissions and other directly incremental costs –
and amortise them over the contract period.
Summary
IAS 16 Property, Plant and Equipment
Definition Recognition Depreciation
Measurement at recognition Measurement after

· Purchase price recognition
· Directly attributable costs
· Finance costs
Cost Revaluation
model model
IAS 38 Intangible Assets
Amortisation/
Definition Recognition
impairment test
Finite useful Indefinite useful

life life
Measurement at Measurement after

recognition recognition
Cost Revaluation
model model
Acquired in Acquisition by Internally Internally

Separate Exchanges
business way of a generated generated
acquisition of assets
combination government grant goodwill intangibles
IAS 2 Inventories
Value at FIFO
lower of AVCO/WACC
Cost including Net

all costs of realisable
purchase/production value
C
H
IAS 11 Construction Contracts A
P
T
E
R
Stage of completion Not measured reliably:
Measured
Costs basis recognise revenue to
reliably
Work certificate extent costs to date
2
are recoverable
Profitable: recognise Loss making: recognise

revenue and profit loss in full immediately
according to stage
of completion
IAS 36 Impairments
Impairment CGUs
Indicators
= Notional goodwill for NCI
carrying value - recoverable amount Allocate any loss to goodwill
then other assets on pro rata basis
IFRS 13 Fair Value
Measurement
Definition of fair value 3 - level hierarchy: Valuation

- Market participants Level 1 - quoted prices in approaches
- Orderly transaction active markets
- Marked-based not Level 2 - other observable
entity-based inputs
Level 3 - unobservable
inputs
Disclosures
IAS 18 Revenue
Sale
Sale og
of goods
goods
Rendering
Sale ogofgoods
services
Other
Sale ogrevenue
goods
SaleIFRIC
og goods
12
SaleIFRIC
og goods
13
Self-test
IAS 2 Inventories
1 Reapehu
The Reapehu Company manufactures a single type of concrete mixing machine, which it sells to
building companies. Reapehu is currently considering the value of its inventories at 31 December
20X7. The following data are relevant at this date:
Cost per item £ C
Variable production costs 200,000 H
Fixed production costs 40,000 A
240,000 P
T
There are 85 mixing machines held in inventory. E
R
The company has a contract to sell 15 concrete mixing machines at £225,000 each to a major
local building company in January 20X8. The normal selling price is £260,000 per machine. Selling
costs are minimal. 2
Requirement
What is the value of Reapehu's inventory at 31 December 20X7, according to IAS 2 Inventories?
2 Utah
The Utah Company manufactures motors for domestic refrigerators. A major customer is The
Bushbaby Company, which is a major international electrical company making refrigerators as one
of its products.
Utah is currently preparing its financial statements for the year to 31 December 20X7 and it
expects to authorise them for issue on 3 March 20X8.
Utah holds significant inventories of motors (which are unique to the Bushbaby contract) as
Bushbaby require to be supplied on a just-in-time basis and has variable production schedules.
On 3 January 20X8, Bushbaby announced that it was fundamentally changing the design of its
refrigerators and that, while this had been planned for some time, it had not been possible to warn
Utah for reasons of commercial confidentiality. As a consequence, it would cease to use Utah's
motors from 30 April 20X8 and would reduce production prior to that date. Details for Utah are as
follows:
Number of motors held in inventory at 31 December 4,000 motors
Expected sales in the four months to 30 April 20X8 1,600 motors
Net selling price per motor sold to Bushbaby £50
Net selling price per motor unsold at 30 April 20X8 £10
Cost per motor £25
Requirement
At what value should the inventories of motors be stated by Utah in its statement of financial
position at 31 December 20X7 according to IAS 2 Inventories, and IAS 10 Events after the Reporting
Period?
IAS 11 Construction Contracts
3 Polikeman
During 20X6 The Polikeman Company was one of a number of entities negotiating for a major
contract to build a new motorway in 20X7-20X8. On 1 January 20X7 Polikeman was identified as
the preferred bidder, and negotiations with all other bidders were stopped.
There were a number of environmental objections to the motorway over a significant period.
Polikeman therefore incurred substantial costs in securing the contract by providing evidence to
the government and specification issues. The costs clearly related to this contract and fell into two
stages as follows:
Year to 31 December 20X6 Stage 1 Feasibility and initial review of environmental impact
Year to 31 December 20X7 Stage 2 Detailed specification of contract and detailed evidence
of environmental impact
The contract was awarded to Polikeman in December 20X7.
Requirement
Which of the pre-contract costs can be treated as attributable to the construction contract
according to IAS 11 Construction Contracts?
4 Diborane
At the start of 20X6 The Diborane Company negotiated a fixed price contract of £14.0 million with
The Benzidine Company for the construction of a container port. Diborane had estimated the costs
of the contract to be £13.3 million. Diborane estimates the stage of completion on its construction
contracts by reference to the physical proportion of the work completed.
During 20X6 the contract suffered protracted delays and difficulties, such that Diborane concluded
that there would be material cost overruns. It negotiated with Benzidine to try to get some
recompense for these unexpected difficulties in the form of contract variations, but without
success. At 31 December 20X6 when the contract was 30% physically complete, the costs incurred
amounted to £4.9 million and the costs to complete were estimated at £11.2 million.
Throughout 20X7 Diborane continued to try to win recompense from Benzidine, but without
success. At 31 December 20X7 when the contract was 80% physically complete, the costs incurred
amounted to £12.6 million and the costs to complete were estimated at £3.5 million. On that day
and after these figures had been drafted, Benzidine suddenly agreed in principle to a contract
variation of £3.5 million, provided that Diborane agreed to pay Benzidine a penalty for late
completion of £280,000. Diborane agreed to these terms and the relevant adjustments were made
to the draft figures.
Requirement
Determine the following amounts in respect of the container port contract in Diborane's financial
statements according to IAS 11 Construction Contracts.
(a) The profit or loss to be recognised in the year ended 31 December 20X6
(b) The revenue to be recognised in the year to 31 December 20X7
(c) The profit or loss to be recognised in the year ended 31 December 20X7
5 Niobium
The Niobium Company operates in the petrol refining industry. A fire at a competitor using similar
plant has revealed a safety problem and the government has introduced new regulations requiring
the installation of new safety equipment in the industry. The refinery had a carrying amount of £30
million prior to the installation of the safety equipment. The new safety equipment cost £5 million
and was fully operational at 31 December 20X7, but it does not generate any future economic
benefits. The refinery would, however, be closed down without such equipment being installed.
At 31 December 20X7 the net selling price of the refinery was estimated at £33 million. In
determining its value in use, the directors have determined that the refinery would generate annual
cash flows of £3.2 million from next year in perpetuity, to be discounted at 10% per annum.
Requirement
According to IAS 16 Property, Plant and Equipment, what is the carrying amount of the refinery in
Niobium's statement of financial position at 31 December 20X7?
6 Oruatua
The Oruatua Company acquired a piece of machinery for £800,000 on 1 January 20X6. It identified
that the asset had three major components as follows:
Component Useful life Cost
£'000
Pump 5 years 110
Filter 4 years 240
Engines 15 years 450
Under the terms of the 15-year licence agreement for the use of the machinery, the engines (but
not the other components) were to be dismantled at the end of the licence period. The machinery
contained three engines, and dismantling costs for all three engines were initially estimated at a
total cost of £480,000 (ie £160,000 per engine) payable in 15 years' time. Oruatua's discount rate C
appropriate to the risk specific to this liability is 7% per annum. H
A
One of the three engines developed a fault on 1 January 20X7 and had to be sold for scrap for P
£40,000. A replacement engine was purchased at a cost of £168,000 on 1 January 20X7, for use T
until the end of the licence period, when dismantling costs on this engine estimated at £150,000 E
would be payable. R
At a rate of 7% per annum the present value of £1 payable in 15 years' time is 0.3624 and of £1
payable in 14 years' time is 0.3878. 2
Requirement
Calculate the following figures for inclusion in Oruatua's financial statements for the year ended 31
December 20X7 according to IAS 16 Property, Plant and Equipment, and IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
(a) The carrying amount of the machinery at 31 December 20X6
(b) The profit/loss on the disposal of the faulty engine
(c) The carrying amount of the machinery at 31 December 20X7
IAS 36 Impairment of Assets
7 Antimony
The Antimony Company acquired its head office on 1 January 20W8 at a cost of £5.0 million
(excluding land). Antimony's policy is to depreciate property on a straight-line basis over 50 years
with a zero residual value.
On 31 December 20X2 (after five years of ownership) Antinomy revalued the non-land element of
its head office to £8.0 million. Antinomy does not transfer annual amounts out of revaluation
reserves as assets are used: this is in accordance with the permitted treatment in IAS 16 Property,
Plant and Equipment.
In January 20X8 localised flooding occurred and the recoverable amount of the non-land element
of the head office property fell to £2.9 million.
Requirement
What impairment charge should be recognised in the profit or loss of Antimony arising from the
impairment review in January 20X8 according to IAS 36 Impairment of Assets?
8 Sundew
The Sundew Company is a vertically integrated manufacturer of chain-saws. It has two divisions.
Division X manufactures engines, all of which are identical. Division Y assembles complete chain-
saws and sells them to third party dealers.
Division X, a cash-generating unit, sells to Division Y at cost price but sells to other chain-saw
manufacturers at cost plus 50%. Details of Division X's budgeted revenues for the year ending 31
December 20X7 are as follows:
Engines Price per engine
Sales to Division Y 2,500 £1,000
Third party sales 1,500 £1,500
Requirement
What are the 20X7 cash inflows which should be used in determining the value in use of Division X
according to IAS 36 Impairment of Assets?
9 Cowbird
The Cowbird Company operates in the television industry. It acquired a licence to operate in a
particular region for 20 years at a cost of £10 million on 31 December 20X3. Cowbird's policy was
to amortise the fee paid for the licence on a straight-line basis.
By 31 December 20X5 it had become apparent that Cowbird had overpaid for the licence and,
measuring recoverable amount by reference to value in use, it recognised an impairment charge of
£4.05 million, leaving a carrying amount of £4.95 million.
At 31 December 20X7 the market place had improved, such that the conditions giving rise to the
original impairment no longer existed. The recoverable amount of the licence by reference to value
in use was now £11 million.
Requirement
What should be the carrying amount of the licence in the statement of financial position of
Cowbird at 31 December 20X7, according to IAS 36 Impairment of Assets?
10 Acetone
The Acetone Company is testing for impairment two subsidiaries which have been identified as
separate cash-generating units.
Some years ago Acetone acquired 80% of The Dushanbe Company for £600,000 when the fair
value of Dushanbe's identifiable assets was £400,000. As Dushanbe's policy is to distribute all
profits by way of dividend, the fair value of its identifiable net assets remained at £400,000 on 31
December 20X7. The impairment review indicated Dushanbe's recoverable amount at 31
December 20X7 to be £520,000.
Some years ago Acetone acquired 85% of The Maclulich Company for £800,000 when the fair
value of Maclulich's identifiable net assets was £700,000. Goodwill of £205,000 (£800,000 –
(£700,000  85%)) was recognised. As Maclulich's policy is to distribute all profits by way of
dividend, the fair value of its identifiable net assets remained at £700,000 on 31 December 20X7.
The impairment review indicated Maclulich's recoverable amount at 31 December 20X7 to be
£660,000.
It is Acetone group policy to value the non-controlling interest using the proportion of net assets
method.
Requirement
Determine the following amounts in respect of Acetone's consolidated financial statements at
31 December 20X7 according to IAS 36 Impairment of Assets.
(a) The carrying amount of Dushanbe's assets to be compared with its recoverable amount for
impairment testing purposes
(b) The carrying amount of goodwill in respect of Dushanbe after the recognition of any
impairment loss
(c) The carrying amount of the non-controlling interest in Maclulich after recognition of any
impairment loss.
11 Titanium
On 1 January 20X7 The Titanium Company acquired the copyright to four similar magazines, each
with a remaining legal copyright period for 10 years. At the end of the legal copyright period,
other publishing companies will be allowed to tender for the copyright renewal rights.
At 31 December 20X7 the following information was available in respect of the assets:
Remaining period over which Value in active
Copyright cost at publication is expected to market at 31
Publication name 1 January 20X7 generate cash flows at 1 December 20X7
January 20X7
Dominoes £900,000 6 years £700,000
Billiards £1,200,000 16 years £1,150,000
Skittles £1,700,000 8 years Unknown
Darts £1,400,000 Indefinite £2,100,000
Titanium uses the revaluation model as its accounting policy in relation to intangible assets.
Requirement
C
What is the total charge to profit or loss for the year ended 31 December 20X7 in respect of these H
intangible assets per IAS 38 Intangible Assets? A
P
12 Lewis T
E
The following issues have arisen in relation to business combinations undertaken by the Lewis R
Company.
(a) Lewis acquired the trademark of a type of wine when it acquired 80% of the ordinary share
capital of The Calcium Company on 1 April 20X7. This wine is produced from a vineyard that 2
is exclusively used by Calcium.
(b) When Lewis bought a football club on 1 May 20X7, it acquired the registrations of a group of
football players.
(c) Lewis acquired a 75% share in the Stilt Company during 20X7. At the acquisition date Stilt
was researching a new pharmaceutical product which is expected to produce future economic
benefits.
The cost of these assets can be measured reliably.
Requirement
Indicate which of the above items should or should not be recognised as assets separable from
goodwill in Lewis's statement of financial position at 31 December 20X7, according to IAS 38
Intangible Assets.
13 Diversified group
The following issues have arisen within a diversified group of businesses.
(a) The Thrasher Company has signed a three-year contract with a team of experts to write
questions for a computer based examination on International Financial Reporting Standards.
The contract states that the experts cannot work on similar projects for rival entities. Thrasher
incurred costs of £5,000 in training the experts to use the software, and believes that the
product developed by the team will be a market leader.
(b) The Curium Company has a loyalty card scheme for customers. Every customer purchase is
recorded in such a way that Curium is able to create a profile of spending amounts and habits
of customers, and uses this to target them with special offers and discounts to encourage
repeat business. The database has cost £60,000 to create and Curium has been approached
by another company wishing to buy the contents of the database.
Requirement
Which of the above items should be classified as intangible assets per IAS 38 Intangible Assets?
14 Cadmium
The Cadmium Company produces a globally recognised dog food that is a market leader. The
trademark was established over 50 years ago and is renewable every eight years. The last renewal
was effective from 1 January 20X2 and cost £65,000. Cadmium intends to continue to renew the
trademark in future years.
Cadmium uses the revaluation model where allowed for measuring intangible assets, in accordance
with IAS 38 Intangible Assets. A valuation of £50 million was made by an independent valuation
expert on 31 December 20X7, who charged £650,000 for the valuation report.
Requirement
What is the carrying amount of the trademark in Cadmium's statement of financial position at 31
December 20X7 per IAS 38 Intangible Assets?
15 Piperazine
The Piperazine Company's financial reporting year ends on 31 December. It has adopted the
revaluation model for intangible assets and revalues them on a regular three-year cycle. For
intangibles with a finite life Piperazine transfers the relevant amount from revaluation reserve to
retained earnings each year.
During 20X4 Piperazine incurred £70,000 on the process of preparing an application for licences
for 15 taxis to operate in a holiday resort where, in order to prevent excessive traffic pollution, the
licensing authority only allowed a small number of taxis to operate. The outcome of its application
was uncertain up to 30 November 20X4 when the local authority accepted its application. In
December 20X4 Piperazine incurred a total cost of £9,000 in registering its licences. The licences
were for a period of nine years from 1 January 20X5. The licences are freely transferable and an
active market in them exists. The fair value of the licences at 31 December 20X4 was £9,450 per
taxi and Piperazine carried them at fair value in its statement of financial position at 31 December
20X4.
At 31 December 20X7 Piperazine undertook its regular revaluation. On that date the licensing
authority announced that it would triple the number of licences offered to taxi operators and there
were transactions in the active market for licences with six years to run at £4,500.
Requirement
Determine the following amounts in respect of the revaluation reserve in respect of these taxi
licences in Piperazine's financial statements according to IAS 38 Intangible Assets.
(a) The balance at 31 December 20X4
(b) The balance at 31 December 20X7 before the regular revaluation
(c) The balance at 31 December 20X7 after the regular revaluation
IFRS 13 Fair Value Measurement
16 Vitaleque
Vitaleque, a public limited company, is reviewing the fair valuation of certain assets and liabilities in
light of the introduction of IFRS 13 Fair Value Measurement.
It carries an asset that is traded in different markets and is uncertain as to which valuation to use.
The asset has to be valued at fair value under International Financial Reporting Standards. Vitaleque
currently only buys and sells the asset in the African market. The data relating to the asset are set
out below.
Year to 30 November 20X2 North American market European market African market
Volume of market – units 4 million 2 million 1 million
Price £19 £16 £22
Costs of entering the £2 £2 £3
market
Transaction costs £1 £2 £2
Additionally, Vitaleque had acquired an entity on 30 November 20X2 and is required to fair value a
decommissioning liability. The entity has to decommission a mine at the end of its useful life,
which is in three years' time. Vitaleque has determined that it will use a valuation technique to
measure the fair value of the liability. If Vitaleque were allowed to transfer the liability to another
market participant, then the following data would be used.
Input Amount
Labour and material cost $2 million
Overhead 30% of labour and material cost
Third party mark-up – industry average 20%
Annual inflation rate 5%
Risk adjustment – uncertainty relating to cash 6%
flows
Risk-free rate of government bonds 4%
Entity's non-performance risk 2%
Jayach needs advice on how to fair value the liability.
Requirement
Discuss, with relevant computations, how Jayach should fair value the above asset and liability
C
under IFRS 13. H
A
IAS 18 Revenue P
17 Laka T
E
On 30 June 20X7 the Laka Company sells kitchen appliances for £4,400, on the basis that a 20% R
deposit is paid on the same date and the balance in a single payment after 24 months' free credit.
Currently the yield on high quality corporate bonds is 6.5% and the rate for an issuer with a credit 2
rating similar to that of the borrower is 8.0% per annum.
Requirement
What is the total amount of income to be recognised under IAS 18 Revenue, by Laka in its
statement of comprehensive income for the year ended 31 December 20X7?
18 Renpet
The Renpet Company operates a franchise system whereby, at the commencement of a franchise,
a franchisee signs two contracts each with a separate fee. The financial terms of the two contracts
are as follows:
(1) The £36,000 fee receivable at the time the first contract is signed covers Renpet's initial set-up
costs and the provision to the franchisee of certain equipment with a fair value of £19,000.
40% of the equipment is delivered to the franchisee when the contract is signed, the
remainder 8 months later and title passes on delivery.
(2) The £9,000 fee receivable at the time the second contract is signed is the first annual fee and
covers the provision of continuing support services. This fee is set at the cost of these services
to Renpet. The fair value of the services is £12,000, which reflects a reasonable profit.
Requirement
According to IAS 18 Revenue, what revenues should Renpet recognise in its financial statements for
the year ended 31 December 20X7 in respect of the £45,000 receivable for a franchise
commencing on 1 September 20X7?
19 Baros
Under a single four-month contract with one of its customers, the Baros Company is obliged to
produce a package of six advertisements for television and to purchase airtime for their broadcast.
Under the contract Baros will receive the £5.4 million fair value for the production of all six
advertisements (on which it expects to incur £4.32 million costs), and a 10% commission on the
£40,000 airtime cost of each broadcast. Each advertisement is to be broadcast 30 times.
Baros's financial year end fell half way through the four-month contract period, at which point
production of four advertisements was complete and work on the other two had not started. By
the year end, booking had been made for two of the advertisements to be broadcast 30 times
each. 15 of these broadcasts for each of the two advertisements had been transmitted by the year
end.
Requirement
According to IAS 18 Revenue, what revenue should Baros recognise in its financial statements for its
year just ended?
20 Health club
The terms for taking up membership of a health club included the requirement to pay a one-off
non-returnable membership fee of £3,000. In exchange, the club offers new members the right
over the first 6 months of their membership to buy equipment with a list price of £1,200 at a
discount of 20%.
On 1 October 20X7, 100 new members joined on these terms. Recent experience is that 40% of
new members take advantage of the offer of discounted equipment, making their £1,200 of
equipment purchases evenly over the relevant period.
Requirement
According to IAS 18 Revenue, what revenue should the club recognise in its financial statements for
the year ended 31 December 20X7 in relation to the £300,000 membership fees?
21 Pears
The Pears Company operates a mobile phone network. On 1 January 20X7 it introduced a new
retail package which combined a 'free' mobile phone, an annual airtime subscription to the
network and 80 'free' minutes per month. Customers will pay £140 per quarter payable in advance
on the first day of each quarter.
The mobile phone has a retail value of £220 and the annual airtime subscription to the network is
sold separately at £50.
Pears has detailed historical records of 'free' minute usage on other price plans. On average 720 of
'free' minutes are used each year by customers. Each 'free' minute has an average call charge value
of £1 if paid for separately. The expected usage of 'free' minutes by quarter is as follows:
Quarter Minutes
January to March 175
April to June 125
July to September 190
October to December 230
720
Requirement
In accordance with IAS 18 Revenue, calculate the following amounts for a customer who subscribes
to a retail package on 1 January 20X7.
(a) The revenue recognised in respect of the mobile phone sale on 1 January.
(b) The revenue recognised for the airtime subscription and 'free' minutes in the six months to
30 June 20X7.
(c) The asset or liability recognised in the statement of financial position of Pears on 30 June 20X7
in respect of the contract.
22 Eco-Ergonom
Eco-Ergonom plc is an AIM quoted company which manufactures ergonomic equipment and
furniture and environmentally friendly household products. You are the Financial Controller, and
the accounting year-end is 31 December 20X7.
It is now 15 March 20X8, and the company's auditors are currently engaged in their work.
Deborah Carroll, the Finance Director, is shortly to go into a meeting with the Audit Engagement
Partner, Brian Nicholls, to discuss some unresolved issues relating to company assets. To save her
time, she wants you to prepare a memorandum detailing the correct accounting treatment. She
has sent you the following email, in which she explains the issues:
To: Financial Controller
From: Deborah Carroll
Date: 15 March 20X8
Subject: Assets
As a matter of urgency, I need you to prepare a memorandum on the correct accounting
treatment of the items below, so that I can discuss this with the auditors.
Stolen lorries
As you know, we acquired a wholly owned subsidiary, a small road-haulage company, on 1 January
20X7 to handle major deliveries once we start producing larger items. So far, it has proved more
profitable to hire out its services to other companies, so the company is a cash-generating unit. We
paid £460,000 for the business, and the value of the assets, based on fair value less costs to sell, at
C
the date of acquisition were as follows:
H
£'000
A
Vehicles (lorries) 240 P
Intangible assets (licences) 60 T
Trade receivables 20 E
Cash 100 R
Trade payables (40)
380
2
Unfortunately, three of the lorries were stolen on 1 February 20X7. The lorries were not insured,
because the road haulage company manager had failed to complete the paperwork in time. The
lorries had a net book value of £60,000, and we estimate that £60,000 was also their fair value less
costs to sell.
I believe that, as a result of the theft of the uninsured lorries, the value in use of the cash
generating unit has fallen. We should recognise an impairment loss of £90,000, inclusive of the loss
of the stolen lorries.
We have another problem with this business. A competitor has started operating, covering similar
routes and customers. Our revenue will be reduced by one quarter, which will in turn reduce the
fair value less costs to sell and the value in use of our haulage business to £310,000 and £300,000
respectively. Part of this decline is attributable to the competitor's actions causing the net selling
value of the licences to fall to £50,000. There has been no change in the fair value less costs to sell
of the other assets, which is the same as on the date of acquisition.
The company will continue to rent out the lorries for the foreseeable future.
How should we show this impairment in the financial statements?
Fall in value of machines
The goods produced by some of our machines have been sold below their cost. This has affected
the value of the machines in question, which has suffered an impairment. The carrying amount of
the machines at depreciated historical cost is £580,000 and their fair value less costs to sell is
estimated to be £240,000. We anticipate that cash inflows from the machines will be £200,000 per
annum for the next three years. The annual market discount rate, as you know, is 10%.
How should we determine the impairment in value of the machines in the financial statements and
how should this be recognised?
Own brand
This year, Eco-Ergonom has been developing a new product, the Envirotop. Envirotop is a new
range of environmentally friendly kitchen products and an ergonomic kitchen design service. The
expenditure in the year to 31 December 20X7 was as follows:
Period from Expenditure type £m
1 Jan 20X7 – 31 March 20X7 Research on size of potential market 6
1 April 20X7 – 30 June 20X7 Prototype kitchen equipment and product 8
design
1 July 20X7 – 31 August 20X7 Wage costs in refinement of products 4
1 September 20X7 – 30 November Development work undertaken to finalise 10
20X7 design of kitchen equipment
1 December 20X7 – 31 December Production and launch of equipment and 12

20X7 products
40
Currently an intangible asset of £40 million is shown in the financial statements for the year ended
31 December 20X7.
Included in the costs of the production and launch of the products are the cost of upgrading the
existing machinery (£6 million), market research costs (£4 million) and staff training costs
(£2 million).
Please explain the correct treatment of all these costs.
Purchase of Homecare
You will also know that, on 1 January 20X7, Eco-Ergonom acquired 100% of Homecare, a private
limited company manufacturing household products. Eco-Ergonom intends to develop its own
brand of environmentally friendly cleaning products. The shareholders of Homecare valued the
company at £25 million based upon profit forecasts which assumed significant growth in the
demand for the 'Homecare' brand name. We took a more conservative view of the value of the
company and estimated the fair value to be in the region of £21 million to £23 million of which £4
million relates to the brand name 'Homecare'. Eco-Ergonom is only prepared to pay the full
purchase price if profits from the sale of 'Homecare' goods reach the forecast levels. The agreed
purchase price was £20 million plus a further payment of £5 million in two years on 31 December
20X8. This further payment will comprise a guaranteed payment of £2 million with no
performance conditions and a further payment of £3 million if the actual profits during this two
year period from the sale of Homecare goods exceed the forecast profit. The forecast profit on
Homecare goods over the two-year period is £3 million and the actual profits in the year to 31
December 20X7 were £0.8 million. Eco-Ergonom did not feel at any time since acquisition that the
actual profits would meet the forecast profit levels. Assume an annual discount rate of 5.5%.
Requirement
Prepare the memorandum asked for by the Finance Director.
Technical reference

 Recognition IAS 16.7
 Initial costs IAS 16.11
 Subsequent costs IAS 16.12
 Measurement at recognition IAS 16.15
 Measurement after recognition IAS 16.29
 Derecognition IAS 16.67-72
C
 Disclosure IAS 16.73-79
H
A
P
 Scope IAS 38.2 T
E
 Definitions IAS 38.8 R
 Intangible assets IAS 38.9-10
 Identifiability IAS 38.11-12
 Control IAS 38.13 2
 Future economic benefits IAS 38.17
 Recognition and measurement IAS 38.18-67
 Recognition of an expense IAS 38.68
 Measurement after recognition IAS 38.72
 Cost model IAS 38.74
 Revaluation model IAS 38.75-87
 Useful life IAS 38.88-96
 Intangible assets with finite useful lives IAS 38.97-106
 Intangible assets with indefinite useful lives IAS 38.107-110
 Recoverability of the carrying amount – impairment losses IAS 38.111
 Retirements and disposals IAS 38.112
 Disclosure IAS 38.118
IAS 2 Inventories
 Measurement and disclosure but not recognition IAS 2.1
 Measured at lower of cost and net realisable value IAS 2.9
 Cost = expenditure incurred, in bringing the items to their present IAS 2.10
location and condition, so the cost of purchase and the cost of
conversion
– Fixed costs included by reference to normal levels of activity IAS 2.13
 Cost formula: FIFO or Weighted average IAS 2.25
 NRV includes costs to complete and selling costs IAS 2.6
 Disclosures include accounting policies, carrying amounts and amounts IAS 2.36 - 38
recognised as an expense
 Definitions IAS 11.3
 Contract revenue IAS 11.11-15
 Contract costs IAS 11.16-21
 Recognition of revenue and expenses

– When outcome estimated reliably recognise by reference to stage IAS 11.22
of completion
– Fixed price contract IAS 11.23
– Cost plus contract IAS 11.24
– Stage of completion IAS 11.25-26
– Methods of determining stage of completion IAS 11.30-31
– When outcome cannot be estimated reliably IAS 11.32
 Recognition of expected losses IAS 11.36-37
 Disclosure IAS 11.39-44

1 Indications
 At each reporting date assess whether indication of impairment: IAS 36.9
– If so, estimate recoverable amount (RA)

– RA is higher of fair value less costs to sell and value in use (present IAS 36.6
value of future cash flows in use and on disposal)
– Review both external and internal information for evidence of IAS 36.12
impairment
 Impairment loss where carrying amount exceeds RA IAS 36.59
2 Fair value less costs to sell

 The way in which fair value is determined depends on whether there is a IAS 36.25-27
binding sale agreement and/or an active market
 Examples of disposal costs IAS 36.28
3 Value in use
 Calculation involves the estimation of future cash flows as follows: IAS 36.39
– Cash flows from continuing use

– Cash flows necessarily incurred to generate cash inflows from
continuing use
– Net cash flows receivable/payable on disposal
 These should reflect the current condition of the asset IAS 36.44
 The discount rate should reflect:
– The time value of money IAS 36.55
– Risks specific to the asset for which the future cash flow estimates
have not been adjusted.
4 Cash-generating units
 Estimate recoverable amount of CGU if not possible to assess for an IAS 36.66
individual asset
 Identification of an asset's CGU involves judgement IAS 36.68
 Goodwill should be allocated to each of the acquirer's CGUs that are IAS 36.80
expected to benefit
 Goodwill that cannot be allocated to a CGU on a non-arbitrary basis is IAS 36.81
allocated to the group of CGUs to which it relates
 Annual impairment review required for any CGU which includes IAS 36.90
goodwill
 Corporate assets should be allocated on a reasonable and consistent IAS 36.102
basis
5 Impairment losses
 If the asset is held under the cost model the impairment should be IAS 36.60
recognised in profit or loss
 If the asset has been revalued the impairment loss is treated as a IAS 36.60
revaluation decrease
 An impairment loss for a CGU should be allocated: IAS 36.104
– To goodwill then
– To all other assets on a pro-rata basis
 When a CGU is a non-wholly owned subsidiary AND non-controlling IAS 36 (Appendix C)
interest is measured at acquisition date at share of net assets, notionally
gross up goodwill for that part attributable to the non-controlling C
interest H
A
6 Reversals P
T
 An impairment loss recognised for goodwill should not be reversed IAS 36.124 E
R
7 Disclosures
 All impairments IAS 36.126
 For a material impairment on an individual asset IAS 36.130 2
 For a material impairment on a CGU IAS 36.130

 Fair value is defined as the price that would be received to sell an asset IFRS 13.9
or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.
 Market-based measure IFRS 13.2
 Three-level hierarchy IFRS 13.72
IAS 18 Revenue
 Revenue recognised when: IAS 18 Objective
– Probable that future economic benefits will flow to the entity and
– These benefits can be measured reliably
 Apply principle of substance over form
 Revenue defined as gross inflows that result in increase in equity IAS 18.7
– Sales taxes (eg VAT) and amounts collected by agent on behalf of IAS 18.8
principal are excluded
 Measured as fair value of consideration – discounted where appropriate IAS 18.9-11
 Recognition of sale of goods: when buyer has obtained significant IAS 18.14
risks/rewards of ownership
 Recognition of rendering of services: can take account of stage of IAS 18.20
completion, if over a long period:
– Include pro rata costs and consider costs to complete

– If overall outcome cannot be estimated reliably, revenue limited to IAS 18.26
costs recoverable from customer
 Practical considerations, including 'free' servicing, where revenue IAS 18 Appendix A
deferred to cover both cost and reasonable profit (all but 9, 10, 13 and 14)
IAS 2 Inventories
1 Reapehu
£20,175,000
IAS 2.31 requires that NRV should take into account the purpose for which inventory is held. The
NRV for the contract is therefore determined separately from the general sales, thus:
£
Contract: NRV is lower than cost thus use NRV, so (£225,000  15) = 3,375,000
General: Use cost as this is less than NRV, so (£240,000  (85–15)) = 16,800,000
20,175,000
2 Utah
£64,000
IAS 2.30 requires the NRV of inventories to be calculated on the basis of all relevant information,
including events after the reporting period. This is supported by the example in IAS 10.9(b).
Thus:
£
£25  1,600 expected to be sold to Bushbaby: 40,000
£10  2,400 remainder 24,000
Total 64,000

3 Polikeman
Stage 2 costs only
IAS 11.21 permits pre-contract costs to be attributable to a construction contract if they are
incurred to secure the contract and it is probable that the contract will be awarded.
Contract costs will include the Stage 2 costs in 20X7. The fact that negotiations with other bidders
were stopped is evidence of the probability that the contract would be awarded.
During 20X6, however, it is not probable that the contract would be won, as there were a number
of other bidders, so the costs would need to be written off in 20X6. They cannot then be included
as construction contract costs in 20X7.
4 Diborane
(a) £(2,100,000)
(b) £9,576,000
(c) £2,996,000
Profit/loss on contract 20X6 20X7
£m £m
Contract price 14.0 14.0
Variation – 3.5
Penalty – (0.28)
14.0 17.22
Costs incurred to date (4.9) (12.6)
Estimated costs to completion (11.2) (3.5)
Profit/loss on contract (2.1) 1.12
Amounts to be recognised 20X7 20X7
20X6 cumulative (cum – 20X6)
£m £m £m
Revenue (30% × £14m / 80% × £17.22m) 4.2 13.776 9.576
Costs (β) (6.3) 6.580
Loss (in full) (2.1)

Profit (80% × £1.12m) 0.896 2.996
At 31 December 20X6 the expected loss must be recognised immediately (IAS 11.36).
Under the agreement made on 31 December 20X7, the contract revenue is increased by the
variation and reduced by the penalty (IAS 11.12).
The profit for the year ended 31 December 20X7 is the profit to date, PLUS the loss recognised in C
20X6. H
A
IAS 16 Property, Plant and Equipment P
T
5 Niobium E
R
£33 million
IAS 16.11 requires the capitalisation of essential safety equipment even if there are no future
2
economic benefits flowing directly from its operation.
It does however subject the total value of all the related assets to an impairment test. In this case
the recoverable amount is £33m, as the net selling price £33m is greater than the value in use
£32m (ie £3.2m / 0.1). As this is less than the total carrying amount of £35m (£30m + 5m), the
assets are written down to £33m.
6 Oruatua
(a) £850,355
(b) £(154,118)
(c) £756,521
(a) The initial cost of the asset must include the dismantling cost at its present value, where the
time value of the money is material (IAS 16.16(c) and IAS 37.45). The present value of these
costs at 1 January 20X6 is £173,952 (£480,000  0.3624), making the total cost of the
engines £623,952. Each part of the asset that has a cost which is significant in relation to the
total asset cost should be depreciated separately (IAS 16.43). Therefore, at the end of 20X6
the carrying amount of the asset is £850,355 (£110,000  4/5) + (£240,000  ¾) +
(£623,952  14/15).
(b) The loss on disposal is (per IAS 16.71) the difference between the carrying amount of an
individual engine at 1 January 20X7 of £194,118 (£623,952 / 3  14/15)) and the scrap sale
proceeds of £40,000, to give a loss of £154,118.
(c) The replacement engine is capitalised at cost of £226,170 (£168,000 + £150,000 x 0.3878),
and then depreciated over the remaining length of the licence of 14 years. The carrying
amount of the asset at 31 December 20X7 is therefore £756,521 (£110,000  3/5) +
(£240,000  2/4) + (£623,952  2/3  13/15) + (£226,170  13/14).
7 Antimony
£0.7 million
IAS 36.60 and 61 (also IAS 16.40) require that an impairment that reverses a previous revaluation
should be recognised through the revaluation reserve to the extent of that reserve. Any remaining
amount is recognised through profit or loss. Thus:
 The carrying amount at 31 December 20X2 is 45/50  £5.0m = £4.5m.
 The revaluation reserve created is £3.5m (ie £8.0m – £4.5m)
 The carrying amount at 31 December 20X7 is 40/45  £8.0m = £7.1m
 The recoverable amount at 31 December 20X7 is £2.9m.
 The total impairment charge is £4.2m (ie £7.1m – £2.9m).
 Of this, £3.5m is a reversal of the revaluation reserve, so only £0.7 million is recognised
through profit or loss.
8 Sundew
£6,000,000
IAS 36.70 requires that in determining value in use where internal transfers are made, then a best
estimate should be made of prices that would be paid in an orderly transaction between market
participants at the measurement date.
Thus revenues are 4,000  £1,500 = £6,000,000
9 Cowbird
£8.0 million
IAS 36.110 requires consideration of whether an impairment loss recognised in previous years has
reversed or decreased.
IAS 36.117 and 118 restrict the recognition of any such reversal to the value of the carrying
amount at the current reporting date had the original impairment not taken place. Thus:
Carrying amount under original conditions = £10m  16/20 years = £8.0m.
10 Acetone
(a) £750,000
(b) £96,000
(c) £99,000
(a) £
Book value of Dushanbe's net assets 400,000
Goodwill recognised on acquisition
£600,000 – (80% × £400,000) 280,000
Notional goodwill (£280,000 × 20/80) 70,000
750,000
(b) The impairment loss is the total £750,000 less the recoverable amount of £520,000 =
£230,000. Under IAS 36.104 this is firstly allocated against the £350,000 goodwill. (As the
impairment loss is less than the goodwill, none is allocated against identifiable net assets.) As
only the goodwill relating to Acetone is recognised, only its 80% share of the impairment loss
is recognised:
£
Carrying value of goodwill 280,000
Impairment (80% × 230,000) (184,000)
Revised carrying amount of goodwill 96,000
(c) £
Carrying amount of Maclulich's net assets 700,000
Recognised goodwill 205,000
Notional goodwill (15/85 × £205,000) 36,176
941,176
Recoverable amount (660,000)
Impairment loss 281,176
Allocated to:
Recognised and notional goodwill 241,176
Other net assets 40,000
Therefore the non-controlling interest is (£700,000 – £40,000)  15% = £99,000.
11 Titanium
£672,500
IAS 38.94 deals with the identification of the useful life of an intangible asset arising from legal
rights.
The Dominoes publication has a useful life of six years, and so should be amortised over this
period. At the year end the carrying amount of £750,000, (900,000  5/6), exceeds the active
market value, so an impairment of £50,000 is required. This gives a total charge of £200,000
(£150,000 amortisation plus £50,000 impairment charge).
The Billiards publication is initially amortised over the period of ten years to the end of the
copyright arrangement, as there is no certainty that the company can publish the magazine after C
this date. This gives a charge of £120,000. H
A
The Skittles publication is amortised over the period it is expected to generate cash flows of eight P
years, giving a charge of £212,500. T
E
The Darts publication has an indefinite period over which it is expected to generate cash flows. R
Under normal circumstances it would be automatically subject to an annual impairment review.
However, because the copyright arrangement does have a finite period, amortisation should take
place over ten years, and so a charge of £140,000 is required. 2
The total charge is £672,500.

12 Lewis
(a) Recognised
(b) Recognised
(c) Recognised
(a) The vineyard trademark is not separable because it could only be sold with the vineyard itself.
But under IAS 38.36, the combination of the vineyard and the trademark should be
recognised.
(b) The footballers' registrations represent a legal right which meets the identifiability criterion in
IAS 38.12.
(c) The research project should be treated as a separate asset as on a business combination it
meets the definition of an asset and is identifiable (IAS 38.34).
13 Diversified group
(a) Not an intangible
(b) An intangible
(a) The training costs would not satisfy the definition of an intangible asset. This is because
Thrasher has insufficient control over the expected future benefits of the team of experts (IAS
38.15).
(b) The database would be classified as an intangible asset because the willingness of another
party to buy the contents provides evidence of a potential exchange transaction for the
relationship with customers and that the asset is separable (IAS 38.16).
14 Cadmium
£16,250
The revaluation model cannot be used for this trademark, because for a unique item there cannot
be the active market required by IAS 38.75. (A professional valuation does not rank as a value by
reference to an active market.) IAS 38.81 requires the cost model to be applied to such an item,
even if it is in a class for which the revaluation model is used.
The cost of renewal should be treated as part of the cost of an intangible, under IAS 38.28(b), but
the valuation expenses should be charged directly to profit or loss, as administration overheads
(IAS 38.29(c)).
The trademark is therefore carried at the cost of renewal, depreciated for the six of the eight years'
life since last renewal, so £65,000  2/8 = £16,250.
15 Piperazine
(a) £132,750
(b) £88,500
(c) £61,500
(a) Under IAS 38.21 the £70,000 spent in 20X4 in applying for the licences must be recognised in
profit or loss, because the generation of future economic benefits is not yet probable. The
£9,000 incurred in December 20X4 in registering the licences is treated as the cost of the
licences because the economic benefits are then probable. The carrying amount of the
licences under the revaluation model at 31 December 20X4 is £141,750 (£9,450  15), so the
balance on the revaluation reserve is the £132,750 uplift (IAS 38.75 and 85).
(b) After three years the accumulated amortisation based on the revalued amount is £47,250
(£141,750  3/9), whereas the accumulated amortisation based on the cost would have been
£3,000 (£9,000  3/9). So £44,250 will have been transferred from the revaluation reserve to
retained earnings (IAS 38.87). The remaining balance before the regular revaluation is
£88,500 (£132,750 – £44,250).
(c) The carrying amount of the licences immediately before the revaluation is £94,500 (£141,750
– £47,250). The revalued carrying amount is £67,500 (£4,500  15). The deficit of £27,000 is
recognised in the revaluation reserve, reducing the balance to £61,500 (IAS 38.86).
16 Vitaleque
(a) Fair value of asset
Year to 30 November 20X2 North American European market African market
market
Volume of market – units 4m 2m 1m
£ £
Price 19 16 22
Costs of entering the market ( 2) ( 2) n/a*
Potential fair value 17 14 22
Transaction costs (1) ( 2) (2)
Net profit 16 12 20
*Notes
(i) Because Vitaleque currently buys and sells the asset in the African market, the costs of
entering that market are not incurred and therefore not relevant.
(ii) Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of
the asset or liability, but may be taken into account when determining the most
advantageous market.
(iii) The North American market is the principal market for the asset because it is the market
with the greatest volume and level of activity for the asset. If information about the
North American market is available and Vitaleque can access the market, then Vitaleque
should base its fair value on this market. Based on the North American market, the fair
value of the asset would be £17, measured as the price that would be received in that
market (£19) less costs of entering the market (£2) and ignoring transaction costs.
(iv) If information about the North American market is not available, or if Vitaleque cannot
access the market, Vitaleque must measure the fair value of the asset using the price in
the most advantageous market. The most advantageous market is the market that
maximises the amount that would be received to sell the asset, after taking into account
both transaction costs and usually also costs of entry, that is the net amount that would
be received in the respective markets. The most advantageous market here is therefore
the African market. As explained above, costs of entry are not relevant here, and so,
based on this market, the fair value would be £22.
It is assumed that market participants are independent of each other and knowledgeable,
and able and willing to enter into transactions.
(b) Fair value of decommissioning liability
Because this is a business combination, Vitaleque must measure the liability at fair value in
accordance with IFRS 13, rather than using the best estimate measurement required by IAS 37
Provisions, contingent liabilities and contingent assets. In most cases there will be no observable
market to provide pricing information. If this is the case here, Vitaleque will use the expected
present value technique to measure the fair value of the decommissioning liability. If
Vitaleque were contractually committed to transfer its decommissioning liability to a market
participant, it would conclude that a market participant would use the inputs as follows,
arriving at a fair value of £3,215,000.
Input Amount C
£'000 H
Labour and material cost 2,000 A
Overhead: 30% × 2,000 600 P
T
Third party mark-up – industry average: 2,600 × 20% 520
E
3120 R
3
Inflation adjusted total (5% compounded over three years): 3,120 × 1.05 3,612
Risk adjustment – uncertainty relating to cash flows: 3,612 × 6% 217
2
3,829
Discount at risk-free rate plus entity's non-performance risk (4% + 2% =

6%): 3,829 ÷ 1.06
3
3,215
IAS 18 Revenue
17 Laka
£4,016
Under IAS 18.11 the selling price must be analysed between the finance income and the sale of
goods income, discounting future receipts at the rate of interest for an issuer with a similar credit
rating to that of the customer.
The finance income is calculated by reference to the amount outstanding after the deposit has
been paid:
£
Initial deposit (£4,400 × 20%) 880
Sale of goods (£4,400 × 80%) / 1.08
2
3,018
Finance income £3,018 × 3.923%* 118
4,016
* the interest rate is √(1 + the full year %) – 1, so √(1.08) – 1= 3.923%.

18 Renpet
£25,600
IAS 18 App.18 sets out guidance in relation to franchise fees.
Of the £36,000 first contract fee:
 £19,000 relates to equipment
– £7,600 (40%) of equipment is delivered this financial year when the contract is signed.
Therefore this amount is recorded as revenue.
– £11,400 (60%) of equipment is delivered in the next financial year; this revenue is
therefore deferred.
 £17,000 is an initial set up fee
When subsequent services are priced below the total of cost and a reasonable profit, that part
of the initial fee which represents the difference is spread over the period of those services,
therefore
– £3,000 must be allocated to the second contract to increase the £9,000 fee to the fair
value of the services £12,000
– The remaining £14,000 of the initial fee is recorded as revenue
Of the £9,000 second contract fee PLUS the £3,000 of the initial set up fee allocated as above:
 £12,000 × 4m/12m = £4,000 relates to this financial year and is recorded as revenue
 The remaining £8,000 is deferred until the following financial year.
Therefore revenue recognised is £7,600 + £14,000 + £4,000 = £25,600.
19 Baros
£3,720,000
 IAS 18 App. 12 states that media commission revenue is recognised when the advertisement
appears before the public. So revenue is two advertisements  15 broadcasts  £40,000 
10% = £120,000.
 Production commissions are recognised by reference to the stage of completion of the
project. The best measure of the stage of completion is the physical quantity of
advertisements produced. Therefore £5.4 million × 4/6 = revenue of £3.6 million.
Total revenue is £3.6 million + £120,000 = £3,720,000.
20 Health club
£295,200
When a fee entitles a member to purchase equipment at a reduced rate, the revenue should not be
recognised immediately in full but on a basis which reflects the timing, nature and value of the
benefit (IAS 18 App. 17). So the relevant proportion is spread over the period during which
discounted purchases may be made.
The amount to be deferred is calculated as:
The number of × Proportion who × Amount of the × Remaining
new members take advantage benefit period over
of offer which offer can
be exercised
100 × 40% × (£1,200  20%) × 3m/6m
= £4,800
Therefore revenue recognised = £300,000 - £4,800 = £295,200
21 Pears
(a) £124
(b) £184
(c) £28
IAS 18.13 requires the recognition criteria to be applied to the separately identifiable components
of a single transaction in order to represent the substance of the transaction. IAS 18 does not,
however, specifically state how an entity should unbundle such contracts although the application
of general principles means that each component should be recognised at its fair value and only
recognised when it meets the specific criteria. If the fair value of the individual components is
greater than the overall price paid for the bundled contract, the discount should be allocated to
each component on a reasonable basis. Typically the discount will be allocated to each component
on a pro-rata basis.
(a) The total revenue over the contract period is £560 (4 quarters  £140). The fair value of the
separate components is £990 (£220 + £50 + (720  £1)). The discount of 43.43% should be
spread across each element. The revenue recognised on the telephone sale will be £124 (£220
 56.57%).
(b) The revenue recognised in the first six months will be:
£
Airtime subscription £50 × 6/12 × 56.57% 14
'Free' call revenue (175 mins + 125 mins) × £1 × 56.57% 170
184
(c) Total revenue recognised in the first six months will be £308 (£124 + £184) whilst the amount
of cash received is £280 (2  £140). The difference will be a receivable in the statement of
financial position.
In practice, estimates should also be revisited throughout the year against actual usage.
22 Eco-Ergonom
C
MEMORANDUM H
A
To: Deborah Carroll, Finance Director P
From: Financial Controller T
Date: 15 March 20X8 E
R
Subject: Accounting treatment of non-current assets
As requested, this memorandum sets out the appropriate accounting treatment for the non-
2
current assets detailed in today's email.
The three lorries that were stolen should be written off at their NBV first and then the impairment
test should be performed.
Recoverable
NBV Impairment amount
£'000 £'000 £'000
Goodwill 80 (80) –
Intangibles 60 (2.5) 57.5
Vehicles (240- 180 (7.5) 172.5
60)
Sundry net 80 80
assets
Total 400 (90) 310 Higher of VIU and NFV
£80,000 is set against goodwill and the remaining £10,000 is split pro rata between the other
two relevant assets: £2,500 against intangibles (£10,000 × 60,000/(60,000+180,000)) and
£7,500 against vehicles (£10,000  180,000/(60,000+180,000)). There is no need here to restrict
the impairment of the intangibles.
Tutorial note
The calculation of the impairment loss is based on the carrying amount of the business including
the trade payables. Recoverable amount is the fair value less costs to sell of the business as a
whole, with any buyer assuming the liabilities. Otherwise, the impairment test would be based on
the carrying amount of the gross assets (IAS 36.76).
Fall in value of machines

An impairment review will be carried out because of the losses and the haulage business
problems.
For the productive machinery
£
Carrying amount 580,000
Fair value less costs to sell 240,000
Value in use (200,000  3, discounted at 10%) 497,200
An impairment loss of £82,800 (580,000 – 497,200) will be recognised in profit or loss.
Development of new product
IAS 38 Intangible Assets divides a development project into a research phase and a development
phase. In the research phase of a project, an entity cannot yet demonstrate that the expenditure
will generate probable future economic benefits. Therefore expenditure on research must be
recognised as an expense when it occurs.
Development expenditure is capitalised when an entity demonstrates all the following.
(a) The technical feasibility of completing the project
(b) Its intention to complete the asset and use or sell it
(c) Its ability to use or sell the asset
(d) That the asset will generate probable future economic benefits
(e) The availability of adequate technical, financial and other resources to complete the
development and to use or sell it
(f) Its ability to reliably measure the expenditure attributable to the asset.
Assuming that all these criteria are met, the cost of the development should comprise all directly
attributable costs necessary to create the asset and to make it capable of operating in the manner
intended by management. Directly attributable costs do not include selling or administrative
costs, or training costs or market research. The cost of upgrading existing machinery can be
recognised as property, plant and equipment. Therefore the expenditure on the project should
be treated as follows:
Recognised in statement of financial
position
Expense Intangible Property,
(income assets plant and
statement) equipment
£m £m £m
Research 6
Prototype design 8
Wage costs 4
Development work 10
Upgrading machinery 6
Market research 4
Training 2
12 22 6
Eco-Ergonom should recognise £22 million as an intangible asset.
Purchase of Homecare
IFRS 3 Business Combinations states that the cost of a business combination is the aggregate of the
fair values of the consideration given. Fair value is measured at the date of exchange. Where any
of the consideration is deferred, the amount should be discounted to its present value. Where
there may be an adjustment to the final cost of the combination contingent on one or more
future events, the amount of the adjustment is included in the cost of the combination at the
acquisition date only if the fair value of the contingent consideration can be measured reliably.
The purchase consideration consists of £20 million paid on the acquisition date plus a further £5
million payable on 31 December 20X8 including £3 million payable only if profits exceed
forecasts. At the acquisition date it appeared that profit forecasts would not be met. However,
under IFRS 3, contingent consideration must be recognised and measured at fair value at the
acquisition date. Therefore the cost of combination at 1 January 20X7 is £24.49 million (£20m +
(£5m  0.898)).
A further issue concerns the valuation and treatment of the 'Homecare' brand name. The brand
name is an internally generated intangible asset of Homecare, and therefore it will not be
recognised in the statement of financial position of Homecare. However, IFRS 3 requires
intangible assets of an acquiree to be recognised if they meet the identifiability criteria in IAS 38
Intangible Assets and their fair value can be measured reliably. For an intangible asset to be
identifiable the asset must be separable or it must arise from contractual or other legal rights. It
appears that these criteria have been met (a brand is separable) and the brand has also been
valued at £4 million for the purpose of the sale to Eco-Ergonom. Therefore the 'Homecare' brand
will be separately recognised in the consolidated statement of financial position.
Answer to Interactive question 1

(a) The double entry is:
Dr Asset value (statement of financial position) £7,000
Cr Profit or loss £2,000
Cr Revaluation surplus (other comprehensive income) £5,000
The case is similar for a decrease in value on revaluation. Any decrease should be recognised as an
C
expense, except where it offsets a previous increase taken as a revaluation surplus in other H
comprehensive income. Any decrease greater than the previous upwards increase in value must be A
recorded as an expense in profit or loss. P
T
(b) The double entry is: E
R
Dr Revaluation surplus (other comprehensive income) £5,000
Dr Profit or loss £2,000
Cr Asset value (statement of financial position) £7,000
2
There is a further complication when a revalued asset is being depreciated. An upward
revaluation means that the depreciation charge will increase. Normally, a revaluation surplus is only
realised when the asset is sold, but when it is being depreciated, part of that surplus is being
realised as the asset is used. The amount of the surplus realised is the difference between
depreciation charged on the revalued amount and the (lower) depreciation which would have
been charged on the asset's original cost. This amount can be transferred to retained (ie
realised) earnings but not through profit or loss.
(c) On 1 January 20X8 the carrying value of the asset is £10,000 – (2  £10,000 ÷ 5) = £6,000. For the
revaluation:
Dr Asset value (statement of financial position) £6,000
Cr Revaluation surplus (other comprehensive income) £6,000
The depreciation for the next three years will be £12,000 ÷ 3 = £4,000 compared to depreciation
on cost of £10,000 ÷ 5 = £2,000. Each year the extra £2,000 is treated as realised and transferred
to retained earnings:
Dr Revaluation surplus £2,000
Cr Retained earnings £2,000
This is a movement within reserves, not an item in profit or loss.

The total cost attributable to Product 1 is calculated as:
£140,000 + £37,000 + (60%  £50,000) = £207,000
The cost per unit therefore being £207,000/690 = £300 each.
The total cost attributable to Product 2 is:
£160,000 + £45,000 + (40%  £50,000) = £225,000
The cost per unit therefore being £225,000/900 = £250 each.
The allocation of the cost for Product 2 is therefore:
£250  675 = £168,750 as inventories
£250  225 = £56,250 as an expense
The indirect costs not specifically identifiable with either product which are allocated to the scrapped
Product 2 cannot be recovered into the cost of Product 1.
£
Cost (being lower than NRV) 36,000
Depreciation (£36,000/3 years) (12,000)
24,000

£
Costs incurred to date 330,000
Estimated future costs 70,000
Total estimated costs 400,000
The contract is therefore 82.5% (330,000/400,000) complete

Revenue to be recognised: £500,000 × 82.5% = £412,500
The profit earned to date is therefore £82,500 (£412,500 – £330,000)

£
20X5 23% × expected profit of £148 34
20X6 53% × expected profit of £49 26

Less: profit previously recognised (34)
Loss recognised in 20X6 (8)
The additional costs represent a change in accounting estimate and are used in the determination of
profit.
20X7 Overall actual profit 148

Less: cumulative profit previously recognised (26)
Profit recognised in 20X7 122

(a) Common examples of intangible assets are:
 Computer software (other than operating systems which are accounted for under IAS 16)
 Patents and copyrights
 Motion picture films
 Customer lists, customer loyalty, customer/supplier relationships
 Airline landing slots
 Fishing licences
 Import quotas
 Franchises
(b) Employees can never be recognised as an asset; they are not under the control of the employer, are
not separable and do not arise from legal rights.

The fair value less costs to sell of the plant is below its carrying value so it may be impaired. It is now
necessary to find the value in use in order to determine whether an impairment has occurred and to
quantify any impairment loss.
Year Discounted future
Future cash flows PV factor at 15% cash flows
£'000 £'000
1 230 0.86957 200
2 211 0.75614 160
3 157 0.65752 103
4 104 0.57175 59
5 233 0.49718 116
638
To calculate the impairment loss, compare the carrying value of £749,000 with the higher of value in
use (£638,000) and fair value less costs to sell (£550,000). The impairment loss is therefore £749,000 –
£638,000 = £111,000.

The key issue is whether the cash-generating unit produces cash flows which are independent of other
assets or not.
The CGUs which appear to have cash flows independent of the other assets (and can therefore be
subject to reliable assessment of their recoverable value) are:
(b) A branch of a pizza restaurant in Warsaw
(d) A commuter monorail C
H
(a) and (c) are not generators of independent cash flows and are therefore too small to be CGUs in their A
own right. In the case of (c) the CGU is the theme park as one entity. P
T
Additionally (e) is a CGU in its own right as there is an external active market for its services, even E
though these are not openly available (IAS 36.71). R
Answer to Interactive question 9 2

(a) (b)
£m £m
Recognised goodwill 90 90
Notional goodwill (£90m × 40/60) 60 60
Carrying amount of net assets 550 550
700 700
Recoverable amount 510 570
Impairment loss 190 130
Allocation of impairment loss:

£m £m
Recognised goodwill cognised goodwill 9090 9 90
Notional goodwill 60 40
Other assets pro rata 40 –
190 130
Carrying value after impairment:

£m £m
Goodwill (90 – (150  60%))/(90 – (130  60%)) – 12
Other net assets (550 – 40) 510 550
510 562

(a) A sale must never be recognised before the goods have even been ordered by a customer. There is
no certainty about the value of the sale, nor when it will take place, even if it is virtually certain that
goods will be sold.
(b) A sale must never be recognised when the customer places an order. Even though the order will be
for a specific quantity of goods at a specific price, it is not yet certain that the sale transaction will
go through. The customer may cancel the order, the supplier might be unable to deliver the goods
as ordered or it may be decided that the customer is not a good credit risk.
(c) A sale will be recognised when delivery of the goods is made only when:
(i) the sale is for cash, and so the cash is received at the same time; or
(ii) the sale is on credit and the customer accepts delivery (eg by signing a delivery note).
(d) The critical event for a credit sale is usually when the customer accepts delivery (see (c)(ii). At this
point, or shortly afterwards, an invoice is usually despatched to the customer. There is then a
legally enforceable debt, payable on specified terms, for a completed sale transaction.
(e) The critical event for a cash sale is when delivery takes place and when cash is received; both take
place at the same time.
It would be too cautious or 'prudent' to await cash payment for a credit sale transaction before
recognising the sale, unless the customer is a high credit risk and there is a serious doubt about his
ability or intention to pay.
(f) It would again be over-cautious to wait for clearance of the customer's cheques before recognising
sales revenue. Such a precaution would only be justified in cases where there is a very high risk of
the bank refusing to honour the cheque.

The director wishes to recognise the sale as early as possible. However, following IAS 18 Revenue, he
cannot recognise revenue from this sale because the risks and rewards of ownership of the caravan have
not been transferred. This happens on the date of delivery, which is 1 August 20X7. Accordingly, no
revenue can be recognised in the current period.
The receipt of cash in the form of the £3,000 deposit must be recognised. However, while the deposit is
termed 'non-refundable', it does create an obligation to complete the contract. The other side of the
entry is therefore to deferred income in the statement of financial position.
The journal entries would be as follows:
DEBIT Cash £3,000
CREDIT Deferred income £3,000
Being deposit received in advance of the sale being recognised.
On 1 August 20X7, when the sale is recognised, this deferred income account will be cleared. In
addition:
The revenue from the sale of the caravan will be recognised. Of this, £12,000 is receivable in two years'
2
time, which, with a 10% discount rate, is: £12,000/ 1.1 = £9,917. £15,000 is receivable on 1 August
20X7.
The service plan is not really 'free' – nothing is. It is merely a deduction from the cost of the caravan. The
£1,500 must be recognised separately. It is deferred income and will be recognised over the three year
period.
The sales revenue recognised in respect of the caravan will be a balancing figure.
The journal entries are as follows
DEBIT Deferred income £3,000
st
DEBIT Cash (1 instalment) £15,000
DEBIT Receivable (balance discounted) £9,917
CREDIT Deferred income (service plan monies
received in advance) £1,500
CREDIT Sales (balancing figure) £26,417
Note: This question is rather fiddly, so do not worry too much if you didn't get all of it right. Read
through our solution carefully, going back to first principles where required.
CHAPTER 3
Events after the reporting

period, provisions and
contingencies
Introduction
Topic List
1 IAS 10 Events After the Reporting Period
2 IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Technical reference
81
Introduction
 Apply knowledge and understanding of IAS 10 in particular circumstances distinguishing

between adjusting and non-adjusting events
 Identify the date up to which events after the reporting period should be considered
 Demonstrate an understanding of the significance of adjusting events that have occurred
after the reporting period and the need for disclosure of non-adjusting events
 Demonstrate an understanding of the requirements of IAS 37 Provisions, Contingent
Liabilities and Contingent Assets
 Identify the circumstances in which a provision should be recognised
 Demonstrate an understanding of the measurement principles in relation to provisions
 Demonstrate an understanding of the relationship between a provision and a contingent

liability
 Identify when a contingent asset becomes an asset that should be recognised, and how it
should be reflected in the financial statements
 Demonstrate knowledge and understanding of IAS 37 in particular scenarios and through
calculation
1 IAS 10 Events After the Reporting Period
Section overview
 Events after the reporting period are split into adjusting and non-adjusting events. Those events
that may affect the going concern assumption underlying the preparation of the financial
statements must be considered further.
 The following is a summary of the material covered in earlier studies.
1.1 Overview of earlier studies

Events after the reporting period are split into adjusting and non-adjusting events.
Adjusting events after the reporting period
Adjusting events are events that provide evidence of conditions that existed at the reporting date, and
the financial statements should be adjusted to reflect them. Examples include:
 Settlement of a court case that confirms that the entity had an obligation at the reporting date
 Evidence that an asset was impaired at the reporting date eg
– Bankruptcy of a customer
– Selling prices achieved for inventory
 Determination of profit-sharing or bonus payments relating to the year C
H
 Finalisation of prices for assets sold or purchased before year end A
P
 The discovery of fraud or errors that show that the financial statements are misstated T
E
 An adjustment to the disclosed earnings per share for transactions such as bonus issues, share splits R
or share consolidations where the number of shares altered without an increase in resources. The
additional shares are thus treated as having been in issue for the whole period.
3
Non-adjusting events after the reporting period
Non-adjusting events are events that are indicative of conditions that arose after the reporting date.
Disclosure should be made in the financial statements where the outcome of a non-adjusting event
would influence the economic decisions made by users of the financial statements.
 A major business combination after the reporting date (IFRS 3 or the disposing of a major
subsidiary)
 Announcement of plan to discontinue an operation
 Major purchases and disposals of assets
 Classification of assets as held for sale
 Expropriation of assets by government
 Destruction of assets, for example by fire or flood
 Announcing or commencing the implementation of a major restructuring
 Major ordinary share transactions (unless these involve transactions such as capitalisation or bonus
issues where there is a change in the number of shares without an inflow or outflow of resources,
see adjusting events above. Such transactions require EPS to be restated as if the new number of
shares was in issue for the whole year).
 Decline in the market value of investments including investment properties after the reporting
date. These should reflect the fair value at the reporting date and should not be affected by
hindsight.
Events after the reporting period, provisions and contingencies 83

Going concern basis
 Financial statements are prepared on the 'going-concern' basis. Where an entity goes into
liquidation after the reporting date, it is no longer considered to be a going concern and the
financial statements should not be prepared on this basis.
 Where the going-concern basis is clearly not appropriate, 'break-up basis' should be adopted. The
break-up basis measures the assets at their recoverable amount in a non trading environment, and
a provision is recognised for future costs that will be incurred to 'break-up' the business.
 Where the financial statements are not prepared on a going-concern basis, this should be fully
disclosed, along with the actual basis of preparation used.
 Management is required to make an explicit assessment of the entity's ability to continue as a
going concern by considering a number of financial, operating and other indicators. Indicative of
inability to continue as a going concern would be major restructuring of debt, adverse key financial
ratios, substantial sale of non-current assets not intended to be replaced, loss of key staff or major
markets. These are discussed further in your Audit Study Manual.
The period of review
 The cut-off date for the consideration of events after the reporting period is the date on which the
financial statements are authorised for issue. Events that occur after the reporting date but before
the financial statements are authorised for issue need to be considered, regardless of what financial
information has been made publicly available during this period.
 Normally the financial statements are authorised by the directors before being issued to the
shareholders for approval; the authorisation date is the date these are authorised for issue to the
shareholders, and not the date they are approved by the shareholders.
 Where a supervisory board is made up wholly of non-executive directors, the financial statements
will first be authorised by the executive directors for issue to that supervisory board for its approval.
The relevant cut-off date for the review of events that have occurred after the reporting date is the
date on which the financial statements are authorised for issue to the supervisory board.
 The date on which the financial statements were authorised for issue should be disclosed, since
events occurring after that date will not be reflected in the financial statements.
Treatment of errors
 Errors identified before the authorisation date will be adjusted in the current financial statements.
Those identified after the financial statements have been published, should be dealt with in a
subsequent period under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. IAS 8
requires an error relating to a prior period to be treated as an adjustment to the comparative
information presented in the subsequent financial statements.
 If a significant event occurs after the authorisation of the financial statements but before the annual
report is published, the entity is not required to apply the requirements of IAS 10. However, if the
event was so material that it affects the entity's business and operations in the future, the entity
may wish to discuss the event in the narrative section at the front of the Annual Review but outside
of the financial statements themselves.
Equity dividends
 These should only be recognised as a liability where they have been declared before the reporting
date, as this is the date on which the entity has an obligation. Where equity dividends are declared
after the reporting date, this fact should be disclosed but no liability recognised at the reporting
date.
Further points to note
Information on customers and suppliers
 Information after the reporting date on either a customer or supplier may not only affect amounts
that have been recorded in the financial statements but also impact on the future trading of the
entity.
 This should be assessed and disclosure made if the liquidation of a major customer or supplier is
likely to influence the economic decisions of users of the financial statements.
 Significant customer and supplier relationships are fundamental where an entity relies on one
major supplier. An example of a significant supplier/customer relationship is Intel Corporation and
Dell Inc, where until recently Dell computers have used only Intel microprocessors. Dell relies
almost totally on the ongoing supplier/customer relationship with Intel, and the success of Intel is
vitally important to the future trade of Dell itself.
Contingent liabilities
Evidence may come to light regarding a contingent liability or provision that an entity was unaware of
at the reporting date. The distinction between a contingent liability and a provision is discussed in IAS
37 Provisions, Contingent Liabilities and Contingent Assets. An example of an unknown provision is where,
because of a major fault with goods which were purchased before the reporting date, an electrical retail
chain has had the goods returned after the reporting date. The fault may raise safety issues and the
retailer may have to recall all such items sold within a period of time in order to repair the fault. In such
circumstances, a provision should be recognised for the repair of all items that have been sold prior to
the reporting date. The entity may not have been aware of the problem at the reporting date, but as it
existed at that date, a provision should be recognised in light of the new information.
Interactive question 1: Various events [Difficulty level: Easy]

The Roach Company is completing the preparation of its draft financial statements for the year ended
31 May 20X6.
On 24 July 20X6, an equity dividend of £200,000 was declared and a contractual profit share payment C
H
of £35,000 was made, both based on the profits for the year to 31 May 20X6.
A
On 20 June 20X6, a customer went into liquidation having owed the company £31,000 for the past six P
T
months. No provision had been made against this debt. E
On 17 July 20X6, a manufacturing plant was destroyed by fire resulting in a financial loss of £200,000. R
Requirement
According to IAS 10 Events After the Reporting Period, which amounts should be recognised in Roach's 3
financial statements for the year to 31 May 20X6 to reflect adjusting events after the reporting period?
Interactive question 2: Significant events [Difficulty level: Easy]

An entity's draft financial statements for the year ended 31 December 20X3 were completed on 30 May
20X4, approved by the finance director on 7 June 20X4, authorised for issue on 20 June 20X4 and
approved by the shareholders on 5 July 20X4.
The following events occurred after the reporting date (assume all amounts are significant to the entity):
(1) Notification on 18 Feb 20X4 that a customer owing £100,000 as at 31 December 20X3 has gone
into liquidation. The financial statements already include a specific provision of £20,000 for this
customer and the entity does not make general provisions.
(2) A rights issue on 6 April 20X4 to raise £1,500,000 for an acquisition.
(3) Confirmation on 28 May 20X4 from the entity's insurer that they will pay £500,000 for inventories
that were destroyed in a fire on 24 December 20X3. The entity had claimed £650,000 and
included this as a receivable in the financial statements.
Requirement
How should the entity treat these events in its financial statements?

Interactive question 3: Dividends proposed and declared [Difficulty level: Easy]
The recent financial calendar of an entity with a 31 December year end, has included the following:
Authorised by directors for Approved in annual
issue general meeting
Financial statements for 20X2 28 February 20X3 3 May 20X3
Financial statements for 20X3 28 February 20X4 4 May 20X4
Dividends on ordinary Proposed by directors Declared by Approved in annual general

shares directors meeting
20X2 final 28 Feb 20X3 no yes
20X3 interim 31 Aug 20X3 yes no
20X3 final 28 Feb 20X4 no yes
Requirement
How will the dividends be dealt with in the entity's financial statements?
2 IAS 37 Provisions, Contingent Liabilities and Contingent

Assets
Section overview
 The following is a summary of the material covered in earlier studies.
2.1 Overview of earlier studies
Definition
A provision: A liability where there is uncertainty over its timing or the amount at which it will be
settled.
Recognition
 A provision should be recognised when:
– An entity has a present obligation (legal or constructive) as a result of a past event;
– It is probable that there will be an outflow of resources in the form of cash or other assets; and
– A reliable estimate can be made of the amount.
 A provision should not be recognised in respect of future operating losses since there is no present
obligation arising from a past event.
Onerous contracts
 If future benefits under a contract are expected to be less than the unavoidable costs under it, the
contract is described as onerous. The excess unavoidable costs should be provided for at the time a
contract becomes onerous.
Restructuring costs
 A constructive obligation, requiring a provision, only arises in respect of restructuring costs where
the following criteria are met:
– A detailed formal plan has been made, identifying the areas of the business and number of
employees affected with an estimate of likely costs and timescales; and
– An announcement has been made to those who will be affected by the restructuring.
Contingent liability
 A contingent liability arises where a past event may lead to an entity having a liability in the future
but the financial impact of the event will only be confirmed by the outcome of some future event
not wholly within the entity's control.
 A contingent liability should be disclosed in the financial statements unless the possible outflow of
resources is thought to be remote.
Contingent asset
 A contingent asset is a potential asset that arises from past events but whose existence can only be
confirmed by the outcome of future events not wholly within an entity's control.
 A contingent asset should be disclosed in the financial statements only when the expected inflow
of economic benefits is probable.
Reimbursement
 An entity may be entitled to reimbursement from a third party for all or part of the expenditure
required to settle a provision. In these circumstances, an entity generally retains the contractual
obligation to settle the expenditure. A provision and reimbursement are therefore recognised
separately in the statement of financial position. A reimbursement should be recognised only when
it is virtually certain that an amount will be received.
Recognition and disclosure
 A full reconciliation of movements in provisions should be presented in the financial statements.
Detailed narrative explanations should also be provided in relation to provisions, contingent C
liabilities and contingent assets. The narrative should include an estimate of the financial amount in H
relation to contingent liabilities and assets as well as indications of uncertainties. A
P
 The required disclosures have already been covered at Professional level. In particular, in relation to T
discounting, any increase in the value of the discounted amount arising from the passage of time E
R
or the effect of any change in the discount rate need to be disclosed.
Disclosure let out
3
 IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent
liabilities and contingent assets if they would be expected to be seriously prejudicial to the
position of the entity in dispute with other parties. However, this should only be employed in
extremely rare cases. Details of the general nature of the provision/contingency must still be
provided, together with an explanation of why it has not been disclosed.
Discounting to present value
 Where the time value of money is material, the amount of provision should be the present value of
the expenditures required to settle the obligation. The main types of provision where the impact of
discounting may be significant are those relating to decommissioning and other environmental
restoration liabilities. For most other provisions, no discounting will be required as the cash flows
are not sufficiently far into the future.
 The discount rate to be used should reflect current market assessments of the time value of money
and the risks specific to the liability (ie it would be a risk adjusted rate). In practice it may be more
appropriate to use a risk-free rate and adjust the cash flows for risk. For further guidance on the
risk-free rate you may refer to your Business Analysis Study Manual. Whichever method is adopted,
it is important not to double count risk.
Unwinding the discount
 Where discounting is used, the carrying amount of the provision increases each period to reflect
the passage of time and this is recognised as a finance cost in profit or loss.

Interactive question 4: Constructive obligation [Difficulty level: Intermediate]
On 25 September 20X7, further to a decision made earlier in the year by the Board of directors,
Industrial plc announced publicly a decision to reduce the level of harmful emissions from its
manufacturing plants.
The directors had reached their decision to proceed with the project after appraising the investment
using discounted cash flow techniques and an annual discount rate of 8%.
The directors estimated that the future cash payments required to meet their stated objective would be:
 £20 million on 30 September 20X8
 £25 million on 30 September 20X9
 £30 million on 30 September 20Y0
No contracts were entered into until after the start of the new accounting year on 1 October 20X7,
however the entity has a reputation of fulfilling its financial commitments after it has publicly
announced them. Industrial included a provision for the expected costs of its proposal in its financial
statements for the year ended 30 September 20X7. The actual expenditure in September 20X8 was £20
million as expected.
The average remaining useful lives of the factories on 30 September 20X7 (the reporting date) was 30
years and depreciation is computed on a straight-line basis and charged to cost of sales.
Requirements
(a) Compute the appropriate provision in the statements of financial position in respect of the
proposed expenditure at 30 September 20X7 AND 30 September 20X8, and explain why the
directors decided to recognise the provision.
(b) Compute the two components of the charge to profit in respect of the proposal for the year ended
30 September 20X8. You should explain how each component arises and identify where in the
statement of profit or loss and other comprehensive income each component is reported.
Interactive question 5: Unwinding the discount [Difficulty level: Intermediate]

A company has a present obligation at 31 December 20X0, which it expects to settle in four years' time
for £200,000. It calculates that the present value of the obligation is £136,603, discounted at 10%.
The unwinding of the discount in 20X1, 20X2, 20X3 and 20X4 is shown in the table below.
Provision
Cr
Cr Unwinding Cr
Balance discount Balance
b/f @10% c/f
1 Jan 31 Dec 31 Dec
£ ££
20X1 136,603 13,660 150,263
20X2 150,263 15,026 165,289
20X3 165,289 16,529 181,818
20X4 181,818 18,182 200,000
Requirement
What are the accounting entries for the above for 20X1?
Interactive question 6: Restructuring [Difficulty level: Intermediate]
(a) An entity has a 31 December year end. The directors approved a major restructuring programme
on 1 December 20X5 and announced the details on the entity's intranet and to the media on 2
December 20X5. The programme involves two stages.
Stage 1 Closure of three production lines during 20X6, the redundancy of 3,000 employees on
31 March 20X6, and the transfer during 20X6 of 500 employees to continuing parts of the
business. All associated costs would be settled during 20X6.
Stage 2 Probable closure of four more production lines during 20X7, with probable redundancies
of 3,500 employees during 20X7. Other staff will be transferred to continuing businesses.
All associated costs would be settled during 20X7. Assume that the details of stage 2 were
formally confirmed on 1 November 20X6.
(b) The entity had some years ago signed a 'take or pay' contract with a supplier, in order to ensure
the reliable supply each year of 100,000 tonnes of critical raw materials to each of the seven
production lines affected by the restructuring programme. Under the contract, the entity must pay
for the 700,000 tonnes each year, even if it decides not to take delivery. This contract falls due for
renewal on 1 January 20X8.
Requirement
How should these matters be recognised in the statement of profit or loss and other comprehensive
income?
C
H
A
Interactive question 7: Obligation to dismantle [Difficulty level: Intermediate] P
T
A company is awarded a contract to build and operate a nuclear power station on 1 January 20X1. The E
power station comes into operation on 31 December 20X3 and the operating licence is for 30 years R
from that date.
The construction cost of the power station was £450m. Part of the agreement for the contract was that
3
in addition to building and operating the power station, the company is obliged to dismantle it at the
end of its 30-year life and make the site safe for alternative use. At 31 December 20X3, the estimated
cost of the obligation was £50m.
An appropriate discount rate reflecting market assessments of the time value of money and risks specific
to the power station is 8%.
Requirement
Explain the treatment of the cost of the power station and obligation to dismantle it as at 31 December
20X3 and for the year ended 31 December 20X4.
Work to the nearest £0.1m.

Summary
Events after the Reporting Period,
provisions and contingencies
IAS 10 IAS 37
Events after the Provisions and
Reporting Period Contingencies
Did the event

occur between Is there a present
No Possible No
the reporting date obligation as a result obligation?
and the date of an obligating event?
on which the
Yes Yes
financial
statements No Yes
were authorised Probable outflow? Remote?
for issue? Yes No
Yes No No (rare)
Reliable estimate?
Does the
event relate Yes
Outside
to a condition the Do nothing
Provide Disclose contingent liability
that existed scope
as at the of IAS 10
reporting date?
Yes No
This is Does the

an adjusting event mean that
event and management
financial statements will have to
should be liquidate the
adjusted as entity or cease
appropriate trading?
Yes No
This is a
Going concern non-adjusting
basis not appropriate. event and the
Disclosure of the numbers in the
change of basis financial statements
to be made in should not be
accordance with changed. However,
IAS 1 Presentation of disclosure should
Financial Statements generally be provided
Self-test
IAS 10 Events After the Reporting Period
1 ABC International
ABC International Inc is a company that deals extensively with overseas entities and its financial
statements include a substantial number of foreign currency transactions. The entity also holds a
portfolio of investment properties.
Requirement
Discuss the treatment of the following events after the reporting date.
(a) Between the reporting date of 31 December 20X6 and the authorisation date of 20 March
20X7, there were significant fluctuations in foreign exchange rates that were outside those
normally expected.
(b) The entity obtained independent valuations of its investment properties at the reporting date
based on current prices for similar properties. On 15 March 20X7, market conditions which
included an unexpected rise in interest rates and the expectation of further rises resulted in a
fall in the market value of the investment properties.
(c) A competitor introduced an improved product on 1 February 20X7 that caused a significant
price reduction in the entity's own products.
2 Saimaa
The Saimaa Company operates in the banking industry. It is attempting to sell one of its major
administrative office buildings and relocate its employees. C
H
Saimaa has found a potential buyer, The Nipigon Company, which operates a chain of retail stores. A
Nipigon would like to convert the building into a new retail store but would require planning P
T
permission for this change of use. Nipigon may, however, still consider purchasing the building E
and using it for its own administrative offices if planning permission is declined. It is estimated that R
there is approximately a 50% probability of planning permission being granted.
A contract for sale of the building is to be drawn up in November 20X7 and two alternatives are
3
available:
Contract 1 This sale contract would be made conditional on planning permission being
granted. Thus the contract would be void if planning permission is not granted but
it would otherwise be binding.
Contract 2 This contract would be unconditional and binding, except that the price would vary
according to whether or not planning permission is granted.
The financial statements of Saimaa for the year to 31 December 20X7 are authorised for issue on
28 March 20X8. A decision on planning permission will be made in February 20X8.
Requirement
With respect to the financial statements of Saimaa for the year to 31 December 20X7, and
according to IAS 10 Events After the Reporting Period, indicate whether the granting of planning
permission on each of the contracts is an adjusting event.
3 Quokka
The Quokka Company manufactures balers for agricultural use. The selling price per baler, net of
selling expenses, at 31 December 20X7 is £38,000. Due to increasing competition, however,
Quokka decides to reduce the selling price by £5,000 on 3 January 20X8.
On 4 January 20X8 a health and safety report was delivered to Quokka by the government,
showing that some of its balers were toppling over on moderate gradients. £9,000 per baler would
need to be incurred by Quokka to correct the fault. No further sales could be made without the
correction. Quokka had been unaware of any problem or health and safety investigation until the
report was delivered.
The financial statements of Quokka for the year to 31 December 20X7 are to be authorised for
issue on 23 March 20X8.

The cost of manufacture for each baler was £36,000 and there were 80 balers in inventory at 31
December 20X7.
Requirement
After adjustment (if any) for the above events, what should be the carrying amount of the
inventory in the financial statements of Quokka at 31 December 20X7, in accordance with IAS 10
Events After the Reporting Period, and IAS 2 Inventories?
4 Labeatis
The financial statements of the Labeatis Company for the year to 31 December 20X7 were
approved and issued with the authority of the board of directors on 6 March 20X8. The financial
statements were not, however, presented to the shareholders' meeting until 27 March 20X8.
The following events took place:
Event 1 On 18 February 20X8 the government announced a retrospective increase in the tax rate
applicable to Labeatis's year ending 31 December 20X7.
Event 2 On 19 March 20X8 a fraud was discovered which had had a material effect on the
financial statements of Labeatis for the year ending 31 December 20X7.
Requirement
State which event (if any) is an adjusting event according to IAS 10 Events After the Reporting Period.
5 Scioto
The Scioto Company's financial statements for the year ended 30 April 20X7 were approved by its
finance director on 7 July 20X7 and a public announcement of its profits for the year was made on
10 July 20X7.
The board of directors authorised the financial statements for issue on 15 July 20X7 and they were
approved by the shareholders on 20 July 20X7.
Requirement
Under IAS 10 Events After the Reporting Period, after which date should consideration no longer be
given as to whether the financial statements to 30 April 20X7 need to reflect adjusting and non-
adjusting events?
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
6 Fushia
The Fushia Company sells electrical goods covered by one-year warranty for any defects.
Of sales of £60 million for the year, the company estimates that 3% will have major defects, 6%
will have minor defects and 91% will have no defects.
The cost of repairs would be £5 million if all the products sold had major defects and £3 million if
all had minor defects.
Requirement
What amount should Fushia provide as a warranty provision?
7 Wilcox
The Wilcox Company has been lead mining in Valovia for many years. To clean the lead, Wilcox
uses toxic chemicals which are then deposited back into the mines. Historically there has not been
any legislation requiring environmental damage to be cleaned up. The company has a policy of
only observing its environmental responsibilities when legally obliged.
In December 20X7, the government of Valovia introduced legislation on a retrospective basis,
forcing mining companies to rectify environmental damage that they have caused.
Wilcox estimates that the damage already caused will cost £27 million to rectify, but the work
would not be paid for until December 20X9. It also estimates that damage caused by its operations
each year for the remaining four years of the mines' lifespan will be £3 million, payable at the end
of the relevant year.
17% is the pre-tax rate that reflects the time value of money and the risk specific to these liabilities.
Requirement
To the nearest £1 million, what provision should be shown in the statement of financial position of
Wilcox at 31 December 20X7 under IAS 37 Provisions, Contingent Liabilities and Contingent Assets?
8 Yau Enterprise
The Yau Enterprise Company signed a non-cancellable lease for a property, Hyde Court, on 1
January 20X4. The lease was for a period of 10 years, at an annual rental of £480,000 payable in
arrears.
On 31 December 20X7, Yau Enterprise vacated Hyde Court to move to larger premises. Yau
Enterprise has the choice of signing a contract to sub-lease Hyde Court at an annual rental of
£120,000 for the remaining six years of the lease, payable in arrears, or immediately to pay
compensation of £2.2 million to Hyde Court's landlord.
5% is the pre-tax rate that reflects the time value of money and the risk specific to these liabilities.
The cumulative present value of £1 for 6 years at an interest rate of 5% is £5.076.
Requirement
What provision should appear in the statement of financial position of Yau Enterprise at 31
December 20X7 under IAS 37 Provisions, Contingent Liabilities and Contingent Assets?
9 Noble
The Noble Company operates a fleet of commercial aircraft. On 1 April 20X7 a new law was
introduced requiring all operators to use aircraft fitted with fuel-efficient engines only. C
H
At 31 December 20X7 Noble had not fitted any fuel-efficient engines and the total cost of fitting A
them throughout the fleet was estimated at £4.2 million. P
T
Under the terms of the legislation, the company is liable for a fine of £1 million for non-compliance E
with legislation for any calendar year, or part of a year, in which the law has been broken. The R
government rigorously prosecutes all violations of the new law.
The effect of the time value of money is immaterial.
3
Requirement
State the provision required in Noble's financial statements for the year ended 31 December 20X7
under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
10 Noname
The Noname Company decided to carry out a fundamental restructuring of its papermaking
division which operates in Hyberia. The effect was that most activities carried out in this location
would cease with a number of employees being made redundant, whereas other activities and
employees would relocate to Sidonia where there was unused capacity. Negotiations with
landlords and employee representatives were concluded on 30 December 20X7 and a formal
announcement was made to all employees on 31 December 20X7.

The restructuring budget approved by the board of directors in November 20X7 included the
following amounts:
£
Payments to employees:
Termination payments to those taking voluntary redundancy 90,000
Termination payments to those being made compulsorily redundant 180,000
One-off payments to employees agreeing to move to Sidonia 37,000
Employment cost for closing down activities in Hyberia in preparation 50,000
for the move to Sidonia
Lease costs:
5 years remaining of a lease which can immediately be sublet for 45,000 per annum
£70,000 per annum
7 years remaining of a lease which can immediately be sublet for 90,000 per annum
£35,000 per annum
Cost of moving plant and equipment from Hyberia to Sidonia 26,000
Impairment losses on non-current assets under IAS 36 Impairment of 110,000
Assets
Trading transactions in Hyberia up to date of closure, other than those
itemised above:
Revenue 850,000
Expenses 1,150,000
None of these amounts has yet been recognised in Noname's financial statements. The effect of
the time value of money is immaterial.
Requirement
Determine the amounts to be included in the financial statements for the Noname Company for
the year ending 31 December 20X7 according to IAS 37 Provisions, Contingent Liabilities and
Contingent Assets.
Technical reference
IAS 10 Events after the Reporting Period
1 Authorisation
 Process of authorisation of financial statements IAS 10.4
 Authorisation date is the date on which financial statements are authorised for IAS 10.5, 10.6
issue to shareholders
 The relevant cut-off date for consideration of events after the reporting period is IAS 10.7
the authorisation date
2 Adjusting events
 Amounts recognised in financial statements should be adjusted to reflect IAS 10.8, 10.9
adjusting events after the reporting date
 Examples of adjusting events include
– Outcome of court case that confirms obligation at reporting date
– Receipt of information on recoverability or value of assets
– Finalisation of profit sharing or bonus payments
– Discovery of fraud or errors C
H
A
3 Non-adjusting events P
T
 An entity should not adjust amounts recognised in financial statements for non- IAS 10.10
E
adjusting events after the reporting period R
 Subsequent decline of market value of investments
 Non-adjusting events may need to be disclosed IAS 10.10 3
 Dividends proposed or declared on equity instruments after the reporting date IAS 10.12
cannot be recognised as a liability at the reporting date
 Dividends proposed or declared after the reporting date should be disclosed IAS 10.13
4 Going concern basis

 Financial statements are not to be prepared on going concern basis if IAS 10.14
management intends to liquidate entity or cease trading
 If going concern assumption no longer appropriate, disclosures required in IAS 10.16
accordance with IAS 1
5 Disclosure
 Date of authorisation to be disclosed IAS 10.17
 Disclosures relating to information after the reporting date to be updated in the IAS 10.19
light of new information
 For material non-adjusting events after the reporting period an entity shall IAS 10.21
disclose
– Nature of event
– Estimate of financial effect

 Scope IAS 37.1
 Recognition of provisions IAS 37.14-15
 Contingent liabilities IAS 37.27
 Contingent assets IAS 37.31
 Measurement best estimate IAS 37.36
 Risks and uncertainties IAS 37.42
 Present value IAS 37.45-47
 Future events IAS 37.48
 Onerous contracts IAS 37.66
IAS 37.70-72
 Restructuring
IAS 37.78-80
IAS 10 Events After the Reporting Period

1 ABC International
(a) Details of the abnormal fluctuations in exchange rates should be disclosed as a non-adjusting
event after the reporting period.
(b) The decline in the value of investment properties is a non-adjusting event as it does not reflect
the state of the market at the reporting date. The valuation should reflect the state of the
market at the reporting date and should not be affected by hindsight or events at a later date.
(c) The improved product issued by the competitor is likely to have been developed over a period
of time. The value of inventories should be reviewed and adjusted to their net realisable value
where appropriate. Non-current assets may need to be reviewed for possible impairment. This
is an adjusting event as it reflects increased competitive conditions which existed at the
reporting date even if the entity was not fully aware of them.
2 Saimaa
Contract 1 is a non-adjusting event. Contract 2 is an adjusting event.
Under IAS 10.3, events after the reporting period are those which occur after the reporting period
but before the financial statements are authorised for issue. The planning permission decision is
C
such an event, because it is to be made before the financial statements are to be authorised for H
issue on 28 March 20X8. Adjusting events are those providing evidence of conditions that existed A
at the reporting date and non-adjusting events are those indicative of conditions that arose after P
that date. T
E
Under Contract 1, the uncertainty surrounding the contract at the reporting date would be such R
that no sale could be recognised as at that date. So there is no transaction for which the planning
permission decision could provide evidence and there would not be an adjusting event.
3
Under Contract 2, there would be an unconditional sale recognised at the reporting date, with
only the consideration needing to be confirmed after the reporting date. According to IAS 10.9(c)
the planning permission decision would provide additional evidence of the proceeds and would be
an adjusting event.
3 Quokka
£1,920,000
IAS 2.9 states that inventories should be stated at the lower of cost and NRV, and under IAS
10.9(b)(ii) the sale of inventories after the reporting date may give evidence of NRV at the
reporting date.
The 3 January price reduction is a response to competitive conditions which would have existed at
the reporting date. So even though it comes after the year end, it is an adjusting event. Similarly,
the safety report received after the year end relates to conditions at the year end (as the balers in
inventories were defective at this date) and is an adjusting event.
The carrying amount is 80 balers at the lower of cost (£36,000) and NRV £(38,000 – 5,000 –
9,000).
So 80  £24,000 = £1,920,000
4 Labeatis
Event 1 is a non-adjusting event. Event 2 happened after the statements were authorised, so does
not constitute an event after the reporting period.
Applying IAS 10.3, events after the reporting period are those which occur after the 31 December
20X7 reporting date but before the financial statements are authorised for issue on 6 March 20X8.

Event 1 occurs before the 6 March 20X8 but is a non-adjusting event, because in accordance with
IAS 10.22(h) this change was not enacted before the reporting date. This is the case even though
the announcement has retrospective effect on the financial statements still being prepared.
Event 2, the discovery of fraud, would have been an adjusting event per IAS 10.9(e), had it
occurred prior to the date of authorisation for issue. As it was not discovered until 19 March 20X8,
it is not even an event after the reporting period, let alone an adjusting event.
5 Scioto
15 July is the correct answer.
IAS 10.7 states that the authorisation date is the date on which the financial statements are
authorised for issue, even if this is after a public announcement of profit. IAS 10.5 confirms that it is
not the date on which the shareholders approve the financial statements.
6 Fushia
£330,000
Provision must be made for estimated future claims by customers for goods already sold.
The expected value (£5 million  3%) + (£3 million  6%) is the best estimate of this amount
(IAS 37.39).
7 Wilcox
£20 million
At the year end a legal obligation exists – through the retrospective legislation – as a result of a past
event (the environmental damage caused in the past) (IAS 37.14). The company should therefore
create a provision for the damage that has already been caused.
It should not now set up a provision for the future damage, because that will be caused by a future
event (the company could close down the mines and therefore not cause further damage to the
environment).
Because the effect of discounting at 17% over two years is material, the cost should be discounted
to present value (IAS 37.45).
2
So, the provision is £27m/1.17 = £20m (to the nearest £m)
8 Yau Enterprise
£1,827,360
The signing of the lease is a past event that creates a legal obligation to pay for the property under
the terms of the contract and is an obligating event (IAS 37.14). The company should therefore
create a provision for the onerous contract that arises on leaving the premises (IAS 37.66). This is
calculated as the excess of unavoidable costs of the contract over the economic benefits to be
received from it. The unavoidable cost is the lower of the cost of fulfilling the contract and the
penalty that arises from failing to fulfil it (IAS 37.68).
The effect of the time value of money over six years is material, so the provision should be
discounted to its present value (IAS 37.45).
The present value of the sub-lease arrangement is £1,827,360 ((£480,000 – £120,000)  5.076).
As this is less than the £2.2m compensation payable, it should be used to measure the provision.
9 Noble
No provision is required for the fitting of the engines. This is because the present obligation as a
result of the past event required by IAS 37.14 does not exist. The company can choose not to fit
the engines and then not to operate the aircraft.
A provision of £1.0 million is, however required in relation to the fines, because at the reporting
date there is a present obligation in respect of a past event (the non-compliance with legislation).
10 Noname
The total amount recognised in profit or loss is the £385,000 lease provision for the onerous lease +
the £270,000 restructuring provision + the £110,000 impairment losses = £765,000
The five-year lease is not an onerous contract in terms of IAS 37.10 because the premises can be
sublet at profit. The seven-year lease is an onerous contract and under IAS 37.66 the provision
should be measured at (£90,000 – 35,000)  seven years = £385,000.
Under IAS 37.80 all the payments to employees should be included in the restructuring provision,
with the exception of the employment costs of £50,000 in preparation for the move to Sidonia and
£37,000 payable to those moving to Sidonia – this relates to the ongoing activities of the business,
so is disallowed by IAS 37.80(b). For the same reason the costs of moving plant and equipment is
disallowed. Impairment losses reduce the carrying amount of the relevant assets rather than
increasing the restructuring provision and revenue less expenses are trading losses which are
disallowed by IAS 37.63. So provision, excluding the onerous lease is £90,000 + 180,000 =
£270,000.
C
H
A
P
T
E
R


The £35,000 profit share payment and the £31,000 bad debt expense are adjusting events and should
be recognised in the financial statements.
See IAS 10.9, 10.12 and 10.22.

(1) This is an adjusting event as it provides more up-to-date information about a provision that was
recognised at the reporting date. The £100,000 receivable should be written off.
(2) This is a disclosable non-adjusting event. The rights issue occurred after the reporting date, but is
considered to be of significant importance and should be disclosed in the financial statements.
(3) This is an adjusting event since it is in relation to an asset that was recognised at the reporting
date. The receivable should be reduced to £500,000.

These dividends will be dealt with in the entity's financial statements for 20X2, 20X3 and 20X4 as
follows:
Financial statements 20X2 20X3 20X4
for:
20X2 final dividend disclosed in the charged to statement of —
notes changes in equity
20X3 interim dividend — charged to statement of —

changes in equity
20X3 final dividend — disclosed in the notes charged to statement
of changes in equity

(a) Provision at 30 September 20X7
£'000
Expenditure on:
30 September 20X8 20,000  0.926 18,520
30 September 20X9 25,000  0.857 21,425
30 September 20Y0 30,000  0.794 23,820
63,765
Provision at 30 September 20X8

£'000
Expenditure on:
30 September 20X9 25,000  0.926 23,150
30 September 20Y0 30,000  0.857 25,710
48,860
A provision should be recognised where
1 There is a present obligation as a result of a past event, and
2 There is a probable outflow of economic benefits, and
3 The amount can be measured reliably.
2 and 3 are clearly met, as Industrial will incur expenditure and the detailed estimates of the
amounts have been prepared.

By announcing the plan to reduce emissions publicly, Industrial has created a constructive
obligation to carry out the project. Therefore, although there is no legal obligation, Industrial
should record a provision for the estimated (and discounted) costs of the project.
(b) The charge to profit or loss for the year ended 30 September 20X8 consists of:
(i) Depreciation (£63,765,000  30) £ 2,125,500
This is reported in cost of sales.

The provision of £63,765,000 also represents an asset as it gives rise to future economic
benefits (it enhances the performance of the factories). This is capitalised and depreciated
over 30 years (the average useful life of the factories).
(ii) Unwinding of the discount (see working) £ 5,095,000
This is reported as a finance cost.

WORKING
£'000
Provision at 1 October 20X7 63,765
Expenditure on 30 September 20X8 (20,000)
Unwinding of discount (balancing figure) 5,095
Provision at 30 September 20X8 48,860
The accounting entry to record the unwinding of the discount in 20X1 will be:
C
Dr Finance costs £13,660 H
Cr Provisions £13,660 A
P
T
E
(a) Detailed information was made available about who would be affected by Stage 1 and when the
various steps in the first stage of the closure programme would take place.
3
The announcement about Stage 2 was more of an overview. It was not until 1 November 20X6
that information was announced in respect of Stage 2 in as much detail as that provided in
December 20X5 about Stage 1. There is a constructive obligation in respect of Stage 1 on 2
December 20X5, no such obligation in respect of Stage 2 is made until 1 November 20X6.
Although the announcement is made as a single restructuring programme, there will be two
entirely separate restructuring provisions.
The costs of this major programme will be recognised in profit or loss for the years ending 31
December 20X5 – 20X7 as follows.
Reason Stage 1 Stage 2
Termination payments to those taking voluntary Restructuring 20X5 20X6
redundancy provision
Termination payments to those being made Restructuring 20X5 20X6
compulsorily redundant provision
Employment costs during closing down activities Restructuring 20X5 20X6
and selling off inventory provision
One-off payments to employees agreeing to Continuing 20X6 20X7
move to continuing parts of the business activities
Cost of moving plant and equipment to Continuing 20X6 20X7
continuing parts of the business activities
Cost of moving saleable inventory to continuing Continuing 20X6 20X7
parts of the business activities

Reason Stage 1 Stage 2
Impairment losses on non-current assets See Note 20X5 & 20X5 to
20X6 20X7
Losses on disposal of non-current assets Year when loss 20X6 20X7
on disposal
incurred
Revenue less expenses up to date of closure, Year when 20X6 20X7
other than itemised expenses operating losses
incurred
Note:
The announcement of a restructuring programme is an indicator of impairment under IAS 36, so
an impairment test should be carried out at the time of the first announcement for all relevant non-
current assets. Despite Stage 2 only being 'probable', its assets should still be tested for impairment
in 20X5.
(b) A provision should be recognised in respect of all contracts when they become onerous, regardless
of whether this is associated with a restructuring programme. If the entity's production lines were
loss-making before the restructuring announcement, then this contract may already have been
classified as onerous.
If it had not already been identified as being onerous, then at a minimum, a provision should be
made for the 300,000 tonnes per annum for the three Stage 1 production lines, for the period
from when they cannot take any further supplies through to the end of the contract on 31
December 20X7.
A provision should be made for the remaining 400,000 tonnes per annum for the four Stage 2
production lines for the period from when they cannot take any further supplies through to the
end of the contract on 31 December 20X7.
NB: This answer includes a comprehensive list of issues to be considered under restructuring
programmes, included for learning purposes.

At 31 December 20X3
The discounted amount of the provision would be included in the initial measurement of the cost of the
power station as at 31 December 20X3:
£m
Cost 450.0
30
Provision (£50m  1/1.08 ) 5.0
455.0
Year ended 31 December 20X4
The power plant would be depreciated over its 30-year life resulting in a charge of £455.0m/ 30 =
£15.2m to profit or loss and a carrying amount of £455m – £15.2m = £439.8m.
The provision would begin to be compounded resulting in an interest charge of £5.0  8% = £0.4m and
an outstanding provision of £5.0 + £0.4 = £5.4m in the statement of financial position.
Any change in the expected present value of the provision would be made as an adjustment to the
provision and to the asset value (affecting future depreciation charges).

CHAPTER 4
Leases, government grants

and borrowing costs
Introduction
Topic List
IAS 17 Leases
1 Overview of material covered in earlier studies
2 Evaluating the substance of transactions involving the legal form of a lease – SIC
27 and Operating lease incentives – SIC 15
3 Determining Whether an Arrangement Contains a Lease – IFRIC 4
4 Current developments
5 IAS 20 Accounting For Government Grants and Disclosure of Government Assistance
6 IAS 23 Borrowing Costs
Technical reference
103
Introduction
 Apply and discuss the classification of leases for lessees and lessors in accordance with
IAS 17 Leases
 Account for and discuss sale and leaseback transactions
 Account for and discuss government grants in accordance with IAS 20 Government Grants
 Account for and discuss borrowing costs in accordance with IAS 23 Borrowing Costs

1 Overview of material covered in earlier studies
Section overview
 IAS 17 Leases was the first Standard to address the problem of substance over form.
 The correct treatment of the transaction in the financial statements of both the lessee and the
lessor is determined by the commercial substance of the lease. The legal form of any lease is that
the title to the asset remains with the lessor.
 The approach to lessor accounting is very similar to that for lessee accounting, the key difference
being the inclusion of 'unguaranteed residual value'.
1.1 Lessee accounting

Lessee accounting
Finance lease Operating lease
 A lease that transfers substantially all the  A lease other than a finance lease
risks and rewards incidental to
ownership of an asset to the lessee. Title
may or may not eventually be transferred
 Capitalise asset and recognise liability at  Rentals are charged to profit or loss on a
fair value of leased property or, if lower, straight-line basis over the lease term
present value of minimum lease payments unless another systematic basis is
representative of the user's benefit
 Add initial direct costs (incremental costs  Incentives to sign operating leases (and
directly attributable to negotiating and initial reverse premiums or rent-free
arranging a lease) to amount recognised as periods) are spread over the life of the
an asset operating lease reducing the overall
payments on the lease charged to profit or
loss (SIC–15) C
H
(see also Section 2)
A
P
 Depreciate asset over the shorter of the
T
useful life and the lease term including any E
secondary period (useful life if reasonable R
certainty the lessee will obtain ownership)
 Apply finance charge so as to give a constant
4
rate on the outstanding liability (using the
interest rate implicit in the lease)
 Rental payments are split between the
finance charge element and the repayment of
capital
1.2 Finance lease classification

IAS 17 identifies five situations which would normally lead to a lease being classified as a finance lease.
 The lease transfers ownership of the asset to the lessee at the end of the lease term
 The lessee has the option to purchase the asset at a price sufficiently below fair value at the option
exercise date, that it is reasonably certain the option will be exercised
 The lease term is for a major part of the asset's economic life even if title is not transferred
Leases, government grants and borrowing costs 105

 Present value of minimum lease payments amounts to substantially all of the asset's fair value at
inception
 The leased asset is so specialised that it could only be used by the lessee without major
modifications being made
Definitions
Lease term: The non-cancellable period for which the lessee has contracted to lease the asset together
with any further terms for which the lessee has the option to continue to lease the asset, with or without
further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise
the option.
Minimum lease payments: The payments over the lease term that the lessee is, or can be required, to
make (excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the
lessor) plus any amounts guaranteed by the lessee or by a party related to the lessee.
1.3 Summary of disclosures

1.3.1 Leased assets
 For each class of asset, the net carrying amount at the reporting date.
1.3.2 Finance lease liabilities

 Give maturity analysis
– Not later than one year
– Later than one year and not later than five years
– Later than five years
 Reconciliation of minimum lease payments and present value
– Within one year
– Less: future finance charges
– Present value of finance lease liabilities
 Present value of finance lease liabilities
– Within one year
1.3.3 Operating leases

Disclose the future minimum lease payments under non-cancellable operating leases analysed as
follows.
 Operating lease payments
– Within one year
Interactive question 1: Lessee [Difficulty level: Intermediate]

A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are to pay:
 A non-refundable deposit of £5,800 on inception.
 Six annual instalments of £16,000 payable in arrears.
The fair value of the asset (equivalent to the present value of minimum lease payments) on 1 January
20X1 is £80,000. Its useful life to the company is five years.

As part of the lease agreement the company guaranteed to the lessor that the asset could be sold for
£8,000 at the end of the lease term. It also incurred £2,000 of costs in setting up the lease agreement.
The interest rate implicit in the lease has been calculated as 10.0%.
Requirements
(a) Prepare the relevant extracts from the financial statements (excluding notes) in respect of the
above lease for the year ended 31 December 20X1.
(b) Explain what would happen at the end of the lease if the asset could be sold by the lessor:
(i) For £10,000
(ii) For only £6,000
1.4 Lessor accounting

Lessor accounting
Finance lease Operating lease
Substance
 Risks and rewards with the lessee (or  Risks and rewards with the lessor
other third parties)
 Recognise a receivable equal to 'net  Asset retained in the books of the lessor and is
investment in the lease'. This is the depreciated over its useful life
gross investment (minimum lease
payments plus any unguaranteed residual
value (see below) accruing to the lessor)
discounted at the interest rate implicit in
the lease
 Initial direct costs incurred by the lessor  Rentals are credited to profit or loss on a
are not added separately to the net straight line basis over the lease term unless
C
investment as they are already included in another systematic basis is more representative H
the discounted figures since they are A
included in the calculation of the interest P
rate implicit in the lease (reducing the T
E
return) R
 Finance income is recognised reflecting
constant periodic rate of return on the
lessor's net investment outstanding 4
1.4.1 Unguaranteed residual value

The unguaranteed residual value is that portion of the residual value of the leased asset which is not
assured or is guaranteed solely by a party related to the lessor.
As we have already seen, to qualify as a finance lease the risks and rewards of ownership must be
transferred to the lessee. One reward of ownership is any residual value in the asset at the end of the
primary period. If the asset is returned to the lessor then it is he who receives this reward of ownership,
not the lessee. This might prevent the lease from being a finance lease if this reward is significant (IAS 17
allows insubstantial ownership risks and rewards not to pass).
IAS 17 does not state at what point it should normally be presumed that a transfer of substantially all
the risks and rewards of ownership has occurred. To judge the issue it is necessary to compare the
present value of the minimum lease payments against the fair value of the leased assets. This is an
application of discounting principles to financial statements. The discounting equation is:

Present value of Present value of Fair value of
minimum lease + unguaranteed = leased asset
payments residual amount
accruing to lessor
Note: Any guaranteed residual amount accruing to the lessor will be included in the minimum lease
payments.
You should now be able to see the scope for manipulation involving lease classification. Whether or
not a lease is classified as a finance lease can hinge on the size of the unguaranteed residual amount due
to the lessor, and that figure will only be an estimate. A lessor might be persuaded to estimate a larger
residual amount than he would otherwise have done and cause the lease to fail the test on present value
of lease payments approximating to the asset's fair value, rather than lose the business.
Interactive question 2: Unguaranteed residual value

[Difficulty level: Exam standard]
A company leased an asset to another company on 1 January 20X1 on the following terms.
Lease term 4 years
Inception of lease 1.1.X1
Annual instalments in advance £22,000
Residual value of asset as guaranteed by lessee £10,000
Expected residual value at end of lease £12,000
Fair value of the asset £82,966
Initial direct costs incurred by the lessor £700
Interest rate implicit in the lease 11%
Requirements
(a) Calculate the unguaranteed residual value and the net investment in the lease as at 1 January 20X1
(b) Prepare extracts from the financial statements of the lessor for the year ended 31.12.X1 (excluding
notes)
1.4.2 Finance income

A lessor should recognise finance income based on the pattern which reflects a constant periodic rate of
return on the net investment recognised. A systematic and rational basis for allocation should be
applied. Use of the actuarial method for determining finance costs will generally be appropriate as this
reflects accurately the constant rate of return on the net investment. IAS 17 does not state that the use
of approximations is allowed by a lessor in the way it is to a lessee, and therefore such approximations
are not appropriate.
1.4.3 Non-current assets held for sale

An asset which is provided by a lessor under a finance lease arrangement but is classified as held for sale
in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations should be treated
in accordance with IFRS 5 rather than IAS 17.
Interactive question 3: Lessor [Difficulty level: Intermediate]

For many years an entity has owned a freehold building which it has recognised as an investment
property under the fair value model of IAS 40. This requires that the property is revalued to fair value at
each reporting date with any gains or losses recognised in profit or loss. At 31 December 20X4, the
carrying amount of the building was £5 million.
On 1 January 20X5, the entity leased it out under a 40-year finance lease. The lease included a clause
transferring title to the lessee at the end of the lease; the lease was therefore recognised as a single
finance lease comprising both the land and building elements.

The annual rental is £400,000 payable in advance and the interest rate implicit in the lease has been
calculated as 8.3%.
Requirement
How should the transaction be recognised on 1 January 20X5 and in the year ending 31 December
20X5?
1.5 Manufacturer or dealer lessors

Context
 Special consideration is needed in the case of:
– Manufacturers, who lease out assets they have made
– Dealers, who acquire assets to lease to third parties
 The cost of the leased asset to its manufacturer is its manufactured cost, while a dealer would
expect to acquire the leased asset at a substantial discount to its retail price. In neither case will
cost reflect the asset's fair value.
 Such entities generally offer assets either for outright purchase or for use under arrangements
whereby the entities themselves provide a form of financing.
 Manufacturers and dealers offering finance leases should recognise separately
– A normal selling profit as if from an outright sale, based on the normal selling price adjusted
for normal volume or trade discounts
– Finance income over the lease term
 The revenue to be recognised at the lease commencement should be measured as the lower of the
fair value of the asset and the present value of the minimum lease payments computed at a market
interest rate.
– The cost of sale to be recognised at the lease commencement should be measured as the
lower of cost of the asset, or its carrying amount if different, less the present value of any
unguaranteed residual value. This will be relevant where the dealer or manufacturer has C
H
ownership of the asset at the end of the lease term and a residual value can be realised.
A
– The profit or loss should be recognised in accordance with the entity's normal accounting P
T
policy for sales transactions.
E
– A market rate of interest is applied to the minimum lease payments to ensure that where a R
dealer or manufacturer quotes an artificially low rate of interest this does not result in an
artificially high profit being recognised immediately on the outright sale component.
4
Interactive question 4: Dealer lessor [Difficulty level: Exam standard]

A motor dealer acquires vehicles of a particular model from the manufacturer for £21,000, a 20%
discount on the recommended retail price of £26,250. It offers them for sale at the recommended retail
price with 0% finance over three years, provided three annual payments of £8,750 are made in
advance. The market rate of interest is 8%.
A sale transaction made on 1 January 20X5 is recognised as a combination of an outright sale and a
finance lease. The present value of the minimum lease payments is treated as the consideration for the
outright sale and at 8% is calculated as follows:

Year Cash flow Discount factor at 8% Present value
£ £
20X5 8,750 1.000 8,750
20X6 8,750 1
= 0.926 8,102
(1.08)
1
20X7 8,750 = 0.857 7,499
(1.08)2
24,351
Requirement
How should the transaction be recognised by the dealer in the year ending 31 December 20X5?
The initial costs incurred by the dealer or manufacturer in negotiating and arranging the lease should
not be recognised as part of the initial finance receivable in the way that they are by other types of
lessors. Such costs are instead expensed at the start of the lease arrangement, because they are 'mainly
related to earning the manufacturer's or dealer's selling profit'.
1.6 Sale and leaseback transactions

Entities sometimes enter into sale and leaseback transactions. These involve the original owner of
the asset selling it, typically to a finance house or bank, and immediately leasing it back, thereby
raising cash and retaining the use of the asset.
 The accounting for a sale and finance leaseback results in any profit being recognised over the
lease term, not immediately.
 The accounting for a sale and operating leaseback depends on the relationship between the sale
price and fair value.
1.7 Sale and leaseback as a finance lease

This transaction is essentially a financing arrangement. The seller (who is subsequently the lessee) does
not dispose of the risks and rewards of ownership (because the leaseback is through a finance lease) and
no profit should be recognised immediately on disposal.
The accounting entries are:
 Derecognise the carrying amount of the asset now sold
 Recognise the sales proceeds
 Calculate the profit on sale and recognise it as deferred income
 Recognise the finance lease as asset and the associated liability in the normal way (at fair value or
the present value of the minimum lease payments, if lower)
 Recognise the profit on sale as income over the lease term
The effect is to adjust the expense in profit or loss to an amount equal to the depreciation expense
before the leaseback transaction.
Interactive question 5: Sale and leaseback as finance lease

An entity recognises its ownership of a freehold building under the IAS 16 cost model. The annual
buildings depreciation charge is £100,000, and at 31 December 20X4 the carrying amount is £3.5
million.
On 1 January 20X5, the entity sells the building to an institution for £5 million, the present value of the
minimum lease payments, and leases it back under a 40-year finance lease.

The lease includes a clause transferring title back to the entity at the end of the lease; the lease is
recognised as a single finance lease comprising both land and building elements. The annual rental is
£400,000 payable in advance and the interest rate implicit in the lease has been calculated as 8.3%.
Requirement
How should the transaction be accounted for in the financial statements on 1 January 20X5 and in the
year ending 31 December 20X5?
Because of IAS 36's provisions in respect of impairment testing any excess of an asset's carrying amount
over recoverable amount should be recognised as an impairment loss before the sale and finance
leaseback transaction is recognised.
1.8 Sale and leaseback as an operating lease

Some businesses arrange sales and operating leasebacks to give them the capital to build a replacement
asset while occupying the original one for a short period of time. For example, a football club might sell
its stadium, and then lease it back for a year, while using the sale proceeds to fund the construction of a
new stadium.
The substance of the transaction is that a sale has taken place both in terms of the legal transfer of
ownership and because the risks and rewards of ownership are not subsequently substantially re-
acquired when the leaseback is an operating lease. There is a genuine profit or loss to be recognised.
The rules about how this profit or loss should be recognised depend on the relationship between the
sale price and fair value.
 If the sale price is established at fair value, any profit or loss should be recognised immediately.
 If the sale price is below fair value and future lease payments are at market levels, any profit or loss
shall be recognised immediately.
– The sale price might be below fair value because the entity is desperate for cash, and so
accepts a low sale price to alleviate its liquidity problems. Under these circumstances it is
appropriate that the whole loss on disposal should be immediately recognised.
C
 If the sale price is below fair value and the loss is compensated for by future lease payments at H
A
below market price, the loss shall be deferred and amortised in proportion to the lease payments P
over the period for which the asset is expected to be used. T
E
 If the sale price is above fair value, the excess over fair value shall be deferred and amortised over R
the period for which the asset is expected to be used.
Considering now the relationship between carrying amount and fair value, if the fair value at the time
of a sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the 4
amount of the difference should be recognised immediately.
The following table summarises these rules.
Sale price at fair value
Carrying amount Carrying amount less Carrying amount

equal to fair value than fair value above fair value
Profit No profit Recognise profit N/A

immediately
Loss No loss N/A Recognise loss
immediately

Sale price below fair value

Profit No profit Recognise profit No profit (Note 1)

immediately
Loss not compensated Recognise loss Recognise loss Note 1
immediately for by immediately immediately
future lease rentals
below market rate
Loss compensated for Defer and amortise Defer and amortise Note 1
by future lease rentals loss loss
below market rate
Sale price above fair value

Profit Defer and amortise Defer and amortise Defer and amortise
profit (sale price less fair profit (Note 2)
value)
Recognise
immediately (fair
value less carrying
amount)
Loss No loss No loss Note 1
Note 1
IAS 17 requires the carrying amount of an asset to be written down to fair value where it is subject to a
sale and leaseback.
Note 2
Profit is the difference between fair value and sale price because the carrying amount would have been
written down to fair value in accordance with IAS 17.
2 Evaluating the substance of transactions involving the

legal form of a lease – SIC 27 and Operating lease
incentives – SIC 15
Section overview
 Entities sometimes enter into a series of structured transactions that involve the legal form of a
lease. These are addressed by SIC 27.
 In negotiating a new operating lease, the lessor may provide incentives to the lessee. These are
dealt with by SIC 15.
2.1 Lease and leaseback arrangements (SIC 27)

SIC 27 – Evaluating the Substance of Transactions Involving the Legal Form of a Lease relates to the
situation where an entity may enter into a series of structured transactions (an arrangement) with an
unrelated party (an investor) that involves the legal form of a lease.

One example of this is a lease and leaseback arrangement where an entity leases an asset to an investor
and then leases the same asset back in order to continue using it.
In these circumstances, if the two leases are similar, then the economic substance is unchanged and the
entity should continue to recognise the lease as previously. Thus, the general rule is that accounting
treatment should reflect the economic substance of the arrangement.
Where there are a series of transactions that involve the legal form of a lease and they are linked they
should be accounted for as one transaction when the overall economic effect cannot be understood
without reference to the series of transactions as a whole.
Companies enter into such arrangements in order to gain tax advantages or cheaper financing, but
these considerations should not determine the financial reporting treatment.
2.2 Operating lease incentives (SIC 15)

In negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee to
enter into the agreement. Examples of such incentives are:
 An up-front cash payment to the lessee
 The reimbursement of costs of the lessee
 Initial rent-free or reduced rent periods
All incentives for the agreement of a new or renewed operating lease should be recognised as an
integral part of the net amount agreed for the use of the leased asset, irrespective of the incentive's
nature or form or the timing of payments.
The Lessor
The lessor should normally recognise the aggregate cost of incentives as a reduction of rental income
over the lease term, on a straight-line basis.
The Lessee
The lessee should normally recognise the aggregate benefit of incentives as a reduction of rental
expense over the lease term, on a straight-line basis.
Interactive question 6: Sale and leaseback as operating lease

[Difficulty level: Intermediate]
C
On 1 January 20X5, a lessor entered into a 21-year operating lease in respect of a retail unit. Leasing H
payments were £30,000 quarterly in advance. It had proved difficult to find a tenant, so the lessor had A
to accept an initial rent-free period of 18 months. P
T
Requirement E
R
How should the transaction be recognised in the financial statements?
4
3 Determining Whether an Arrangement Contains a Lease –

IFRIC 4
Section overview
 Sometimes entities enter into transactions that may contain a lease even though they do not take
the legal form of a lease. These are addressed by IFRIC 4.

Background
An entity may enter into an arrangement, comprising a transaction or a series of related transactions,
that does not take the legal form of a lease, but conveys a right to use an asset in return for a payment
or series of payments.
Examples of arrangements in which one entity (the supplier) may convey such a right to use an asset to
another entity (the purchaser), often together with related services, include:
 Outsourcing arrangements (eg the outsourcing of the data processing functions of an entity).
 Arrangements in the telecommunications industry, in which suppliers of network capacity enter
into contracts to provide purchasers with rights to capacity.
 Take-or-pay and similar contracts, in which purchasers must make specified payments regardless of
whether they take delivery of the contracted products or services (eg a take-or-pay contract to
acquire substantially all of the output of a supplier's power generator).
IFRIC 4 provides guidance for determining whether such arrangements are, or contain, leases that
should be accounted for in accordance with IAS 17. It does not provide guidance for determining how
such a lease should be classified under IAS 17.
The key features of IFRIC 4 in determining whether an arrangement is, or contains, a lease are as follows.
Determining whether an arrangement is, or contains, a lease
Determining whether an arrangement is, or contains, a lease is based on the substance of the
arrangement and requires an assessment of whether:
 Fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset); and
 The arrangement conveys a right to use the asset.
Fulfilment of the arrangement is dependent on the use of a specific asset
Although a specific asset may be explicitly identified in an arrangement, it is not the subject of a lease if
fulfilment of the arrangement is not dependent on the use of the specified asset.
For example, if the supplier is obliged to perform building work and has the right and ability to carry out
the task using other assets not specified in the arrangement, then fulfilment of the arrangement is not
dependent on the specified asset and the arrangement does not contain a lease.
Arrangement conveys a right to use the asset
An arrangement conveys the right to use the asset if the arrangement conveys to the purchaser (lessee)
the right to control the use of the underlying asset.
 The purchaser, while obtaining or controlling more than an insignificant amount of the asset's
output
– Has the ability to operate the asset or direct others to operate the asset or
– Has the ability or right to control physical access to the asset.
 There is only a remote possibility that parties other than the purchaser will take more than an
insignificant amount of the asset's output and the price the purchaser will pay is neither fixed per
unit of output nor equal to the current market price at the time of delivery.
The IFRIC's view is that where a purchaser is taking substantially all of the output from an asset it has the
ability to restrict the access of others to the output of that asset. In these circumstances, the purchaser is
seen as controlling access to the economic benefits of the asset even if it does not physically control the
asset.

Is the arrangement a No
contractual relationship?
Yes
Is arrangement dependent
on use of a specific asset? No
May be Not a
. Implicitly specified Lease
. Explicitly identified
Yes
Does the purchaser (lessee)

No
have the right to control
the asset's use?
(See conditions to be met)
Yes
Arrangement
contains a lease
Worked example: Arrangement that contains a lease

An entity (the supplier) enters into an arrangement to supply electricity for the building for a new
airport. To be able to fulfil this obligation, the supplier builds a power station next to the new airport
site.
The supplier has no access to any other electricity generating stations and maintains ownership and
control of the power station.
The contractual agreement provides for the following. C
H
 The power generating station is specifically identified in the agreement. The supplier has the right A
P
to provide electricity from other sources although doing so is not feasible.
T
 The supplier has the right to provide electricity to other customers. However, this is not E
R
economically feasible as the power station is designed to meet only the purchaser's needs.
 The purchaser pays a fixed capacity charge and a variable charge based on electricity power taken.
The variable charge is based on normal energy costs. 4
Requirement
Does the arrangement contain a lease within the scope of IAS 17 Leases?
Solution
Yes. The arrangement contains a lease within the scope of IAS 17 Leases.
The first condition, ie the existence of an asset (which in this case is specifically identified) is fulfilled.
The second condition is also fulfilled as it is remote that one or more parties other than the purchaser
will take more than an insignificant amount of the facility's output and the price the purchaser will pay is
not contractually fixed per unit of output nor equal to the market price at the time of delivery.

Section overview
 The IASB has decided to undertake a leasing project with the objective of developing a single
method of accounting for leases that would not rely on the distinction between operating and
finance leases.
The distinction between classification of a lease as an operating or finance lease has a considerable
impact on the financial statements, most notably on indebtedness, gearing ratios, ROCE and interest
cover. It is argued that the current accounting treatment of operating leases is inconsistent with the
definition of assets and liabilities in the IASB's Framework.
There have therefore been calls for the capitalisation of non-cancellable operating leases in the
statement of financial position on the grounds that if non-cancellable, they meet the definitions of assets
and liabilities, giving similar rights and obligations as finance leases over the period of the lease.
Leasing had been on the IASB's agenda for some time when in May 2003 the IASB decided to actively
undertake a project with the objective of developing a single method of accounting for leases that is
consistent with the Framework. The single method would not rely on a distinction between operating
and finance leases.
It has subsequently been decided to scope lessor accounting out of the project and concentrate only on
lessee accounting initially. An exposure draft of the IASB's proposals was issued in August 2010. This is
not examinable, but is included here to give an awareness of how things are likely to develop.
Below are the main changes, which would affect both lessees and lessors unless otherwise stated:
(a) The current IAS 17 model of classification of leases would cease to exist.
(b) Lessees would no longer be permitted to treat leases as 'off-balance sheet' financing, but
instead would be required to recognise an asset and liability for all leases within the scope of the
proposed standard.
(c) For leases currently classified as operating leases, rent expense would be replaced with
amortisation expense and interest expense. Total expense would be recognised earlier in the
lease term.
(d) The lease liability would include estimates of contingent rentals, residual value guarantees, and
term option penalties. An expected outcome approach would be used.
(e) Rentals during renewal periods would be included as part of the lease liability on the basis of
the longest possible lease term that is more likely to occur than not.
(f) If the facts or circumstances indicate that there will be a significant change in lease payments and
renewal periods, then the estimates of these must be revised.
(g) The proposed standard has two accounting models for lessors:
(i) Performance obligation approach. This is used by lessors who retain exposure to significant
risks or benefits associated with the underlying asset.
(ii) Derecognition approach. This is used by lessors who do not retain exposure to significant
risks or benefits associated with the underlying asset.
Reaction to the August 2010 Exposure Draft
Many respondents commented that the proposed approach was overly complex, expensive, and in
some cases, inconsistent with the economics of the underlying transactions. In response, the IASB
made a number of significant changes to their original proposals for lessee accounting.
• Lease terms would typically be shortened – optional periods are included only if there is a
significant economic incentive to extend.
• More non-lease costs would be separated from the lease, reducing amounts recognised on the
statement of financial position.

• Contingent rents based on performance and usage are excluded from lease payments. Purchase
option payments are included only when there is a significant economic incentive to exercise.
• Lessees would have the option to apply current operating lease accounting to all short-term leases.
• Arrangements with bargain purchase options or ownership transfer would be considered leases,
not purchases.
Current status
The IASB and FASB re-exposed their proposals in May 2013 with comments received by September
2013.
5 IAS 20 Accounting for Government Grants and Disclosure of

Government Assistance
Section overview
 This section gives a very brief overview of the material covered in earlier studies.
Definitions
Government assistance: Action by government designed to provide an economic benefit specific to an
entity or range of entities qualifying under certain criteria.
Government grants: Assistance by government in the form of transfers of resources to an entity in
return for past or future compliance with certain conditions relating to the operating activities of the
entity. They exclude those forms of government assistance which cannot reasonably have a value placed
upon them and transactions with government which cannot be distinguished from the normal trading
transactions of the entity.
Grants related to assets: Government grants whose primary condition is that an entity qualifying for
them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also
be attached restricting the type or location of the assets or the periods during which they are to be
acquired or held.
Grants related to income: Government grants other than those related to assets.
C
Forgivable loans: Loans which the lender undertakes to waive repayment of under certain prescribed H
conditions. A
P
T
E
Accounting treatment R
 Recognise government grants and forgivable loans once conditions complied with and
receipt/waiver is assured.
4
 Grants are recognised under the income approach: recognise grants as income to match them
with related costs that they have been received to compensate.
 Use a systematic basis of matching over the relevant periods.
 Grants for depreciable assets should be recognised as income on the same basis as the asset is
depreciated.
 Grants for non-depreciable assets should be recognised as income over the periods in which the
cost of meeting the obligation is incurred.
 A grant may be split into parts and allocated on different bases where there are a series of
conditions attached.
 Where related costs have already been incurred, the grant may be recognised as income in full
immediately.
 A grant in the form of a non-monetary asset may be valued at fair value or a nominal value.

 Grants related to assets may be presented in the statement of financial position either as deferred
income or deducted in arriving at the carrying value of the asset.
 Grants related to income may be presented in the statement of profit or loss and other
comprehensive income (in profit or loss) either as a separate credit or deducted from the related
expense.
 Repayment of government grants should be accounted for as a revision of an accounting estimate.
Disclosure
 Accounting policy note
 Nature and extent of government grants and other forms of assistance received
 Unfulfilled conditions and other contingencies attached to recognised government assistance
Interactive question 7: Government grants [Difficulty level: Intermediate]

IAS 20 suggests that there are two approaches to recognising government grants: a capital approach
(credit directly to shareholders' interests) and an income approach. IAS 20 requires the use of the
income approach.
Requirement
What are the arguments in support of each method?
6 IAS 23 Borrowing Costs
Section overview
 This section gives a very brief overview of the material covered in earlier studies.
 IAS 23 deals with the treatment of borrowing costs, often associated with the construction of self-
constructed assets, but which can also be applied to an asset purchased that takes time to get
ready for use/sale.
Definitions
Borrowing costs: Interest and other costs incurred by an entity in connection with the borrowing of
funds.
Qualifying asset: An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale.
Until the IASB issued a revised IAS 23 in 2007, entities had the choice of whether to account for 'directly
attributable' borrowing costs as part of the cost of the asset or as an expense in profit or loss. The
revised IAS 23 removes the option of recognising them as an expense. It is mandatory for accounting
periods beginning on or after 1 January 2009.
The revised standard is now consistent with US GAAP and was developed as part of the convergence
project being undertaken with the US FASB. The IASB believes that the new standard will improve
financial reporting in three ways:
 The cost of an asset will in future include all costs incurred in getting it ready for use or sale
 Comparability is enhanced because the choice in previous accounting treatments is removed
 The revision to IAS 23 achieves convergence in practice with US GAAP

 Borrowing costs must be capitalised as part of the cost of the asset if they are directly attributable to
acquisition/construction/production. Other borrowing costs must be expensed.
 Borrowing costs eligible for capitalisation are those that would have been avoided otherwise.
Use judgement where a range of debt instruments is held for general finance.
 Amount of borrowing costs available for capitalisation is actual borrowing costs incurred less
any investment income from temporary investment of those borrowings.
 For borrowings obtained generally, apply the capitalisation rate to the expenditure on the asset
(weighted average borrowing cost). It must not exceed actual borrowing costs.
 Capitalisation is suspended if active development is interrupted for extended periods. (Temporary
delays or technical/administrative work will not cause suspension.)
 Capitalisation ceases (normally) when physical construction of the asset is completed,
capitalisation should cease when each stage or part is completed.
 Where the carrying amount of the asset falls below cost, it must be written down/off.
Disclosure
 Amount of borrowing costs capitalised during the period
 Capitalisation rate used to determine borrowing costs eligible for capitalisation
Interactive question 8: Borrowing cost 1 [Difficulty level: Exam standard]

On 1 January 20X8 Rechno Co borrowed £15m to finance the production of two assets, both of which
were expected to take a year to build. Production started during 20X8. The loan facility was drawn
down on 1 January 20X8 and was utilised as follows, with the remaining funds invested temporarily.
Asset X Asset Y
£m £m
1 January 20X8 2.5 5.0
1 July 20X8 2.5 5.0
The loan rate was 10% and Rechno Co can invest surplus funds at 8%.
Requirement
Ignoring compound interest, calculate the borrowing costs which must be capitalised for each of the
assets and consequently the cost of each asset as at 31 December 20X8. C
See Answer at the end of this chapter. H
A
P
T
E
Interactive question 9: Borrowing cost 2 [Difficulty level: Exam standard]
R
Zenzi Co had the following loans in place at the beginning and end of 20X8.
1 January 31 December
4
20X8 20X8
£m £m
10.0% Bank loan repayable 20Y3 120 120
9.5% Bank loan repayable 20Y1 80 80
8.9% debenture repayable 20Y8 – 150
The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X8.
On 1 January 20X8, Zenzi Co began construction of a qualifying asset, a piece of machinery for a hydro-
electric plant, using existing borrowings. Expenditure drawn down for the construction was: £30m on
1 January 20X8, £20m on 1 October 20X8.
Requirement
Calculate the borrowing costs to be capitalised for the hydro-electric plant machine.

Summary
Leases
Finance Operating
leases leases
Lessee Lessor Lessee Lessor

Accounting Accounting Accounting Accounting
Capitalise asset Derecognise asset Charge rentals on Recognise income

(lower of fair value (in substance risks a systematic basis on a systematic
and present value and rewards over lease period basis over lease
of minimum lease transferred to period
payments) lessee)
Set up finance Recognise operating

lease liability Set up a receivable incentives on a
balance at the net straight-line basis
investment in the over lease term
lease (UK GAAP: spread
over shorter of lease
term and period to
next rent review)
Repayments: Receipts:
· Split between · Split between
finance charge and finance income
capital and capital
· Allocate using · Allocate using
actuarial method actuarial method
or sum of digits
method

Self-test
IAS 17 Leases
1 Hypericum
On 31 December 20X7 The Hypericum Company leased from a bank three different machines, X,
Y and Z. Each lease is for three years.
£100,000 is payable annually in advance for each machine on 1 January 20X8, 20X9 and 20Y0.
Hypericum uses its annual incremental borrowing rate of 10% to determine the present value of
the minimum lease payments.
Under the contract for machine Z, Hypericum is also required to pay a lease premium of £50,000
on 31 December 20X7.
Other details are as follows.
Machine X Machine Y Machine Z
£ ££
Fair value 280,000 265,000 300,000
Residual value at 31 December 20Y0 1,000 100,000 3,000
All the machines are to be returned to the lessor at the end of the lease period. The useful life of
Machine Y is six years. The useful life of the other machines is three years.
Requirement
Which of the machines should be recognised at its fair value in the statement of financial position
of Hypericum at 31 December 20X7, according to IAS 17 Leases?
2 Sauvetage
The Sauvetage Company enters into a sale and leaseback arrangement which results in an
operating lease for five years from 1 January 20X7. The agreement is with its bank in respect of a
major piece of equipment that Sauvetage currently owns. The details at 1 January 20X7 are as
follows.
£m
Carrying amount of equipment 6.0
Proceeds generated from sale and leaseback 8.0
Fair value of equipment 7.2
The lease rentals are £4.0 million per year.
C
Requirement H
A
By how much should the pre-tax profit of Sauvetage be reduced in respect of the sale and P
leaseback arrangement for the year to 31 December 20X7, according to IAS 17 Leases? T
E
3 Mocken R
The Mocken Company enters into a sale and leaseback arrangement which results in a finance
lease for five years from 1 January 20X7. The agreement is with its bank in respect of a major piece
4
of equipment that Mocken currently owns. The residual value of the equipment after five years is
zero.
The carrying amount of equipment at 1 January 20X7 is £140,000. The sale proceeds are at fair
value at 1 January 20X7 of £240,000. There are five annual rentals each of £56,000 payable
annually in advance.
Mocken recognises depreciation on all non-current assets on a straight-line basis. Finance charges
on a finance lease are recognised on a sum of digits basis.
Requirement
What total amount should be recognised in the profit or loss of Mocken in respect of the sale and
leaseback arrangement for the year to 31 December 20X7 according IAS 17 Leases?

4 Szczytno
At 31 December 20X6 the carrying amount of a freehold property in The Szczytno Company's
financial statements was £436,000, of which £366,000 was attributable to the building which had
a remaining useful life of 36 years.
On 1 January 20X7 Szczytno sold the property to a financial institution for £697,000 and
immediately leased it back under a 35-year lease at an annual rental of £43,600 payable in
advance.
Other information available is as follows.
Land Building
Fair value of a 35-year interest £90,000 £607,000
The interest rate implicit in the lease is 6% per annum and the present value factor for a constant
amount annually in advance over 35 years is 15.368.
Requirements
Determine the following amounts for inclusion in Szczytno's financial statements for the year ended
31 December 20X7 in accordance with IAS 17 Leases.
(a) The profit on sale recognised in the year
(b) Excluding any profit on sale, the total effect on profit or loss for the year of the building
element of the lease
(c) The total liability to the financial institution at 31 December 20X7
5 Bodgit
Bodgit Ltd started trading 16 years ago manufacturing traditional toys. On that date it acquired a
freehold factory (and land) in Warwick for £200,000.
Bodgit Ltd has seen a significant decline in profitability due to falling demand for traditional toys as
a result of competition from more modern electronic toys and games.
Following a series of board meetings the management has decided to change its focus of
production to game consoles and computer games. This will require significant investment.
In order to finance this investment the management is planning to enter into a sale and leaseback
arrangement in respect of the Warwick property. It is expected that the property will fetch
£750,000 in sale proceeds and would be sold on 1 January 20X7.
The property would then be leased back on a 20-year lease at an initial rental of £95,000. Both the
sale and the rental are at market value, and the land element of the property represents one fifth of
these amounts.
Bodgit's incremental borrowing rate is 12%.
Requirement
Explain the accounting implications of the sale and leaseback arrangement.

Technical reference
IAS 17 Leases
1 Lease classification
 If substantially all of the risks and rewards of ownership are transferred to the IAS 17.4
lessee, then a lease is a finance lease (Note. 90% rule for UK GAAP). Factors:
– Ownership passing at end of term IAS 17.10-11

– Bargain purchase option
– Lease term the major part of asset's life
– Very substantial charges for early cancellation
– Peppercorn rent in secondary period
– PV of minimum lease payments substantially all of asset's fair value. IAS 17.10(d)
 Otherwise, an operating lease IAS 17.4
 Classify at inception IAS 17.13
 Land and buildings elements within a single lease are classified separately IAS 17.15
(Note: Together, usually as operating lease, for UK GAAP)
 Can be a lease even if lessor obliged to provide substantial services IAS 17.3
2 Finance lease
 Non-current asset and liability for the asset's fair value (or PV of minimum lease
payments, if lower): IAS 17.20
– Measured at inception of lease IAS 17.4

– Recognised at commencement of lease term IAS 17.4
 Depreciate asset over its useful life, or the lease term if shorter and no IAS 17.27
reasonable certainty that lessee will obtain ownership at end of lease
 Consider whether IAS 36 impairment procedures needed IAS 17.30 C
H
 Debit lease payments to liability, without separating into capital and interest
A
 Charge lease interest to profit or loss and credit lease liability P
T
 Charge interest so as to produce constant periodic rate of charge on reducing IAS 17.25 E
R
liability – approximations allowed
 Disclosures:
4
– Show carrying value of each class of leased assets IAS 17.31
– In the statement of financial position split the liability between current and IAS 17.23
non-current
– In a note, show analysis of total liability over amounts payable in 1, 2 to 5 IAS 17.31(b)
and over five years, both gross and net of finance charges allocated to
future periods
– General description of material leasing arrangements IAS 17.31(e)
– Other IAS 16 disclosures re leased PPE assets IAS 17.32

3 Operating lease
 Charge lease payments to profit or loss on straight-line basis, unless some other IAS 17.33
systematic basis is more representative of users' benefit
 Disclosures:
– Lease payments charged as expense in the period IAS 17.35(c)
– In a 'commitment' note, show analysis of amounts payable in 1, 2 to 5 IAS 17.35(a)

and over five years, even though not recognised in statement of financial
position
– General description of significant leasing arrangements IAS 17.35(d)
4 Lessor accounting
Finance lease:
 Recognise a receivable measured at an amount equal to the net investment in IAS 17.36
the lease
 Net investment in the lease is the gross investment in the lease discounted at IAS 17.4
the interest rate implicit in the lease
 Include initial direct costs incurred but exclude general overheads IAS 17.38
 Recognition of finance income should be based on a pattern reflecting a IAS 17.39

constant periodic rate of return on the lessor's net investment
 Finance income should be allocated on a systematic and rational basis IAS 17.40
 Special rules for manufacturer/dealer lessors IAS 17.42
 Disclosures IAS 17.47
 Operating lease:
– The asset should be recorded in the statement of financial position IAS 17.49
according to its nature
– Operating lease income should be recognised on a straight-line basis over IAS 17.50
the lease term, unless another basis is more appropriate
– Asset should be depreciated as per other similar assets IAS 17.53
– IAS 36 should be applied to determine whether the asset is impaired IAS 17.54
 Disclosures IAS 17.56
5 Sale and finance leaseback

 Recognise excess sale proceeds as deferred income and amortise over the lease IAS 17.59-60
term
 Alternative: treat as a secured loan
6 Sale and operating leaseback

 Treatment depends on relationship between sale price and fair value: IAS 17.61
– Sale price at fair value

– Sale price below fair value
– Sale price above fair value
 If the fair value at the time of the sale and leaseback is less than the carrying IAS 17.63
amount of the asset, the loss (carrying amount minus fair value) is recognised
immediately
 Lease and leaseback arrangements SIC 15 & 27

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance
1 Treatment
 Should only be recognised if reasonable assurance that: IAS 20 (7)
– Entity will comply with conditions

– Grant will be received
 Manner in which received does not affect accounting method adopted IAS 20 (9)
 Should be recognised as income over periods necessary to match with related IAS 20 (12)
costs
 Income approach, where grant is taken to income over one or more periods IAS 20 (13)
should be adopted
 Grants should not be accounted for on a cash basis IAS 20 (16)
 Grants in recognition of specific expenses are recognised as income in same IAS 20 (17)
period as expense
 Grants related to depreciable assets usually recognised in proportion to IAS 20 (17)
depreciation
 Grants related to non-depreciable assets requiring fulfilment of certain IAS 20 (18)
obligations should be recognised as income over periods which bear the cost of
meeting obligations
 Grant received as compensation for expenses already incurred recognised in IAS 20 (20)
period in which receivable
 Non-monetary grants should be measured at fair value IAS 20 (23)
2 Presentation of grants related to assets

 Can be presented in the statement of financial position by: IAS 20 (24)
– Setting up the grant as deferred income or

– Netting it off against the carrying amount of the asset
IAS 20 (29)
3 Presentation of grants related to income
C
 Either: H
A
– Recognised in profit or loss as income separately or under a general P
heading or T
E
– Deducted in arriving at the amount of the related expense recognised in R
profit or loss
4 Repayment of government grants
4
 Accounted for as a revision to an accounting estimate IAS 20 (32)
5 Government assistance
 The following forms of government assistance are excluded from the definition IAS 20 (34-35)
of government grants:
– Assistance which cannot reasonably have a value placed on it
– Transactions with government which cannot be distinguished from the
normal trading transactions of the entity
6 Disclosures
 Required disclosures IAS 20 (39)

IAS 23 Borrowing Costs
 Core principle IAS 23 (1 and 8)
 Qualifying asset IAS 23 (5 and 7)
 Directly attributable borrowing costs IAS 23 (10-11)
 Eligible borrowing costs IAS 23 (12-15)
 Excess of carrying amount over recoverable amount of asset IAS 23 (16)
 Commencement of capitalisation IAS 23 (17-19)
 Suspension of capitalisation IAS 23 (20-21)
 Cessation of capitalisation IAS 23 (22-25)
 Disclosure IAS 23 (26)

1 Hypericum
Machine Z
IAS 17.20 requires that assets under finance leases should be stated at the lower of the fair value
and the present value of the minimum lease payments. The latter amount is calculated as:
Cash flows(£) 10% discount factor PV(£)
100,000 1.0 100,000
100,000 1/1.1 90,909
100,000 1/(1.1 × 1.1) 82,645
273,554
For Machine Z, this is increased by the £50,000 premium to £323,554.

As Machine Z has a lower fair value, it should be recognised at fair value.
Machine X has a higher fair value, while Machine Y will be held under an operating lease – the
residual value indicates that plenty of reward has been retained by the lessor, so it cannot be
classified as a finance lease. This is confirmed by the useful life being substantially longer than the
lease period.
2 Sauvetage
£2,640,000
The arrangement results in a profit of £2.0m (proceeds £8.0m less carrying amount 6.0m) of which
£0.8m relates to the difference between proceeds and fair value and £1.2m to that between fair
value and carrying amount.
IAS 17.61 requires that where the proceeds of a sale and leaseback re an operating lease are above
fair value, then the excess shall be deferred and matched over the period that the asset is to be
used. But any excess of the fair value over the carrying amount should be recognised immediately,
per IAS 17 Implementation Guidance Footnote 3.
Thus the charge to profit or loss is: £'000
Rental 4,000 C
Immediate profit (1,200) H
Release of deferred profit (£0.8m/5 years) (160) A
2,640 P
T
3 Mocken E
R
£44,000 expense
IAS 17.59 and 60 require that where a sale and finance leaseback takes place and the sale proceeds
exceed the carrying amount then it shall not be recognised as profit but shall be deferred and 4
recognised over the lease term.
£
Depreciation (£240,000/5) 48,000
Release of deferred profit [(£240,000 – £140,000)/5] (20,000)
Finance charge 4/10  [(£56,000  5) – £240,000] 16,000
Total 44,000
4 Szczytno
(a) £26,886
(b) £49,405
(c) £578,286

(a) The leaseback of the land element results in an operating lease because land normally has an
infinite life (IAS 17.14). The leaseback of the building element results in a finance lease
because in leasing it back for 35 of its 36 years Szczytno has access to substantially all the risks
and rewards of ownership (IAS 17.4). The sale and leaseback is at fair value, because the sales
proceeds are substantially equal to the sum of the fair values of the 35-year interest.
The portion of the total profit on the sale of £261,000 (£697,000 – £436,000) to be
recognised depends on the type of lease involved in the leaseback (IAS 17.58). The profit
attributable to the land operating lease is recognised immediately (IAS 17.61), but the profit
attributable to the building finance lease is spread over the lease term (IAS 17.59).
Land profit: proceeds £90,000 – carrying amount (£436,000-£366,000) = £20,000
Building profit: proceeds £607,000 – carrying amount £366,000 = £241,000
Profit on sale recognised in year: £
Full land profit 20,000
Proportion of building profit (£241,000/35 years) 6,886
26,886
(b) The annual rental is allocated between the two elements in proportion to the relative fair
values of the leasehold interest (IAS 17.16), so the amount allocated to the building element
is:
£43,600  607,000/(607,000 + 90,000) = £37,970
The present value over 35 years is £37,970  15.368 = £583,523.
This amount is recognised as a non-current asset and a liability.
The 20X7 depreciation charge on the asset is £583,523/35 = £16,672, while since the lease
payments are in advance, the finance charge is £(583,523 – 37,970)  6% = £32,733.
The total effect on profit or loss is £16,672 + £32,733 = £49,405.
(c) The liability at the year end is £583,523 – £37,970 + £32,733 interest = £578,286.
5 Bodgit
Accounting
Type of sale and leaseback
The transaction includes two elements:
 Sale and leaseback of the property itself, and
 Sale and leaseback of the land on which the property stands.
In the case of the leaseback of the land on which the property stands, IAS 17 requires the lease to
be classified as an operating lease.
As regards the property, from the information provided, it would appear that Bodgit Ltd has
entered into a sale and finance leaseback.
The key factors which indicate this are as follows.
 The lease term of 20 years. This is not a long period of time for property, so does not clarify
the situation.
 Rentals. The present value of discounted future rentals relating to the property is (4/5 ×
£95,000) × 20-year annuity discount factor @ 12%, ie £76,000 × 7.469 = £567,644. This is
approximately 95% of fair market value of 4/5 × £750,000 = £600,000.
The land and building should be derecognised in Bodgit's accounts and a profit or loss calculated
based upon the difference between the proportion of the proceeds allocated to each element (land
being 1/5 × £750,000 = £150,000 and the building being the remaining £600,000) and their
carrying value.
Based on the original cost to Bodgit of the factory (including land) of £200,000, this is likely to
result in a profit in both cases.

Sale and leaseback as an operating lease
The sale is at fair value and IAS 17 therefore requires that the land is derecognised and the profit
made on the sale is recognised immediately.
The operating lease is then recorded in the normal way by spreading the annual rental amounts
over the lease term and recording them as an expense. The annual rental expense is therefore
1/5 × £95,000 = £19,000.
Sale and leaseback as a finance lease
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides finance to
the lessee, with the asset as security. For this reason it is not appropriate to regard any excess of
sales proceeds over the carrying amount as income. The profit arising should therefore be deferred
and amortised over the term of the lease.
The finance lease is then recorded in the normal way, with the building asset and corresponding
liability both initially recognised at £567,644, being the lower of the fair value (4/5 x £750,000 =
£600,000) and present value of minimum lease payments.
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(a) Financial statement extracts
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED
31 DECEMBER 20X1 (EXTRACT)
£
Depreciation [(80,000 + 2,000 – 8,000)/5)] 14,800
Finance costs (Working) 7,420
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)
£
Non-current assets
Leased asset [(80,000 + 2,000) – ((80,000 + 2,000 – 8,000)/5)] 67,200
Finance lease liability (Working) 56,182
Current liabilities
Finance lease liability (Working) (65,620 – 56,182) 9,438
WORKING
Bal b/f Interest accrued at 10% Payment 31 Bal c/f 31 Dec
Dec
£ £ £ £
80,000
(5,800)
20X1 74,200 7,420 (16,000) 65,620
20X2 65,620 6,562 (16,000) 56,182
(b) Treatment of guaranteed residual value

At the end of the lease, the lessee will have an asset at residual value of £8,000 in its statement of
financial position and a finance lease liability of £8,000 representing the residual value guaranteed
to the lessor.
(i) If the lessor is able to sell the asset for more than the value guaranteed by the lessee, the
lessee has no further liability and derecognises the asset and lease liability:
Dr Finance lease liability £8,000
Cr Asset carrying amount £8,000
(ii) If the lessor is unable to sell the asset for the value guaranteed by the lessee, the lessee has a
liability to make up the difference of £8,000 – £6,000 = £2,000:
Recognise impairment loss on asset (as soon as known during the lease term):
Make guaranteed payment to lessor and derecognise the asset and lease liability:
Dr Finance lease liability £8,000
Cr Cash £2,000

(a) Unguaranteed residual value and net investment in the lease at 1 January 20X1
Date Gross Discount Net
investment factor investment
(11%)
£ £
1.1.X1 Instalment 22,000 1 22,000
1.1.X2 Instalment 22,000 0.901 19,822
1.1.X3 Instalment 22,000 0.812 17,864
1.1.X4 Instalment 22,000 0.731 16,082
31.12.X4 Guaranteed residual value 10,000 0.659 6,590
Lessee's
Minimum lease payments 98,000 82,358
liability
31.12.X4 Unguaranteed residual value 2,000 0.659 1,318
Investment in the lease 100,000 83,676 Lessor's
asset
Note: The net investment in the lease is equal to the fair value of the asset of £82,966 plus the
lessor's costs of £700. In this instance there is a rounding difference of £10.
(b) Financial statement extracts

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X1
(EXTRACT)
£
Finance income (Working) 6,784
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)
£
Non-current assets
Net investment in finance lease (Working) 46,460
Current assets
Net investment in finance lease (Working) (68,460 – 46,460) 22,000
WORKING
Net investment in finance lease
Interest
Instalments in income at C
Bal b/f advance c/f 11% Bal c/f 31 Dec H
£ £ £ £ £ A
20X1 83,676 (22,000) 61,676 6,784 68,460 P
20X2 68,460 (22,000) 46,460 T
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The transaction will be recognised by the entity as follows.
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1 January 20X5 Derecognise £5 million investment property asset
Recognise £5 million finance lease receivable
Recognise £400,000 cash received as a reduction in the receivable
Note that the net investment in the lease is equal to the fair value of the asset plus any costs incurred by
the lessor. In this case there were no such costs and therefore the fair value of the asset is the net
investment in the lease.
31 December 20X5 Increase the receivable by £381,800 (8.3%  (£5,000,000 – £400,000))
Recognise finance income of £381,800 in profit or loss

Statement of comprehensive income
£
Revenue (lower of FV £26,250 and PV of MLPs £24,351) 24,351
Cost of sales (lower of cost and CV – PV of unguaranteed residual value) (21,000)
Profit 3,351
Finance income: (Working) 1,248
Statement of financial position
Receivable (Working) 16,849
WORKING
Instalments in Interest income Bal c/f
Bal b/f advance c/f at 8% 31 Dec
£ £ £ £ £
20X5 24,351 (8,750) 15,601 1,248 16,849

On 1 January 20X5, the transaction will be recorded by the entity as follows:
 Recognise cash proceeds received of £5,000,000
 Derecognise the asset of £3,500,000
 Recognise deferred income of £1,500,000 and release the profit over the lease term (£37,500 per
annum)
 Recognise the building at £5,000,000
 Recognise a finance lease liability at £5,000,000
 Recognise £400,000 cash paid
For the year ended 31 December 20X5, the entity will recognise:
 Income of £37,500 out of the deferred profit, being £1.5m/40 years
 Depreciation of £125,000 (£5m/40 years)
 Finance charge of £381,800 being 8.3% of (£5m – £0.4m).

The amount lost as a result of agreeing to the rent-free period is treated as a reduction in the net
consideration receivable by the lessor, which has the effect of spreading it over the lease term. The total
consideration receivable over the 21-year lease is:
19.5 years  4 quarterly payments  £30,000 = £2,340,000.
This results in an annual income of £2,340,000/21 years = £111,429.
At 31 December 20X5, no cash will have been received from the lessee, so the lessor recognises a
receivable £111,429 – the first year's rent.

IAS 20 gives the following arguments in support of each method.
Capital approach
(a) The grants are a financing device, so should go through the statement of financial position. In the
statement of profit or loss and other comprehensive income they would simply offset the expenses
which they are financing. No repayment is expected by the Government, so the grants should be
credited directly to shareholders' interests.
(b) Grants are not earned, they are incentives without related costs, so it would be wrong to record
them in profit or loss.

Income approach
(a) The grants are not received from shareholders so should not be credited directly to shareholders'
interests.
(b) Grants are not given or received for nothing. They are earned by compliance with conditions
and by meeting obligations. There are therefore associated costs with which the grant can be
matched in the statement of profit or loss and other comprehensive income as these costs are
being compensated by the grant.
(c) Grants are an extension of fiscal policies and so as income and other taxes are charged against
income, so grants should be credited to income.

Asset X Asset Y
£'000 £'000
Borrowing costs
£5.0m/£10m  10% 500 1,000
Less investment income
To 30 June 20X8 £2.5m/£5.0m  8%  6/12 (100) (200)
400 800
£'000 £'000
Cost of assets
Expenditure incurred 5,000 10,000
Borrowing costs 400 800
5,400 10,800

120 80
Capitalisation rate = weighted average rate = (10%  ) + (9.5%  ) = 9.8%
120  80 120  80
Borrowing costs = (£30m  9.8%) + (£20m  9.8%  3/12)

= £3.43m
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CHAPTER 5
Financial instruments –
presentation and disclosure
Introduction
Topic List
IAS 32 Financial Instruments: Presentation
1 Overview of material from earlier studies
IFRS 7 Financial Instruments: Disclosures
2 Objective and scope
3 Disclosures in financial statements
4 Other disclosures
5 Financial instruments risk disclosure
Technical reference
135
Introduction
 Apply the requirements of IAS 32 Financial Instruments: Presentation
 Prepare and present extracts of financial statements in accordance with IFRS 7 Financial
Instruments: Disclosures

Section overview
 IAS 32 applies to all entities and to all types of financial instruments except where explicitly
covered by another standard such as IFRS 10 for subsidiaries and IAS 28 for associates and joint
ventures.
 A financial instrument should be classified as either equity, financial liability or financial asset. This
classification is made at the time the financial instrument is issued and not changed subsequently.
 Compound financial instruments, ie instruments that contain both a liability and an equity
component should be split into their component parts at the date they are issued.
 Interest, dividends, losses and gains arising from financial instruments classified as financial
liabilities are recognised in the profit or loss for the year. Dividends paid to holders of a financial
instrument classified as equity are charged directly against equity.
 Financial assets and financial liabilities are presented as separate items in the statement of financial
position with offset being allowed only in limited cases.
 Treasury shares are deducted from equity with the consideration paid or received recognised
directly in equity. Gains or losses on the purchase, sale, issue or cancellation of equity instruments
are not recognised in profit or loss.
1.1 Test your memory

Try these questions to see how well you remember the material covered in your earlier studies.
Interactive question 1: Financial instruments [Difficulty level: Easy]

Why do you think that physical assets and prepaid expenses do not qualify as financial instruments?
Interactive question 2: Liability or equity? [Difficulty level: Easy]

During the financial year ended 31 December 20X5, Kim issued the financial instrument described
below. Identify whether it should be classified as liability or equity, giving reasons for your choice.
Redeemable preference shares with a coupon rate 5 per cent. The shares are redeemable on 31
December 20X9 at premium of 20 per cent.
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Interactive question 3: Convertible bond 1 [Difficulty level: Exam standard] P
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An entity issues a convertible bond for £1,000. The bond is convertible into equity shares of the issuer at E
the discretion of the holder at any time in the next ten years. The bond converts into a variable number R
of shares equal to the value of the liability.
The entity also issues £7,000 of 8% convertible redeemable preference shares. In five years' time the
5
preference shares will either be redeemed or converted into 5,000 equity shares of the issuer, at the
option of either the holder or issuer.
Financial instruments – presentation and disclosure 137

Requirement
How should the entity account for the instruments according to IAS 32?
Interactive question 4: Convertible bond 2 [Difficulty level: Exam standard]

An entity issued 5,000 8% convertible bonds at par value of £10 on 1 January 20X5. Each bond is
convertible into three ordinary shares on 31 December 20X6. Interest is payable annually in arrears. The
entity incurred transaction costs of £1,000. On the date of issue the market interest rate for similar debt
without the conversion option was 10%.
Requirement
Calculate the liability and equity component of the convertible bond on issue.
Interactive question 5: Options contract [Difficulty level: Exam standard]

An entity enters into an options contract to acquire 100 ounces of platinum in 90 days' time. The entity
will settle the contract by delivering as many of its own shares as are equal to the cash value of £1,000
on the purchase date.
Requirement
Explain whether the options contract should be classified as a financial asset, financial liability or equity.
Interactive question 6: Offsetting [Difficulty level: Exam standard]

An entity issues debt with a variable rate of interest linked to LIBOR. It enters into a corresponding,
receive floating, pay fixed interest rate swap for the period of the debt. The effect of the two
instruments is to synthesise a fixed-rate long-term loan.
Requirement
Explain whether the two instruments should be presented separately or whether they should be offset.
2 Objective and scope
Section overview
 This section discusses the objectives and sets out the scope of IFRS 7 Financial Instruments:
Disclosures.

2.1 Objective
The principles of IFRS 7 complement the principles for recognising, measuring and presenting financial
assets and financial liabilities in IAS 32 Financial Instruments: Presentation and IAS 39 Financial
Instruments: Recognition and Measurement.
IFRS 7 requires entities to provide disclosures in their financial statements that enable users to evaluate:
 The significance of financial instruments for the entity's financial position and performance; and
 The nature and extent of risks arising from financial instruments to which the entity is exposed
during the period and at the reporting date, and how the entity manages those risks.
The main presentation and disclosure requirements as detailed in IFRS 7 and IAS 32 together with
certain aspects of recognition and measurement of IAS 39 have already been covered at Professional
level. This chapter extends the coverage of the disclosure requirements of IFRS 7 and the presentation
requirements.
2.2 Scope
IFRS 7 applies to all entities and to all types of financial instruments, except instruments that are
specifically covered by other standards. Examples of financial instruments not covered by IFRS 7
include:
 Interests in subsidiaries, associates and joint ventures that are accounted for in accordance with
IFRS 10 Consolidated Financial Statements or IAS 28 Investments in Associates and Joint Ventures.
 Employers' rights and obligations arising from employee benefit plans, to which IAS 19 Employee
Benefits applies.
 Insurance contracts as defined in IFRS 4 Insurance Contracts.
 Financial instruments, contracts and obligations under share-based payment transactions to which
IFRS 2 Share-based Payment applies.
IFRS 7 applies to recognised and unrecognised financial instruments. Recognised financial instruments
include financial assets and financial liabilities that are within the scope of IAS 39. Unrecognised financial
instruments include some financial instruments that, although outside the scope of IAS 39, are within
the scope of IFRS 7 (such as some loan commitments).
IFRS 7 also applies to contracts to buy or sell a non-financial item that are within the scope of IAS 39
because they can be settled net and there is not the expectation of delivery, receipt or use in the
ordinary course of business.
2.3 General considerations
Classes of financial instruments and level of disclosures

IFRS 7 requires that certain disclosures should be given by class of financial instruments. The classes of
financial instruments that will be disclosed should be appropriate to the nature of the information
disclosed and should take into account the characteristics of those financial instruments. An entity
should provide sufficient information to permit reconciliation to the line items presented in the C
statement of financial position. H
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In deciding how to disclose the classes of financial instruments, an entity should not necessarily adopt P
the classification of IAS 39. The classes should be determined by the entity, but at the minimum it T
should: E
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 Provide distinctive classes for financial instruments at amortised cost and financial instruments at
fair value
5
 Provide a separate class or classes for financial instruments outside the scope of IFRS 7
Note that a 'class' is not the same as a classification under IAS 39 ('available for sale', 'held to maturity',
'loans and receivables' and 'fair value through profit or loss').

Significance of financial instruments for financial position and
performance
An entity must disclose information that enables users of its financial statements to evaluate the
significance of financial instruments for its financial position and performance.
Risks from financial instruments

IFRS 7 requires qualitative and quantitative disclosure about the following risks associated with financial
instruments:
 Market risk. This is the risk of changes in the market value of a financial instrument. When changes
in the market value can be attributed to changes in interest rates then the market risk is normally
called interest rate risk, and when it can be attributed to changes in exchange rates, market risk is
called currency risk.
 Credit risk. This is the risk that one party to a financial instrument will fail to fulfil the obligations
that arise for the financial instrument causing loss to the other party.
 Liquidity risk. This is the risk that an entity will encounter difficulty in meeting obligations
associated with financial liabilities.
3 Disclosures in financial statements
Section overview
 This section discusses the basic disclosures required by IFRS 7 in the financial statements.
3.1 Statement of financial position

3.1.1 Categories of financial assets and financial liabilities
The carrying amounts of each of the following categories, as defined in IAS 39, must be disclosed either
in the statement of financial position or in the notes:
 Financial assets at fair value through profit or loss, showing separately:
– Those designated as such upon initial recognition
– Those classified as held for trading in accordance with IAS 39
 Held-to-maturity investments
 Loans and receivables
 Available-for-sale financial assets
 Financial liabilities at fair value through profit or loss, showing separately:
– Those designated as such upon initial recognition and
– Those classified as held for trading in accordance with IAS 39
 Financial liabilities measured at amortised cost.
3.1.2 Loans and receivables at fair value through profit or loss

(a) Disclosures
If the entity has designated a loan or receivable (or group of loans or receivables) as at fair value
through profit or loss, it should disclose:
 The maximum exposure to credit risk of the loan or receivable (or group of loans or
receivables) at the reporting date.
 The amount by which any related credit derivatives or similar instruments mitigate that
maximum exposure to credit risk.

 The amount of change, during the period and cumulatively, in the fair value of the loan or
receivable (or group of loans or receivables) that is attributable to changes in the credit risk of
the financial asset.
 The amount of the change in the fair value of any related credit derivatives or similar
instruments that has occurred during the period and cumulatively since the loan or receivable
was designated.
(b) Calculation
The amount of any change in the fair value attributable to credit risk, can be calculated as the
amount of the change not attributed to market risk. That is
 Amount of change in fair value  total amount of   Amount of change in fair value 
attributed to credit risk   change in fair value   attributed to market risk 
     
(c) Alternative method

The standard allows the employment of an alternative method to calculate the amount of change
in the fair value attributed to credit risk if the entity believes that such a method more faithfully
represents the amount of change in its fair value that is attributable to changes in the credit risk of
the asset.
(d) Market risk
Changes in market conditions that give rise to market risk include changes in an observed
(benchmark) interest rate, commodity price, foreign exchange rate or index of prices or rates.
3.1.3 Financial liabilities at fair value through profit or loss

(a) Disclosures
If the entity has designated a financial liability as at fair value through profit or loss it should
disclose:
 The amount of change, during the period and cumulatively, in the fair value of the financial
liability that is attributable to changes in the credit risk of that liability.
 The difference between the financial liability's carrying amount and the amount the entity
would be contractually required to pay at maturity to the holder of the obligation.
(b) Calculation
The amount of any change in the fair value attributable to credit risk can be calculated as the
amount of the change not attributed to market risk. That is
 Amount of change in fair value  total amount of   Amount of change in fair value 
attributed to credit risk   change in fair value   attributed to market risk 
     
(c) Alternative method

The standard allows the employment of an alternative method to calculate the amount of change
in the fair value attributed to credit risk if the entity believes that such a method is more accurate.
(d) Market risk
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Changes in market conditions that give rise to market risk include changes in a benchmark interest H
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rate, the price of another entity's financial instrument, a commodity price, a foreign exchange rate
P
or an index of prices or rates. For contracts that include a unit-linking feature, changes in market T
conditions include changes in the performance of the related internal or external investment fund. E
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The example below illustrates how an entity can arrive at the change in fair value attributable to
credit risk by estimating the amount of change in fair value attributable to risks other than credit
risk.
5

Illustration: Credit risk and change in value
On 1 January 20X6, an entity issues a five-year bond with a par value of £200,000, and an annual fixed
coupon rate of 7%. The coupon rate reflects the market LIBOR rate and the credit spread associated
with the bond at the time of the issue. At the time of the issue LIBOR was 5% implying a credit spread
of 2%.
The price of the bond will subsequently change either due to change in LIBOR (market risk) or due to a
change in the credit spread (credit risk).
Thus a change in the fair value of the bond attributed to credit risk can be calculated by subtracting
from the total change in the fair value the changes due to market risk (ie due to changes in LIBOR).
Suppose that on 31 December 20X6, the value of the bond has decreased to £196,651, as the LIBOR
has increased to 5.25%. The yield to maturity for the bond has now risen to 7.50%. The credit spread
has now increased to 2.25% implying deterioration in the credit quality of the bond.
In order to calculate the change in the value of the bond due to changes in LIBOR alone, we shall
calculate the fair value of the bond, at the new LIBOR of 5.25% assuming that the credit spread has
remained at 2%. This means that we need to discount the remaining 4 payments using a discount rate
of 7.25%.
Using this discount factor produces
14,000 14,000 14,000 14,000  200,000
    £198,316
1.0725 1.07252 1.07253 1.07254
Total change in market value (£200,000 – £196,651) £3,349
Change in market value due to market risk (£200,000 – £198,316) £1,684
Difference in value due to credit risk (£198,316 – £196,651) £1,665
3.1.4 Reclassification
If an entity has reclassified a financial asset, previously measured at fair value as measured at cost or
amortised cost or vice versa, it should disclose the amount reclassified into and out of each category
and the reason for that reclassification.
3.1.5 Derecognition
An entity may have transferred financial assets in such a way that part or all of the financial assets do
not qualify for de-recognition. In such a case, the entity should disclose for each class of financial
assets:
 The nature of the assets
 The nature of the risks and rewards of ownership to which the entity remains exposed
 When the entity continues to recognise all of the assets, the carrying amounts of the assets and of
the associated liabilities; and
 When the entity continues to recognise the assets to the extent of its continuing involvement, the
total carrying amount of the original assets, the amount of the assets that the entity continues
to recognise, and the carrying amount of the associated liabilities.
3.1.6 Collateral
An entity should disclose:
 The carrying amount of financial assets it has pledged as collateral for liabilities or contingent
liabilities, including amounts that have been reclassified
 The terms and conditions relating to its pledge

When an entity holds collateral (of financial or non-financial assets) and is permitted to sell or re-pledge
the collateral in the absence of default by the owner of the collateral, it shall disclose:
 The fair value of the collateral held
 The fair value of any such collateral sold or re-pledged, and whether the entity has an obligation
to return it; and
 The terms and conditions associated with its use of the collateral.
3.1.7 Profit or loss for the year

Items of income, expense, gains or losses
An entity should disclose the following items of income, expense, gains or losses either in the statement
of profit or loss and other comprehensive income or in the notes:
 Net gains or net losses on:
– Financial assets or financial liabilities at fair value through profit or loss, showing separately
those on financial assets or financial liabilities designated as such upon initial recognition, and
those on financial assets or financial liabilities that are classified as held for trading in
accordance with IAS 39
– Available-for-sale financial assets, showing separately the amount of gain or loss recognised
directly in equity during the period and the amount removed from equity and recognised in
profit or loss for the period
– Held-to-maturity investments
– Loans and receivables
– Financial liabilities measured at amortised cost
 Total interest income and total interest expense (calculated using the effective interest method)
for financial assets or financial liabilities that are not at fair value through profit or loss
 Fee income and expense (other than amounts included in determining the effective interest rate)
arising from:
– Financial assets or financial liabilities that are not at fair value through profit or loss; and
– Trust and other fiduciary activities that result in the holding or investing of assets on behalf of
individuals, trusts, retirement benefit plans, and other institutions.
 Interest income on impaired financial assets
 The amount of any impairment loss for each class of financial asset
4 Other disclosures
Section overview
 This section discusses additional quantitative and qualitative disclosures in the financial C
statements. H
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4.1 Accounting policies E
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An entity should disclose, in the summary of significant accounting policies, the measurement basis (or
bases) used in preparing the financial statements and the other accounting policies used that are
relevant to an understanding of the financial statements. 5
4.2 Hedge accounting

Hedge accounting is covered in Chapter 7. The disclosures are dealt with in that chapter.

4.3 Fair value
IFRS 7 retains the following general requirements in relation to the disclosure of fair value for those
financial instruments measured at amortised cost:
(a) For each class of financial assets and financial liabilities an entity should disclose the fair value of
that class of assets and liabilities in a way that permits it to be compared with its carrying
amount.
(b) In disclosing fair values, an entity should group financial assets and financial liabilities into classes,
but should offset them only to the extent that their carrying amounts are offset in the
It also states that disclosure of fair value is not required where:
 Carrying amount is a reasonable approximation of fair value
 For investments in equity instruments that do not have a quoted market price in an active market
for an identical instrument, or derivatives linked to such equity instruments
IFRS 13 (see Chapter 2, Section 2) provides disclosure requirements in respect of the fair value of
financial instruments measured at fair values. It requires that information is disclosed to help users
assess:
(a) For assets and liabilities measured at fair value after initial recognition, the valuation techniques
and inputs used to develop those measurements.
(b) For recurring fair value measurements (ie those measured at each period end) using significant
unobservable (Level 3) inputs, the effect of the measurements on profit or loss or other
comprehensive income for the period.
In order to achieve this, the following should be disclosed as a minimum for each class of financial
assets and liabilities measured at fair value:
(c) The fair value measurement at the end of the period.
(d) The level of the fair value hierarchy within which the fair value measurements are categorised in
their entirety.
(e) For assets and liabilities measured at fair value at each reporting date (recurring fair value
measurements), the amounts of any transfers between Level 1 and Level 2 of the fair value
hierarchy and reasons for the transfers.
(f) For fair value measurements categorised within Levels 2 and 3 of the hierarchy, a description of the
valuation techniques and inputs used in the fair value measurement, plus details of any changes in
valuation techniques.
(g) For recurring fair value measurements categorised within Level 3 of the fair value hierarchy:
(i) A reconciliation from the opening to closing balances.
(ii) The amount of unrealised gains or losses recognised in profit or loss in the period and the line
item in which they are recognised.
(iii) A narrative description of the sensitivity of the fair value measurement to changes in
unobservable inputs.
(h) For recurring and non-recurring fair value measurements categorised within Level 3 of the fair value
hierarchy, a description of the valuation processes used by the entity.
An entity should also disclose its policy for determining when transfers between levels of the fair value
hierarchy are deemed to have occurred.
Illustration: Fair value disclosures

For assets and liabilities measured at fair value at the end of the reporting period, the IFRS requires
quantitative disclosures about the fair value measurements for each class of assets and liabilities.
An entity might disclose the following for assets:

$'000 Fair value measurements at the end of the
reporting period using
Description 31.12.X9 Level 1 inputs Level 2 inputs Level 3 inputs
Trading equity securities 45 45
Non-trading equity securities 32 32
Corporate securities 90 9 81
Derivatives – interest rate 78 78
contracts
Total recurring fair value 245 54 159 32

measurements
5 Financial instruments risk disclosure
Section overview
 An entity should disclose information that enables users of its financial statements to evaluate the
nature and extent of risks arising from financial instruments to which the entity is exposed at the
reporting date. These risks include, but are not limited to, credit risk, liquidity risk and market risk.
5.1 Types of risk

In undertaking transactions in financial instruments, an entity may assume or transfer to another party
one or more of different types of financial risk as defined below. The disclosures required by the
standard show the extent to which an entity is exposed to these different types of risk, relating to both
recognised and unrecognised financial instruments.
Credit risk The risk that one party to a financial instrument will cause a financial loss for the
other party by failing to discharge an obligation.
Currency risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in foreign exchange rates.
Interest rate risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market interest rates.
Liquidity risk The risk that an entity will encounter difficulty in meeting obligations associated
with financial liabilities.
Loans payable Loans payable are financial liabilities, other than short-term trade payables on
normal credit terms.
Market risk The risk that the fair value or future cash flows of a financial instrument will C
fluctuate because of changes in market prices. Market risk comprises three types H
of risk: currency risk, interest rate risk and other price risk. A
P
Other price risk The risk that the fair value or future cash flows of a financial instrument will T
fluctuate because of changes in market prices (other than those arising from E
interest rate risk or currency risk), whether those changes are caused by factors R
specific to the individual financial instrument or its issuer, or factors affecting all
similar financial instruments traded in the market.
5
Past due A financial asset is past due when a counterparty has failed to make a payment
when contractually due.

5.2 Qualitative disclosures
For each type of risk arising from financial instruments, an entity must disclose:
(a) The exposures to risk and how they arise
(b) Its objectives, policies and processes for managing the risk and the methods used to measure the risk
(c) Any changes in (a) or (b) from the previous period
5.3 Quantitative disclosures

For each financial instrument risk, summary quantitative data about risk exposure must be disclosed.
This should be based on the information provided internally to key management personnel. More
information should be provided if this is unrepresentative.
Information about credit risk must be disclosed by class of financial instrument:
(a) Maximum exposure at the year end
(b) Any collateral pledged as security
(c) In respect of the amount disclosed in (b), a description of collateral held as security and other
credit enhancements
(d) Information about the credit quality of financial assets that are neither past due nor impaired
(e) Financial assets that are past due or impaired, giving an age analysis and a description of collateral
held by the entity as security
(f) Collateral and other credit enhancements obtained, including the nature and carrying amount
of the assets and policy for disposing of assets not readily convertible into cash
For liquidity risk entities must disclose:
(a) A maturity analysis of financial liabilities
(b) A description of the way risk is managed
Disclosures required in connection with market risk are:
(a) Sensitivity analysis, showing the effects on profit or loss of changes in each market risk
(b) If the sensitivity analysis reflects interdependencies between risk variables, such as interest rates and
exchange rates the method, assumptions and limitations must be disclosed.
5.4 Sensitivity analysis: more detail

The standard requires that an entity should disclose a sensitivity analysis for each type of market risk to
which the entity is exposed.
The standard gives two options regarding disclosure of the sensitivity analysis.
Option 1
An entity should disclose:
 Sensitivity analysis for each type of market risk to which the entity is exposed at the reporting date,
showing how profit or loss and equity would have been affected by changes in the relevant risk
variable that were reasonably possible at that date. Risk variables that are relevant to disclosing
market risk include, but are not limited to:
– The yield curve of market interest rates, for example the LIBOR rate. It may be necessary to
consider both parallel and non-parallel shifts in the yield curve.
– Foreign exchange rates
– Prices of equity instruments
– Market prices of commodities
 The methods and assumptions used in preparing the sensitivity analysis; and
 Changes from the previous period in the methods and assumptions used, and the reasons for such
changes.

The effect on profit or loss and equity of reasonably possible changes in the relevant risk variables may
include changes in the prevailing interest rates for interest sensitive instruments, and or changes in
currency rates for foreign currency financial instruments.
For interest rate risk, the sensitivity analysis might show separately the effect of a change in market
interest rates on interest income and expenditure, on other items of profits and on equity.
Option 2
Alternatively, if an entity prepares a sensitivity analysis, such as value-at-risk, that reflects
interdependencies between risk variables (eg interest rates and exchange rates) and uses it to manage
financial risks, it may use that sensitivity analysis in place of the analysis specified in the previous
paragraph. In this case the entity should also disclose:
 An explanation of the method used in preparing such a sensitivity analysis, and of the main
parameters and assumptions underlying the data provided; and
 An explanation of the objective of the method used and of limitations that may result in the
information not fully reflecting the fair value of the assets and liabilities involved.
5.5 Other market risk disclosures

Other market risk is any market risk which is not currency or interest rate risk. When the disclosure of
sensitivity analyses discussed above are unrepresentative of a risk inherent in a financial instrument (for
example because the year-end exposure does not reflect the exposure during the year), the entity shall
disclose that fact and the reason it believes the sensitivity analyses are unrepresentative.
C
H
A
P
T
E
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Summary
Statement of Profit or loss

financial position Other disclosures
and equity
Categories of Accounting policies

Other disclosures Income, expenses,
assets/liabilities gains and losses
at carrying
value
Reclassification Hedge accounting
Net gains/losses
Further detailed on all asset/liability
disclosures categories
Derecognition Fair value
relating to
risk for financial
assets/liabilities
at fair value Total interest
Collateral income Credit risk
through profit
or loss
Allowances accounted Fee income and

Liquidity risk
for credit loss expenditure
Financial assets/
liabilities not
through profit or
Compound financial loss Market risk
instrument with Trust and other
multiple embedded fiduciary activities
derivatives
Interest income
on impaired
Defaults and breaches financial assets
Amount of
impairment loss
for each class of
financial asset

Presentation in financial
statements
Treasury shares (own shares) acquired by entity

To be deducted from equity
Consideration paid/received recognised in OCI
Liability or equity
Compound financial instruments,

Equity Liability Offsetting eg convertible instruments
Ordinary Shares Redeemable Legally enforceable
Irredeemable preference shares right of set-off
preference shares not Entity intends to
requiring payment of settle net or
an annual fixed simultaneously Liability element Equity element
dividend (valued as fair value (valued as fair value
Interests, dividends, gains of similar liability
and losses relating to a - fair value of
without equity similar liability)
financial liability to component)
Transaction costs of an be recognised in profit
equity transaction to be or loss
accounted for as a
deduction from equity
Distributions to holders
of an equity instrument
to be debited to equity
C
H
A
P
T
E
R

Self-test
1 What is the main objective of the disclosure requirements of IFRS 7?
2 How does IFRS 7 define the following?
(a) Liquidity risk
(b) Market risk
3 Why does IFRS 7 require entities to disclose sensitivity analysis to market risk?
4 Warburton
The Warburton Company issued £10 million of convertible bonds at par on 31 December 20X7.
Interest is payable annually in arrears at a rate of 7%. The bonds are redeemable on 31 December
20X9. The bonds can be converted at any time up to maturity into 12.5 million ordinary shares.
At the time of issue, the market interest rate on debt with a similar credit status and the same cash
flows, but without conversion rights, was 10% per annum.
Requirement
What carrying amount should be recognised for the liability in the statement of financial position of
Warburton at 31 December 20X7 in respect of the convertible bond, in accordance with IAS 32
Financial Instruments: Presentation?
5 Erubus
The Erubus Company issued £15 million of 6% convertible bonds at par on 31 December 20X7.
The bonds are redeemable at 31 December 20Y1. The bonds can be converted by their holders
any time up to maturity into ordinary shares of Erubus.
At 31 December 20X7 the present value of the future capital and interest payments discounted at
the prevailing market interest rate for similar bonds without the conversion rights is £13 million.
The transaction costs directly attributable to the issue of the convertible bonds were £400,000.
These costs are deductible against Erubus' taxable profits. Erubus' tax rate is 25%.
Requirement
What increase in equity should be recognised in the statement of financial position of Erubus at 31
December 20X7 as a result of the issue of the convertible bonds, in accordance with IAS 32
Note: Some of the requirements of IAS 32 relate to derivatives and embedded derivatives. These will be
tested after you have covered those topics in Chapter 6.

Technical reference

1 Presentation of equity and liabilities
 Classification as financial asset, financial liability or equity instrument IAS 32.15-16
 Contractual obligation and substance of instrument IAS 32.17-18
 Settlement options IAS 32.26-27
 Treasury shares IAS 32.33-34
 Interest, dividends, losses and gains IAS 32.35-36
 Offsetting IAS 32.42
2 Compound instruments
 Recognising liability and equity elements IAS 32.28
 Example of convertible bonds IAS 32.29-30
 Calculation of liability and equity elements IAS 32.31-32

IFRS 7.8-19
1 Statement of financial position disclosures
IFRS 7.20
2 Statement of profit or loss and other comprehensive income and statement of
changes in equity disclosures
3 Nature and extent of risks arising from financial instruments

 Purpose of disclosures IFRS 7.31-32
 Qualitative disclosures IFRS 7.33
 Quantitative disclosures IFRS 7.34-35
C
H
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T
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IFRS 7 Financial instruments: Disclosures

1 The main objective of the disclosure requirements of IFRS 7 is to show the significance of financial
instruments for an entity's financial position and financial performance and qualitative and
quantitative information about exposure to risks arising from financial instruments.
2 (a) Liquidity risk is defined as the risk that an entity will encounter difficulty in meeting the
obligations associated with its financial liabilities.
(b) Market risk is the risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices.
3 Sensitivity analysis helps users of financial statements to evaluate the effect of possible changes in
the entity's financial position and financial performance due to changes in market risk factors.
IAS 32 Financial instruments: Presentation
4 Warburton
£9,479,339
IAS 32.28 requires the separation of the compound instrument into its liability and equity
elements. IAS 32.31 and 32 explain how this separation should be made. IAS 32.AG30 – AG35
explain the application of this principle.
2
Thus the liability is (£0.7m/1.10) + (£10.7m/1.10 ) = £9,479,339.
5 Erubus
£1,960,000
IAS 32.28 requires the separation of a compound instrument into liability and equity elements
where this is appropriate.
IAS 32.35 and 32.37 require that transaction costs of an equity transaction shall be deducted from
equity net of tax.
IAS 32.38 requires that transaction costs directly attributable to a compound financial instrument
should be allocated to the liability and equity components in proportion to the allocation of the
proceeds.
Liability component of gross proceeds: £13m
Equity component of gross proceeds: £2m
Issue costs are £400,000, allocated:
Liability component (13/15) £346,667
Equity component (2/15) £53,333
The initial liability recognised is therefore (£13m – £346,667) £12,653,333.
The equity component is (£2m – (£53,333 – 25% tax relief on £53,333)) £1,960,000
Note that tax relief on the issue costs allocated to the liability component will be given as they are
amortised against profit or loss. Initially they attract no relief and so there is no tax adjustment for
them in the original allocation of the issue costs.


Refer to the definitions of financial assets and liabilities.
(a) Physical assets: control of these creates an opportunity to generate an inflow of cash or other
assets, but it does not give rise to a present right to receive cash or other financial assets.
(b) Prepaid expenses, etc: the future economic benefit is the receipt of goods/services rather than the
right to receive cash or other financial assets.

Liability. The preference shares require regular distributions to the holders but more importantly have
the debt characteristic of being redeemable. Therefore, according to IAS 32 Financial Instruments:
Presentation they must be classified as liability.

The convertible bond is not a compound financial instrument as it is not settled in a fixed amount of
shares. It should instead be wholly classified as a liability.
The convertible redeemable preference shares are compound instruments. They have a financial liability
component as there is an obligation to deliver cash through dividends and on redemption in five years'
time to deliver either cash or equity instruments (through the holder's right to convert into equity).

The liability component is computed as the present value of the maximum potential cash flows
discounted at 10%.
Time Cash flow Discount PV
factor
£ @ 10% £
1 4,000 0.909 3,636
2 54,000 0.826 44,604
48,240
The equity component of the gross proceeds is therefore (50,000 – 48,240) £1,760.
The issue costs of £1,000 are split in the ratio 48,240:1,760, ie £965 is netted against the liability and
£35 is netted against the equity.
The entries are therefore:
£ £
Dr Cash 50,000
C
Cr Liability 48,240 H
Cr Equity 1,760 A
and P
Cr Cash 1,000 T
Dr Liability 965 E
Dr Equity 35 R
The net liability initially recognised is £47,275. This is then amortised to £50,000 over the next two
years at an effective interest rate of 11.19% (the IRR of the cash flows of £47,275, –£4,000 and 5
–£54,000) as follows:

Interest
expense at
Year B/fwd 11.19% Cash flow C/fwd
£ £ £ £
1 47,275 5,290 (4,000) 48,565
2 48,565 5,435 (4,000) 50,000

The contract is a financial asset or financial liability, even though the entity must settle it by issuing its
own equity. It is not an equity instrument as it is settled using a variable number of the entity's own
equity instruments.

Offsetting is not appropriate.
Each of the financial instruments has its own terms and conditions and may be transferred or settled
separately. The risks of the financial instruments are different.
They should not be offset unless they meet the criteria in IAS 32 (legal right of set-off and intention to
settle net), which is unlikely. However, disclosure of the relationship between the two financial
instruments would provide useful information to users of the financial statements.

CHAPTER 6
recognition and
measurement
Introduction
Topic List
1 Introduction and overview of earlier studies
2 Recognition and derecognition
3 Measurement and impairment
4 Derivatives
5 Embedded derivatives
6 IFRS 9 Financial Instruments and current developments
Technical reference
155
Introduction
 Apply and discuss the recognition, measurement and derecognition of financial assets and
financial liabilities
 Apply and discuss the treatment of gains and losses arising on financial assets and financial
liabilities
 Apply and discuss the treatment of impairments of financial assets
 Account for derivative financial instruments, and simple embedded derivatives

1 Introduction and overview of earlier studies C
H
A
Section overview P
T
 This section gives a chapter overview and summarises the material covered at professional level in E
order to consolidate student knowledge before more advanced issues are covered. R
 IAS 32
– Financial instruments should be presented as assets, liabilities or equity in the statement of 6
financial position.
– Compound financial instruments should be split between their liability and equity
components.
– Interest, dividends, gains and losses should be presented in a manner consistent with the
classification of the related instrument.
– Financial assets and financial liabilities can only be offset in limited circumstances.
 IAS 39
– A financial instrument should initially be measured at fair value, usually including transaction
costs.
– Subsequent re-measurement depends upon how the financial asset or financial liability is
classified.
– Financial assets and liabilities should be measured either at fair value or at amortised cost.
– IAS 39 contains detailed requirements regarding the derecognition of financial instruments.
– Financial assets (other than assets recognised at fair value through profit or loss, and fair
value can be measured reliably) should be reviewed at each reporting date for objective
evidence of impairment.
 IFRS 9
– Simplifies the requirements of IAS 39
– A work in progress. IAS 39 remains the main standard on recognition and measurement of
financial instruments, but it is important to have an awareness of IFRS 9.
1.1 Introduction
The purpose of this chapter is to provide a thorough coverage of the accounting treatment of financial
instruments. The main presentation and disclosure requirements as detailed in IAS 32 Financial
Instruments: Presentation and IFRS 7 Financial Instruments: Disclosures together with certain aspects of
recognition and measurement of IAS 39 Financial Instruments: Recognition and Measurement have already
been covered at professional level. This chapter extends the coverage of recognition and derecognition
of financial assets and liabilities, their initial and subsequent measurement and impairment, and finally
discusses particular issues relating to the definition of derivatives and the accounting treatment of
derivatives and embedded derivatives.
1.2 Summary of material covered at professional level

The accounting treatment of financial instruments is covered at professional level. The emphasis at that
level is on presentation and disclosure and less on recognition and measurement. The main points
covered at professional level can be summarised as follows:
 A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.
 An equity instrument is any contract that evidences a residual interest in the assets of another
entity after deducting all of its liabilities.
Financial instruments – recognition and measurement 157

 A financial asset is any asset that is cash, an equity instrument of another entity, a contract that
(subject to certain conditions) will or may be settled in the entity's own equity instruments or a
contractual right:
– To receive cash or another financial asset from another entity; or
– To exchange financial assets or financial liabilities with another entity under conditions that
are potentially favourable to the entity.
 Financial assets are classified into one of four categories:
– Financial assets at fair value through profit or loss
– Held-to-maturity investments
– Loans and receivables and
– Available-for-sale financial assets.
 A financial liability is any liability that is a contract that (subject to certain conditions) will or may
be settled in the entity's own equity instruments or a contractual obligation:
– To deliver cash or another financial asset to another entity; or
– To exchange financial assets or financial liabilities with another entity under conditions that
are potentially unfavourable to the entity.
 Financial liabilities are classified into one of two categories:
– Financial liabilities at fair value through profit or loss and
– Other financial liabilities
 A derivative is a financial instrument or other contract (such as an option) with all three of the
following characteristics:
– Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable, provided in the case of a non-financial variable that the variable is not
specific to a party to the contract (sometimes called the 'underlying');
– It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors; and
– It is settled at a future date.
 At the time it issues a financial instrument, an entity should classify it or its component parts
according to the substance of the contract under which it is being issued.
 A compound financial instrument (that is one that has features of both debt and equity) should
be split into its component parts according to their substance at the date that it is issued.
 Interest, dividends, losses or gains relating to a financial instrument (or a component) that is a
financial liability should be recognised as income or expense in profit or loss.
 Dividend distributions paid to holders of an equity instrument should be debited directly to
equity, net of any related income tax benefit. These should be presented in the statement of
changes in equity.
 If an entity reacquires its own shares ('treasury shares'), the amount paid should be deducted
directly from equity and no gain or loss should be recognised on the transaction.
 A financial asset or a financial liability should be recognised when an entity becomes a party to
the contractual provisions of the instrument.
 Financial assets and financial liabilities should generally be presented as separate items in the
statement of financial position. No offsetting is allowed except where it is required because an
entity has a legally enforceable right to set off recognised amounts and the entity intends to settle
on a net basis, or to realise the asset and settle the liability simultaneously.
 Financial assets and financial liabilities should be initially recognised at fair value plus or minus, in
certain circumstances, any directly attributable transaction costs, such as fees.

 A financial asset should be derecognised when the contractual rights to the cash flows from the
asset expire or the entity transfers the rights to those cash flows in such a way that it transfers C
substantially all the risks and rewards of ownership. A financial liability should be derecognised H
A
where an entity discharges the obligations in a contract or the obligations expire.
P
 Written explanations as well as numerical disclosures are required to provide users of the financial T
E
statements with an understanding of the effect the financial instruments have had on an entity's R
financial position and performance, and the nature and extent of risks arising from the
financial instruments.
6
Interactive question 1: Classification of equity instruments [Difficulty level: Easy]
Are there circumstances in which an investment in equity should be classified as a held-to-maturity
investment?
Interactive question 2: Classification [Difficulty level: Easy]

During the financial year ended 28 February 20X5, Dennis issued the two financial instruments
described below. For each of the instruments, identify whether it should be classified as a financial
liability or as part of equity, explaining the reason for your choice.
(a) Redeemable preferred shares with a coupon rate of 8%. The shares are redeemable on 28 February
20X9 at a premium of 10%.
(b) A grant of share options to senior executives. The options may be exercised from 28 February
20X8.
Interactive question 3: Transactions covered by IAS 39 [Difficulty level: Easy]

Should the following be recognised under IAS 39?
(a) A guarantee to replace or repair goods sold by a business in the normal course of business
(b) A firm commitment (order) to purchase a specific quantity of cocoa beans for use in manufacturing
(c) A forward contract to purchase cocoa beans at a specified price and quantity on a specified date
1.3 Overview of accounting treatment of financial assets and liabilities

IAS 39 follows a mixed measurement model under which some financial instruments are carried at fair
value while others are carried at amortised cost, and some gains or losses are recognised in profit or loss
and others in other comprehensive income.
The following two tables summarise the accounting treatment of each category of financial asset and
financial liability under IAS 39, provided they have not been designated as hedged items. The
accounting treatment of hedged items follows different rules and these are discussed in the next
chapter.

Summary of accounting treatment of assets
Measurement
Asset after initial Gains
category Description recognition and losses
Financial assets at Any financial asset which is held for the Fair value In profit or loss
fair value through purpose of selling in the short term (held for
profit or loss trading) or, in limited circumstances, is
designated under this heading.
Available-for-sale Non-derivative financial assets designated as Fair value In other

financial assets available for sale or not classified under any of comprehensive
the other three headings. income, except
that investment
income,
impairment losses
and foreign
exchange gains
and losses are in
profit or loss.
Loans and Non-derivative financial assets with fixed or Amortised cost In profit or loss
receivables determinable payments that are:
 Not quoted in an active market
 Not designated as at fair value through
profit or loss
 Not held for trading or designated as
available for sale
(ie loans and receivables are none of the above)
Held-to-maturity Non-derivative financial assets with fixed or Amortised cost In profit or loss
investments determinable payments and fixed maturity
that an entity has the positive intention and
ability to hold to maturity and are not
designated/classified under any of the other
three headings.
Note: These categories are simplified under IFRS 9 (see Section 6), but this standard is incomplete, so
the IAS 39 categories should be used in questions unless asked specifically for the IFRS 9 ones.
Summary of accounting treatment of liabilities
Measurement
Liability after initial Gains
category Description recognition and losses
Financial liabilities Any financial liability which is held for the Fair value In profit or loss
at fair value purpose of selling in the short term (held for
through profit or trading) or, in limited circumstances, is
loss designated under this heading.
Other liabilities Financial liabilities that are not classified as at Amortised cost In profit or loss
fair value through profit or loss.

2 Recognition and derecognition C
H
A
Section overview P
T
 This section deals with certain aspects of recognition and derecognition and includes the E
guidelines of the Standard. R
2.1 Introduction 6
IAS 39 requires that a financial asset or a financial liability should be recognised by an entity in its
statement of financial position when the entity becomes a party to the contractual provisions of the
financial asset or financial liability.
IAS 39 also requires that a financial asset or financial liability should be derecognised, that is removed,
from an entity's statement of financial position, when the entity ceases to be a party to the financial
instrument's contractual provisions.
The recognition of financial instruments is in general more straightforward than derecognition and IAS
39 pays more attention to establishing rules for the latter.
2.2 Initial recognition

In most cases, the date on which an entity becomes a party to a financial instrument's contractual
obligations is fairly obvious. For example, unconditional receivables are recognised as assets when an
entity acquires the legal right to receive cash.
An important consequence of recognition on becoming party to contractual provisions is that all
derivatives should be recognised in the statement of financial position.
When an entity enters into a derivative transaction involving a contract that is recognised under IAS 39
as a financial instrument, it should be recognised when the entity enters into the contract, not when the
transaction stipulated by the derivative contract occurs. For example, the purchase of a 6-month
forward contract with a zero fair value at its inception exposes the entity to risks and rewards due to
changes in the value of the underlying and it should therefore be recognised when the contract is
initiated.
2.3 Regular way transactions

Most financial markets set out regulations for 'regular way' transactions whereby purchases and sales are
contractually deliverable (and therefore settled) on a specified date. Settlement date is later than the
contractual date of the transaction (the 'trade date'). A regular way purchase or sale is the acquisition or
disposal of a financial asset under a contract requiring delivery within a specified time frame. The time
frame may be established through regulation or simply convention in the market.
Regular way purchases and sales of financial instruments should be recognised using either the trade
date or the settlement date. The method chosen should be applied consistently for each of the four
classes of financial asset. A contract for a derivative is not a regular way contract since it can be settled
on a net basis.
For purchases, trade date accounting requires the recognition of an asset and the liability to pay for it
at the trade date. After initial recognition the financial asset is subsequently measured either at
amortised cost or at fair value depending on its initial classification. For sales of financial assets, the asset
is derecognised and the receivable from the buyer together with any gain or loss on disposal are
recognised on the trade date.
With settlement date accounting, an asset purchased is not recognised until the date on which it is
received. Movements in fair value of the contract between the trade date and settlement date are
recognised in the same way as the acquired asset. That is, for assets carried at cost or amortised cost,
the change in value is not recognised, for assets classified as assets at fair value through profit or loss,
the change is recognised in profit or loss, and for available-for-sale assets, the change is recognised in
other comprehensive income. For sales of financial instruments, the asset is derecognised and the

receivable from the buyer, together with any gain or loss on disposal, are recognised on the day that it
is delivered by the entity. Any change in the fair value of the asset between the trade date and
settlement date is not recognised, as the sale price is agreed at the trade date, making subsequent
changes in fair value irrelevant from the seller's perspective.
Worked example: Regular way purchase of a financial asset

An entity entered into a contractual commitment on 27 December 20X4 to purchase a financial asset
for £1,000. On 31 December 20X4, the entity's reporting date, the fair value was £1,005. The
transaction was settled on 5 January 20X5 when the fair value was £1,007. The entity has classified the
asset as at fair value through profit or loss.
Requirement
How should the transactions be accounted for under trade date accounting and settlement date
accounting?
Solution
Trade date accounting
 On 27 December 20X4, the entity should recognise the financial asset and the liability to the
counterparty at £1,000.
 At 31 December 20X4, the financial asset should be remeasured to £1,005 and a gain of £5
recognised in profit or loss.
 On 5 January 20X5, the liability to the counterparty of £1,000 will be paid in cash. The fair value of
the financial asset should be remeasured to £1,007 and a further gain of £2 recognised in profit or
loss.
Settlement date accounting
 No transaction should be recognised on 27 December 20X4.
 On 31 December 20X4, a receivable of £5 should be recognised (equal to the fair value movement
since the trade date) and the gain recognised in profit or loss.
 On 5 January 20X5, the financial asset should be recognised at its fair value of £1,007. The
receivable should be derecognised, the payment of cash to the counterparty recognised and the
further gain of £2 recognised in profit or loss.
Interactive question 4: Regular way sale of a financial asset

An entity acquired an asset on 1 January 20X4 for £1,000. On 27 December 20X4, it entered into a
contract to sell the asset for £1,100. On 31 December 20X4, the entity's reporting date, the fair value of
the asset was £1,104. The transaction was settled on 5 January 20X5. The entity classified the asset as
available for sale.
Requirement
How should the transactions be accounted for under trade date accounting and settlement date
accounting?
In practice, many entities use settlement date accounting but apply it to the actual date of settlement
rather than when payment is due.

2.4 Derecognition of financial assets
C
2.4.1 Criteria for derecognition H
A
Derecognition is the removal of a previously recognised financial instrument from an entity's statement P
of financial position. T
E
An entity should derecognise a financial asset when: R
(a) The contractual rights to the cash flows from the financial asset expire, or
(b) The entity transfers substantially all the risks and rewards of ownership of the financial asset to 6
another party.
Derecognition of a financial asset is often straightforward as the above criteria can be implemented
easily. For example, a trade receivable should be derecognised when an entity collects payment. The
collection of payment signifies the end of any exposure to risks or any continuing involvement.
However, more complex transactions may involve the transfer of legal title to another entity but only a
partial transfer of risks and rewards, so that the original owner of the asset is still exposed to some of the
risks and rewards of owning the asset. This is discussed further below.
Worked example: Risks and rewards

Can you think of an example of a situation in which:
(a) An entity has transferred substantially all the risks and rewards of ownership?
(b) An entity has retained substantially all the risks and rewards of ownership?
Solution
IAS 39 includes the following examples:
(a) (i) An unconditional sale of a financial asset.
(ii) A sale of a financial asset together with an option to repurchase the financial asset at its fair
value at the time of repurchase. Because any repurchase is at the then fair value, all risks and
rewards of ownership are with the buying party.
(b) (i) A sale and repurchase transaction where the repurchase price is a fixed price or at the sale
price plus a lender's return.
(ii) A sale of a financial asset together with a total return swap that transfers the market risk
exposure back to the entity.
2.4.2 Accounting treatment

On derecognition of a financial asset the difference between the carrying amount and any
consideration received should be recognised in profit or loss. Any accumulated gains or losses that
have been recognised in other comprehensive income should also be reclassified to profit or loss
on derecognition of the asset.

Worked example: Derecognition
The Polyact Company purchased £60,000 of shares, which were classified as held for trading. One year
later Polyact sold 50% of the shares for £40,000.
Requirement
What is the amount of the gain or loss on the disposal to be recognised in profit or loss?
Solution
On derecognition of a financial asset the difference between the carrying amount and any consideration
received should be recognised in profit or loss. On the assumption that the asset was not remeasured
during the year, the carrying amount of 50% of the asset is £30,000. The proceeds from the sale of 50%
of the asset is £40,000, yielding a gain of £10,000 to be recognised in profit or loss.
2.4.3 The IAS 39 derecognition steps

The complexity of financial transactions and the difficulty of establishing whether the transfer of legal
title leaves residual risk and reward exposure as well as control and involvement, has prompted the IASB
to produce a fairly prescriptive set of rules to aid companies in the derecognition of financial assets.
The following flowchart is included in the application guidance which accompanies IAS 39 as an integral
part of the standard. It summarises the evaluation of whether, and to what extent, a financial asset
should be derecognised.

Consolidate all subsidiaries (including any SPE) C
H
A
P
T
E
Determine whether the derecognition principles below are applied R
to a part or all of an asset (or group of similar assets)
Have the rights to the Yes

cash flows from the Derecognise the asset
asset expired?
No
Has the entity transferred

its rights to receive
the cash
flows from the asset?
No
Has the entity assumed

Yes an obligation to No
Continue to recognise the asset
pay the cash flows
from the asset?
Yes
Has the entity transferred Yes

substantially all risks Derecognise the asset
and rewards?
No
Has the entity retained Yes

substantially all risks Continue to recognise the asset
and rewards?
No
Has the entity retained No

Derecognise the asset
control of the assets?
Yes
Continue to recognise the asset to the extent of the entity's

continued involvement

The following points relate to this flowchart:
 If the contractual rights to receive the cash flows from the asset have expired or have been wholly
transferred, the whole of the asset should be derecognised. This is also the case if the contractual
rights have been retained by the entity but it has assumed a contractual obligation to pay the cash
flows to one or more recipients. Such an obligation is only assumed if:
– There is no obligation to pay unless amounts are actually collected
– The entity is forbidden to sell or pledge the original asset other than to the recipient of the
cash flows; and
– The entity must remit the cash flows collected without material delay.
 If an entity has sold just a portion of the cash flows arising from an asset, only part of the asset
should be derecognised.
 If substantially all the risks and rewards of ownership have been transferred, the financial asset
should be derecognised; if they have not, it should not.
 If the entity has neither retained nor transferred all the risks and rewards of ownership, it should
determine whether it has retained control of the financial asset. If it has, it continues to recognise
the asset to the extent of its continuing involvement.
Some common transactions, such as repurchase agreements, factoring and securitisations, that are
employed in order to try to remove assets from the statement of financial position are discussed below.
Remember always to apply the principle of substance over form.
2.4.4 Repurchase agreements

In a repurchase agreement, a financial asset such as a bond is sold with a simultaneous agreement to
buy it back at some future date at a specified price, which may be the future market price.
Illustration: Derecognition of repurchase agreement

An entity sold an equity investment classified as available for sale to a counterparty for £840. The entity
had previously recognised a gain of £100 in other comprehensive income in respect of this investment
and reclassified this £100 gain from other comprehensive income to profit or loss. On the same date it
entered into a 60-day contract to repurchase the equity investment from the counterparty for £855 less
any equity distributions received by the counterparty during the 60-day period.
The substance of the transaction is that the risks and rewards of ownership have not been transferred,
because in effect the proceeds of the sale are collateralised borrowing.
The entity should recognise a financial liability of £840 when it receives the cash from the 'sale'. The
£100 gain should not be reclassified from other comprehensive income. The premium on repurchase of
£15 should be recognised as a finance cost in profit or loss over the 60-day period.
2.4.5 Factoring
Factoring activity tends to increase as banks become reluctant to lend. This has been the case during the
credit crunch of 2008, continuing to the present day.
In a factoring transaction, one party transfers the right to some receivables to another party for an
immediate cash payment. Factoring arrangements are either with recourse or without recourse.
(a) In factoring without recourse, the transferor does not provide any guarantees about the
performance of the receivables. In such a transaction the entity has transferred the risks and
rewards of ownership and should derecognise the receivables.
(b) In factoring with recourse, the transferor fully or partially guarantees the performance of the
receivables. The transferor has not therefore transferred fully the risks to another party. In most
factoring with recourse transactions, the transferor does not allow the transferee to sell the
receivables, in which case the transferor still retains control over the asset. In this case the criteria
for derecognition are not satisfied and the asset should not be derecognised.

Illustration: Factoring without recourse
C
Entity A carries in its statement of financial position receivables measured at £10m. It sells the H
receivables in a factoring transaction without recourse to Entity B for £8.5m of cash. A
P
Entity A should derecognise the receivables as it has transferred the risks and rewards to Entity B. The T
loss of £1.5m should be recognised in profit or loss. E
R
Illustration: Factoring with full recourse 6
Entity A carries in its statement of financial position receivables measured at £10m. It sells the
receivables in a factoring transaction with full recourse to Entity B for £8.5m of cash. Entity A
guarantees to reimburse Entity B in cash if the receivables realise less than £8.5m.
In this example Entity A has transferred the right to receive the receivables to Entity B but it has not
transferred all the risks. The asset should not be derecognised. The cash received should be credited to a
liability account (in essence a loan from the factor).
2.4.6 Securitisations
Securitisation is the process whereby an originator packages pools of, for instance, loans, receivables or
the rights to future income streams that it owns and then sells the packages. Investors buy the
repackaged assets by providing finance in the form of securities or loans which are secured on the
underlying pool and its associated income stream. Securitisation thereby converts the originator's illiquid
assets into liquid assets.
Illustration: Securitisation
Some football clubs have needed to raise cash quickly to buy players. They have therefore obtained
immediate cash which has been securitised to the lender by the rights to the income from the first
tranche of future season ticket sales.
Another example is a bank that has extended mortgages to individuals. It will receive cash flows in
future in the form of interest payments. However, it cannot demand early repayment of the mortgages.
If, however, it sells the rights to the interest cash flows from the mortgages to a third party, it could
convert the income stream into an immediate lump sum (therefore, receiving today the present value of
a future cash flow).
Securitisation often involves the use of a special purpose entity (SPE) to acquire the originator's
receivables or loans. The SPE issues debt to third parties to raise the finance to repay the originator.
Illustration: Special purpose entities

The banking crisis of 2008 was caused partly by securitisation of sub-prime mortgages and the use of
special purpose entities.
Whether the securitised assets will be derecognised depends on whether the SPE has assumed all the
risks and rewards of the ownership of the assets and whether the originator has ceded control of the
assets to the SPE.
If the SPE is a mere extension of the originator and it continues to be controlled by the originator, then
the SPE should be consolidated and any securitised assets should continue to be recognised in the
group accounts. Securitisation will not in this case lead to derecognition.
Even when the SPE is not controlled by the originator, the risks and rewards of ownership will not have
passed completely to the SPE if the lenders to the SPE require recourse to the originator to provide
security for their debt.

A key aspect of whether risk is transferred would be whether the originator retains the risk of bad debts.
Thus if the originator sells 90% of a package to the SPE and retains 10%, then it is arguable that
substantially all risks and rewards of ownership have been transferred. If, however, the originator
transfers the 90% package but agrees to retain all the bad debt risk of the entire portfolio, then risks and
rewards have not been transferred and the loan package should not be derecognised.
The derecognition criteria will be met if the SPE is not under the control of the originator and there are
no guarantees provided by the originator. In this case the derecognition takes the package of loans out
of the group accounts and the group recognises cash received instead. The benefit then is that it
improves the credit rating of the originator as cash is a better asset than the package of mortgages.
Securitisation has had a bad name since 2008, when the repackaging of sub-prime loans was partly
responsible for the crises in some American banks.
2.5 Derecognition of financial liabilities

The principle remains that the substance of transactions should be accounted for, not just their form.
An entity should derecognise a financial liability when it is extinguished ie when the obligation
specified in the contract is discharged or cancelled or expires.
Illustration: Extinguishing a financial liability

Entity A has borrowed £10m from a bank to invest in commercial development. However, due to the
recession the shops built did not yield the expected rental income and Entity A cannot service the debt.
It negotiates with the bank to transfer the ownership of the development to the bank in settlement of
the outstanding debt. The market value of the development is £7m. The development's carrying
amount was £7m as it was measured at fair value.
As a result of the transfer, Entity A should extinguish the liability but it should also recognise a gain of
£3m in profit or loss, arising from the difference between the carrying amount of the liability (£10m)
and the value of the development (£7m) that was transferred to the bank.
2.6 Partial derecognition of financial assets and financial liabilities

It is possible for only part of a financial asset or liability to be derecognised. This is the case if the part
comprises:
(a) Only specifically identified cash flows; or
(b) Only a fully proportionate (pro rata) share of the total cash flows.
For example, if an entity holds a bond, it has the right to two separate sets of cash inflows: those
relating to the principal and those relating to the interest. It could sell the right to receive the interest to
another party while retaining the right to receive the principal.
On derecognition, the amount to be included in profit or loss for the year is calculated as follows:
£ £
Carrying amount of asset/liability (or the portion of asset/liability) transferred X
Less: Proceeds received/paid X
Any cumulative gain or loss on a financial asset recognised in other X
comprehensive income
(X)
Difference to profit or loss X
Where only part of a financial asset is derecognised, the carrying amount of the asset should be
allocated between the part retained and the part transferred based on their relative fair values on the
date of transfer. A gain or loss should be recognised based on the proceeds for the portion transferred.

Interactive question 5: Derecognition of financial assets and liabilities
[Difficulty level: Intermediate] C
H
Discuss whether the following financial instruments should be derecognised. A
P
(a) AB Co sells an investment in shares, but retains a call option to repurchase those shares at any time T
at a price equal to the market value current at the date of repurchase. E
R
(b) CD Co sells an investment in shares and enters into a 'total return swap' with the buyer. Under a
'total return swap' arrangement, the buyer returns any increases in value to the seller, and the seller
compensates the buyer for any decrease in value plus interest.
6
(c) EF Co enters into a stocklending agreement where an investment is lent to a third party for a fixed
period of time for a fee.
(d) GH Co sells title to some of its receivables to a debt factor for an immediate cash payment of 90%
of their value. The terms of the agreement are that GH Co has to compensate the factor for any
amounts not recovered by the factor after six months.
2.7 Exchange or modification of debt

If a new loan is agreed between a borrower and a lender, or the two parties agree revised terms for an
existing loan, the accounting depends on whether the original liability should be derecognised and a
new liability recognised, or whether the original liability should be treated as modified.
A new liability should be recognised if the new terms are substantially different from the old terms. The
terms are substantially different if the present value of the cash flows under the new terms, including
any fees payable/receivable, discounted at the original effective interest rate, is 10% or more different
from the present value of the remaining cash flows under the original terms. There is said to be an
'extinguishment' of the old liability. In these circumstances
 The difference between the carrying amount extinguished and the consideration paid should be
recognised in profit or loss
 The fees payable/receivable should be recognised as part of that gain or loss.
If the difference between the two present values is below this cut-off point, there is said to be a
modification of the terms. In these circumstances
 The existing liability is not derecognised.
 Its carrying amount is adjusted by the fees payable/receivable and amortised over the remaining
term of the modified liability.
3 Measurement and impairment
Section overview
 This section deals with certain aspects of initial and subsequent measurement of financial
instruments, especially the treatment of transaction costs and of valuation methods when fair
values are not available.
3.1 Introduction
It was noted earlier that financial assets and financial liabilities should initially be measured at fair
value (cost). Subsequently:
 Financial assets should be remeasured to fair value, unless they are loans and receivables, held-to-
maturity investments or financial assets whose value cannot be reliably measured

 Financial liabilities should be remeasured to amortised cost unless they are at fair value through
profit or loss.
Note: IFRS 9 modifies the rules (see Section 6) but it is not yet complete, so you need to know the IAS
39 rules.
3.2 Initial measurement

Financial instruments should initially be measured at the fair value of the consideration given or
received (ie, cost) plus (in most cases) transaction costs that are directly attributable to the
acquisition or issue of the financial instrument.
The exception to this rule is where a financial instrument is at fair value through profit or loss. In this
case transaction costs are immediately recognised in profit or loss.
The fair value of the consideration is normally the transaction price or market prices. If market prices are
not reliable, the fair value may be estimated using a valuation technique (for example, by discounting
cash flows).
The categories for financial instruments are important because they determine how a particular
instrument should be measured subsequent to initial recognition. The definitions given in section 1 of
this chapter are now set in fuller detail.
Definitions
A financial asset or liability at fair value through profit or loss is one which meets either of the
following conditions:
(a) It is classified as held for trading. A financial asset or liability is classified as held for trading if it is:
(i) Acquired or incurred principally for the purpose of selling or repurchasing it in the near term
(ii) Part of a portfolio of identified financial instruments that are managed together and for which
there is evidence of a recent actual pattern of short-term profit-taking, or
(iii) A derivative (unless it is a designated and effective hedging instrument – see the next
chapter).
(b) Upon initial recognition it is designated by the entity as at fair value through profit or loss. An
entity may only use this designation in severely restricted circumstances, ie where:
(i) It eliminates or significantly reduces a measurement or recognition inconsistency
('accounting mismatch') that would otherwise arise.
(ii) A group of financial assets/liabilities is managed and its performance is evaluated on a fair
value basis.
Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments
and fixed maturity that an entity has the positive intent and ability to hold to maturity other than:
(a) Those that the entity upon initial recognition designates as at fair value through profit or loss
(b) Those that the entity designates as available for sale
(c) Those that meet the definition of loans and receivables
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are
not quoted in an active market, other than:
(a) Those that the entity intends to sell immediately or in the near term, which should be classified as
held for trading and those that the entity upon initial recognition designates as at fair value
through profit or loss
(b) Those that the entity upon initial recognition designates as available for sale, or
(c) Those for which the holder may not recover substantially all of the initial investment, other than
because of credit deterioration, which shall be classified as available for sale.

An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a
mutual fund or a similar fund) is not a loan or a receivable. C
H
Available-for-sale financial assets are those non-derivative financial assets that are designated as A
available for sale or are not classified as: P
T
(a) Loans and receivables, E
(b) Held-to-maturity investments, or R
(c) Financial assets at fair value through profit or loss. (IAS 39)
Worked example: Fair value of interest free loan

Entity A is a new business which can borrow money at 12%. As part of an initiative to build a closer
working relationship with Entity A, Entity B lends it £20,000 for three years on an interest-free basis.
Requirement
How should the loan be accounted for by Entity B?
Solution
The initial fair value of the loan should be determined by discounting the £20,000 receivable in three
years time to its present value, using the interest rate applicable to Entity A. The present value is
3
£14,235 (20,000/1.12 ) and the remaining £5,765 should immediately be recognised as an expense in
profit or loss.
Each year Entity B should recognise finance income of 12% on the balance of the loan, increasing the
loan's carrying amount by the amount recognised in profit or loss.
3.3 Transaction costs

Transaction costs are defined as the incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset or liability. Transaction costs should be added to the initial fair value
except for financial assets and financial liabilities classified as at fair value through profit or loss where
they should be recognised in profit or loss. The detailed requirements of IAS 39 are set out below:
 For financial instruments that are measured at fair value through profit or loss, transaction costs
should not be added to the fair value measurement at initial recognition. They are expensed when
incurred.
 For other financial assets, transaction costs, for example fees and commissions, should be added to
the amount initially recognised.
 For other financial liabilities, directly related costs of issuing debt should be deducted from the
amount of debt initially recognised.
 For financial instruments that are carried at amortised cost (such as held-to-maturity
investments, loans and receivables, and financial liabilities that are not at fair value through
profit or loss) transaction costs should be included in the calculation of amortised cost using the
effective interest method and amortised through profit or loss over the life of the instrument. In
practice many entities write off the transaction costs on a straight-line method. Whilst not in
accordance with IAS 39 they claim that the difference is immaterial.
 For available-for-sale financial assets, transaction costs should be recognised in other
comprehensive income as part of a change in fair value at the next remeasurement. If an available-
for-sale financial asset does not have fixed or determinable payments and has an indefinite life, the
transaction costs are reclassified to profit or loss when the asset is derecognised or becomes
impaired. If an available-for-sale financial asset has fixed or determinable payments and does not
have an indefinite life, the transaction costs are amortised to profit or loss using the effective
interest method.

Transaction costs expected to be incurred on transfer or disposal of a financial instrument should not be
included in the remeasurement of the financial instrument to fair value.
It is not uncommon for explicit transaction costs to be immaterial and for market traders to trade
financial instruments by offering bid and offer/ask prices. In such circumstances the transaction costs are
effectively within the bid-ask price spread.
Worked example: Transaction costs 1

An entity acquires a financial asset in an active market for £52. This was the offer price at the time of the
transaction. The bid price at that time was £50.
Requirement
At what amount should the asset initially be recognised?
Solution
IAS 39 effectively treats the bid-offer spread as a transaction cost. If the financial instrument is classified
as at fair value through profit or loss, the notional transaction cost of £2 should be recognised as an
expense and the financial asset initially recognised at £50. If the instrument is classified under any other
category, the transaction cost should be added to the fair value and the financial asset initially
recognised at £52.
Worked example: Transaction costs 2

An entity acquires an available-for-sale (AFS) financial asset at its fair value of £50. Purchase commission
of £3 is also payable. At the end of the entity's financial year, the asset's quoted market price is £55. If
the asset was to be sold, a commission of £3 would be payable.
Requirement
At what amount should the asset be recognised initially and at the end of the financial year?
Solution
As the asset is classified as available for sale, the entity should initially recognise the financial asset at its
fair value plus the transaction costs, that is, at £53. At the end of the entity's financial year, the asset
should be remeasured at £55 (the commission of £3 payable on a sale is not taken into account). The
change in fair value of £2 should be recognised in other comprehensive income.
3.4 Subsequent measurement of financial assets

After initial recognition loans and receivables and held to maturity investments should be
remeasured at amortised cost using the effective interest method.
Certain investments in equity instruments should be measured at cost. These are equity investments
that do not have a quoted market price in an active market and whose fair value cannot be reliably
measured, together with derivatives that are linked to and must be settled by delivery of such unquoted
equity instruments.
All other financial assets should be remeasured to fair value, without any deduction for transaction
costs that may be incurred on sale or other disposal.

Definition
C
The amortised cost of a financial asset or financial liability is the amount at which the financial asset or H
liability is measured at initial recognition minus principal repayments, plus or minus the cumulative A
amortisation using the effective interest method of any difference between that initial amount and the P
maturity amount, and minus any write-down (directly or through the use of an allowance account) for T
E
impairment or uncollectability. R
The effective interest method is a method of calculating the amortised cost of a financial instrument
and of allocating the interest income or interest expense over the relevant period.
6
The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts
through the expected life of the financial instrument to the net carrying amount of the financial asset or
liability.
Gains and losses on remeasurement should be recognised as follows:

 Changes in the carrying amount of financial assets at fair value through profit or loss should be
 Changes in the carrying amount of loans and receivables and held-to-maturity investments
should be recognised in profit or loss. Changes arise when these financial assets are derecognised
or impaired and through the amortisation process.
 In respect of available-for-sale financial assets:
– Impairment losses and foreign exchange differences should be recognised in profit or loss
– Interest on an interest-bearing asset should be calculated using the effective interest method
and recognised in profit or loss
– All other gains and losses should be recognised in other comprehensive income and held in a
separate component in equity. On derecognition, either through sale or impairment, gains and
losses previously recognised in other comprehensive income should be reclassified to profit or
loss, becoming part of the gain or loss on derecognition.
Note: IFRS 9 simplifies the categories (see Section 6) but it is not yet complete, so you need to know the
IAS 39 rules.
Interactive question 6: IAS 39 [Difficulty level: Easy]

Which of the following can be held at amortised cost under IAS 39?
(1) A trade receivable
(2) 6% Debentures issued by the reporting company on 1 January 20X1 and repayable at a premium
of 20% after three years
(3) An interest rate option
(4) Investment in the redeemable preference shares of another company
A (1) and (2) only
B (2) and 4 only
C (2), (3) and (4) only
D (1), (2) and (4) only
Worked example: Measurement of held to maturity asset

On 1 January 20X4 an entity subscribed for a £20,000 5% bond, interest being payable annually in
arrears. The bond was issued at a discount of 5% and was redeemed at a premium of 5% on 31
December 20X6. The effective interest rate of the financial instrument was calculated as 8.49%. As a
result in changes in general interest rates, the fair value of the bond was £19,400 at 31 December 20X4
and £20,400 at 31 December 20X5.

Requirements
Calculate the amounts to be recognised in the entity's financial statements for each of the three years
ended 31 December 20X6 if:
(a) The asset was classified as held to maturity.
(b) The asset was classified as available for sale.
Solution
(a) A held-to-maturity investment should be measured at amortised cost using the effective interest
method. The amounts in the financial statements should be determined as follows.
Statement of financial Statement of financial
position carrying Interest at 8.49% effective Cash received at 5% of position carrying
Year amount b/f rate recognised in profit or loss £20,000 nominal value amount c/f
£ £ £ £
20X4 19,000 1,613 (1,000) 19,613
20X5 19,613 1,665 (1,000) 20,278
20X6 20,278 1,722 (22,000)* 0
* includes redemption of £20,000 × 105% = £21,000.
(b) The interest on an available-for-sale financial asset should be recognised in profit or loss using the
effective interest method. The carrying amount should then be remeasured to fair value with
changes being recognised in other comprehensive income.
Carrying amount Interest as Cash flow Fair value Carrying amount
Year b/f before as before change (bal fig) c/f
£ £ £ £ £
20X4 19,000 1,613 (1,000) (213) 19,400
20X5 19,400 1,665 (1,000) 335 20,400
20X6 20,400 1,722 (22,000) (122) 0
Included in other comprehensive income is a debit of £213 in 20X4 for the loss in fair value, a credit of
£335 in 20X5 for the gain in fair value and a debit in 20X6 as the cumulative gain is removed.
When shares ('old shares') classified as available for sale are exchanged for other shares ('new shares'),
perhaps as a result of a takeover, any gains or losses on the old shares previously recognised in other
comprehensive income should be reclassified from other comprehensive income to profit or loss and the
new shares should be measured at their fair value.
Worked example: Exchange of shares

ABC acquires a small number of shares in DEF for their fair value of £100; the shares are quoted on a
securities exchange and ABC classifies them as available for sale. One year later, their fair value has risen
to £110 and a gain of £10 is recognised in other comprehensive income. The following year GHI, a
larger competitor, acquires DEF for an offer that values ABC's shareholding at £150. The consideration is
satisfied by ABC receiving new equity shares in GHI.
Requirement
How should the acquisition of the shares in GHI be recognised?
Solution
The transaction requires the derecognition of the shares in DEF. A profit on disposal of £50 should be
recognised in profit or loss, comprising the £40 gain since the remeasurement plus the £10 reclassified
from other comprehensive income. The shares in GHI should initially be measured at £150.

3.5 Classification and reclassification
C
3.5.1 Classification H
A
Financial assets and financial liabilities should be classified at the time of their initial recognition. P
T
For a financial asset to be classified as a held-to-maturity investment it must meet the specified narrow E
criteria. The entity must have a positive intent and a demonstrated ability to hold the investment to R
maturity. These conditions are not met if:
(a) The entity intends to hold the financial asset for an undefined period
6
(b) The entity stands ready to sell the financial asset in response to changes in interest rates or risks,
liquidity needs and similar factors (unless these situations could not possibly have been reasonably
anticipated)
(c) The issuer has the right to settle the financial asset at an amount significantly below its amortised
cost (because this right will almost certainly be exercised)
(d) The entity does not have the financial resources available to continue to finance the investment
until maturity
(e) The entity is subject to an existing legal or other constraint that could frustrate its intention to hold
the financial asset to maturity
An equity instrument cannot meet the criteria for classification as held to maturity, because it has no
fixed maturity.
Any financial asset may be designated as available for sale.
3.5.2 Reclassification
Reclassification into another category is not allowed for assets or liabilities at fair value through profit or
loss (but see the amended rules in the next paragraph).
Other financial assets may be reclassified if circumstances change. For example, if in respect of held-to-
maturity investments there is a change of intention or ability to hold to maturity, it is no longer
appropriate for such investments to continue in the same category. They should instead be reclassified
as available for sale and measured at their then fair value. Any gain or loss on reclassification should be
recognised in other comprehensive income.
There is a penalty for reclassifying (or indeed selling) a held-to-maturity investment:
 All remaining held-to-maturity investments should also be classified as available for sale and
remeasured to fair value.
 No investment may be classified as held to maturity if there has been a reclassification or sale
during the current financial year or during the two preceding financial years. The held-to-maturity
classification is said to be tainted.
This penalty is applied unless:
 The amount reclassified/sold is insignificant compared to the total amount of held-to-maturity
investments; or
 The reclassification or sale was within three months of maturity or after the entity has collected
substantially all the amounts of the original principal or was the result of an event beyond the
entity's control and which could not reasonably have been anticipated.
Worked example: Reclassifying financial assets

On 1 January 20X4, an entity classifies a portfolio of ten six-year bonds as held-to-maturity investments.
On 30 June 20X5, the entity sells six of the assets for their fair value of £16 each. At that date the
amortised cost of each financial asset using the effective interest method was £12. On 1 January 20X8,
the fair value of each financial asset was £21. The entity has a 31 December reporting date.
Requirement
How should the above be accounted for?

Solution
The held-to-maturity category is tainted on 30 June 20X5 when the entity sells more than an
insignificant amount (in this case 60%) of the held-to-maturity financial assets. At that date, the
remaining financial assets should be reclassified as available for sale. They should be measured at £64 (4
× £16) and the gain of £16 (4 × (£16–£12)) recognised in other comprehensive income.
The category of held-to-maturity investments is unavailable for classification for the remainder of the
20X5 financial year and the two following financial years. The financial assets may be reclassified as held
to maturity on 1 January 20X8 when the classification is cleansed. On that date, the fair value of £84 (4
× £21) becomes the new amortised cost and the total gain of £36 (4 × (£21–£12)) recognised in other
comprehensive income should be amortised to profit or loss over the remaining two-year term to
maturity, using the effective interest rate method.
3.6 Amended reclassification rules

Changes introduced in October 2008 permit entities to reclassify non-derivative financial assets out of
the 'fair value through profit or loss' and 'available-for-sale' categories in limited circumstances.
Additional disclosures are required.
In October 2008, the IASB published amendments to IAS 39 Financial instruments: recognition and
measurement and IFRS 7 Financial instruments: disclosures. The IASB had come under pressure to bring
the reclassification of financial assets into line with US GAAP, thus creating a 'level playing field'. The
amendments are effective retrospectively from 1 July 2008.
3.6.1 Scope
The amendment only applies to reclassification of some non-derivative financial assets recognised in
accordance with IAS 39. Reclassification is not permitted for financial liabilities, derivatives and financial
assets that are designated as at fair value through profit or loss (FVTPL) on initial recognition under the
'fair value option'.
The amendments therefore only permit reclassification of debt and equity financial assets subject to
meeting specified criteria. They do not permit reclassification into FVTPL.
3.6.2 Criteria for reclassification out of fair value through profit or loss and available for sale
The criteria vary depending on whether the asset would have met the definition of 'loans and
receivables' if it had not been classified as FVTPL or available for sale (AFS) on initial recognition.
(a) If a debt instrument would have met the definition of loans and receivables, had it not been
required to be classified as held for trading at initial recognition, it may be reclassified out of FVTPL
provided the entity has the intention and ability to hold the asset for the foreseeable future
or until maturity.
(b) If a debt instrument was classified as AFS, but would have met the definition of loans and
receivables if it had not been designated as AFS, it may be reclassified to the loans and receivables
category provided the entity has the intention and ability to hold the asset for the
foreseeable future or until maturity.
(c) Other debt instruments or any equity instruments may be reclassified from FVTPL to AFS or, in the
case of debt instruments only, from FVTPL to held to maturity (HTM) if the asset is no longer held
for selling in the short term.
3.6.3 Measurement at the reclassification date

Reclassified assets must be measured at fair value at the date of reclassification.
(a) Previously recognised gains and losses cannot be reversed.
(b) The fair value at the date of reclassification becomes the new cost, or amortised cost of the
financial asset.

3.6.4 Measurement after the reclassification date
C
After the reclassification date, the normal IAS 39 requirements apply. For example, in the case of H
financial assets measured at amortised cost, a new effective interest rate will be determined. If a fixed A
rate debt instrument is reclassified as loans and receivables and held to maturity, this effective interest P
rate will be used as the discount rate for future impairment calculations. T
E
For assets reclassified out of AFS, amounts previously recognised in other comprehensive income must R
be reclassified to profit or loss.
Reclassified debt instruments are treated differently. If, after the instrument has been reclassified, an 6
entity increases its estimate of recoverability of future cash flows, the carrying amount is not adjusted
upwards (in accordance with existing IAS 39 rules). Instead, a new effective interest rate must be
applied from that date on. This enables the increase in recoverability of cash flows to be recognised
over the expected life of the financial asset.
3.6.5 Disclosures
IFRS 7 has been amended to require additional disclosures for reclassifications that fall within the
scope of the above amendments. They relate to the amounts reclassified in and out of each category,
the fair values of reclassified assets, fair value gains or losses recognised in the period of reclassification
and any new effective interest rate.
3.6.6 Reclassification in action: Deutsche Bank

One of the first companies to take advantage of the change was Deutsche Bank. For illustrative
purposes, here is the relevant extract from the Annual Report for the year ended 31 December 2008:
Following the amendments to IAS 39 and IFRS 7 Reclassification of Financial Assets, the Group
reclassified certain trading assets and financial assets available for sale to loans and receivables. The
Group identified assets, eligible under the amendments, for which at the reclassification date it had a
clear change of intent and ability to hold for the foreseeable future rather than to exit or trade in the
short term. The disclosures below detail the impact of the reclassifications to the Group.
In the third quarter 2008, reclassifications were made with effect from July 1, 2008 at fair value at that
date. As the consolidated financial statements for the year ended December 31, 2008 were prepared,
adjustments relating to the reclassified assets as disclosed previously in the Group's interim report as of
September 30, 2008 were made to correct immaterial errors. Disclosure within this note has been
adjusted for the impact of these items.
The following table shows carrying values and fair values of the assets reclassified at July 1, 2008.
Jul 1, 2008 Dec 31, 2008
In € m Carrying value Carrying value Fair value
Trading assets reclassified to loans 12,677 12,865 11,059
Financial assets available for sale reclassified to loans 11,354 10,787 8,628
Note: IFRS 9 restricts re-classification further (see Section 6) but it is not yet complete, so you need to
know the current rules.
3.7 Subsequent measurement of financial liabilities

Financial liabilities at fair value through profit or loss should be remeasured at fair value, excluding
disposal costs, and any change in fair value should be recognised in profit or loss.
All other financial liabilities should be remeasured at amortised cost using the effective interest method.
Where a liability is carried at amortised cost, a gain or loss is recognised in profit or loss when the
financial liability is derecognised or through the amortisation process.

Worked example: Measurement at amortised cost
Artemis Co purchased £10 million 8% debentures at par on 1 January 20X5 when the market rate of
interest was 8%. Interest is paid annually on 31 December. The debentures are redeemable at par on
31 December 20X6.
Requirement
Show the charge or credit to profit or loss for the years to 31 December 20X5 and 20X6 if the
debentures are held-to-maturity. Also show the statement of financial position amounts at these dates.
Solution
Held-to-maturity assets are measured at amortised cost with gains and losses recognised in profit or loss.
20X5 20X6
£'000 £'000
Statement of profit or loss and other comprehensive income
Interest income 800 800

Financial asset 10,000 –
WORKINGS
£'000
Cash – 1.1.20X5 10,000
Effective interest at 8% (same as nominal as no discount or premium to be 800
amortised)
Coupon received (nominal interest 8%  10m) (800)
At 31.12.20X5 10,000
Effective interest at 8% 800
Coupon and capital received ((8%  10m) + 10m) (10,800)
At 31.12.20X6 0
Interactive question 7: Financial instruments – valuation of bonds

(a) Graben Co purchases a bond for £441,014 on 1 January 20X1. It will be redeemed on 31
December 20X4 for £600,000. The bond will be held to maturity and carries no coupon.
Requirement
Using the table below calculate the measurement of the bond for the statement of financial
position as at 31 December 20X1 and the finance income to be recognised in profit or loss for that
year.
n
Compound sum of £1: (1 + r)
Year 2% 4% 6% 8% 10% 12% 14%
1 1.0200 1.0400 1.0600 1.0800 1.1000 1.1200 1.1400
2 1.0404 1.0816 1.1236 1.1664 1.2100 1.2544 1.2996
3 1.0612 1.1249 1.1910 1.2597 1.3310 1.4049 1.4815
4 1.0824 1.1699 1.2625 1.3605 1.4641 1.5735 1.6890
5 1.1041 1.2167 1.3382 1.4693 1.6105 1.7623 1.9254
(b) Baldie Co issues 4,000 convertible bonds on 1 January 20X2 at par. Each bond is redeemable three
years later at its par value of £500 per bond, which is its nominal value.
The bonds pay interest annually in arrears at an interest rate (based on nominal value) of 5%. Each
bond can be converted at the maturity date into 30 £1 shares.
The prevailing market interest rate for three year bonds that have no right of conversion is 9%.

Cumulative three year annuity factors:
C
5% 2.723 H
9% 2.531 A
P
Requirement T
E
Calculate the amounts to be recognised at 1 January 20X2.
R
6
Worked example: Debt instrument with fixed or market-based variable rate
An entity issues irredeemable debt instruments at their par value of £5 million with an 8% coupon, the
market rate for such instruments.
Requirement
Explain how these instruments should be measured on initial recognition and subsequently.
Solution
These instruments should initially be measured at their fair value of £5 million.
There is no evidence that these instruments were issued for trading purposes, so they should
subsequently be measured at amortised cost. Because they are irredeemable, there is no maturity
amount to be compared with the amount initially recognised, so there is no difference to be amortised
to profit or loss. They should always be carried at £5 million.
Worked example: Perpetual debt instrument with decreasing interest rate

Requirement
If the stated interest rate on a perpetual debt instrument decreases over time would amortised cost
equal the principal amount in each period?
Solution
No. From an economic perspective, the interest payments are repayments of the principal amount. For
example, the interest rate may be stated as 16% for the first ten years and as zero per cent in
subsequent periods. In that case the initial recognised amount is amortised to zero over the first ten
years.
3.8 Fair value measurement issues

The definition and determination of fair value is crucial, given its importance as a measurement principle
for certain financial instruments. The definition of fair value in IAS 39 is consistent with that in other
standards: it is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable willing parties in an arm's length transaction.
(Note that this definition will change when IFRS 13 comes into force to: '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.' – see Chapter 2 Section 1.6.)
IAS 39 provides a hierarchy of approaches for the determination of the fair value based on
 The quoted price of an instrument that trades in an active market
 Valuation techniques for instruments that do not trade in active markets.
Unquoted equity instruments and their derivatives which cannot be measured reliably at fair value
should be measured at cost.

For instruments that trade in active markets, dealers often quote two prices, such as 315p – 317p. The
315p price is the price at which the dealers will buy (the bid price) and the 317p price is the price at
which they will sell (the offer or ask price).
IAS 39 specifies that the quoted price that should be used for measurement purposes is as follows:
Instrument held Instrument to be acquired
Financial asset Bid Ask (but adjust for transaction costs)
Financial liability Ask Bid
Worked example: Measurement of financial asset

An entity purchases 10,000 units of a financial asset which is quoted at 198p – 200p and pays
commission totalling 3p per unit. At the entity's first subsequent year end, the market quotes the
financial asset at 218p – 220p and it would cost 6p per unit to dispose of it.
Requirement
Explain how this financial asset should be measured on initial recognition and at the subsequent year
end assuming it is classified as:
(a) A financial asset at fair value through profit or loss
(b) An available-for-sale financial asset
(c) A held-to-maturity investment.
Solution
(a) A financial asset at fair value through profit or loss
On initial recognition the asset should be measured at fair value. For financial assets treated as at
FVTPL, IAS 39 regards the bid price as the fair value. The bid-offer spread is considered as a
transaction cost and, along with any other transaction costs, are recognised as an expense in profit
or loss. So the asset should be measured at £19,800 (10,000 × 198p bid price) and the £500
(10,000 × 5p) transaction costs recognised as an expense. (Transaction costs comprise both
commission of 3p per unit and the bid-offer spread of 2p per unit.)
At the year end no account should be taken of the potential disposal costs, so the asset should be
remeasured at the 218p bid price, so £21,800, with the £2,000 gain in fair value being recognised
in profit or loss.
(b) An available-for-sale financial asset
For an available-for-sale financial asset the bid-offer spread is considered as a transaction cost, but
(along with other transaction costs) is added to the fair value (bid price) of the financial asset
(rather than being treated as an expense as for FVTPL assets). On initial recognition the asset
should therefore be measured at fair value with the addition of the transaction costs. So the asset
should be measured at £20,300 (10,000 × (198p bid price + 5p transaction costs)).
At the year end no account should be taken of the potential disposal costs, so the asset should be
remeasured at the 218p bid price, so £21,800, with the £1,500 gain in fair value being recognised
in other comprehensive income.
(c) A held-to-maturity investment
On initial recognition the asset should be measured in the same way as if it was an available-for-
sale financial asset, so it is recognised at £20,300.
It should subsequently be remeasured at amortised cost (there is insufficient information to be able
to calculate this).

Interactive question 8: Pompeii [Difficulty level: Easy]
C
On 1 January 20X6 The Pompeii Company purchased 7% bonds at par with nominal value of £500,000, H
classifying them as at fair value through profit or loss. A
P
The fair values of Pompeii's holding of the bonds (before the sale referred to below) have been: T
E
At 1 January 20X6 £500,000 R
At 31 December 20X6 £560,000
At 31 December 20X7 £600,000
Interest on the bonds is payable on 31 December each year. 6
On 31 December 20X7 Pompeii sold one quarter of its holding of the bonds ex-interest for £150,000.
Transaction costs incurred on the sale were £6,000.
Requirement
Calculate the total amount to be recognised in profit or loss in respect of this financial asset in Pompeii's
financial statements for the year ending 31 December 20X7.
Interactive question 9: Forstar [Difficulty level: Easy]

On 1 January 20X6, The Forstar Company purchased 500,000 ordinary shares in The Pokurukuru
Company, a company quoted on an active market, designating them as available-for-sale financial
assets.
The fair values of Forstar's holding of the shares (before the sale referred to below) have been:
At 1 January 20X6 £500,000
At 31 December 20X6 £560,000
At 31 December 20X7 £600,000
Pokurukuru does not pay any dividends.
On 31 December 20X7 Forstar sold one quarter of its holding of the shares for £150,000. Transaction
costs incurred on the sale were £4,000.
Requirement
Calculate the total amounts to be recognised in profit or loss and in other comprehensive income in
respect of this financial asset in Forstar's financial statements for the year ending 31 December 20X7.
Interactive question 10: Greentree [Difficulty level: Intermediate]

Greentree Co had the following transactions in financial instruments in the year ended 31 December
20X2:
(a) Purchased 4% debentures in MT Co on 1 January 20X2 (their issue date) for £100,000 as an
investment. Greentree decided to hold them until their redemption after six years at a premium of
17%. Transaction costs of £2,000 were incurred on purchase. The internal rate of return of the
bond is 6%.
(b) Entered into a speculative interest rate option costing £7,000 on 1 September 20X2 to borrow
£5,000,000 from GF Bank commencing 31 March 20X3 for six months at 5.5%. Value of the
option at 31 December 20X2 was £13,750.
(c) Purchased 25,000 shares in EG Co in 20X1 for £2.00 each as an available-for-sale financial asset.
Transaction costs on purchase or sale are 1% of the purchase/sale price. The share price on 31
December 20X1 was quoted at £2.25 – £2.28. Greentree sold the shares on 20 December 20X2
for £2.62 each.

(d) Sold some shares in BW Co 'short' (ie sold shares that were not yet owned) on 22 December 20X2
for £24,000 (the market price of the shares on that date) to be delivered on 10 January 20X3. The
market price of the shares at 31 December 20X2 was £28,000.
Requirement
Show the accounting treatment of these transactions and relevant extracts from the financial statements
for the year ended 31 December 20X2.
Use of mid-market prices

The standard does not permit the use of mid-market prices (average of bid and offer prices) for
valuation purposes. The reason is that to do so would be to recognise early the gains or losses between
the bid/offer price and mid-market price.
The only case where mid-market prices can be used is when an entity holds assets and liabilities with
offsetting market risks. In those circumstances the entity may use mid-market prices as a basis for
establishing fair values for the offsetting risk positions and apply the bid or ask price to the net open
position as appropriate. The IASB believes that use of the mid-market price is appropriate because the
entity has locked in its cash flows from the asset and liability and potentially could sell the matched
position without incurring the bid-ask spread. It is presumed that such matching positions would be
settled within a similar time period.
Unavailability of published prices

Where current prices of financial instruments are unavailable at the reporting date, the price of the most
recent transaction should be used, adjusted for any changes in conditions between the date of the
transaction and the year end.
Valuation of large holdings

The existence of published prices in an active market is the most reliable measure of fair value. 'Quoted
in an active market' means that prices are readily and regularly available from an exchange, dealer,
broker or industry group. These prices should represent actual occurring market trades. The fair value
of an instrument is its market price multiplied by the number held. No adjustment is made for the size
of the holding and the effect on the market valuation that liquidity could have.
Worked example: Valuation of large holding

Entity A holds 15% of Entity B's share capital. The shares are publicly traded in an active market. The
currently quoted bid price is £100. Daily trading volume is 0.1% of outstanding shares. Because it
believes that the fair value of the Entity B shares it owns, if sold as a block, is greater than the quoted
market price, Entity A obtains several independent estimates of the price it would obtain if it sells its
holding. These estimates indicate that Entity A would be able to obtain a price of £105, that is, a 5%
premium above the quoted price.
Requirement
How should the holding be measured?
Solution
The published price quotation in an active market is the best estimate of fair value. Therefore, Entity A
should use the published price quotation (£100). Entity A cannot depart from the quoted market price
solely because independent estimates indicate that Entity A would obtain a higher (or lower) price by
selling the holding as a block.

Valuation techniques in the absence of active markets
C
If there is no active market for a particular financial instrument, fair value should be determined using a H
valuation technique. The aim of the technique is to obtain an estimate of the price that would be A
obtained in a market transaction. Such techniques could include recent market transactions, P
transactions in other shares or securities that are substantially the same, discounted cash flow models T
E
and option pricing models. The inputs to such models should be market based and not entity specific,
R
that is they should incorporate data which market participants would use to value the asset but should
not take account of factors which are only relevant to the owner of the asset (such as strategic
importance to it).
6
Appropriate techniques for valuing financial instruments should include observable data about the
market conditions that are likely to affect the fair value of an instrument. IAS 39 includes the time value
of money, credit risk, exchange rates, volatility, equity prices, prepayment risk and servicing costs as
examples of factors to be considered.
Recognition where no reliable fair value is available
In the limited circumstances where no active market exists and no reliable fair value is available, equity
investments, such as unquoted equity, and their related derivatives should be measured at cost less
impairment. This exclusion only applies where the range of reasonable fair value estimates is significant
and the probabilities of various estimates cannot be reasonably assessed. The exclusion is only
appropriate for financial instruments linked to unquoted equity investments. IAS 39 requires all other
equity instruments to be measured at fair value.
3.9 Impairment
A summary of the impairment process is as follows.
At each year end, an entity should assess whether there is any objective evidence that a financial asset or
group of assets is impaired.
The following are indications that a financial asset or group of assets may be impaired.
(a) Significant financial difficulty of the issuer
(b) A breach of contract, such as a default in interest or principal payments
(c) The lender granting a concession to the borrower that the lender would not otherwise consider,
for reasons relating to the borrower's financial difficulty
(d) It becomes probable that the borrower will enter bankruptcy
(e) The disappearance of an active market for that financial asset because of financial difficulties
(f) An adverse change in the payment status of borrowers in a group of financial assets
(g) Economic conditions that correlate with defaults on the assets in a group of financial assets
Where there is objective evidence of impairment, the entity should determine the amount of any
impairment loss.
3.9.1 Financial assets at fair value through profit or loss

No special impairment tests need to be carried out for such assets, because they are measured at fair
value and all changes in fair value are recognised in profit or loss.
3.9.2 Financial assets carried at amortised cost

The impairment loss is the difference between the asset's carrying amount and the present value of
estimated future cash flows (excluding future credit losses which have not been incurred) discounted at
the financial instrument's original effective interest rate.
Note that it is the original rate of interest which is used. Using market rates current at the time of the
impairment would result in a fair value approach being adopted for the measurement of financial assets
carried at amortised cost.
The amount of the loss should be recognised in profit or loss.

Worked example: Carrying amount
An entity has a 7% loan receivable of £1,000. Interest is payable annually in arrears and the principal is
repayable in three years' time. The amortised cost of the loan is £1,000. The original effective rate of
interest was 7% and the current effective interest rate is 8%.
The borrower is in financial difficulty and the entity has granted a concession in that no annual interest
is payable and the principal will be repaid in four years' time at a premium of 10%.
Requirement
Explain how the carrying amount of the loan should be calculated.
Solution
The financial difficulty of, and the granting of a concession to, the issuer are both objective evidence of
impairment. The recoverable amount should be calculated as £839 by discounting the £1,100 agreed
repayment at the original effective interest rate of 7% over a 4-year period.
In Year 1, interest income of £59 (7%  £839) should be recognised and the carrying amount of the
loan increased to £898. This process should be repeated through Years 2–4, at which point the loan will
be carried at £1,100 immediately prior to repayment.
Interactive question 11: Restructuring [Difficulty level: Intermediate]

Because of Customer B's financial difficulties, Entity A is concerned that Customer B will not be able to
make all principal and interest payments due on a loan in a timely manner. It negotiates a restructuring
of the loan. Entity A expects that Customer B will be able to meet its obligations under the restructured
terms.
Requirement
In which of the following cases should Entity A recognise an impairment loss?
(a) Customer B will pay the full principal amount of the original loan five years after the original due
date, but none of the interest due under the original terms.
(b) Customer B will pay the full principal amount of the original loan on the original due date, but
none of the interest due under the original terms.
(c) Customer B will pay the full principal amount of the original loan on the original due date with
interest only at a lower interest rate than the interest rate inherent in the original loan.
(d) Customer B will pay the full principal amount of the original loan five years after the original due
date and all interest accrued during the original loan term, but no interest for the extended term.
(e) Customer B will pay the full principal amount of the original loan five years after the original due
date and all interest, including interest for both the original term of the loan and the extended
term.
Interactive question 12: Impairment of financial asset [Difficulty level: Intermediate]

Broadfield Co purchased 5% debentures in A Co on 1 January 20X3 (their issue date) at par for
£100,000. The term of the debentures was 5 years and the maturity value is £130,525. The effective
rate of interest on the debentures is 10% and Broadfield classified them as a held-to-maturity
investment.
At the end of 20X4 A Co went into liquidation. All interest had been paid until that date. On 31
December 20X4 the liquidator of A Co announced that no further interest would be paid and only 80%
of the maturity value would be repaid, on the original repayment date.
The market interest rate on similar bonds is 8% on 31 December 20X4.

Requirements
C
(a) What should the carrying amount of the debentures be at 31 December 20X4 before the H
impairment became apparent? A
P
(b) What should the carrying amount be at that date after impairment? T
E
(c) How should the impairment be recognised in the financial statements for the year ended 31
R
December 20X4?
6
If the impairment loss decreases at a later date (and the decrease relates to an event occurring after the
impairment was recognised) the reversal should be recognised in profit or loss. The carrying amount of
the asset should not exceed what the amortised cost would have been if no impairment had been
recognised.
3.9.3 Financial assets carried at cost

The impairment loss on unquoted equity instruments carried at cost is the difference between the asset's
carrying amount and the present value of estimated future cash flows, discounted at the current
market rate of return for a similar financial instrument. Such impairment losses should not be reversed.
Illustration: Banks in the credit crunch

Impairment losses have been a topical issue in the credit crunch of 2008, continuing to the present day,
particularly for the banks. For example, the interim accounts of HSBC, for the period ending 30 June
2009, state:
“Loan impairments increased by £1,223 million to £1,795 million as deterioration in credit quality
was experienced across all customer groups as the European economies weakened.”
In the same period, Barclays saw its impairment charges increase by 86% to £4,556 million. These came
from credit market exposure, corporate failures and in consumer lending.
3.9.4 Available-for-sale financial assets

Because available-for-sale financial assets are carried at fair value with gains and losses recognised in
other comprehensive income, short-term falls in fair value will result in debits to other comprehensive
income and potentially a debit balance held in equity in respect of an individual asset. If the asset is
subsequently determined to be impaired, the loss previously recognised in other comprehensive
income should be reclassified to profit or loss, even though the asset has not been derecognised.
The impairment loss to be reclassified is the difference between the acquisition cost (net of any
principal repayment and amortisation) and current fair value, less any impairment loss on that asset
previously recognised in profit or loss.
Impairment losses relating to such equity instruments should not be reversed. Impairment losses relating
to such debt instruments should be reversed through profit or loss if, in a later period, the fair value of
the instrument increases and the increase can be objectively related to an event occurring after the loss
was recognised.
Worked example: Equity instrument

An equity instrument was acquired for £2,000 a number of years ago and was classified as available for
sale. At 31 December 20X4, the cumulative loss recognised in other comprehensive income was £100
and the financial asset was carried at fair value of £1,900.
At 31 December 20X5, the equity issuer was in severe financial difficulty and the fair value had fallen to
£1,600.
As a result of a takeover of the issuer, the fair value increased during 20X6 to £2,200.

Requirement
How should the equity instrument be accounted for in 20X5 and 20X6?
Solution
In 20X5 an impairment loss of £400 should be recognised in profit or loss and £100 credited to other
comprehensive income in respect of the loss previously recognised there.
In 20X6 a gain of £600 (£2,200 – £1,600) should be recognised in other comprehensive income,
because impairment losses on available for sale equity instruments should not be reversed through profit
or loss.
The following table summarises the impairment requirement for debt, equity and derivative
instruments.
Financial asset Classification Measurement basis Impairment test
FVTPL Fair value No
Debt HTM Amortised cost Yes
Loans and receivables Amortised cost Yes
AFS Fair value Yes
FVTPL Fair value No
FVTPL Cost when the fair

value cannot be
Yes
measured reliably
AFS Fair value Yes

Equity
AFS Cost when the fair
value cannot be
Yes
measured reliably
Derivative instruments (other FVTPL Fair value No

than hedging instruments)
Equity derivatives FVTPL Cost when the fair

value cannot be
Yes
measured reliably
3.9.5 More detail on impairment

A financial asset or a group of financial assets is impaired if and only if a past event or series of past
events provides evidence of a reduction in the future cash flows that can be measured reliably. IAS 39
does not require that an entity be able to identify a single, distinct past causal event to conclude that it
is probable that an impairment loss on a financial asset has been incurred. It may not be possible to
identify a single, discrete event that caused the impairment. Rather the combined effect of several
events may have caused the impairment. Other factors that an entity considers in determining whether
it has objective evidence that an impairment loss has been incurred include:
 Information about the debtors' or issuers' liquidity, solvency and business and financial risk
exposures
 Levels of and trends in delinquencies for similar financial assets
 National and local economic trends and conditions; and
 The fair value of collateral and guarantees.
These and other factors may, either individually or taken together, provide sufficient objective evidence
that an impairment loss has been incurred in a financial asset or group of financial assets.

Although a significant credit downgrade is not considered by itself to be an indication that an
impairment has occurred, it may be objective evidence when considered with other evidence. C
H
The decline in fair value to below cost is not necessarily evidence of impairment. As an example, the fair A
value of fixed rate debt classified as an available-for-sale financial asset will fall if the risk-free rate of P
interest rises. But this rise may be reversed over a relatively short time period, resulting in the debt's fair T
E
value increasing. It is to cover such circumstances that a debit balance on the separate component of
R
equity in relation to available-for-sale financial assets is permitted. For equity investments, however, a
significant or prolonged decline in fair value is objective evidence of impairment. No further guidance is
provided on what constitutes a significant or prolonged decline and therefore an entity should exercise
6
judgement in making this assessment, but the standard includes a number of indicators showing that
the equity investment costs may not be recovered. These indicators include:
 Technological changes that change the industry permanently
 Competitive changes in the industry as a result of the industry being exposed for example to
foreign competition
 Permanent fall in the demand for the products of the company
 Changes in the political or legal environment
Future losses
Losses expected as a result of future events, however likely, should not be recognised. For
example, it would not be appropriate for a lender which over time has experienced an average default
rate of 2% to recognise an immediate impairment of £200 at the time of advancing a loan of £10,000;
the reason is that at the time of making the loan there cannot have been a past event to cause an
impairment loss.
Collateral
Many loans and receivables are collateralised. This may involve the security from a mortgage of
property, for example. In determining the impairment loss on such a financial asset, the assessment of
impairment should include the cash flows from obtaining and disposing of the collateral, regardless of
whether foreclosure is probable. This may involve obtaining estimates of the realisable value of property,
using appropriately qualified valuers.
Evaluation of impairment on a portfolio basis

Banks and financial institutions that conduct lending activities have large portfolios of financial assets
that are individually insignificant. As a result, IAS 39 requires impairment testing to be undertaken on a
collective basis only in such circumstances.
 An entity is required to consider impairment for any individually significant financial assets first
 If no impairment exists, the remaining assets should be grouped with other assets that have similar
credit characteristics and tested for impairment on an aggregate basis.
The aggregation of assets is based on data on a debtor's ability to pay the amounts due, including past
due status, collateral type and geographical location. Impairment is then assessed by considering the
contractual cash flows of the assets in the group and the historical loss experience of assets with a similar
credit risk profile. The historical loss experience may need to be adjusted for effects that no longer exist.
These estimates should be updated from period to period to reflect current experience and to reduce
the difference between estimated and actual losses. Events such as unemployment rates, property prices
and currency changes may be relevant in adjusting historical data.
Worked example: Collective assessment

An entity has a portfolio of 100 small loans made to individuals. Each loan is for £100 and carries a fixed
interest rate of 8%. Each debtor belongs to the same credit group in the same geographical area.
Adverse economic conditions have increased the group's unemployment rate. One borrower has
notified the entity that he has become unemployed and the entity has rescheduled his payments. It has
allowed him an interest free payment holiday.

Requirement
How should the assessment for impairment be made?
Solution
The individual balance relating to the unemployed person should be assessed separately for impairment.
The remaining 99 loans should be assessed collectively for impairment.
4 Derivatives
Section overview
 This section covers aspects relating to financial derivatives not covered at professional level.
4.1 Definition of a derivative – further examples

The definition of derivative was set out earlier in the summary of the material covered at professional
level. A quick reminder – it is a financial instrument:
 Whose value changes in response to the change in price of an underlying security,
commodity, currency, index or other financial instrument(s)
 Where the initial net investment is zero or is small in relation to the value of the underlying
security or index
 That is settled at a future date
A derivative normally has a notional amount, such as a number of shares or other quantity specified in
the contract. For example, a forward currency contract has a quoted amount of currency even though
neither the holder nor writer is required to invest or receive this amount at the inception of the contract.
However, this is not a requirement and a derivative could require a fixed payment or a variable payment
based on the outcome of some future event that is unrelated to the notional amount. For example, a
contract that requires the fixed payment of £1,000 if a commodity price increases by 5% or more is a
derivative.
Common types of derivatives include:
 Swaps
 Purchased or written options (call and put)
 Futures and
 Forwards.
Underlying variables
Examples of underlying variables attaching to the derivatives include:
 Interest rates
 Currency rates
 Commodity prices
 Equity prices and
 Credit related variables.
In determining whether a derivative exists, the substance of the transaction should be considered. Non-
derivative transactions should be aggregated and treated as derivatives when the transactions result, in
substance, in derivatives. For example if Entity A grants a fixed rate loan to Entity B and in return Entity
B grants a variable rate loan of the same amount and maturity, both entities should treat the
arrangement as an interest rate swap and account for it as a derivative.
 A defining characteristic of a derivative is that it requires either no initial investment or an initial
net investment smaller than would be required for other types of contracts that would be

expected to have a similar response to changes in market factors. A purchased call option contract,
for example, meets this definition because the premium is less than the investment that would be C
required to obtain the underlying financial instrument to which the option is linked. H
A
 An interest rate swap in which the parties settle on a net basis qualifies as a derivative instrument. P
This is because the definition of a derivative makes reference to future settlement, but not to the T
E
method of settlement. R
 If a party prepays its obligation under a pay-fixed, receive-variable interest rate swap at
inception, the swap should be classified as a derivative.
6
 However if the fixed rate payment obligation is prepaid subsequent to initial recognition this
would be regarded as a termination of the old swap and an origination of a new instrument.
 A prepaid pay-variable, receive-fixed interest rate swap is not a derivative if it is prepaid at
inception and it is no longer a derivative if it is prepaid after inception because it provides a return
on the prepaid (invested) amount comparable to the return on a debt instrument with fixed cash
flows. The prepaid amount fails the 'no initial net investment or an initial net investment that is
smaller than would be required for other types of contracts that would be expected to have a
similar response to changes in market factors' criterion of a derivative.
 An option which is expected not to be exercised, for example, because it is 'out of the money'
still qualifies as a derivative. This is because an option is settled upon exercise or at its maturity.
Expiry at maturity is a form of settlement even though there is no additional exchange of
consideration.
 Many derivative instruments, such as futures contracts and exchange traded written options,
require margin accounts. The margin account is not part of the initial net investment in a
derivative instrument. Margin accounts are a form of collateral for the counterparty or clearing
house and may take the form of cash, securities or other specified assets, typically liquid assets.
Margin accounts are separate assets that are accounted for separately.
 A derivative may have more than one underlying variable.
 A contract to buy or sell a non-financial asset is a derivative if:
(a) It can be settled net in cash or by exchanging another financial instrument; and
(b) The contract was not entered for the purpose of receipt or delivery of the non-financial item
to meet the entity's expected purchase, sale or usage requirements.
An example would be a gas supply contract in the UK (where there is an active market) where the
supplier or purchaser has the right to refuse delivery or receipt of the gas for financial reasons, for
example because they can get a better price in the market. However if the right to refuse delivery
on the part of the seller can only be invoked for operational reasons (ie they do not have the gas
available to supply) this does not on its own make the contract a derivative.
4.1.1 Currency swaps

A currency swap (or cross currency swap) is an interest rate swap with cash flows in different currencies.
It is an agreement to make a loan in one currency and to receive a loan in another currency. With the
currency swap there are three sets of cash flows. Initially, the underlying principals are exchanged when
the swap starts; interest payments are then made over the life of the swap; and finally the underlying
principal amounts are re-exchanged.
A currency swap could also be interpreted as issuing a bond in one currency (and paying interest on this
bond) whilst investing in a bond in another currency (and receiving interest on this bond).
Worked example: Currency swap

Two entities enter into a ten-year fixed currency swap of € and £. Current interest rates relating to € and
£ are 4% and 6% respectively. At inception of the contract the current rate of exchange is €2 per £. The
contract requires the initial exchange of €2,000 and £1,000.
Annual interest payments are made between the parties without netting of €80 (4%  €2,000) and £60
(6%  £1,000). After ten years, the swap terminates and the original principal amounts are returned.

Requirement
Does the instrument fit the definition of a derivative?
Solution
The currency swap meets the definition of a derivative, as the exchange of the initial fair values means
there is zero initial investment, its value changes in response to a specified exchange rate, and it is
settled at a future date.
Interactive question 13: Loan agreement as derivatives [Difficulty level: Intermediate]

Two entities make loans to each other for the same amount and on the same terms except that one is
based upon a fixed rate of interest and the other on a variable rate of interest. There are no transfers of
principal at inception of the transaction since the two entities have a netting agreement.
Requirement
Does the transaction fit the definition of a derivative?
Worked example: Forward contract to buy commodity

SML, a tools manufacturer entered into a contract to buy 50 tonnes of steel in 12 months' time, in
accordance with its expected use requirements. The contract permits SML to take physical delivery of
the steel or to pay or receive a net settlement in cash based on the change in the market price of steel.
Requirement
Is the contract a derivative?
Solution
The contract meets some of the criteria of a derivative, that is no initial investment and it is to be settled
at a future date. However, because the underlying is a non-financial asset, classification as a derivative
will depend on whether the contract was entered into in order to benefit from short-term price
fluctuations by selling it. If SML intends to take delivery of the steel and use it as an input in its
production process, then the contract is not a derivative.
4.2 Accounting for derivatives

As noted previously, derivatives are classified as held for trading (unless they are hedging instruments –
see the next chapter), so they should be measured at fair value and changes in fair value should be
recognised in profit or loss. The following example highlights the accounting treatment of derivatives.
Illustration: Accounting treatment of purchased option

st
On December 31 20X0 Entity Theta purchases put options over 100,000 shares in Omega which
st
expire on December 31 20X2. The exercise price of the option is £2, the market price on December
st
31 20X0, and the premium paid is £11,100.
The intrinsic value of the option (ie the exercise price less the price per share, times the number of
shares specified in the option contract) is zero at acquisition. The cost of £11,100 reflects the time value
of the option which depends on the time to expiration, the price of the stock and its volatility.
If the stock price falls below £2 the put becomes in-the-money by the amount below the £2 strike price
times the number of option shares. For instance if the price of Omega stock fell to £1.90, the intrinsic
value gain on the put option is £0.10 per share. If the stock price rises and stays above £2 for the term

of the contract, the put option expires worthless to the buyer because it is out-of-the-money. The
purchaser of the put option loses the premium which is kept by the seller (writer). C
H
Economic assumptions A
P
The value of the shares in Omega and the put options is shown in the table below. The value of the put T
option increases as the stock price decreases. E
R
31.12.20X0 30.6.20X1 31.12.20X1
Omega shares
Price per share (£) 2.00 1.90 1.85
6
Value of put option (£) 11,100 13,500 15,000
On 31 December 20X1, Theta sells the option.
Solution
Accounting entries under IAS 39:
Debit Credit
£ £
st
31 December 20X0
Financial asset – put option 11,100
Cash 11,100
(To record the purchase of the put option)
th
30 June 20X1
Financial asset – put option (13,500 – 11,100) 2,400
Profit or loss – gain on put option 2,400
(To record the increase in the fair value of the put option)
st
31 December 20X1
Financial asset – put option (15,000 – 13,500) 1,500
Profit or loss – gain on put option 1,500
(To record the increase in the fair value of the put option)
Cash 15,000
Financial asset – put option 15,000
(To record the sale of the put option on 31.12.20X1)
5 Embedded derivatives
Section overview
 This section deals with the definition and accounting treatment of embedded derivatives.
5.1 Introduction
Certain contracts that are not themselves derivatives (and may not be financial instruments) include
derivative contracts that are 'embedded' within them.
Definition
An embedded derivative is a component of a hybrid (combined) instrument that also includes a
non-derivative host contract – with the effect that some of the cash flows of the combined instrument
vary in a way similar to a stand-alone derivative.

5.2 The basics
Below we look at some basic examples and their treatment. Then we will look in detail at more complex
issues.
Examples of host contracts
Possible examples include:
(a) A lease
(b) A debt or equity instrument
(c) An insurance contract
(d) A sale or purchase contract
(e) A construction contract
Examples of embedded derivatives
Possible examples include:
(a) A term in a lease that provides for rent increases in excess of local inflation:
'Host' Accounted for as normal

Lease
contract
Treat as derivative, ie remeasured to FV with

Embedded Inflation- changes recognised in profit or loss
derivative related rentals
(b) A bond which is redeemable in five years' time with part of the redemption price being based on
the increase in the FTSE 100 index.
(c) A construction contract priced in a foreign currency. The construction contract is a non-derivative
contract, but the changes in foreign exchange rate is the embedded derivative.
Accounting treatment of embedded derivatives
The basic rule for accounting for an embedded derivative is that it should be separated from its host
contract and accounted for as a derivative. The purpose is to ensure that the embedded derivative is
measured at fair value and changes in its fair value are recognised in profit or loss. But this separation
should only be made when the following conditions are met.
(a) The economic characteristics and risks of the embedded derivative are not closely related to the
economic characteristics and risks of the host contract.
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative.
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in profit or loss (if changes in the fair value of the total hybrid instrument are
recognised in profit or loss, then the embedded derivative is already accounted for on this basis, so
there is no benefit in separating it out).
The meanings of “closely related” and “not closely related” are dealt with in more detail below, but a
simple example may help. A lease of retail premises may provide for the amounts payable to the lessor
to include contingent rentals based on the lessee's sales from the leased premises. The variable nature
of the contingent rentals makes them fall within the definition of an embedded derivative. But these
contingent rentals are considered to be “closely related” to the lease host contract, so this embedded
derivative should not be separated out for accounting purposes.
Note that an entity may, subject to conditions, designate any hybrid contract as at fair value through
profit or loss, thereby avoiding the need to measure the fair value of the embedded derivative separately
from that of the host contract.

Illustration: Embedded forward contract
C
An entity, whose functional currency is the £, enters into a contract to purchase a non-current asset for H
$500 payable in 90 days. The functional currency of the vendor is the € and transactions in the vendor's A
country are not routinely undertaken in $. P
T
The purchase contract has a non-option embedded derivative which has been determined as being not E
closely related to the host contract. R
The embedded derivative is a forward foreign exchange contract to sell £ and receive $500 in 90 days.
5.3 Key characteristics of embedded derivatives

An embedded derivative causes some or all of the cash flows of the host contract to be modified,
based on a specified interest rate, financial instrument price, commodity price, foreign exchange rate,
index of price or rates, credit rating or credit index or other variables. As a result the financial payoffs of
the hybrid instrument will resemble those of a stand-alone derivative.
Another example of an embedded derivative is that within a convertible bond. A convertible bond is a
hybrid or combined instrument that is made up of a straight bond (the host contract) and a call option
(the embedded derivative) that gives the holder of the bond the right to exchange the bond for shares
in the company.
A key characteristic of embedded derivatives is that the embedded derivative cannot be transferred
to a third party independently of the instrument. For example, a bond with a detachable warrant, which
gives the right to the owner to exercise the warrant and buy shares whilst retaining the bond, is not a
hybrid or combined instrument. The warrant is a separate financial instrument, not an embedded
derivative.
5.4 Separation of host and embedded derivatives

The measurement and recognition of derivatives at fair value through profit or loss may create volatility.
As a result, an entity may try to structure a derivative in such a way that measurement at fair value could
be avoided, for example, by embedding the derivative in another contract or financial instrument that is
not carried at fair value. It is to prevent such avoidance that IAS 39 requires separation if the three
conditions listed above are all met.
The diagram shows how these three conditions should be tested for.

Is the hybrid
instrument Yes
Do not separate
measured at fair out the embedded
value through derivative
profit or loss?
No
Would it be No
a derivative Do not separate
if it was a out the embedded
separate derivative
instrument?
Yes
Are its
characteristics/ Yes Do not separate
risks closely out the embedded
related to those derivative
of the host
contract?
No
Account
separately for
the embedded
derivative
Where an entity is unable to measure an embedded derivative that is required to be separated from its
host, either on acquisition or subsequently, the entire hybrid contract should be designated as at fair
value through profit or loss.
If the fair value of the embedded derivative cannot be determined due to the complexity of its terms
and conditions, but the value of the hybrid and the host can be determined, then the value of the
embedded derivative should be determined as the difference between the value of the hybrid and the
value of the host contract.
5.5 Identification of embedded derivatives

Embedded derivatives can be structured deliberately, as has been already mentioned, or they may arise
inadvertently. An example of this would be a currency that is different from the functional
currencies of both the lessor and lessee. Multiple embedded derivatives are treated as if they were a
single embedded derivative, unless they relate to different risk exposures which can be identified and
separated, in which case they can be accounted for separately.
Although, theoretically the host of an embedded derivative could be any type of contract that is not
recorded at fair value, in practice there is a small number of contracts that have derivatives embedded in
them, the most common of which are:
 Debt instruments
 Equity instruments
 Leases
 Insurance contracts
 Executory contracts such as purchase and sale contracts

Identification of embedded derivatives requires the entity to consider all financial assets and liabilities
that are carried at amortised cost or classified as available for sale and all executory contracts such as C
operating leases, purchases and sales contracts and commitments. H
A
Although the identification of the host instrument does not present a serious problem, the identification P
of the embedded derivative is more problematic. Going back to the definition of a derivative, we can T
E
use the main characteristics of a derivative in order to identify embedded derivatives. For example an
R
embedded derivative may be identified if contracts contain:
 Rights or obligations to exchange at some time in the future
6
 Rights or obligations to buy or sell
 Provisions for adjusting the cash flows according to some interest rate, price index or specific time
period
 Options which permit either party to do something not closely related to the contract
 Unusual pricing terms (eg a bond which pays interest at rates linked to the FTSE 100 yield contains
an embedded swap)
Finally, a comparison of the terms of a contract such as maturity, cancellation or payment provisions
with the terms of another similar non-complex contract may indicate the existence, or not, of an
embedded derivative.
5.6 Examples of closely related embedded derivatives

No definition of 'closely related' is included in IAS 39. In general, an embedded derivative is considered
to be closely related if it modifies the inherent risk of the combined contract but leaves the
instrument substantially unaltered. Some common examples of closely related embedded derivatives
are given below (IAS 39, Appendix A, Application Guidance AG 33).
 An embedded floor or cap on the interest rate on a debt contract or insurance contract, provided
the floor is at or below, and the cap is at or above, the market rate of interest when the contract is
issued, and the cap or floor is not leveraged in relation to the host contract.
 An embedded foreign currency derivative that provides a stream of principal or interest payments
that are denominated in a foreign currency and is embedded in a host debt instrument (eg a dual
currency bond). Such a derivative is not separated from the host instrument because IAS 21
requires foreign currency gains and losses on monetary items to be recognised in profit or loss.
 An embedded foreign currency derivative in a host contract that is an insurance contract or not a
financial instrument (such as a contract to purchase a non-financial item where the price is
denominated in a foreign currency), provided the payment is to be in the functional currency of
one of the substantial parties to the contract or in the currency in which the contracted good or
service is routinely denominated (such as the US dollar for crude oil transactions).
 An embedded prepayment option in an interest-only or principal-only strip is closely related to the
host contract provided the host contract (i) initially resulted from separating the right to receive
contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded
derivative, and (ii) does not contain any terms not present in the original host debt contract.
 An embedded derivative in a host lease contract is closely related to the host contract if the
embedded derivative is (i) an inflation-related index such as an index of lease payments to a
consumer price index (provided that the lease is not leveraged and the index relates to inflation in
the entity's own economic environment), (ii) contingent rentals based on related sales or (iii)
contingent rentals based on variable interest rates.
 A unit-linking feature embedded in a host financial instrument or host insurance contract is closely
related to the host instrument or host contract if the unit-denominated payments are measured at
current unit values that reflect the fair values of the assets of the fund. A unit-linking feature is a
contractual term that requires payments denominated in units of an internal or external investment
fund.

 A derivative embedded in an insurance contract is closely related to the host insurance contract if
the embedded derivative and host insurance contract are so interdependent that an entity cannot
measure the embedded derivative separately (ie without considering the host contract).
In all these circumstances the hybrid contract is accounted for as a whole – the embedded derivative is
not separated out.
5.7 Examples of not closely related embedded derivatives

Examples where the embedded derivative is not closely related to the host instrument include the
following (IAS 39, Appendix A, Application Guidance AG 30):
 The option to extend the term on a fixed rate debt instrument without resetting the interest rate to
market rates
 Credit derivatives in a debt instrument
 Put option embedded in an instrument that enables the holder to require the issuer to reacquire
the instrument for an amount of cash or other assets that varies on the basis of the change in an
equity or commodity price or index
 From the point of view of the holder only, a call option embedded in an equity instrument that
enables the issuer to reacquire that equity instrument at a specified price
 Equity-indexed interest or principal payments embedded in a host debt instrument or insurance
contract
 Commodity-indexed interest or principal payments embedded in a host debt instrument or
insurance contract
 An equity conversion feature embedded in a convertible debt instrument
 A call, put, or prepayment option embedded in a host debt contract or host insurance contract
In all these circumstances the embedded derivative is separated out from the host contract for
accounting purposes.
5.8 Accounting for embedded derivatives

A common transaction involving an embedded derivative is the purchase or sale of goods at a price
denominated in a foreign currency, for example, the purchase by an entity of 1,000 items for N£10
each with settlement in 90 days, where the functional currency of the purchasing entity is £. Under the
guidance set out above, the embedded derivative should be separated out unless
 The vendor's functional currency is the N£; or
 The items in the transaction are routinely denominated in N£ in international commerce.
The terms of non-option based derivatives such as forwards and swaps should be determined such that
the derivative has a fair value of nil at inception. Option based derivatives such as puts, swaptions and
caps should be separated on the terms in the contract. Multiple embedded derivatives are required to
be separated as a single compound embedded derivative.
Illustration: Purchase of convertible bond

A purchase of a convertible bond that is convertible before maturity generally cannot be classified as a
held-to-maturity investment because that would be inconsistent with paying for the conversion feature
– the right to convert into equity shares before maturity.
An investment in a convertible bond can be classified as an available-for-sale financial asset provided it is
not purchased for trading purposes. The equity conversion option is an embedded derivative.
If the bond is classified as available for sale (ie fair value changes are recognised directly in other
comprehensive income until the bond is sold), the equity conversion option (the embedded derivative)
should be separated out. The amount paid for the bond is split between the debt instrument without
the conversion option and the equity conversion option. Changes in the fair value of the equity

conversion option are recognised in profit or loss unless the option is part of a cash flow hedging
relationship. C
H
If the convertible bond is measured at fair value with changes in fair value recognised in profit or loss, A
separating the embedded derivative from the host bond is not permitted. P
T
E
R
Interactive question 14: Embedded derivatives [Difficulty level: Exam standard]
The Sebacoyl Company operates in the construction industry and is based in Ermania. Its functional 6
currency is the £. In the ordinary course of business it entered into the following contracts.
Contract (1) On 31 March 20X7 Sebacoyl made a contract with The Lenny Company, which
manufactures plant and machinery in Okastan. The functional currency of Lenny is the
R£. Under the contract Sebacoyl will purchase a very large excavating machine for
R£700,000, payable on 1 February 20X8.
Contract (2) On 30 October 20X7 Sebacoyl made a contract with Pettrill Company, which operates in
Aslan and whose functional currency is the L£. Under the contract Sebacoyl will build a
major runway installation in Aslan for a fixed price of N£9 million and Sebacoyl is due to
receive N£1.5 million on 30 June and 31 December in each of 20X8, 20X9 and 20Y0.
The N£ is infrequently used as the measure of contract prices in Ermania or Aslan.
Neither contract is measured at fair value through profit or loss.
Requirement
Explain in respect of each contract whether there is an embedded derivative and, if so, whether it
should be recognised separately in the financial statements of Sebacoyl for the year to 31 December
20X7.
5.9 IFRIC 9 Reassessment of embedded derivatives

IAS 39 describes an embedded derivative as a component of a financial instrument that has the features
of a stand-alone derivative; that is, it causes cash flows under the instrument to vary with a specified
interest rate, market price, foreign exchange rate or other financial variable. IAS 39 requires an
embedded derivative to be separated from the non-derivative elements of the contract, and accounted
for as a stand-alone derivative, unless the derivative features are 'closely related' to the non-derivative
features of the compound instrument.
IFRIC 9 addresses the question of whether it is necessary to reassess the treatment of an embedded
derivative throughout the life of a contract if certain events occur after an entity first becomes a party to
the contract. It concludes that reassessment is not permitted unless there is a significant change to
the terms of the contract.
5.10 IFRS 9 Change to rules

IFRS 9 changes the rules for embedded derivatives that are financial assets (see Section 6) but it is not
yet complete, so you need to know the current rules.
6 IFRS 9 Financial Instruments and current developments
Section overview
 IFRS 9 Financial Instruments, issued in November 2009, replaced certain parts of IAS 39, in
particular with respect to the classification of financial assets. This standard is a work in progress
and in due course will be developed further to fully replace IAS 39.

6.1 Background
It has been the IASB's intention to replace IAS 39 with a principles-based standard for some time, due to
criticism of the complexity of IAS 39, which is difficult to understand, apply and interpret.
The replacement of IAS 39 has become more urgent after the financial crisis. The IASB and US FASB set
up a Financial Crisis Advisory Group (FCAG) to advise on how improvements in financial reporting could
help enhance investor confidence in financial markets.
As a result the project to replace IAS 39 has been divided into three phases:
Phase 1: Classification and Measurement. IFRS 9 was issued in November 2009. In 2010, IFRS 9 was
updated to include the classification and measurement of financial liabilities and the
derecognition of financial assets and liabilities.
Phase 2: Impairment Methodology. An Exposure Draft Financial Instruments: Amortised Cost and
Impairment was issued in November 2009 (see below), with a supplement in January 2011.
An Exposure Draft Expected Credit Losses was issued in March 2013.
Phase 3: Hedging. An Review Draft was issued in September 2012. The finalised requirements,
which would represent a significant change to the current hedge accounting approach
under IAS 39, are expected to be issued in the second or third quarters of 2013.
The standard has been criticised, notably by the European Union, who warned that the new rules could lead
to greater volatility in accounts, undermining broader financial stability, and postponed its EU adoption.
6.2 Implementation dates and significance for your exam

The mandatory effective date for IFRS 9 is 1 January 2015. Earlier adoption is permitted. If an entity does
apply IFRS 9 early, it needs to disclose this in its financial statements and apply all the consequential
amendments to other standards at the same time. IFRS 9 is applied on a modified retrospective basis,
including permitting certain instruments to be reclassified based on conditions at the date of
application. Until 2015 entities can choose whether to apply the versions of IFRS 9 issued in 2009
(financial assets), 2010 (financial liabilities and derecognition added) or 2012 (hedging added, see
Section 6.17, provided in each case the requirements of each version are applied in full.
Whether an entity will adopt the standard early may depend partly on the kind of financial assets it has.
For example, for some entities the new 'fair value through other comprehensive income' category for
equity investments will be quite attractive as it potentially removes some volatility in reported profits by
eliminating the requirement to recycle losses to profit or loss where there is a significant or prolonged
decline in fair value below cost. On the other hand, companies without significant financial assets may
find that the impact is likely to be small and early adoption may not offer much improvement on
current requirements.
There will be further amendments to IFRS 9 as the IASB finalises its proposals on accounting for hedging
and impairment. When these projects are completed, then IFRS 9 will be a complete replacement for
IAS 39.
6.2.1 Your exam

Because IFRS 9 is a work in progress, you need to know IAS 39 as the current standard in detail, but you
will need an awareness of IFRS 9 and how the rules are expected to change.
6.3 Definitions and scope

The scope of IFRS 9 is the same as that of IAS 39, and the IFRS 9 definitions relating to financial assets
are the same as those in IAS 39. Note that the definition of fair value will change when IFRS 13 comes
into force.

6.4 Recognition of financial instruments
C
A financial asset or financial liability must be recognised in an entity's statement of financial position H
when the entity becomes party to the contractual provisions of the instrument. A
P
These recognition criteria are unchanged from IAS 39. T
E
R
6.5 De-recognition of financial instruments
Derecognition is the removal of a previously recognised financial instrument from an entity's statement
6
of financial position.
An entity should derecognise a financial asset when:

(a) The contractual rights to the cash flows from the financial asset expire, or
(b) The entity transfers substantially all the risks and rewards of ownership of the financial asset to
another party.
A financial liability is derecognised when it is extinguished – ie when the obligation specified in the
contract is discharged or cancelled or expires.
6.6 Classification of financial assets

On recognition, IFRS 9 requires that financial assets are classified as measured at either:
 Amortised cost, or
 Fair value
This classification is made on the basis of both:
(a) The entity's business model for managing the financial assets, and
(b) The contractual cash flow characteristics of the financial asset.
A financial asset is classified as measured at amortised cost where:
(a) The objective of the business model within which the asset is held is to hold assets in order to
collect contractual cash flows and
(b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely
payments of principal and interest on the principal outstanding.
An application of these rules means that equity investments may not be classified as measured at
amortised cost and must be measured at fair value. This is because contractual cash flows on specified
dates are not a characteristic of equity instruments. In addition, all derivatives are measured at fair value.
A debt instrument may be classified as measured at either amortised cost or fair value depending on
whether it meets the criteria above. Even where the criteria are met at initial recognition, a debt
instrument may be classified as measured at fair value through profit or loss if doing so eliminates or
significantly reduces a measurement or recognition inconsistency (sometimes referred to as an
'accounting mismatch') that would otherwise arise from measuring assets or liabilities or recognising the
gains and losses on them on different bases.
Note that the IFRS 9 requirement to classify financial assets on recognition as one of two types is a
significant simplification of the previous IAS 39 rules. These required financial assets to be classified as
one of four types, being:
 At fair value through profit or loss
 Held to maturity
 Available for sale, and
 Loans and receivables
6.7 Re-classification of financial assets

Although on initial recognition financial instruments must be classified in accordance with the
requirements of IFRS 9, in some cases they may be subsequently reclassified. IFRS 9 requires that when

an entity changes its business model for managing financial assets, it should reclassify all affected
financial assets. This reclassification applies only to debt instruments, as equity instruments must be
classified as measured at fair value.
6.8 Classification of financial liabilities

On recognition, IFRS 9 requires that financial liabilities are classified as measured at either:
(a) At fair value through profit or loss, or
(b) Financial liabilities at amortised cost
A financial liability is classified at fair value through profit or loss if:
(a) It is held for trading, or
(b) Upon initial recognition it is designated at fair value through profit or loss.
Derivatives are always measured at fair value through profit or loss.
These classification rules are unchanged from those previously contained within IAS 39.
6.9 Initial measurement: financial assets

IFRS 9 requires that financial assets are initially measured at the fair value of consideration given. In
the case of financial assets classified as measured at amortised cost, transaction costs directly attributable
to the acquisition of the financial asset increase this amount.
6.10 Subsequent measurement: financial assets

Financial assets are subsequently measured at:
 Fair value with changes in value normally recognised in profit or loss, or
 Amortised cost with interest recognised in profit or loss
6.10.1 Financial assets measured at fair value

Where a financial asset is classified as measured at fair value, fair value is established at each period end
by reference to either the market price, where the instrument is quoted, or valuation techniques
otherwise. IFRS 9 also states that in some cases, cost may be the best estimate of fair value.
Any changes in fair value are normally recognised in profit or loss. There is an exception to this rule
where the financial asset is an investment in an equity instrument not held for trading. In this case the
entity can make an irrevocable election to recognise changes in the fair value in other comprehensive
income.
Worked example: Asset measurement

On 6 November 20X3 Stripe Co acquires an equity investment with the intention of holding it in the
long term. The investment cost £500,000. At Stripe Co's year end of 31 December 20X3, the market
price of the investment is £520,000. How is the asset initially and subsequently measured?
Stripe Co has elected to present the equity investment in other comprehensive income.
Solution
 The asset is initially recognised at the fair value of the consideration, being £500,000
 At the period end it is remeasured to £520,000
 This results in the recognition of £20,000 in other comprehensive income

6.10.2 Financial assets measured at amortised cost
C
IFRS 9 does not define amortised cost, but it refers to the definition of this and other relevant terms in H
IAS 39. A
P
6.11 Comparison table T
E
The following table shows the extent to which IFRS 9 simplifies the IAS 39 definitions. R
Old IAS 39 Category Measured at Gains and losses

6
Financial asset at fair value through profit or loss Fair value Profit or loss
Available for sale financial asset Fair value Other comprehensive income
Financial asset held to maturity Amortised cost Profit or loss
Loans and receivables Amortised cost Profit or loss
6.12 Initial measurement: financial liabilities

IFRS 9 requires that financial liabilities are initially measured at transaction price, ie the fair value of
consideration received except where part of the consideration received is for something other than the
financial liability. In this case the financial liability is initially measured at fair value determined as for
financial assets (see above). Transaction costs are added to this amount for financial liabilities classified
as measured at amortised cost.
6.13 Subsequent measurement: financial liabilities

After initial recognition, all financial liabilities should be measured at amortised cost, with the exception
of financial liabilities at fair value through profit or loss (including most derivatives). These should be
measured at fair value, but where the fair value is not capable of reliable measurement, they should
be measured at cost.
6.14 Embedded derivatives

6.14.1 Financial asset host contracts
Where the host contract is a financial asset within the scope of the standard, the classification and
measurement rules of the standard are applied to the entire hybrid contract.
This is a simplification of the IAS 39 rules, which required that an embedded derivative be separated
from its host contract and accounted for as a derivative under certain conditions.
6.14.2 Other host contracts

Where the host contract is not a financial asset within the scope of IFRS 9, the standard requires that
an embedded derivative be separated from its host contract and accounted for as a derivative when
the following conditions are met.
(a) The economic characteristics and risks of the embedded derivative are not closely related to the
economic characteristics and risks of the host contract.
(b) A separate instrument with the same terms as the embedded derivative would meet the definition
of a derivative.
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in the profit or loss (a derivative embedded in a financial liability need not be separated
out if the entity holds the combined instrument at fair value through profit or loss).
6.15 Exposure Draft: Amortised Cost and Impairment

A brief outline of this exposure draft, published in 2009, is included for completeness. It is Phase 2 of the
revision of IAS 39, IFRS 9 on assets and liabilities being Phase 1 and hedging being Phase 3. The specifics
are not examinable, but an awareness of the context of IFRS 9 may be helpful.

6.15.1 Amortised cost
(a) The ED states that the objective of amortised cost is 'to provide information about the effective
return on a financial asset or financial liability by allocating interest revenue or interest expense
over the expected life of the financial instrument'.
(b) It contains guidance on amortised cost of a variable instrument (ie it is the spread that amortised
cost applies to).
6.15.2 Impairment
IAS 39 currently uses an 'incurred loss' model for the impairment of financial assets. This model assumes
that all loans will be repaid until evidence to the contrary. Only at this point is the impaired loan written
down to a lower value.
Under the proposals an 'expected loss' model will be applied: expected losses are recognised
throughout the life of the loan (or other financial asset measured at amortised cost), and not just after a
loss event has been identified. The effective interest rate will include an initial estimate of any expected
credit losses. Credit losses will be held in a separate allowance account. Losses due to changes in cash
flow estimates are disclosed as a separate line item. If the item is considered uncollectable, write-offs will
be made directly to the financial asset account.
Extensive disclosure requirements would provide investors with an understanding of the loss estimates
that an entity judges necessary.
6.16 Supplement
In January 2011, the IASB issued a supplement to the ED addressing some of the major operational
difficulties identified by respondents, particularly for open portfolios. The aim is to make it easier for
entities to implement the original proposals in the ED. The supplement applies only to financial assets
measured at amortised cost and managed in an open portfolio, excluding short-term trade receivables.
A distinction is made in many financial institutions between two broad groups of financial assets:
(a) Loans that are considered problematic (the 'bad book'). These are generally monitored on a
portfolio basis.
(b) Loans that are not considered problematic (the 'good book'). These are generally managed more
closely, often on an individual basis.
6.17 Exposure Draft: Expected credit losses

Expected credit losses are an estimate of losses that an entity expects will result from a credit event, such
as payment default. They are a cost of lending activity.
In March 2013, the IASB issued an Exposure Draft Expected Credit Losses. The proposals are intended to
replace the guidance on impairment of financial assets in IAS 39 and are to be integrated into IFRS 9
when finalised.
The ED proposes to use a forward looking model with the aim of achieving earlier recognition of
(expected) credit losses on financial assets, guarantees and commitments as compared to the currently
used 'incurred loss model' that delays recognition of credit losses until the occurrence of a loss event.
The ED proposes to recognise a loss allowance:
(a) Measured at an amount equal to full lifetime expected credit losses where credit risk has increased
significantly since initial recognition, the asset was credit impaired when acquired/originated or, as
an accounting policy choice, for trade receivables that do not constitute a financing transaction; or
(b) Measured at an amount equal to the twelve-month expected credit losses (lifetime expected credit
losses from default events that could occur within twelve months after the reporting date) for all
other assets subject to the proposals
The most significant impact of the proposals will be on the financial services industry but t the
accounting for bad debt allowances on trade receivables for non-financial service entities will also be
affected.

6.18 Review Draft: Hedge accounting section of IFRS 9
C
This is the third phase of the project to replace IAS 39.The hedge accounting rules have been criticised H
as being complex and not reflecting the entity's risk management activities, nor the extent to which A
they are successful. The IASB aims to address these issues in its revision of the current hedge accounting P
T
rules E
In September 2012, the IASB issued a Review Draft of the hedge accounting chapter of IFRS 9 Financial R
Instruments. The Review Draft has been issued as a 'fatal flaw' check before becoming Chapter 6 of IFRS
9 and has taken into account comments received on an Exposure Draft issued in December 2010.
6
6.18.1 Hedge effectiveness

Under the proposals the 80%-125% 'bright line' test of whether a hedging relationship qualifies for
hedge accounting would be replaced by an objective-based assessment, ie that:
(a) There is an economic relationship between the hedged item and the hedging instrument, ie the
hedging instrument and the hedged item have values that generally move in the opposite
direction because of the same risk, which is the hedged risk;
(b) The effect of credit risk does not dominate the value changes that result from that economic
relationship, ie the gain or loss from credit risk does not obscure the effect of underlying changes in
the value of the hedging instrument or the hedged item, even if those changes were significant;
and
(c) The hedge ratio of the hedging relationship (quantity of hedging instrument vs quantity of hedged
item) is the same as that resulting from the quantity of the hedged item that the entity actually
hedges and the quantity of the hedging instrument that the entity actually uses to hedge that
quantity of hedged item.
This allows genuine hedging relationships to be accounted for as such whereas the IAS 39 rules
sometimes prevented management from accounting for an actual hedging transaction as a hedge.
6.18.2 Fair value hedges

The IAS 39 treatment of recognising both changes in the fair value of the hedged item and changes in
value of the hedging instrument in profit or loss will be retained.
However, if the hedged item is an investment in an equity instrument held at fair value through other
comprehensive income, the gains and losses on both the hedged investment and the hedging
instrument will be recognised in other comprehensive income.
This ensures that hedges of investments of equity instruments held at fair value through other
comprehensive income can be accounted for as hedges.
6.18.3 Cash flow hedges

These will continue to be accounted for as under IAS 39. Hedging gains and losses recognised in other
comprehensive income will be recognised in a separate cash flow hedge reserve in equity.
6.18.4 Disclosures
IFRS 7 Financial Instruments: Disclosures is revised by IFRS 9.
Disclosures relating to hedging must be presented in a single note (or alternatively a separate section)
of the financial statements. In that way, all the effects of hedging are seen together in detail in this
note.
6.19 Transitional rules

6.19.1 Overview
IFRS 9's transitional rules are complicated. The main requirements are as follows.
IFRS 9 is required to be applied retrospectively subject to certain transitional provisions. For the purpose
of applying these transitional provisions, it is necessary to determine the date of initial application,
which is the date when an entity first applies the requirements of IFRS 9.

6.19.2 The date of initial application
The determination of the date of initial application depends on whether the entity adopted IFRS 9
before or after 1 January 2011.
(a) If IFRS 9 was adopted before 1 January 2011, the date of initial application was the adoption date
which fell between the issue of IFRS 9 (12 November 2009) and 31 December 2010.
(b) If IFRS 9 is adopted on or after 1 January 2011, the date of initial application is the beginning of the
first reporting period in which it is adopted.
6.19.3 Advantages of early adoption

(a) Reduced complexity in accounting for financial assets as a result of having only two measurement
categories.
(b) Improved ability to align accounting with the company's business model for managing financial
assets.
(c) Opportunity to reclassify financial assets on initial adoption provided all the criteria are met.
(d) Simplified accounting for and valuation of financial instruments containing embedded derivatives.
(e) Greater flexibility on date of initial application for early adopters.
6.19.4 Disadvantages of early adoption

(a) Another set of impairment and hedging rules to comply with when these parts of IFRS 9 are
finalised.
(b) The possibility of accounting mismatches where IFRS 9's requirements are incompatible with
existing hedge accounting designations.
(c) Chasing a moving target – IFRS 9 may change again.

Summary and Self-test C
H
A
P
T
E
R
Summary
IAS 39 Financial Instrument: 6

Recognition and Measurement
Financial assets Financial liabilities
Derivatives
Embedded derivative
Measurement of
Recognition
financial instrument
Derecognition
Subsequent Transaction costs

Initial measurement measurement
Impairment

Self-test
1 Peacock
The Peacock Company purchases £40,000 of bonds. The asset has been designated as at fair value
One year later, 10% of the bonds are sold for £6,000. Total cumulative gains previously recognised
in profit or loss in respect of the asset are £1,000.
Requirement
In accordance with IAS 39 Financial Instruments: Recognition and Measurement, what is the amount
of the gain on the disposal to be recognised in profit or loss?
2 Vanadic
Some years ago the Vanadic Company raised finance on arm's-length terms, whereby interest of
5.5% would be paid annually in arrears and the loan repaid in full on 31 December 20X8. Taking
into account the transaction costs, the effective interest rate was 6.0%. Vanadic had paid all the
interest and capital due up to 31 December 20X2. The carrying amount of the loan on that date
was £10 million.
During 20X2 Vanadic encountered financial difficulties and agreed with its lenders revised terms for
20X3 onwards. Under the revised terms the coupon on the loan was raised and the term of the
loan extended.
The effective interest rate of the revised terms, excluding transaction costs, was 8.0% per annum.
The present value of the cash flows, excluding transaction costs, under the revised terms was £10.5
million at 6.0% per annum and £9.5 million at 8.0%.
In addition, transaction costs of £700,000 were payable on 1 January 20X3 in respect of the
negotiations for the revised terms.
Requirement
Discuss and explain whether the following statements are true, according to IAS 39 Financial
Instruments: Recognition and Measurement.
(a) In all circumstances the transaction costs incurred in renegotiating the terms of any loan
should be recognised in profit or loss when payable.
(b) The revised terms negotiated by Vanadic are such that the original loan should be
derecognised and a new financial liability recognised.
3 Basic
The Basic Company manufactures personal computers. The Plank Company is a key supplier of
silicon chips to Basic.
Plank is having short-term liquidity problems so, in order to ensure continuity of supplies of silicon
chips, Basic made an interest free loan of £7.0 million to Plank on 31 December 20X7. The loan is
repayable at par on 31 December 20X8. The market interest rate on loans with a similar credit
rating and term is 7% per annum. The annual interest rate on government bonds is 6%.
Requirement
What should the carrying amount of the loan be (to the nearest £1,000) in the statement of
financial position of Basic at 31 December 20X7 according to IAS 39 Financial Instruments:
Recognition and Measurement?

4 Colyear
C
The Colyear Company operates a small chain of shoe shops. Due to competition from larger rivals, H
revenue has fallen and Colyear is experiencing some liquidity problems. Colyear has therefore A
entered into two financing contracts, both of which have derivatives embedded within them. P
T
Contract (1) On 31 December 20X7 Colyear issued £15 million of 8% fixed rate debt maturing E
on 31 December 20Y2. Colyear has the option to extend the term of the loan for an R
additional 3 years at the same rate of interest. This debt has not been classified as a
financial liability at fair value through profit or loss.
6
Contract (2) On 30 June 20X7 Colyear signed a lease for a new retail site. The terms of the lease
provided for Colyear to benefit from paying a relatively low fixed annual rental of
£100,000. However, an additional rental payment of £50,000 would be made for
each year that annual revenue from the new retail site exceeded £5 million.
Requirement
Explain whether in each of the two contracts the embedded derivative should be separated from
the host contract in the financial statements of Colyear for the year to 31 December 20X7,
according to IAS 39 Financial Instruments: Recognition and Measurement.
5 Macmanus
On 1 January 20X7 The Macmanus Company issued a three-year £10 million bond at par. It has
not been classified as a financial liability at fair value through profit or loss.
The bond is redeemable on 1 January 20Y0 at a premium of 10%. The nominal interest rate is 6%,
payable on 31 December each year. The issue costs associated with the bond are £300,000. The
effective interest rate is 10.226%.
Requirement
What is the carrying amount of this liability in Macmanus' financial statements for the year ending
31 December 20X7 in accordance with IAS 39 Financial Instruments: Recognition and Measurement?
6 Boyes
The Boyes Company is about to issue a 5% fixed interest bond on 1 January 20X8 and is finalising
the terms of the issue with its investment bankers. The bond is not a financial liability at fair value
Requirement
Using the effective interest rate method, and assuming the other terms of the bond are held
constant, discuss and explain what impact any issue costs and any premium on redemption would
have on the effective interest rate with respect to the bond in Boyes' financial statements for the
year ending 31 December 20X8 in accordance with IAS 39 Financial Instruments: Recognition and
Measurement.
7 Gmund
The Gmund Company is a large manufacturer of jewellery. Gmund enters into a fixed price forward
contract to purchase 150 kilos of titanium in order to provide greater certainty as to its raw
material costs: titanium is a commodity traded on international commodities exchanges
worldwide.
The contract is in standard form and therefore permits Gmund either to take physical delivery of
the titanium after 12 months or to pay a net settlement in cash based on changes in the market
value of titanium. Gmund intends to take delivery of the titanium to make jewellery, as it always
has done with similar contracts in the past.
The Hononga Company is a wholesaler of titanium. It purchases large quantities of the metal and
then quickly delivers physical quantities of titanium to small jewellers, attempting to generate a
profit from short-term price fluctuations. Hononga enters into a one month fixed price forward
contract to purchase 50 kilos of titanium.

Requirement
Explain whether each of the above two forward contracts should be treated as derivatives
according to IAS 39 Financial Instruments: Recognition and Measurement.
8 Luworth
Luworth Co purchased a £20 million 6% debenture at par on 1 January 20X1 when the market rate
of interest was 6%. Interest is paid annually on 31 December. The debenture is redeemable at par
The market rate of interest on debentures of equivalent term and risk changed to 7% on
31 December 20X1.
Requirement
Show the charge or credit to profit or loss for each of the two years to 31 December 20X2 if the
debentures are classified as:
(a) Held-to-maturity investments
(b) Financial assets at fair value through profit or loss
(c) Available-for-sale financial assets.
Fair value is to be calculated using discounted cash flow techniques.
9 Pike
The Pike Company issued £18 million of convertible bonds at par on 31 December 20X7. Interest is
payable annually in arrears at a rate of 11%. The bondholders can convert into 8 million ordinary
shares after 31 December 20Y1.
The bond has no fixed maturity and contains a call option whereby Pike can redeem the bond at
any time at par value.
At 31 December 20X7, a bond with a similar credit status and the same cash flows as the one
issued by Pike, but without conversion rights or a call option, is valued in the market at £11 million.
Using an option pricing model, it is estimated that the value of the call option on a similar bond
without conversion rights would be £3 million.
Requirement
What carrying amount should be recognised for the liability in respect of the convertible bond in
the statement of financial position of Pike at 31 December 20X7, in accordance with IAS 32
10 Mullet
The Mullet Company issued £55 million of convertible bonds at par on 31 December 20X7.
Interest is payable annually in arrears at a rate of 8%. The bondholders can convert into 20 million
ordinary shares after 31 December 20Y1.
The bond has no fixed maturity and contains a call option whereby Mullet can redeem the bond at
any time at par value.
At 31 December 20X7, a bond with a similar credit status and the same cash flows as the one
issued by Mullet but without conversion rights or a call option is valued in the market at £52
million.
Using an option pricing model it is estimated that the value of the call option on a similar bond
without conversion rights would be £1 million.
Requirement
What carrying amount should be recognised for the equity element of the convertible bond in the
statement of financial position of Mullet at 31 December 20X7, in accordance with IAS 32 Financial
Instruments: Presentation?

Technical reference C
H
A
P
T
E
Recognition and derecognition R
 Initial recognition IAS 39.14
 Derecognition of financial asset IAS 39.17 6
– Transfers qualifying IAS 39.18-20
– Transfers that do not qualify IAS 39.29-35
IAS 39.38, AG 53-

 Regular way transactions
56
 Derecognition of financial liabilities IAS 39.39-41
Measurement
 Initial measurement of financial assets and liabilities IAS 39.43-44
 Classification of financial assets IAS 39.9
 Classification of financial liabilities IAS 39.9
 Subsequent measurement of financial assets IAS 39.45-46
 Transaction costs IAS 39.43
 Subsequent measurement of financial liabilities IAS 39.47
 Fair value measurement considerations IAS 39.48
 Reclassification of financial assets IAS 39.50-54
 Gains and losses IAS 39.55-57
 Impairment of financial assets
– Objective evidence IAS 39.58-62
– Financial assets carried at amortised cost IAS 39.63-65
– Financial assets carried at cost IAS 39.66
– Available-for-sale assets IAS 39.67-70
Derivatives
 Derivatives – definition and classification IAS 39.9
 Embedded derivatives
– Definition IAS 39.10
– Relation with host instrument IAS 39.11-11A
– Accounting treatment IAS 39.11-11A

1 Peacock
IAS 39.27 states that upon derecognition of a part of a financial asset the amount recognised in
profit or loss should be the difference between the carrying amount allocated to the part
derecognised and the sum of
(i) The consideration received for the part derecognised and
(ii) Any cumulative gain or loss allocated to it that had been recognised in other comprehensive
income.
The previous gains had been recognised in profit or loss and so are not included in the calculation.
The carrying amount is measured as original cost plus previous gains £4,100 (ie 10%  41,000).
The carrying amount of the proportion sold is deducted from the proceeds (£6,000) to give the
gain of £1,900.
2 Vanadic
It is not the case that 'the transaction costs incurred in renegotiating the terms of any loan should
be recognised in profit or loss when payable' in all circumstances.
It is true that 'the revised terms negotiated by Vanadic are such that the original loan should be
derecognised and a new financial liability recognised'.
Transaction costs are recognised in profit or loss if the revision of loan terms is to be treated as the
extinguishment of the loan. But if the revision is treated as a modification, the costs are amortised
over the remaining life of the modified liability (IAS 39 AG 62).
Derecognition of the old loan and recognition of the new liability is required if the present value of
the cash flows under the new terms is 10% or more different from the present value of the original
loan. The cash flows under the new terms must be discounted at the 6.0% effective interest rate of
the original loan and include the £700,000 transaction costs (IAS 39 AG 62).
With transaction costs payable at the start of the period of the revised terms, they are added on in
full to the £10.5m present value, giving a total of £11.2m. This is 12% different from the £10.0m
present value of the old loan, so the original loan should be derecognised and the new financial
liability recognised.
3 Basic
IAS 39.43 requires a financial asset to be measured initially at fair value, ie the amount for which it
could be exchanged in an arm's-length transaction (IAS 39.9).
A zero interest rate loan issued at par would not result from an arm's-length transaction and IAS 39
AG 64 requires the fair value in such a case to be determined as the present value of the cash
receipts (ie redemption amount) under the effective interest method. The discount rate should be
that on similar loans. So initially it will be measured at £7.0m/1.07 = £6,542,000.
This loan will fall within IAS 39.9's definition of loans and receivables which under IAS 39.46 should
be subsequently measured at amortised cost using the effective interest method. As this
subsequent measurement is made on the same day as the initial measurement, the carrying
amount will be £6,542,000.
4 Colyear
IAS 39.11 requires an embedded derivative to be separated from the host contract if
(i) The embedded derivative's economic characteristics and risks are not closely related to those
of the host contract
(ii) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative; and
(iii) The hybrid contract is not measured at fair value through profit or loss.

Contract (1) This appears to satisfy the conditions in IAS 39 for separation (IAS 39.11). IAS
39.11 and IAS 39 AG 30 (c) require the separation of the embedded derivative C
where a loan agreement contains the option to extend, unless the interest rate H
A
is reset to market rate at the time of the extension.
P
Contract (2) In general terms, leases are outside the scope of IAS 39 although derivatives T
E
embedded in leases are within its scope (IAS 39.2 (b)). This derivative is closely
R
related to the host contract as they are both part of the same lease contract
covering the same period. The derivative element is merely an additional
means of determining the rentals payable, albeit on a contingent basis. The
6
contingent element should thus be treated as part of the host contract and not
accounted for separately. This is consistent with the example in IAS 39 (AG
33(f)(ii)).
5 Macmanus
IAS 39.43 requires financial liabilities to be measured initially at fair value including transaction
costs, which include issue costs, per IAS 39 AG 13. Per IAS 39.47 subsequent measurement is at
amortised cost, applying the effective interest method, which per IAS 39.9 includes any discount or
premium on issue or redemption.
On 1 January 20X7 the liability should be measured at £10m less the issue cost of £300,000 =
£9.7m. It should be increased by interest at the 10.226% effective rate (to £10,691,900) and
reduced by the £600,000 interest paid on 31 December 20X7. The carrying amount on 31
December 20X7 should therefore be £10,091,900.
6 Boyes
The greater the issue costs, the greater the effective interest rate. The greater the premium on
redemption, the greater the effective interest rate.
IAS 39 requires that a premium on redemption should be built into the effective interest rate in
order to annualise its effect (IAS 39.9). As a consequence, the greater the premium, the greater the
effective interest rate. Also, the greater the issue costs, the greater the effective interest rate as the
initial liability should be recognised net of the issue costs, leading to a greater uplift to redemption.
Issuing at par rather than at a discount would reduce, rather than increase, the effective interest
rate; it increases the amount at which the bond is initially recognised and thus reduces the
annualised charge.
7 Gmund
In the case of Gmund, IAS 39.5 excludes from its scope contracts that were entered into for the
purchase of a non-financial item in accordance with the entity's expected sale, purchase or usage
requirements.
In the case of Hononga, IAS 39.6(c) includes in its scope contracts that were entered into for the
receipt of a non-financial item where it is sold shortly thereafter to exploit short-term price
changes.

8 Luworth
(a) Held-to- (b) FV through P/L (c) AFSFA
maturity
20X1 20X2 20X1 20X2 20X1 20X2
£'000 £'000 £'000 £'000 £'000 £'000
Profit or loss
Interest income (W1)/(W2) 1,200 1,200 1,200 1,387 1,200 1,387
Gain/(loss) due to change in
FV (W2) – – (187) – – *(187)
1,200 1,200 1,013 1,387 1,200 1,200
Other comprehensive income
Available-for-sale financial
assets – – – – (187) 187
1,200 1,200 1,013 1,387 1,013 1,387

Financial asset (W1)/(W2) 20,000 – 19,813 – 19,813 –
Reserves
Gain/(loss) due to change in
FV (W2) – – – – (187) –
* reclassified from equity to profit or loss on derecognition.

WORKINGS
1 Amortised cost
£'000
Cash – 1.1.20X1 20,000
Effective interest at 6% (same as nominal as no discount on 1,200
issue/premium on redemption)
Coupon received (nominal interest 6%  20m) (1,200)
At 31.12.20X1 20,000
Effective interest at 6% 1,200
At 31.12.20X2 0
2 Fair value
£'000
Cash 20,000
Effective interest (as above) 1,200
Coupon received (as above) (1,200)
Fair value loss (187)
At 31.12.20X1 (W3) 19,813
Interest at 7% (7%  19,813) 1,387
At 31.12.20X2 0
3 Fair value at 31.12.20X1

£'000
Interest and capital due on 31.12.20X2 at new market rate (21.2m/1.07) 19,813
9 Pike
£8 million
IAS 32.31 requires that any derivative features embedded within a compound financial instrument
(such as the call option) are 'included' in the liability component. The value of the option (£3m)
which is an asset for the company as it enables it to buy back the bonds when it wants to, is
deducted from the liability element of the compound instrument (£11m).

10 Mullet
C
£4 million H
A
IAS 32.31 requires that any derivative features embedded within a compound financial instrument
P
(such as the call option) are included in the liability component. The value of the option (£1m) is T
deducted from the liability element of the compound instrument (£52m) giving a final liability E
element of £51m. R
The equity element is the fair value of the compound instrument (£55m) less the liability element
after taking account of the derivative (£51m) as IAS 32.31 requires that no gain or loss should arise
6
on initial recognition of the component elements. The equity element is therefore £4m.


There are no circumstances in which an investment in equity should be classified as a held-to-maturity
investment. An equity investment does not have a fixed maturity, one of the conditions for such
classification.

(a) The redeemable preferred shares require regular distributions to the holders but more importantly
have the debt characteristic of being redeemable. Therefore according to IAS 32 they should be
classified as debt (a financial liability).
(b) According to IFRS 2 Share-based Payment the grant of share options must be recognised in equity.
Share options are an alternative to cash as remuneration, so an expense should be measured in
profit or loss with a credit to equity.

(a) A guarantee to replace or repair goods sold by a business in the normal course of business does not
fall within the definition of a financial liability, so it should be dealt with under IAS 37 Provisions,
(b) A firm commitment (order) to purchase a specific quantity of cocoa beans for use in manufacturing
is not a financial liability. This is a normal operating purchase which is not recognised until delivery
when there is a contractual obligation on the part of the purchaser to pay for the cocoa beans.
(c) A forward contract such as this falls within the definition of a derivative, so in principle it does fall
within IAS 39. The only exception would be if the contract is for the entity's expected usage of
cocoa beans in its business (outside the scope of IAS 39, para 5). This would be accounted for as a
normal purchase on delivery, as (b).

Trade date accounting
 The financial asset should be derecognised on 27 December 20X4 and a receivable of £1,100
recognised. At the same date a gain of £100 should be recognised in profit or loss, which includes
any previous gains recognised in other comprehensive income which are now reclassified to profit
or loss.
 On 5 January 20X5, the counterparty pays the £1,100 to clear the receivable.
Settlement date accounting
 The financial asset should be remeasured at the fair value of £1,100 on 27 December 20X4. The
cumulative gain of £100 should be recognised in other comprehensive income.
 No further entries are made on 31 December 20X4 as the entity has no right to further fair value
movements.
 On 5 January 20X5 the financial asset should be derecognised and the gain of £100 reclassified to
profit or loss.

C
(a) AB Co should derecognise the asset. Its option is to repurchase the shares at their then fair value, so H
it has transferred substantially all the risks and rewards of ownership. A
P
(b) CD Co should not derecognise the asset as it has retained substantially all the risks and rewards of T
ownership. E
R
(c) EF Co should not derecognise the asset as it has retained substantially all the risks and rewards of
ownership. The investment should be retained in its books even though legal title is temporarily
transferred. 6
(d) GH Co has received 90% of its transferred receivables in cash, but whether it can retain this
amount permanently is dependent on the performance of the factor in recovering all of the
receivables. GH Co may have to repay some of it and therefore retains the risks and rewards of
100% of the receivables amount. The receivables should not be derecognised (IAS 39 para 16(b)).
The cash received should treated as a loan.
The 10% of the receivables that GH Co will never receive in cash should be treated as interest over
the six month period; it should be recognised as an expense in profit or loss and increase the
carrying amount of the loan.
At the end of the six months, the receivables should be derecognised by netting them against the
amount of the loan that does not need to be repaid to the factor. The amount remaining are bad
debts which should be recognised as an expense in profit or loss.
If there was any indication during the six months that the receivables were irrecoverable, the
impairment loss should be recognised earlier.

D.
Interest rate options are always treated as held for trading and therefore are held at 'fair value through
profit or loss' (ie gains and losses reported immediately in profit or loss). An investment in another
company's redeemable preference shares is not an available-for-sale financial asset, because their
redeemable nature makes them in substance debt and they are treated an investment held to maturity
providing this is the intention (IAS 39).

(a) Statement of financial position
£
Non-current assets Financial asset (441,014 + 35,281) 476,295
Finance income (441,014  (Working) 8%) 35,281
WORKING
Effective interest rate
600,000
= factor of 1.3605. From the four years line in the table the effective interest rate is 8%.
441,014
(b) Compound instrument

Presentation
Non-current liabilities £
Financial liability component of convertible bond (Working) 1,797,467
Equity
Equity component of convertible bond (2,000,000 – (Working) 1,797,467) 202,533

WORKING
£
Fair value of equivalent non-convertible debt
Present value of principal payable at end of three years 1,544,367
(4,000  £500 = £2m  1
)
(1.09)3
Present value of interest annuity payable annually in arrears
for 3 years [(5%  £2m)  2.531] 253,100
1,797,467

The gains in fair value to be recognised in profit or loss in 20X7 should be calculated as:
 £4,000 in respect of the bonds sold, ie £150,000 proceeds less (1/4  £560,000 carrying amount
brought forward plus £6,000 sale transaction costs).
 £30,000 in respect of the bonds retained, ie 3/4  (£600,000 year end fair value less £560,000
carrying amount brought forward).
So a total of £34,000.
In addition, interest received at 7% on £500,000 = £35,000 should be recognised in finance income.
The total amount is £69,000.

The gain to be recognised in profit or loss in 20X7 should be the total gain in respect of the shares sold
since their acquisition, calculated as £150,000 proceeds less (1/4  £500,000 initial fair value plus
£4,000 sale transaction costs) = £21,000.
The amount to be recognised in other comprehensive income in 20X7 is:
 A credit of £30,000 in respect of the increase in fair value in the year of the 375,000 shares
retained (3/4  (£600,000 year end fair value less £560,000 carrying amount brought forward))
and
 A debit of £15,000 in respect of the increase in fair value in 20X6 of the 125,000 shares sold (1/4 
(£560,000 carrying amount brought forward less £500,000 initial fair value)) which should be
reclassified to profit or loss.

Statement of financial position extracts at 31 December 20X2
£
Financial assets
4% debentures in MT Co (W1) 104,120
Interest rate option (W2) 13,750
Shares in EG Co (W3) 0
Financial liabilities
Shares in BW Co sold 'short' (W4) (28,000)
Statement of comprehensive income extracts year ended 31 December 20X2
£
Profit or loss
Finance income
Effective interest on 4% debentures in MT Co (W1) 6,120
Gain on interest rate option (W2) 6,750
Gain on sale of shares in EG Co (W3) 14,345
Finance costs
Loss on shares in BW Co sold 'short' (W4) (4,000)

£
Other comprehensive income C
Available-for-sale financial assets – shares in EG Co (W3) (5,750) H
A
P
WORKINGS
T
1 Debentures (Financial asset held-to-maturity) E
£ R
Cash paid on 1.1.20X2 (100,000 + 2,000) 102,000
Effective interest income (102,000  6%) 6,120
Coupon paid (100,000  4%) (4,000) 6
Amortised cost at 31.12.20X2 104,120
2 Option (Financial asset at fair value through profit or loss)
1.9.20X2
Dr Financial asset £7,000
Cr Cash £7,000
31.12.20X2
Dr Financial asset (£13,750 – £7,000) £6,750
3 Shares (Available-for-sale financial asset – re-classification)
20X1
£
Purchase for cash ((25,000  £2) + (1%  £50,000)) 50,500
Fair value gain at 31.12.20X1 ((25,000  £2.25 bid price) – 5,750 other
£50,500)) comprehensive
income
Fair value at 31.12.20X1 56,250
20.12.20X2
Dr Cash ((25,000  £2.62) – (1%  65,500)) £64,845
Dr Other comprehensive income (reclassified) £5,750
Cr Financial asset £(56,250)
4 Shares sold 'short' (Financial liability at fair value through profit or loss)
22.12.20X2
Dr Cash £24,000
Cr Financial liability £24,000
31.12.20X2
Dr Profit or loss (£28,000 – £24,000) £4,000

An impairment loss has been incurred if there is objective evidence of impairment. The amount of the
impairment loss for a loan measured at amortised cost is the difference between the carrying amount of
the loan and the present value of future principal and interest payments discounted at the loan's original
effective interest rate. In cases (a)–(d), the present value of the future principal and interest payments
discounted at the loan's original effective interest rate will be lower than the carrying amount of the
loan. Therefore, an impairment loss is recognised in those cases.
In case (e), even though the timing of payments has changed, the lender will receive interest on
interest, and the present value of the future principal and interest payments discounted at the loan's
original effective interest rate will equal the carrying amount of the loan. Therefore, there is no
impairment loss. However, this is unlikely given Customer B's financial difficulties.

(a) The debentures were classified as a held-to-maturity investment, so they should have been
measured at amortised cost:
£
Initial cost 100,000
Interest at 10% effective rate 10,000
Cash received at 5% of par value (5,000)
At 31 December 20X3 105,000
Interest at 10% 10,500
Cash at 5% (5,000)
(b) After the impairment, the debentures should be measured at the present value of estimated future
cash flows, using the original effective interest rate of 10%:
3
80%  £130,525  (1/1.1 ) = £78,452
(c) The impairment of £32,048 (£110,500 – £78,452) should be recognised as follows:
DEBIT Profit or loss £32,048
CREDIT Financial asset £32,048

In substance, the effect of the two transactions is an interest rate swap with no initial investment. This
therefore meets the definition of a derivative since there is no initial net investment, an underlying
variable is present and future settlement will take place. This would be the same even if no netting
agreement existed because the definition of a derivative does not include a requirement for net
settlement.

In Contract (1) there is an embedded derivative but this should not be separated from the host contract.
In Contract (2) there is an embedded derivative which should be separated from the host contract.
IAS 39.11 requires an embedded derivative to be separated from the host contract if
(i) The economic characteristics and risks are not closely related to the host contract
(ii) A separate instrument with the same terms would meet the definition of a derivative; and
(iii) The combined instrument has not been designated as at fair value through profit or loss.
Contract (1)
Although there is a derivative embedded in the contract (it is not denominated in Sebacoyl's functional
currency), it does not satisfy the conditions for separation from the host contract. Its economic
characteristics and risks are closely related to those of the host contract, in that the R£ is the functional
currency of one substantial party to the contract.
Contract (2)
The derivative embedded in this contract must be separated out, because the N£, the currency in which
the contract is denominated, is not the functional currency of either party, nor is it the currency used
internationally as the measure of contract prices.

CHAPTER 7
hedge accounting
Introduction
Topic List
1 Hedge accounting: the main points
2 Hedged items
3 Hedging instruments
4 Fair value hedge
5 Cash flow hedge
6 Hedge of a net investment
7 Conditions for hedge accounting
8 Disclosures
Technical reference
219
Introduction
 Demonstrate an understanding of the rationale of hedge accounting and how it modifies

the usual accounting treatment of financial derivatives
 Apply the criteria for a hedging relationship to qualify for hedge accounting
 Demonstrate an understanding of the definitions and qualifications of hedged items and

hedging instruments
 Demonstrate an understanding of and identify fair value hedges, cash flow hedges and
hedges of a net investment in a foreign entity
 Demonstrate an understanding of and apply the definition and measurement criteria for
hedge effectiveness

1 Hedge accounting: the main points
Section overview
 Pay particular attention to this first section as it contains the main points you need to know.
1.1 Introduction
In earlier stages of your study for the ACA qualification, such as Financial Management, you have
covered the way hedging is an important means by which a business can manage the risks it is exposed
to.
C
As an example, a manufacturer of chocolate can fix now the price at which it buys a specific quantity of H
cocoa beans at a predetermined future date by arranging a forward contract with the cocoa beans A
producer. P
T
The forward price specified in the forward contract may be higher or lower than the spot price at the E
time the contract is agreed, depending on seasonal and other factors. But by agreeing the forward R
contract both the manufacturer and the producer have removed the risk they otherwise would face of
unfavourable price movements (price increases being unfavourable to the chocolate manufacturer and
price decreases unfavourable to the cocoa beans producer) between now and the physical delivery date. 7
Equally, they have removed the possibility of favourable price movements (price decreases being
favourable to the chocolate manufacturer and price increases favourable to the cocoa beans producer)
over the period.
Another way of achieving the same effect would be for the chocolate manufacturer to purchase cocoa
bean futures on a recognised trading exchange. On the delivery date the manufacturer would close out
the futures in the futures market and then buy the required quantity in the spot market. The
profit/(loss) on the futures transaction should offset the increase/(decrease) in the spot price over the
period.
Hedge accounting is the accounting process which reflects in financial statements the commercial
substance of hedging activities. It results in the gains and losses on the linked items (eg the purchase of
coffee beans and the futures market transactions) being recognised in the same accounting period and
in the same section of the statement of profit or loss and other comprehensive income, ie both in profit
or loss, or both in other comprehensive income.
Hedge accounting reduces or eliminates the volatility in profit or loss which would arise if the items
were not linked for accounting purposes.
Point to note:
The forward contract is a derivative. Without hedge accounting, the profit/(loss) in the futures market
would be recognised when the closing transaction in that market is carried out, but the
increased/(decreased) cost of the cocoa beans would be recognised at the later date when the
chocolate is sold. Both would be recognised in profit or loss, but possibly in different accounting
periods.
In the previous chapter the point was made that financial assets should be classified/designated at the
time of their initial recognition, not at any later date. This is to prevent businesses making
classifications/ designations with the benefit of hindsight so as to present figures to their best
advantage. Similarly, hedge accounting is only permitted by IAS 39 if the hedging relationship between
the two items (the cocoa beans and the futures contract in the above example) is designated at the
inception of the hedge. And designation is insufficient by itself; there must be formal documentation,
both of the hedging relationship and of management's objective in undertaking the hedge.
The effect is that hedge accounting is an accounting policy option, not a requirement. If the hedging
relationship does not meet IAS 39's conditions (eg it is not properly documented), then hedge
accounting is not permitted. Some businesses take the view that the costs of meeting these conditions
outweigh the benefits of hedge accounting; just by not preparing the right documentation they avoid
having to comply with the relevant parts of IAS 39.
Financial instruments – hedge accounting 221

But if a business does comply with IAS 39's conditions for hedge accounting, then the hedge
accounting provisions of this standard do become compulsory.
1.2 Overview
In simple terms the main components of hedge accounting are as follows:
 The hedged item: this is an asset, a liability, a firm commitment (such as a contract to acquire a
new oil tanker in the future) or a forecast transaction (such as the issue in four months' time of
fixed rate debt) which exposes the entity to risks of fair value/cash flow changes. The hedged item
generates the risk which is being hedged.
 The hedging instrument: this is a derivative or other financial instrument whose fair value/cash
flow changes are expected to offset those of the hedged item. The hedging instrument
reduces/eliminates the risk associated with the hedged item.
 There is a designated relationship between the item and the instrument which is documented.
 At inception the hedge must be expected to be highly effective and it must turn out to be highly
effective over the life of the relationship
 To qualify for hedging, the changes in fair value/cash flows must have the potential to affect profit
or loss.
 There are two main types of hedge:
– The fair value hedge: the gain and loss on such a hedge are recognised in profit or loss
– The cash flow hedge: the gain and loss on such a hedge are initially recognised in other
comprehensive income and subsequently reclassified to profit or loss.
Points to note:
1 The key reason for having the two types of hedge is that profits/losses are initially recognised
in different places.
2 In some circumstances the entity can choose whether to classify a hedge as a fair value or a
cash flow hedge.
3 There is a third type of hedge: the hedge of a net investment in a foreign operation, such as
the hedge of a loan in respect of a foreign currency subsidiary. This is accounted for similarly
to cash flow hedges.
1.3 Effectiveness of the hedge

The effectiveness of the hedge is measured as the extent to which the change in the hedging
instrument offsets the change in the hedged item.
 If the loss on the hedged item is £10,000 and the gain on the hedging instrument is £10,000, the
hedge is fully effective.
 If the loss on the hedged item is £10,000 and the gain on the hedging instrument is £9,000, the
hedge is not fully effective. Its effectiveness can be measured as 10,000/9,000 = 111% or as
9,000/10,000 = 90%.
 Hedge accounting is only permitted if, both at inception and during the life of the hedging
relationship, the measure of effectiveness falls between 80% and 125%.

Definitions
Note: Here are three definitions you may need for the illustration that follows.
A forward contract is a commitment to undertaking a future transaction at a set time and at a set price.
A future represents a commitment to an additional transaction in the future that limits the risk of
existing commitments.
An option represents a commitment by a seller to undertake a future transaction, where the buyer has
the option of not undertaking the transaction.
Illustration 1: basic hedging

C
1 January H
A
On 1 January the price (the spot price) of a consignment of cocoa beans is £1,000. P
T
You know you will need to buy a consignment of cocoa beans on 28 February, as they will be needed to E
fulfil a customer order. You are afraid that the price of cocoa beans will rise significantly between R
1 January and 28 February.
You therefore contract with a cocoa beans supplier to buy a consignment of cocoa beans at £1,050 on
7
28 February.
28 February
The price of a consignment of cocoa beans is now £1,100.
You nevertheless can hold the supplier to the forward contract and can buy the cocoa beans at £1,050.
If however the market had not behaved as predicted and the price of cocoa beans was £980 on
28 February, you would still be obliged to buy the cocoa beans at the price of £1,050.
Similarly if the customer had pulled out of the transaction, you would still have to buy the consignment
of cocoa beans and dispose of them as best you could.
Hedging deals with the bad news you don't expect!
1 January
On 1 January the price (the spot price) of a consignment of cocoa beans is £1,000.
You have already agreed to buy a consignment of cocoa beans for £1,200 on 28 February, which means
you appear to be at risk of paying too much for the cocoa beans.
You buy a three-month cocoa futures contract at £1,100 that expires on 31 March. This means you
are committing to buying an additional consignment of cocoa beans, not at today's spot price, but
at the futures price of £1,100. £1,100 represents what the market thinks the spot price will be on
31 March.
28 February
You buy the consignment of cocoa beans at £1,200.
You are still committed to buying the consignment at £1,100 on 31 March, but that will mean that you
have two consignments of cocoa beans rather than just the one you need. You therefore sell the futures
contract you bought on 1 January to eliminate this additional commitment. The futures contract is now
priced at £1,233, as the market now believes that £1,233 will be the spot price on 31 March.
Because you have sold the contract for more than the purchase price, you have made a gain on the
futures contract of 1,233 – 1,100 = £133. This can be set against the purchase you made.
Net cost = 1,200 – 133 = £1,067; the cost of paying more for the cocoa beans has been offset by the
profit made on the futures contract.
1 January
On 1 January the price (the spot price) of a consignment of cocoa beans is £1,000.

You know you will need to buy a consignment of cocoa beans on 28 February, as they will be needed to
fulfil a customer order. You think it is likely that the price of cocoa beans will rise significantly between
1 January and 28 February, but you believe that with current market uncertainty, the price of cocoa
beans could even fall.
You therefore take out an option to buy cocoa beans at £1,050 on 28 February. Because you are being
given the privilege of choosing whether or not to fulfil the option contract, you have to pay a premium
of £30.
28 February
Scenario 1
What if the price of the cocoa beans has now risen to £1,100?
You can hold the supplier to the option contract and buy the cocoa beans at £1,050.
Total cost = 1,050 + 30 = £1,080.
Scenario 2
What if the price of cocoa beans has fallen to £980? You could let the option contract lapse and buy
cocoa beans at £980.
Total cost = 980 + 30 = £1,010.
Scenario 3
What if your customer pulls out of the contract? You would not have to buy the cocoa beans and the
only cost to you will be the premium of £30.
Illustration 2: basic hedging

Red, whose functional currency is the £, has invested 4.75 million euro in purchasing a majority
shareholding in Blue. The investment in Blue is entirely financed by a loan in euro. The directors of Red
decide to designate the loan as a hedging instrument and the investment as the related hedged item.
Describe the accounting treatment of any gains or losses arising on the investment and the loan,
assuming that the hedging relationship meets all the conditions required by IAS 39 Financial Instruments:
Recognition and Measurement to qualify for hedge accounting.
Solution
The transaction entered into by Red is a hedging transaction of a net investment in a foreign entity. The
loan is the hedging instrument and the investment in Blue is the hedged item.
As the loan has been designated as the hedging instrument at the outset and the transaction meets the
hedging criteria of IAS 39, the exchange movements in both items should be recognised in other
comprehensive income. Any ineffective portion of the hedge should be recognised in profit or loss for
the year.
Below are two simple illustrative examples of accounting for a fair value hedge and accounting for a
cash flow hedge. The definitions and rules for a fair value hedge and a cash flow hedge are covered in
greater detail in Sections 4 and 5 of this chapter.
1.4 Accounting for a simple fair value hedge

On 1 August 20X5 an entity owned 50,000 litres of vegetable oil which had cost it £5 per litre and
which had a selling price (spot price = fair value) of £6 per litre. The entity was concerned that the fair
value might fall over the next three months, so it took out a 3-month future to sell at £6 per litre. On
31 October the spot price of the oil had fallen to £5.60. On that date the entity closed out its future
and sold its inventory, both transactions being at the spot price.

The sale of 50,000 litres at £5.60 generates revenue of £280,000; deducting the cost of £250,000 the
profit recognised in profit or loss should be £30,000.
The entity also makes a profit of £0.40 (6.00 – 5.60) per litre in the futures market, so on 50,000 litres a
profit of £20,000 should be recognised in profit or loss.
Subject to any futures market transactions costs, the entity has protected itself against a fall in fair value
below the £6 fair value at 1 August 20X5.
1.5 Accounting for a simple cash flow hedge

On 1 November 20X5 an entity, whose functional currency is the £, entered into a contract to sell
goods on 30 April 30X6 for $300,000. In fixing this $ price it worked on the basis of the spot exchange
rate of $1.50 = £1, so that revenue would be £200,000. To ensure it received £200,000 on 30 June C
20X6 the entity took out a 6-month future to sell $300,000 for £200,000. H
A
On 31 December 20X5 (which is the company's reporting date) the spot exchange rate was $1.65 = £1. P
The future was therefore worth £18,182 (£200,000 – ($300,000/1.65)) and the entity recognised that T
amount as a financial asset and as a profit in other comprehensive income. E
R
On 30 April 20X6 the spot exchange rate was $1.75 = £1 and the future was worth £28,571 (£200,000
– ($300,000/1.75)). The entity closed out its future position at the then spot price and sold the goods.
The accounting entries should be: 7
Dr Customer ($300,000/1.75) £171,429
Dr Financial asset (28,571 – 18,182) £10,389
Dr Other comprehensive income £18,182
(Reclassification of gain to profit or loss)
Cr Revenue £200,000
The customer account and the financial asset are then cleared by cash receipts. Note that revenue is
measured at the amount fixed as a result of the hedging transaction.
2 Hedged items
Section overview
 This section deals with detailed issues related to hedged items in a hedging relationship.
Definitions
A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net
investment in a foreign operation that:
 Exposes the entity to risk of changes in fair value or future cash flows; and
 Is designated as being hedged.
A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a
specified price on a specified future date or dates.
A forecast transaction is an uncommitted but anticipated future transaction.
Point to note:
Neither firm commitments nor forecast transactions are normally recognised in financial statements. As
is explained in more detail in a later part of this chapter, it is only when they are designated as hedged
items that they are recognised.

2.1 Financial risks
Hedged items as defined above are exposed to a variety of risks that affect the value of their fair value
or cash flows. For hedge accounting, these risks need to be identified and hedging instruments
which modify the identified risks selected and designated. The risks for which the above items can be
hedged are normally classified as:
 Market risk
Which can be made up of:
– Price risk
– Interest rate risk
– Currency risk
 Credit risk
 Liquidity risk
IAS 39 allows for a portion of the risks or cash flows of an asset or liability to be hedged. The hedged
item may, for example, be
 Oil inventory (which is priced in $) for a UK company, where the fair value of foreign currency risk
is being hedged but not the risk of a change in $ market price of the oil
 A fixed rate liability, exposed to foreign currency risk, where only the interest rate and currency risk
are hedged but the credit risk is not hedged
2.2 Nature of hedged items

In this section we discuss some of the key aspects of the definition of a hedged item.
 The hedged item can be:
– A single asset, liability, unrecognised firm commitment, highly probable forecast transaction
or net investment in a foreign operation
– A group of assets, liabilities, firm commitments, highly probable forecast transactions or net
investments in foreign operations with similar risk characteristics or
– A portion of a portfolio of financial assets or financial liabilities which share exposure to
interest rate risk. In such a case the portion of the portfolio that is designated as a hedged
item is a hedged item with regard to interest rate risk only.
 Assets and liabilities designated as hedged items can be either financial or non-financial items.
– Financial items can be designated as hedged items for the risks associated with only a
portion of their cash flows or fair values. So a fixed rate liability which is exposed to foreign
currency risk can be hedged in respect of currency risk, leaving the credit risk not hedged.
– But non-financial items such as inventories shall only be designated as hedged items for
foreign currency risks or for all risks. The reason is that it is not possible to separate out the
appropriate portions of the cash flow or fair value changes attributable to specific risks other
than foreign currency risk.
 Unrecognised assets and liabilities cannot be designated as hedged items. So unrecognised
intangibles cannot be hedged items.
 Only assets, liabilities, firm commitments or highly probable transactions that involve a party
external to the entity can be designated as hedged items. The effect is that hedge accounting
can be applied to transactions between entities or segments in the same group only in the
individual or separate financial statements of those entities or segments and not in the consolidated
financial statements.
 As an exception, an intra-group monetary item qualifies as a hedged item in the consolidated
financial statements if it results in an exposure to foreign exchange rate gains and losses that are
not eliminated on consolidation.

Illustration: Intra-group hedge
The functional currency of Entity A and its subsidiary Entity B are £ and $ respectively. B sells $100 of
goods to A just before the year end. The amount remains unsettled at the year end.
Whilst the inter-company balances are eliminated on consolidation, the exchange differences that
arise in A from the retranslation of the monetary liability are not eliminated on consolidation.
Hence, the inter-company monetary item can be designated as a hedged item in a foreign currency
hedge.
2.3 Designation of a group of assets as hedged items

IAS 39 permits the designation of a group of assets as a hedged item provided that the following two
conditions are met. C
H
 The individual assets or liabilities in the group share the risk exposure that is designated as A
being hedged. P
T
 The change in the fair value attributable to the hedged risk for each individual item in the group E
is expected to be approximately proportional to the overall change in fair value attributable to the R
hedged risk of the group items.
7
Worked example: Group of assets
An entity constructs a portfolio of shares to replicate a stock index and uses a put option on the index to
protect itself from fair value losses.
Requirement
Can the portfolio of shares be designated as a hedged item?
Solution
The portfolio cannot be designated as a hedged item. Similar financial instruments should be
aggregated and hedged as a group only if the change in fair value attributable to the hedged risk for
each individual item in the group is expected to be approximately proportional to the overall change in
fair value attributable to the hedged risk of the group. In the scenario above, the change in the fair value
attributable to the hedged risk for each individual item in the group (individual share prices) is not
expected to be approximately proportional to the overall change in fair value attributable to the hedged
risk of the group; even if the index rises, the price of an individual share may fall.
2.4 Hedging an overall net position

Although an entity's hedging strategy and risk management practices may assess cash flow risk on a net
basis IAS 39 does not permit an overall net position to be designated as a hedged item for hedge
accounting purposes. The reason for this is that in a hedging relationship the gains or losses in the
hedging instrument will need to be allocated to the individual items in the net position. This is difficult
since in a net position there may be assets or liabilities which may have payoffs different to that of the
hedging instruments. However, the same purpose can be achieved by designating a part of the gross
items, equal to the net position, as the hedged item.
Worked example: Hedging net positions

An entity has a firm commitment to make a purchase of £5 million in a foreign currency in 30 days'
time. On the same date it has a firm commitment to make a sale of £4 million in the same foreign
currency.
Solution
The entity can hedge the net amount of £1 million by acquiring a derivative and designating it as a
hedging instrument associated with £1 million of the firm purchase commitment of £5 million.

2.5 Held-to-maturity investments and loans and receivables
As noted above, to qualify for hedging the changes in fair value or cash flows must have the potential to
affect profit or loss. Held-to-maturity investments cannot be designated as hedged items for interest rate
risk or prepayment risk, because over the total period to maturity there are no changes in fair value
which can affect profit or loss. Even prepayment risk (ie the risk of an issuer repaying a loan early
because interest rates have fallen) is a function of interest rates and consequently cannot be treated as
hedgeable risk.
Fair value hedge accounting is permitted for exposure to interest rate risk in fixed rate loans that are
classified as loans and receivables. Like held-to-maturity investments, loans and receivables are
measured at amortised cost and it is the case that they may be held until they mature. (Banking
institutions, for example, in many countries hold the bulk of their loans and receivables until they
mature. Thus, changes in the fair value of such loans and receivables that are due to changes in market
interest rates will not affect profit or loss.) But the holder of an investment classified under loans and
receivables could sell it before its maturity, in which case any change in fair values would affect profit or
loss. Thus fair value hedge accounting is permitted for loans and receivables even if they turn out to be
held until their maturity.
2.6 Firm commitments as hedged items

Firm commitments (as defined above) are the result of legally binding contracts which normally specify
penalties for non-performance. A firm commitment can be a hedged item.
2.7 Forecast transactions as hedged items

A forecast transaction (as defined above) qualifies as a hedged item only if the transaction is highly
probable. Examples of forecast transaction that qualify as a hedged item include:
 The anticipated issue of fixed rate debt. This can be recognised as a hedged item under a cash flow
hedge of a highly probable forecast transaction that will affect profit or loss.
 Expected, but not contractual, future foreign currency revenue streams, provided that the revenues
are highly probable. A hedge of an anticipated sale can qualify as a cash flow hedge.
Illustration: Forecast transaction

An airline may use models based on past experience and historical economic data to project its revenues
in various currencies. If it can demonstrate that forecast revenues for a period of time into the future in a
particular currency are highly probable, it may designate a currency borrowing as a cash flow hedge of
the currency risk of future revenue stream. The portion of the gain or loss on the borrowing that is
determined to be an effective hedge is recognised in other comprehensive income until the revenues
occur.
It is unlikely that an entity can reliably predict 100% of revenues for a future year. On the other hand, it
is possible that a portion of predicted revenues, normally those expected in the short term, will meet the
'highly probable' criterion.
Because forecast transactions can only be hedged under cash flow hedges, the ways to assess the
probability of a future transaction are covered below under cash flow hedges.
2.8 Intra-group and intra-entity hedging transactions

It has already been noted that hedged items have to involve a party external to the entity, with the
result that intra-group transactions can be designated as hedged items only in the individual or separate
financial statements and not in consolidated financial statements. There are only two cases, both
involving foreign exchange translation, where intra-group transactions will be recognised in the
consolidated financial statements.

The first case is a result of IAS 21 under which foreign exchange gains and losses on an intra-group
monetary asset or liability between entities with different functional currencies are not fully eliminated in
the consolidated profit or loss. This is because a foreign currency monetary item represents a
commitment to convert one currency into another one and exposes the reporting entity to a gain or
loss through currency fluctuations. Because such exchange differences are not fully eliminated on
consolidation, they will affect profit or loss in the entity's consolidated financial statements and hedge
accounting may be applied.
The second case arises because IAS 39 permits the foreign currency risks of a highly probable forecast
intra-group transaction to be designated as a hedged item in the consolidated financial statements
provided the following two conditions are met.
 The highly probable forecast intra-group transaction is denominated in a currency other than the
functional currency of the group member entering into that transaction.
C
 The foreign currency risk will affect the group's consolidated profit or loss. H
A
P
T
Worked example: Hedging intra-group monetary items E
An Australian company, whose functional currency is the Australian dollar, has forecast purchases in R
Japanese yen that are highly probable. The Australian entity is wholly owned by a Swiss entity, which
prepares consolidated financial statements (which include the Australian subsidiary) in Swiss francs. The
Swiss parent entity enters into a forward contract to hedge the change in yen relative to the Australian 7
dollar.
Requirement
Explain whether that hedge can qualify for hedge accounting in the Swiss entity's consolidated financial
statements.
Solution
The hedge can qualify for hedge accounting. Since the Australian entity did not hedge the foreign
currency exchange risk associated with the forecast purchases in yen, the effects of exchange rate
changes between the Australian dollar and the yen will affect the Australian entity's profit or loss and,
therefore, would also affect consolidated profit or loss. IAS 39 does not require the operating unit that is
exposed to the risk being hedged to be a party to the hedging instrument.
2.9 Items that do not qualify as hedged items

Because the hedged item must expose the entity to risk of changes in the fair value or future cash flows
that could affect the profit or loss, a number of items cannot qualify as hedged items. These items are:
 The entity's own equity instruments
 Held to maturity investments (with exceptions)
 Equity method investments and investments in consolidated subsidiaries in respect of fair value
hedges
 Future earnings
 Derivative instruments
 General business risk
These non-qualifying items are analysed below.
Own equity instruments

Hedge accounting does not apply for hedges of items included in equity or transactions that directly
affect equity. A highly probable forecast transaction in the entity's own equity instruments or forecast
dividend payments to shareholders both relate to transactions which will be recognised in the statement
of changes in equity, so they cannot be designated as a hedged item in a cash flow hedge. However, a
declared dividend that has not yet been paid and is recognised as a financial liability may qualify as a
hedged item, for example for foreign currency risk if it is denominated in a foreign currency.

Held-to-maturity investments
It was noted above that held to maturity investments cannot be designated as hedged items for interest
rate risk or prepayment risk.
Worked example: Held to maturity asset

An entity cannot designate a pay-variable, receive-fixed interest rate swap as a cash flow hedge of a
variable rate, held-to-maturity investment because it is inconsistent with the designation of a debt
investment as being held to maturity to designate a swap as a cash flow hedge of the debt investment's
variable interest rate payments.
A forecast purchase of a held-to-maturity investment, on the other hand, can be a hedged item with
respect to interest rate risk. Held-to-maturity investments can also be a hedged item with respect to
foreign currency risk and credit risk.
Equity method investments and investment in subsidiaries in respect of

fair value hedges
The equity method of accounting (eg for associates) recognises in profit or loss a share of (the
associate's) profit or loss, not the change in the fair value of the investment (in the associate). The
definition of a fair value hedge does not include risks associated with changes in shares of profit or loss.
The same analysis applies to investments in subsidiaries.
Future earnings
Future earnings cannot be hedged items because they are the net result of different transactions with
different risk profiles. Highly probable forecast transactions can be hedged items, however, so it is
theoretically possible to hedge the individual components of future revenue and future expenses.
Derivative instruments
IAS 39 does not permit designating a derivative instrument (whether a stand-alone or a separately
recognised embedded derivative) as a hedged item (obviously, they may be a hedging instrument)
either individually or as part of a hedged group in a fair value or cash flow hedge. This is not really a
problem because derivatives are always classified as held for trading, so gains/losses are recognised in
profit or loss. So if from a commercial perspective a derivative is hedged by another derivative, the
normal accounting treatment means that they would both be booked at fair value through profit or loss
and a natural offset in profit or loss would occur.
As exceptions:
 Derivatives may be designated as hedging instruments (not hedged items) in a cash flow hedge.
 The effect of IAS 39 AG 94 is to permit the designation of a purchased option as a hedged item.
Business risk
IAS 39 does not permit an entity to apply hedge accounting to a hedge of the risk that a transaction will
not occur, even if, for example, that would result in less revenue to the entity than expected. The risk
that a transaction will not occur is an overall business risk that is not eligible as a hedged item. Hedge
accounting is permitted only for risks associated with recognised assets and liabilities, firm
commitments, highly probable forecast transactions and net investments in foreign operations.

3 Hedging instruments
Section overview
 This section considers in detail the financial instruments that can be designated as hedging
instruments for hedge accounting purposes.
3.1 Hedging instruments
Definition
C
A hedging instrument is a designated derivative or, for a hedge of the risk of changes in foreign H
currency exchange rates only, a designated non-derivative financial asset or non-derivative financial A
liability, whose fair values or cash flows are expected to offset changes in the fair value or cash P
T
flows of a designated hedged item.
E
R
An implication of this definition is that financial assets and liabilities whose fair value cannot be reliably
measured cannot be designated as hedging instruments. 7
The types of hedging instruments that can be designated in hedge accounting are:
 Derivatives, such as forward contracts, futures contracts, options and swaps, and
 Non-derivative financial instruments, but only for the hedging of currency risk. This category
includes foreign currency cash deposits, loans and receivables, available for sale monetary items
and held-to-maturity instruments carried at amortised cost.
3.2 Derivatives
Any derivative financial instrument, with the exception of written options to which special rules apply,
can be designated as a hedging instrument. Derivative instruments have the important property that
their fair value is highly correlated with that of the underlying.
3.3 Options
Options provide a more flexible way of hedging risks compared to other derivative instruments such as
forwards, futures and swaps, because they give to the holder the choice as to whether or not to exercise
the option.
Purchased options
When an entity purchases a put option, it buys the right to sell the underlying at the strike price. If the
price of the underlying falls below the strike price, the entity exercises its option and receives the strike
price; it has protected the value of its position. Similarly if an entity needs to buy an asset in the future, it
can purchase a call option on the asset that gives the entity the right to purchase the asset at the strike
price, protecting it from a rise in the price of the asset in the future.
The difference between the purchased option and a forward contract is that under a forward contract
the entity is obliged to buy or sell at the strike price, whereas under a purchased option it has the right,
but not the obligation, to buy or sell at the strike price.
Purchased options, whether call options or put options, have the potential to hedge price, currency
and interest rate risks and can always qualify as hedging instruments.
Examples of purchased options include options on equities, options on currencies and options on
interest rates. An interest rate floor is achieved through a put option on an interest rate, and an interest
rate cap is achieved through a call option on an interest rate.

Illustration: Use of purchased options in cash flow hedges
An entity, whose functional currency is the £, has contracted with one of its customers to sell a fixed
quantity of its products in three months' time for £800,000. The sale price was fixed on the assumption
that the £/US$ exchange rate would remain at £1 = US$1.80. The entity sources many of its
manufacturing inputs from the USA and its profitability would be substantially reduced if the £ fell
against the US dollar.
To hedge against this risk, the entity purchased a three–month call option with an exercise price of £1 =
US$1.80, for £800,000. As a result the entity would benefit from an appreciation of £ against the US
dollar and be protected against a depreciation.
The entity can designate the purchased option as a hedging instrument in a cash flow hedge. The
exposure hedged is the change in cash flows if the US dollar appreciated over the three-month period.
3.4 Designation as hedging instrument in whole or in part

In a hedging relationship, the hedging instrument is normally designated in its entirety. The only
exceptions are that the following are permitted (but not required):
(a) Separating the intrinsic value of an option and its time value and designating only the change in
the intrinsic value as the hedging instrument.
(b) Separating the interest element and the spot price of a forward.
Those exceptions recognise that the intrinsic value of the option and the premium on the forward
generally can be measured separately.
Illustration: Purchased options in fair value hedges

Entity A has purchased a three year £10 million debt with fixed 4% interest. The debt was bought at par
and the entity wishes to hedge the risk of an decrease in the fair value of the debt resulting from a
possible increase in interest rates. It buys a £10 million three year interest rate cap on a three month
LIBOR with an exercise price of 4%. An interest rate cap is a call option on LIBOR that pays the holder
the difference between the market rate of LIBOR and the exercise price. The payment that the buyer of
the interest rate cap receives compensates for the decrease in the value of the bond caused by the
increase in interest rates.
The interest rate cap can be designated as a hedging instrument in a hedge of changes in the fair value
of the three year debt as a result of changes in interest rates. The change in the fair value of the debt
can result not only from changes in the risk-free element of the interest rate, but also from a
deterioration in the credit rating of the debt. In the section on hedged items, it was stated that IAS 39
allows a financial item to be hedged with respect to the risks associated with only a portion of its cash
flow or fair value, provided that effectiveness can be established.
It is therefore possible to designate the hedge as the risk of changes in the fair value resulting from a
increase in interest rates above 4%. The effectiveness of the hedge will be improved if the entity
designated only the intrinsic value of the cap as the hedging instrument. The time value of the cap will,
in this case, be excluded from the hedge relationship and changes in its value will be recognised in
profit or loss as they occur.
4 Fair value hedge

Section overview
 The application of fair value hedge accounting is discussed through a number of practical
examples.

4.1 Fair value hedges
A fair value hedge is a hedge of an entity's exposure to changes in fair value of a recognised asset
or liability or an unrecognised firm commitment, or a part thereof, that is attributable to a particular
risk and could affect profit or loss. Examples of fair value hedges include the hedge of exposures to
changes in fair value of fixed rate debt using an interest rate swap and the use of an oil forward contract
to hedge movements in the price of oil inventory.
Examples of fair value hedging
Hedged item Risk exposure Type of risk Example of hedging

instrument
Commodity inventory Change in value due to Market risk Forward contract C

changes in the price of (price risk) H
commodity A
P
Equities Change in the value of the Market risk Purchase put option T
investments due to (price risk) E
R
changes in the price of
equity
Issued fixed rate bond Change in the value of the Market risk Interest rate swap 7
bond as interest rates (interest rate risk)
change
Purchase of materials Depreciation of the local Market risk Forward contract
denominated in foreign currency and increase in (foreign
currency in three months the cost of material currency)
Hedge accounting and risk reduction

IAS 39 does not require that in order for a hedging relationship to qualify for hedge accounting, it
should lead to a reduction in the overall risk of the entity. A hedging relationship that satisfies the
conditions for hedge accounting may be designed to protect the value of a particular asset. The
following example illustrates the point.
Worked example: Qualification for hedge accounting

An entity has a fixed rate financial asset and a fixed rate financial liability, each having the same principal
amount. Under the terms of the instruments, interest payments on the asset and liability occur in the
same period and the net cash flow is always positive because the interest rate on the asset exceeds the
interest rate on the liability. The entity wishes to hedge the financial asset and enters into an interest
rate swap to receive a floating interest rate and pay a fixed interest rate on a notional amount equal to
the principal of the asset. It designates the interest rate swap as a fair value hedge of the fixed rate asset.
Requirement
Does the hedging relationship qualify for hedge accounting even though the effect of the interest rate
swap on an entity-wide basis is to create an exposure to interest rate changes that did not previously
exist?
Solution
Yes. IAS 39 does not require risk reduction on an entity-wide basis as a condition for hedge accounting.
Exposure is assessed on a transaction basis and, in this instance, the asset being hedged has a fair value
exposure* to interest rate increases that is offset by the interest rate swap.
* The fair value of a loan is the present value of the cash flows. A fixed rate loan has constant cash flows
so the fair value is directly affected by a change in the discount rate (ie the market interest rate).

4.2 Fair value hedge accounting
If a fair value hedge meets the conditions for hedge accounting during the period, it should be
accounted for as follows:
 The gain or loss from remeasuring the hedging instrument at fair value (for a derivative
hedging instrument) or the foreign currency component of its carrying amount measured in
accordance with IAS 21 (for a non-derivative hedging instrument) should be recognised in profit
or loss; and
 The gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount
of the hedged item and is recognised in profit or loss.
It is normal for gains and losses on derivatives to be recognised in profit or loss, so the first of the above
rules is to be expected. But the second rule, requiring the recognition of the gain or loss on the hedged
item in profit or loss, has two unusual consequences:
 If the hedged item is an available-for-sale financial asset, the gain or loss attributable to the risk
being hedged should be recognised in profit or loss, rather than in other comprehensive income.
But the remainder of any fair value change, ie that arising from hedging ineffectiveness, should still
be recognised in other comprehensive income.
 If the hedged item is something such as inventory which otherwise would be measured at cost, the
gain or loss attributable to the risk being hedged should be adjusted against the item's carrying
amount.
Note that even though gains or losses on both the hedged item and the hedging instrument are
recognised in profit or loss, the hedge should still be checked for being highly effective. The reason is
that if it is not highly effective and hedge accounting is not allowed, there will be no change to the
carrying amount of what was previously the hedged item and only the gain or loss on what was
previously the hedging instrument will be recognised in profit or loss.
Illustration: Gain or loss on hedged item recognised in profit or loss

At 1 November 20X5 an entity held inventory with a cost of £400,000 and a fair value of £600,000.
The entity acquired a derivative to hedge against a fall in the fair value of its inventory below £600,000.
At its year end two months later the fair value of its inventory had fallen by £20,000 and the derivative it
holds had a value of £20,000.
The journals required at the year end are as follows.
Dr Financial asset £20,000
To recognise the gain on the derivative hedging instrument
Cr Inventories £20,000
To adjust the carrying amount of inventories by the loss in its fair value (because closing inventories
reduce cost of sale, a decrease in their carrying amount increases cost of sales and reduces profit).
The effect is that:
 The loss on the hedged item has been recognised in profit or loss
 There is a nil net effect in profit or loss, because the hedge has been 100% effective.
 Inventories are carried at £380,000. This is neither cost (£400,000) nor fair value (£580,000).
 The entity has been protected against loss of profit. If it had sold the inventory on 1 November, it
would have made a profit of £200,000 (600,000 – 400,000); if it sells the inventory on 1 January
20X6, it will make a profit of £200,000 (580,000 – 380,000).

Interactive question 1: Fair value hedge [Difficulty level: Intermediate]
A company owns inventories of 40,000 gallons of oil which cost £800,000 on 1 December 20X3.
In order to hedge the fluctuation in the market value of the oil, on 1 December 20X3 the company
signs a futures contract to deliver 40,000 gallons of oil on 31 March 20X4 at the futures price of £22 per
gallon.
The market price of oil on 31 December 20X3 is £22.25 per gallon and the futures price at that date for
delivery on 31 March 20X4 is £24 per gallon.
Requirement
Explain how these transactions should be accounted for at 31 December 20X3:
(a) Without hedge accounting C
(b) With hedge accounting. H
A
See Answer at the end of this chapter. P
T
E
If only particular risks attributable to a hedged item are hedged, recognised changes in the hedged R
item's fair value unrelated to the hedged risk are recognised in accordance with paragraph IAS 39.55.
This means that changes in fair value of a hedged financial asset or liability that is not part of the
hedging relationship would be accounted as follows: 7
 For instruments measured at amortised cost, such changes would not be recognised.
 For instruments measured at fair value through profit or loss, such changes would be recognised in
profit or loss in any event.
 For available-for-sale financial assets, such changes would be recognised in other comprehensive
income, as explained above. However exceptions to this would include foreign currency gains and
losses on monetary items and impairment losses, which would be recognised in profit or loss in any
event.
If the fair value hedge is 100% effective (as in the above Illustration), then the change in the fair
value of the hedged item will be wholly offset by the change in the fair value of the hedging
instrument and there will be no effect in profit or loss. Whenever the hedge is not perfect and the
change in the fair value of the hedged item is not fully cancelled by change in the fair value of the
hedging instrument, the resulting difference will be recognised in profit or loss. This difference is
referred to as hedge ineffectiveness.
Worked example: Fair value hedge of variable rate debt instrument

Does IAS 39 permit an entity to designate a portion of the risk exposure of a variable rate debt
instrument as a hedged item in a fair value hedge?
Solution
Yes. A variable rate debt instrument may have an exposure to changes in its fair value due to credit risk.
It may also have an exposure to changes in its fair value relating to movements in the market interest
rate in the periods between which the variable interest rate on the debt instrument is reset. For
example, if the debt instrument provides for annual interest payments reset to the market rate each
year, a portion of the debt instrument has an exposure to changes in fair value during the year.
Interactive question 2: Fair value hedge of inventory [Difficulty level: Intermediate]

Can an entity designate inventories, such as copper inventory, as the hedged item in a fair value hedge
of the exposure to changes in the price of the inventories, such as the copper price, although
inventories are measured at the lower of cost and net realisable value under IAS 2 Inventories?

Worked example: Fair value hedge of inventory
On 1 July 20X6 a jewellery trader acquired 10,000 ounces of a material which it held in its inventory.
This cost £200 per ounce, so a total of £2 million. The trader was concerned that the price of this
inventory would fall, so on 1 July 20X6 he sold 10,000 ounces in the futures market for £210 per ounce
for delivery on 30 June 20X7. On 1 July 20X6 the conditions for hedge accounting were all met.
At 31 December 20X6, the end of the trader's reporting period, the fair value of the inventory was £220
per ounce while the futures price for 30 June 20X7 delivery was £227 per ounce. On 30 June 20X7 the
trader sold the inventory and closed out the futures position at the then spot price of £230 per ounce.
Requirement
Set out the accounting entries in respect of the above transactions.
Solution
£ £
1 July 20X6 Debit Credit
Inventory 2,000,000
Cash 2,000,000
(To record the initial purchase of material)
At 31 December 20X6 the increase in the fair value of the inventory was £200,000 (10,000 × (£220 –
£200)) and the increase in the forward contract liability was £170,000 (10,000 × (£227 – £210)).
Hedge effectiveness was 85% (170,000 as a % of 200,000), so hedge accounting was still permitted.
£ £
31 December 20X6 Debit Credit
Profit or loss 170,000
Financial liability 170,000
(To record the loss on the forward contract)
Inventories 200,000
(To record the increase in the fair value of the inventories)
At 30 June 20X7 the increase in the fair value of the inventory was another £100,000 (10,000 × (£230 –
£220)) and the increase in the forward contract liability was another £30,000 (10,000 × (£230 – £227)).
30 June 20X7
(To record the loss on the forward contract)
Inventories 100,000
(To record the increase in the fair value of the inventories)
Profit or loss 2,300,000
Inventories 2,300,000
(To record the inventories now sold)
Cash 2,300,000
Profit or loss – revenue 2,300,000
(To record the revenue from the sale of inventories)
Cash 200,000
(To record the settlement of the net balance due on closing the financial
liability)
Note that because the fair value of the material rose, the trader made a profit of only £100,000 on the
sale of inventories. Without the forward contract, the profit would have been £300,000 (2,300,000 –
2,000,000). In the light of the rising fair value the trader might in practice have closed out the futures
position earlier, rather than waiting until the settlement date.

4.3 Hedging of firm commitments
The hedging of a firm commitment should be treated as a fair value hedge except that a firm
commitment with a price fixed in foreign currency may be treated as either a fair value hedge or a
cash flow hedge of the foreign currency risk.
When an unrecognised firm commitment to acquire an asset or to assume a liability is designated as a
hedged item in a fair value hedge, the accounting treatment is as follows:
 The subsequent cumulative change in the fair value of the firm commitment attributable to the
hedged risk since inception of the hedge is recognised as an asset or liability with a corresponding
gain or loss recognised in profit or loss.
 The changes in the fair value of the hedging instrument are also recognised in profit or loss.
C
 When the firm commitment is fulfilled, the initial carrying amount of the asset or liability is H
adjusted to include the cumulative change in the firm commitment that has been recognised in A
the statement of financial position under the first point above. P
T
E
4.4 Discontinuing fair value hedge accounting R
Fair value hedge accounting should be discontinued if the hedging instrument expires or is sold,
terminated or exercised, if the criteria for hedge accounting are no longer met or if the entity revokes 7
the designation.
The discontinuance should be accounted for prospectively, ie the previous accounting entries are not
reversed. The hedged item is not adjusted for any further changes in its fair value and adjustments
already made are recognised in profit or loss over the life of the item.
5 Cash flow hedge
Section overview
 The application of cash flow hedge accounting is discussed in this section through a series of
practical examples.
5.1 Cash flow hedge

A cash flow hedge is a hedge of the variability in an entity's cash flows. The variability should be
attributable to a particular risk associated with:
 A recognised asset or liability; or
 A highly probable forecast transaction
and could affect profit or loss.
Examples of cash flow hedges include:
 The use of interest rate swaps to change floating rate debt into fixed rate debt. The entity is
hedging the risk of variability in future interest payments which may arise for instance from
changes in market interest rates. The fixed rate protects this cash flow variability (but with the
consequence that the fair value of the instrument may now vary in response to market interest
movements).
 The use of a commodity forward contract for a highly probable sale of the commodity in future.
The entity is hedging the risk of variability in the cash flows to be received on the sale, due to
changes in the market price of the goods.
The hedge of foreign currency assets and liabilities using forward exchange contracts can be treated as
either a fair value or a cash flow hedge. This is because movements in exchange rates change both the
fair value of such assets and liabilities and ultimate cash flows arising from them. Similarly a hedge of the
foreign currency risk of a firm commitment may be designated as either a fair value or a cash flow
hedge.

5.2 Forecast transaction
A forecast transaction is an uncommitted but anticipated future transaction. To qualify for cash flow
hedge accounting, the forecast transaction should be
 Specifically identifiable as a single transaction or a group of individual transactions which share
the same risk exposure for which they are designated as being hedged.
 Highly probable. The factors to be taken into account when assessing the probability of the
transaction are discussed further below.
 With a party that is external to the entity.
5.2.1 Specifically identifiable

Identification of hedged forecast transaction
A forecast transaction such as the purchase or sale of the last 15,000 units of a product in a specified
period or as a percentage of purchases or sales during a specified period does not qualify as a hedged
item.
This is because the hedged forecast transaction must be identified and documented with sufficient
specificity so that when the transaction occurs, it is clear whether the transaction is or is not the hedged
transaction. Therefore, a forecast transaction may be identified as the sale of the first 15,000 units of a
specific product during a specified three-month period, but it could not be identified as the last 15,000
units of that product sold during a three-month period because the last 15,000 units cannot be
identified when they are sold. For the same reason, a forecast transaction cannot be specified solely as a
percentage of sales or purchases during a period.
Documentation of timing of forecast transaction
For a hedge of a forecast transaction, the documentation of the hedge relationship that is established at
inception of the hedge should identify the date on which, or time period in which, the forecast
transaction is expected to occur. This is because the hedge must relate to a specific identified risk and it
must be possible to measure its effectiveness reliably. In addition, the hedged forecast transaction must
be highly probable.
To meet these criteria, an entity is not required to predict and document the exact date a forecast
transaction is expected to occur. However, it is required to identify and document the time period
during which the forecast transaction is expected to occur within a reasonably specific and generally
narrow range of time from a most probable date, as a basis for assessing hedge effectiveness. To
determine that the hedge will be highly effective, it is necessary to ensure that changes in the fair value
of the expected cash flows are offset by changes in the fair value of the hedging instrument and this test
may be met only if the timing of the cash flows occur within close proximity to each other.
5.2.2 What is 'highly probable'?

The term 'highly probable' indicates a much greater likelihood of happening than the term 'more likely
than not'. An assessment of the likelihood that a forecast transaction will take place is not based solely
on management's intentions because intentions are not verifiable. A transaction's probability should be
supported by observable facts and the attendant circumstances.
In assessing the likelihood that a transaction will occur, an entity should consider the following
circumstances:
 The frequency of similar past transactions
 The financial and operational ability of the entity to carry out the transaction
 Substantial commitments of resources to a particular activity (for example, a manufacturing facility
that can be used in the short run only to process a particular type of commodity)
 The extent of loss or disruption of operations that could result if the transaction does not occur
 The likelihood that transactions with substantially different characteristics might be used to achieve
the same business purpose (for example, an entity that intends to raise cash may have several ways
of doing so, ranging from a short-term bank loan to an offering of ordinary shares); and
 The entity's business plan.

5.2.3 Further matters to consider
The length of time until a forecast transaction is projected to occur is also a factor in determining
probability. Other factors being equal, the more distant a forecast transaction is, the less likely it is that
the transaction would be regarded as highly probable and the stronger the evidence that would be
needed to support an assertion that it is highly probable.
For example, a transaction forecast to occur in five years may be less likely to occur than a transaction
forecast to occur in one year. However, forecast interest payments for the next 20 years on variable rate
debt would typically be highly probable if supported by an existing contractual obligation.
In addition, other factors being equal, the greater the physical quantity or future value of a forecast
transaction in proportion to the entity's transactions of the same nature, the less likely it is that the
transaction would be regarded as highly probable and the stronger the evidence that would be required
to support an assertion that it is highly probable. For example, less evidence generally would be needed C
to support forecast sales of 100,000 units in the next month than 950,000 units in that month when H
A
recent sales have averaged 950,000 units per month for the past three months. P
A history of having designated hedges of forecast transactions and then determining that the forecast T
E
transactions are no longer expected to occur would call into question both an entity's ability to predict R
forecast transactions accurately and the propriety of using hedge accounting in the future for similar
forecast transactions.
7
5.3 Cash flow hedge accounting
If a cash flow hedge meets the qualifications for hedge accounting during the period it should be
accounted for as follows:
 The portion of the gain or loss on the hedging instrument that is determined to be an effective
hedge should be recognised in other comprehensive income and held in a separate
component in equity; and
 The ineffective portion of the gains or loss on the hedging instrument should be recognised in
profit or loss.
On a cumulative basis the effective portion can be calculated by adjusting the separate component of
equity associated with the hedged item to the lesser of the following (in absolute amounts):
 The cumulative gain or loss on the hedging instrument from inception of the hedge
 The cumulative change in the fair value (present value) of the expected future cash flows on the
hedged item from inception of the hedge.
Any remaining gain or loss on the hedging instrument is the ineffective portion and should be
Note that the hedged item is not itself recognised in the financial statements.
As an exception to the general rule set out above, if an entity designates a non-derivative monetary
asset as a foreign currency cash flow hedge of the repayment of the principal of a non-derivative
monetary liability, the exchange differences on both the monetary asset and the monetary liability are
recognised in profit or loss in the period in which they arise under IAS 21. IAS 39 AG 83 confirms that if
there is a hedge relationship between a non-derivative monetary asset and a non-derivative monetary
liability, changes in the foreign currency component of those financial instruments are recognised in
profit or loss.
Interactive question 3: Cash flow hedge [Difficulty level: Intermediate]

A company enters into a hedge in order to protect its future cash inflows relating to a recognised
financial asset held at amortised cost.
At inception the value of the hedging instrument was £0, but by the year end a gain of £8,800 was
made when measured at market value. The corresponding loss in respect of the future cash flows
amounted to £9,100 in fair value terms.
How should the transaction be accounted for?

Interactive question 4: Swap in cash flow hedge 1 [Difficulty level: Exam standard]
An entity issues a fixed rate debt instrument and enters into a receive-fixed, pay-variable, interest rate
swap to offset the exposure to interest rate risk associated with the debt instrument. Can the entity
designate the swap as a cash flow hedge of the future interest cash outflows associated with the debt
instrument?
Interactive question 5: Swap in cash flow hedge 2 [Difficulty level: Exam standard]
An entity manages interest rate risk on a net basis. On 1 January 20X6 it forecasts aggregate cash
inflows of £1 million on a fixed rate financial asset and aggregate cash outflows of £900,000 on a fixed
rate financial liability in the first quarter of 20X7. For risk management purposes it uses a receive-
variable, pay-fixed, forward rate agreement (FRA) to hedge the forecast net cash inflow of £100,000.
The entity designates as the hedged item the first £100,000 of cash inflows on fixed rate assets in the
first quarter of 20X7. Can it designate the receive variable, pay-fixed FRA as a cash flow hedge of the
exposure to variability to cash flows in the first quarter of 20X7 associated with the fixed rate assets?
5.4 Reclassification of gains/losses to profit or loss

If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or
liability, the associated gains or losses that were recognised previously in other comprehensive income,
should be reclassified to profit or loss in the same period or periods during which the asset acquired, or
liability assumed, affects profit or loss, such as in the periods when the interest income or expense is
recognised.
If a hedge of a forecast transaction results in the recognition of a non-financial asset or liability, then
the entity should adopt either of the following approaches as its accounting policy to be applied
consistently.
 It should reclassify the associated gains and losses that were previously recognised in other
comprehensive income into profit or loss in the same period or periods during which the asset
acquired or the liability assumed affects profit or loss (such as in the periods when a depreciation
expense or cost of sales is recognised). However if an entity expects that all or a portion of a loss
recognised in other comprehensive will not be recovered in one or more future periods, it should
reclassify to profit or loss the amount that is not expected to be recovered.
 It should remove the associated gains and losses that were recognised in other comprehensive
income and include them in the initial cost or other carrying amount of that asset or liability (this
adjustment to the carrying amount is often referred to as basis adjustment).
Both these policies result in all the gains/losses originally recognised in other comprehensive income
being reclassified to profit or loss.
If a forecast transaction for a non-financial asset or liability becomes a firm commitment, for which
fair value hedge accounting is applied, one of the above two approaches should also be followed based
on the entity's choice of accounting policy.
Worked example: Cash flow hedge

Bets Co has the £ as its functional currency and a reporting date of 31 December. Bets Co signs a
contract on 1 November 20X1 to purchase a non-current asset in foreign currency (LC) on 1 November
20X2 for LC60 million. Bets Co hedges the foreign currency risk in this transaction by entering into a
forward contract to buy LC60 million on 1 November 20X2 at £1: LC1.5.
Spot and forward exchange rates at the following dates are:
Spot Forward (for delivery on 1.11.X2)
1.11.X1 £1: LC1.45 £1: LC1.5
31.12.X1 £1: LC1.20 £1: LC1.24
1.11.X2 £1: LC1.0 £1: LC1.0 (actual)

The conditions for hedge accounting are met at 1 November 20X1.
Requirement
Show the accounting entries relating to these transactions at 1 November 20X1, 31 December 20X1
and 1 November 20X2.
Solution
Entries at 1 November 20X1
The fair value of the forward contract at inception is zero so no entries should be recorded (other than
any transaction costs), but risk disclosures should be made.
The contractual commitment to buy the asset should be disclosed if material (IAS 16). C
Entries at 31 December 20X1 H
A
The gain on the forward contract should be calculated as: P
£ T
Value of contract at 31.12.X1 (LC60m/1.24) 48,387,097 E
R
Value of contract at 1.11.X1 (LC60m/1.5) 40,000,000
Gain on contract 8,387,097
The change in the fair value of the expected future cash flows on the hedged item (which is not 7
recognised in the financial statements) should be calculated as:
£
At 31.12.X1 (LC60m/1.20) 50,000,000
At 1.11.X1 (LC60m/1.45) 41,379,310
8,620,690
As this change in fair value is greater than the gain on the forward contract, the hedge is deemed to be
fully effective and the whole of the gain on the forward should be recognised in other comprehensive
income:
Dr Financial asset (Forward a/c) £8,387,097
Cr Other comprehensive income £8,387,097
Entries at 1 November 20X2
The further gain on the forward contract should be calculated as:
£
Gain on contract 11,612,903
The further change in the fair value of the expected future cash flows on the hedged item should be
calculated as:
£
At 31.12.X1 (LC60m/1.00) 60,000,000
At 1.11.X1 (LC60m/1.20) 50,000,000
10,000,000
As this change in fair value is less than the gain on the forward contract, part of the gain on the forward
contract is said to be ineffective and this part should be recognised in profit or loss. The effective part, ie
£10m, should be recognised in other comprehensive income. The remainder should be recognised in
profit or loss:
Dr Financial asset (Forward a/c) £11,612,903
Cr Other comprehensive income £10,000,000
Cr Profit or loss £1,612,903
Note that the hedge is still highly effective (and hence hedge accounting should continue to be used):
£10,000,000/£11,612,903 = 86% which is within the 80% – 125% range.
Purchase of asset at market price
Dr Asset (LC60m/1.0) £60,000,000
Cr Cash £60,000,000

Settlement of contract to purchase non-current asset
Dr Cash £20,000,000
Cr Financial asset (Forward a/c) £20,000,000
Realisation of gain on hedging instrument
The cumulative gain of £18,387,097 recognised in other comprehensive income and held in equity
should be:
 Reclassified to profit or loss as the asset is used, ie to reduce depreciation charges over the asset's
useful life; or
 Adjusted against the initial cost of the asset (reducing future depreciation).
Interactive question 6: Foreign currency hedge [Difficulty level: Intermediate]

Entity A has a foreign currency liability payable in six months' time and it wishes to hedge the amount
payable on settlement against foreign currency fluctuations. To that end, it takes out a forward contract
to buy the foreign currency in six months' time. The conditions for hedge accounting were met.
Requirement
Should the hedge be treated as a fair value hedge of the foreign currency liability or as a cash flow
hedge of the amount to be settled in the future?
How should gains and losses on the liability and the forward contract be accounted for?
Interactive question 7: Foreign currency hedge [Difficulty level: Intermediate]

An entity exports a product at a price denominated in a foreign currency. At the date of the sale, the
entity obtains a receivable for the sale price payable in 90 days and takes out a 90-day forward
exchange contract in the same currency as the receivable to hedge its foreign currency exposure. The
conditions for hedge accounting were met.
Under IAS 21, the sale is recorded at the spot rate at the date of sale, and the receivable is restated
during the 90-day period for changes in exchange rates with the difference being taken to profit or loss
(IAS 21.23 and IAS 21.28).
Requirement
If the foreign exchange forward contract is designated as a hedging instrument, does the entity have a
choice whether to designate it as a fair value hedge of the foreign currency exposure of the receivable or
as a cash flow hedge of the collection of the receivable?
How should gains and losses on the receivable and the forward contract be accounted for?
Interactive question 8: Cash flow hedge [Difficulty level: Exam standard]

Bruntal is a manufacturer and retailer of gold jewellery.
On 31 October 20X1, the cost of Bruntal's inventories of finished jewellery was £8.280 million with a
gold content of 24,000 troy ounces. At that date their sales value was £9.938 million.
The selling price of gold jewellery is heavily dependent on the current market price of gold (plus a
standard percentage for design and production costs).
Bruntal's management wished to reduce their business risk of fluctuations in future cash inflow from sale
of the jewellery by hedging the value of the gold content of the jewellery. In the past this has proved to
be an effective strategy.
Therefore it sold futures contracts for 24,000 troy ounces of gold at £388 per troy ounce at 31 October
20X1. The contracts mature on 30 October 20X2.

On 30 September 20X2 the fair value of the jewellery was £9.186m and the forward price of gold per
troy ounce for delivery on 30 October 20X2 was £352.
Requirement
Explain how the above transactions would be treated in Bruntal's financial statements for the year ended
30 September 20X2.
Interactive question 9: Hedging [Difficulty level: Exam standard]

PQR has entered into a foreign currency forward contract, purchased to hedge the commitment to
purchase a machine in foreign currency in six months' time. C
H
Requirement A
Explain, with reference to IAS 39, how this should be accounted for. P
T
See Answer at the end of this chapter. E
R
5.5 Discontinuing cash flow hedge accounting 7
Cash flow hedge accounting should be discontinued if the hedging instrument expires or is sold,
terminated or exercised, if the criteria for hedge accounting are no longer met, a forecast transaction is
no longer expected to occur or if the entity revokes the designation.
The discontinuance should be accounted for prospectively, ie the previous accounting entries are not
reversed. The cumulative gain or loss on the hedging instrument should be reclassified to profit or loss
as the hedged item is recognised in profit or loss.
6 Hedge of a net investment
Section overview
 This section discusses issues specific to the accounting treatment of hedge of net investments.
6.1 Definition
In a hedge of a net investment in a foreign operation the hedged item is the amount of the
reporting entity's interest in the net assets of that operation. Under this definition from IAS 21
monetary items that are receivable from or payable to a foreign operation for which settlement is
neither planned nor likely to occur in the foreseeable future form part of the net investment.
The amount that an entity may designate as a hedge of a net investment may be all or a proportion of
its net investment at the commencement of the reporting period. This is because the exchange rate
differences reported in equity on consolidation which form part of a hedging relationship relate only to
the retranslation of the opening net assets. Profits or losses arising during the period cannot be
hedged in the current period. But they can be hedged in the following periods, because they will then
form part of the net assets which are subject to translation risk.
6.2 Accounting treatment

Hedges of a net investment in a foreign operation should be accounted in a similar way to cash flow
hedges, that is:
 The portion of gain or loss on the hedging instrument that is determined to be an effective
hedge should be recognised in other comprehensive income; and
 The ineffective portion should be recognised in profit or loss.

The gain or loss on the hedging instrument that has been recognised in other comprehensive income
should be reclassified to profit or loss on disposal of the foreign operation. If only part of an interest in a
foreign operation is disposed of, only the relevant proportion of this gain or loss should be reclassified to
profit or loss.
6.3 Hedging with a non-derivative financial instrument

As noted earlier in this chapter a non-derivative financial asset or liability can only be designated as a
hedging instrument for hedges of foreign currency risk. So a foreign currency borrowing can be
designated as a hedge of a net investment in a foreign operation, with the result that any translation
gain or loss on the borrowing should be recognised in other comprehensive income to offset the
translation loss or gain on the investment. (Normally gains or losses on such financial liabilities are
recognised in profit or loss.)
Worked example: Use of non-derivative to hedge a net investment

Entity A, whose functional currency is £, has a subsidiary in France. The subsidiary was purchased on 30
June 20X6 for €20 million and the acquisition was financed with a loan of €20 million. The carrying
amount of subsidiary in the consolidated financial statements (including goodwill acquired in the
business combination) is €20 million. Entity A has designated the foreign currency loan of €20 million as
a hedge of its net investment in the foreign subsidiary.
Entity A has a 30 June year end. The foreign currency rates at 30 June 20X6 and 30 June 20X7 were £1
= €1.52 and £1= €1.48 respectively. In the year ended 30 June 20X7 the exchange difference on the
opening net investment should be calculated as:
€ £
At 30 June 20X6 20,000,000 13,157,895
At 30 June 20X7 20,000,000 13,513,514
Exchange gain 355,619
There is a corresponding loss on the foreign currency loan of £355,619. Because the hedge is perfectly
effective, both the gain and the entire loss will be recognised in other comprehensive income. There is
no ineffective portion of the loss on the hedging instrument to be recognised in profit or loss.
6.4 Hedging with derivatives

A net investment can be hedged with a derivative instrument such as a currency forward contract. In
this case, however, it would be necessary to designate at inception that effectiveness can be measured
by reference to changes in spot exchange rates or changes in forward exchange rates.
6.5 IFRIC 16 Hedges of a Net Investment in a Foreign Operation

IFRIC 16 was published in July 2008. It gives guidance on accounting for the hedge of a net investment
in a foreign operation in an entity's consolidated financial statements. Practice in this area had been
inconsistent because views differed as to which risks are eligible for hedge accounting according to IFRS.
IFRIC 16 applies to an entity that hedges the foreign currency risk arising from its net investments in
foreign operations and wishes to qualify for hedge accounting in accordance with IAS 39. It does not
apply to other types of hedge accounting.
The principal effect of the change should be to eliminate the possibility of an entity applying hedge
accounting for a hedge of the foreign exchange differences between the functional currency of a foreign
operation and the presentation currency of the parent's consolidated financial statements.

6.6 Summary of hedge accounting
The following table summarises the accounting treatment under IAS 39 of the two types of hedges.
Fair value hedge Cash flow hedge
Gain or loss on hedging instrument Profit or loss Other comprehensive

income
Adjustment to hedged item Profit or loss N/A
Hedge ineffectiveness is recorded in profit or loss Yes Yes
Gains or loss reclassified to profit or loss later N/A Yes
C
6.7 Types of hedge and their treatment H
A
The following grid will be useful in distinguishing the types of hedge and their treatment. P
T
FIRM COMMITMENT FORECAST TRANSACTION E
R
(highly probable)
Either fair value hedge or cash flow
FOREIGN CURRENCY hedge Cash flow hedge
7
(Interactive question 6) (Section 5.2 illustration)
OTHER Fair value hedge Cash flow hedge

(Section 5.4 example)
(Section 4.3 example)
7 Conditions for hedge accounting

Section overview
 This section discusses in detail the conditions for hedge accounting, paying particular attention to
establishing effectiveness.
7.1 Summary of conditions

To qualify for hedge accounting a hedging relationship must meet conditions in respect of the formal
designation of the hedging relationship and the testing for hedge effectiveness. In summary the
conditions, all of which must be met, are:
 At inception of the hedge there is a formal designation and documentation of the hedging
relationship and the entity's risk management objective and strategy for undertaking the hedge
 The hedge is expected to be highly effective
 The effectiveness of the hedge can be reliably assessed
 The hedge is assessed for effectiveness on an ongoing basis
 In respect of a cash flow hedge a forecast transaction is highly probable
7.2 Designation and documentation

Documentation must include identification of the hedging instrument, the hedged item or transaction,
the nature of the risk being hedged, details of how the hedge effectiveness will be calculated and a
statement of the entity's risk management objective and strategy for undertaking the hedge.
Note that retrospective designation with the benefit of hindsight is not permitted. Hedge accounting
may only be applied prospectively, from the later of the date of designation and the date that the

formal documentation is prepared. This date may be later than the date on which an entity acquires the
hedging instrument itself.
Point to note:
Hedge accounting is prohibited if the hedging relationship is designated for only part of the life of the
hedging instrument.
In addition to the above, the documentation relating to the hedge of a forecast transaction must
include the date on, or the period in, which the forecast transaction is expected to occur. This is
because hedge accounting relates to a specific identified and designated risk, so it must be possible to
measure its effectiveness and the hedged forecast transaction has to be highly probable.
Illustration: Hedge documentation

Entity A manufactures and sells umbrellas. Its functional currency is the US dollar, but 40% of its sales
are made in the UK and denominated in sterling. Entity A forecasts highly probable sales in the UK for
the next winter season on a monthly basis. Using these forecasts it enters into forward contracts to sell
pounds sterling in exchange for dollars.
It is probably the case that Entity A is not able to forecast individual sales transactions in respect of its
umbrellas. But it can still treat a number of sales (such as the first 10,000 in any period) as a highly
probable forecast transactions and designate the forward contracts as hedging instruments under a cash
flow hedge.
7.3 Hedge effectiveness
Definition
Hedge effectiveness: The degree to which the changes in the fair value or cash flows of the hedged
item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the
hedging instrument.
Hedge effectiveness should be tested on both a prospective and retrospective basis because hedge
accounting should only be applied when
 At the time of designation the hedge is expected to be highly effective; and
 The hedge turns out to have been highly effective throughout the financial reporting periods for
which it was designated.
At a minimum an entity should assess effectiveness when preparing its interim or annual financial
statements.
Highly effective criteria
Hedge effectiveness should be determined in accordance with the methodology in the hedge
documentation. The highly effective hurdle is achieved if the actual results of a hedge are within the
range from 80% to 125%. One of the ways of calculating this is to express the absolute amount of the
change in value of the hedging instrument as a percentage of the absolute amount of the change in
value of the hedged item, or vice versa.
Methodology
IAS 39 does not specify a method to be used in assessing the effectiveness of a hedge. Several
mathematical techniques can be used to measure hedge effectiveness, including the ratio analysis
method referred to above and statistical measurement techniques such as regression analysis. If
regression analysis is used, the entity's documented policies for assessing effectiveness must specify how
the results of the regression will be assessed.
The method chosen should, however, be based on an entity's risk management strategy, documented
upfront and applied consistently over the duration of the hedging relationship.

After-tax basis
IAS 39 permits, but does not require, assessment of hedge effectiveness on an after-tax basis. If the
hedge is undertaken on an after-tax basis, it should be so designated at inception as part of the formal
documentation of the hedging relationship and strategy.
Requirement to assess effectiveness
IAS 39 requires an entity to assess hedges for hedge effectiveness on an ongoing basis. An entity cannot
assume hedge effectiveness just because the principal terms of the hedging instrument and of the
hedged item are the same. This is because hedge ineffectiveness may arise because of other attributes
such as the liquidity of the instruments or their credit risk.
It may, however, designate only certain risks in an overall exposure as being hedged and thereby
improve the effectiveness of the hedging relationship. For example, for a fair value hedge of a debt
C
instrument, if the derivative hedging instrument has a credit risk that is equivalent to the AA-rate, it may H
designate only the risk related to AA-rated interest rate movements as being hedged, in which case A
changes in credit spreads generally will not affect the effectiveness of the hedge. P
T
Periodic or cumulative assessment E
R
The issue arises as to whether hedge effectiveness should be assessed separately for each period or
cumulatively over the life of the hedging relationship. IAS 39 allows both methods.
Expected hedge effectiveness may only be assessed on a cumulative basis if the hedge is so designated 7
and that condition is incorporated into the appropriate hedging documentation. The effect of using a
cumulative basis is that even if a hedge is not expected to be highly effective in a particular period,
hedge accounting is still permitted if effectiveness is expected to remain sufficiently high over the life of
the hedging relationship. However, ineffectiveness in any period is required to be recognised in profit or
loss as it occurs.
To illustrate: an entity designates a LIBOR-based interest rate swap as a hedge of a borrowing whose
interest rate is UK base rate plus a margin. UK base rate changes perhaps once each quarter or less, in
increments of 25-50 basis points, while LIBOR changes daily. Over a period of one-two years, the hedge
is expected to be almost perfect. However, there will be quarters when UK base rate does not change at
all, while LIBOR has changed significantly. Hedge accounting is still permitted.
Illustration: Periodic or cumulative assessment

In the period by period approach the changes in the fair value of the hedging items are compared to
the changes in the fair value of the hedged item attributable to the hedged risk during each period.
The cumulative approach compares the cumulative changes in the fair value of the two instruments
from the inception of the hedge until the test date.
Period by period basis Cumulative basis
Assessment Changes in the fair value Ratio Changes in the fair value Ratio
period
Hedging Hedged item Hedging Hedged item
instrument instrument
Quarter 1 50 (50) 100% 50 (50) 100%
Quarter 2 55 (57) 96% 105 (107) 98%
Quarter 3 24 (13) 184% 129 (120) 108%
Quarter 4 (14) 4 350% 115 (116) 99%
In this example the hedge is not effective in Quarters 3 and 4 if tested on a period by period basis but it
is effective throughout the four quarters if tested on a cumulative basis. It would therefore be vital in this
case that the hedging documentation specified effectiveness testing on a cumulative basis.

7.4 Credit risk
In assessing the effectiveness of a hedge, both on inception of the hedge relationship and subsequently,
an entity must consider the likelihood of default by the counterparty to the hedging instrument.
For a cash flow hedge, if it becomes probable that a counterparty will default, an entity would be
unable to conclude that the hedging relationship is expected to be highly effective in achieving
offsetting cash flows. As a result, hedge accounting should be discontinued. For a fair value hedge, if
there is a change in the counterparty's creditworthiness, the fair value of the hedging instrument will
change, which affects the assessment of whether the hedge relationship is effective and whether it
qualifies for continued hedge accounting.
7.5 Hedge ineffectiveness: more detail

The change in the fair value or the cash flow of the hedging instrument will rarely offset exactly the
change in the fair value or the cash flow of the hedged item. The part of the change in fair value or cash
flow of the hedged item that is not offset represents the ineffectiveness of the hedging relationship. In a
fair value hedge, the change in fair value which represents ineffectiveness is automatically recognised in
profit or loss (as changes in the fair value of both the hedged item and hedging instrument are reported
there).
In a cash flow hedge the ineffective portion of the gain or loss on the hedging instrument should be
recognised in profit or loss (the effective portion being recognised in other comprehensive income).
Worked example: Measuring ineffectiveness in a fair value hedge

An entity holds significant inventories of copper for use in its production process. It enters into a
derivative in respect of all of its inventories linked to the price of copper and completes the
documentation to designate it as a hedge of changes in the fair value of the copper inventory. The
hedge is expected to be highly effective.
At the next reporting date the copper inventory has increased in fair value by £2,000 and the fair value
of the derivative is a liability of £2,100. The hedge is 105% effective (2,100/2,000). Alternatively it may
be determined as being 95.24% effective (2,000/2,100).
Requirement
Calculate the net expense in profit or loss.
Solution
The copper inventory being the hedged item, its carrying amount is increased by the £2,000 increase in
its fair value, with the same amount being recognised in profit or loss. The derivative is recorded as a
financial liability at £2,100, with the same amount being recognised in profit or loss. The net expense in
profit or loss of £100 represents the hedge ineffectiveness.
Worked example: Ineffectiveness in a cash flow hedge

On 30 September 20X5, Entity A hedges the anticipated sale of 24 tonnes of pulp on 1 March 20X6 by
entering into a short forward contract on 24 tonnes of pulp. The contract requires net settlement in
cash determined as the difference between the future spot price on a specified commodity exchange
and £1,000. Entity A expects to sell the pulp in a different local market. Entity A determines that the
forward contract is an effective hedge of the anticipated sale and that the other conditions for hedge
accounting are met. Hedge effectiveness is assessed by comparing the entire change in the fair value of
the forward contract with the change in the fair value of the expected cash inflows. On 31 December
20X5, the spot price of pulp has increased both in the local market and on the exchange. The increase
in the local market exceeds the increase in the exchange. As a result the present value of the expected
cash inflow from the sale on the local market is £1,100. The fair value of the Entity A's forward contract
is negative £80. Entity A determines that the hedge is still highly effective.
Requirement
Calculate any hedge ineffectiveness that should be recognised in profit or loss.

Solution
There is no ineffectiveness to be recognised in profit or loss.
In a cash flow hedge, the effective portion of the hedge is limited to the lower of:
 The cumulative gain/loss on the hedging instrument, ie £80; and
 The cumulative change in fair value of the hedged item, ie £100.
The gain/loss on the hedging instrument is the lower amount, so there is no ineffectiveness to be
recognised in profit or loss. The accounting entry required is
Dr Other comprehensive income £80
Cr Forward £80
C
7.6 Macro hedging H
A
Macro hedging, also known as portfolio hedging is a technique whereby financial instruments with P
similar risks are grouped together and the risks of the portfolio are hedged together. Often this is done T
on a net basis with assets and liabilities included in the same portfolio. For example, instead of using E
interest rate swaps to hedge interest rate exposure on a loan by loan basis, banks hedge the risk of their R
entire loan book or specific portions of the loan book.
In general, IAS 39 does not permit an overall net position to be designated as a hedged item, for 7
example a UK entity that has to make a purchase of £10m in 30 days and a sale of £2m in 30 days
cannot designate the net purchase of £8m as the hedged item. The exception is that IAS 39 permits
macro hedging for the interest rate risk associated with a portfolio of financial assets or liabilities. There
are, however, clearly prescribed procedures that must be followed in order to do so.
8 Disclosures
Section overview
 This section covers the disclosures required in respect of hedging.
Under IFRS 7 an entity should disclose the following separately for each type of hedge described in
IAS 39 (ie fair value hedges, cash flow hedges, and hedges of net investments in foreign operations):
 A description of each type of hedge
 A description of the financial instruments designated as hedging instruments and their fair values
at the reporting date; and
 The nature of the risks being hedged
For cash flow hedges, an entity should disclose:
 The periods when the cash flows are expected to occur and when they are expected to affect profit
or loss;
 A description of any forecast transaction for which hedge accounting had previously been used,
but which is no longer expected to occur
 The amount that was recognised in other comprehensive income during the period
 The amount that was re-classified from equity to profit or loss for the year, showing the amount
included in each line item in the statement of comprehensive income; and
 The amount that was re-classified from equity during the period and included in the initial cost or
other carrying amount of a non-financial asset or non-financial liability whose acquisition or
incurrence was a hedged highly probable forecast transaction
An entity should disclose separately:
 In fair value hedges, gains or losses
– On the hedging instrument; and
– On the hedged item attributable to the hedged risk

 The ineffectiveness recognised in profit or loss that arises from cash flow hedges; and
 The ineffectiveness recognised in profit or loss that arises from hedges of net investments in foreign
operations.
In September 2012, the IASB issued a Review Draft of the hedging section of IFRS 9 Financial
Instruments, which is to replace IAS 39 with effect from January 2015. This proposes a principles-based
approach to hedge accounting and to align accounting with risk management activities. The ED was
covered in Chapter 6, Section 6.17.

Summary
IAS 39 Financial Instruments:

Recognition and Measurement
Designated C
H
Hedging Relationships
A
P
T
Hedged items Hedging instrument E
R
Hedge Accounting
Conditions
7
Hedge effectiveness Documentation
Types of Hedge
Fair value hedges Cashflow hedges Hedge of

net investment
IFRS 7 Financial Instruments:

Disclosures
Hedge accounting

Self-test
1 Hedging
A company owns 100,000 barrels of crude oil which were purchased on 1 July 20X2 at a cost of
$26.00 per barrel.
In order to hedge the fluctuation in the market value of the oil the company signs a futures
contract on the same date to deliver 100,000 barrels of oil on 31 March 20X3 at a futures price of
$27.50 per barrel. The conditions for hedge accounting were met.
Due to unexpected increases in production, the market price of oil on 31 December 20X2 was
$22.50 per barrel and the futures price for delivery on 31 March 20X3 was $23.25 per barrel at
that date.
Requirement
Explain the impact of the transactions on the financial statements of the company for the year
ended 31 December 20X2.
2 Columba
The Columba Company has hedged the cash flows relating to its interest rate risk by purchasing an
interest rate cap. The conditions for hedge accounting were met.
Interest rates have risen and the hedge has proved to be 85% effective based on the amount
hedged. Additional interest charges up to the end of the financial year amount to £17,000 whilst
the fair value of the interest rate cap increased by £20,000.
Requirement
What amount relating to the interest rate cap should be recorded in profit or loss?
3 Pula
The Pula Company manufactures heavy engineering equipment which it sells in many countries
throughout the world. The functional currency of Pula is the £.
On 1 November 20X7 Pula entered into contract with the Roadmans Company, whose functional
currency is the N$, to sell a bulldozer for delivery on 1 April 20X8. The contract price is fixed in N$.
Also on 1 November 20X7, Pula entered into a foreign currency forward contract to hedge its
future exposure to changes in the £:N$ exchange rate, arising from the contract with Roadmans.
The conditions for hedge accounting were met.
Requirement
What designations are available to Pula in respect of the hedging arrangement?
4 Macgorrie
The Macgorrie Company makes silver wire. On 30 June 20X7 Macgorrie enters into a firm
commitment to buy 110 tonnes of silver on 31 December 20X8. The spot price of silver at 30 June
is £350 per tonne.
Also on 30 June 20X7, in order to reduce the risk of increases in silver prices, Macgorrie enters into
a forward contract which is a derivative, to buy 90 tonnes of silver at £350 per tonne on 31
December 20X8. The forward contract has a nil fair value at 30 June 20X7. Macgorrie has
designated the forward contract as a fair value hedge. The conditions for hedge accounting were
met.
On 31 December 20X7 the spot price of silver was £385 per tonne and the forward contract had a
positive fair value of £2,835.
Requirement
Indicate whether the following statements are true or false in respect of the hedging arrangement
in the financial statements of Macgorrie for the year to 31 December 20X7.
(a) The unhedged 20 tonnes of silver must be part of the hedge effectiveness calculation.
(b) The hedging arrangement falls within the required range of 80% to 125% for the hedge to be
highly effective.

Technical reference
Hedging relationships IAS 39.71
 Types of hedging relationships IAS 39.86-87
 Examples IAS 39 AG 102-104
Hedge accounting
 Definition IAS 39.85 C

H
 Conditions IAS 39.88 A
P
Hedged items T
E
 Qualifying item IAS 39.78-80, AG 99A R
 Items that cannot be designated IAS 39 AG 98-99
 Intra-group transactions IAS 39.80 7
 Portion of an instrument as a hedged item IAS 39.81
 Groups of assets as hedged instruments IAS 39.83-84
 Interest rate exposure of a portfolio IAS 39.81A
 Non-financial assets IAS 39.82, AG 100
Hedging instruments
 Qualifying instruments IAS 39.72-73
 Written and purchased options IAS 39 AG 94
 Non qualifying instruments IAS 39 AG 95-97
 Designations of hedging instruments IAS 39.74-77
Fair value hedges

 Definition IAS 39.86
 Recognition of gains or losses IAS 39.89
 Discontinuing fair value hedge accounting IAS 39.91
Cash flow hedges

 Definition IAS 39.86
 Recognitions of gain or loss IAS 39.95
 Hedge of a forecast transaction IAS 39.97
 Discontinuing cash flow hedge accounting IAS 39.101
Hedges of a net investment IAS 39.102
Hedge effectiveness
 Criteria IAS 39 AG 105
 Timing of assessment IAS 39 AG 106
 Methods of assessing effectiveness IAS 39 AG 107

1 Hedging
The futures contract was entered into to protect the company from a fall in oil prices and hedge
the value of the inventories. It is therefore a fair value hedge.
The inventories should be recorded at their cost of $2,600,000 (100,000 barrels at $26.00) on 1
July 20X2.
The futures contract has a zero value at the date it is entered into, so no entry is made in the
(Tutorial note: however, the existence of the contract and associated risk would be disclosed from
that date in accordance with IFRS 7.)
At the year end the inventories should be measured at the lower of cost and net realisable value.
Hence they should be measured at $2,250,000 (100,000 barrels at $22.50) and a loss of $350,000
However, a gain has been made on the futures contract:
$
The company has a contract to sell 100,000 barrels on 31 March 20X3 at $27.50 2,750,000
A contract entered into at the year end would sell these barrels at $23.25 on 31 March 2,325,000
20X3
Gain (= the value the contract could be sold on for to a third party) 425,000
The gain on the futures contract should also be recognised in profit or loss:
Dr Future contract asset $425,000
Cr Profit or loss $425,000
The net effect on profit or loss is a gain of $75,000 ($425,000 less $350,000) whereas without the
hedging contract there would have been a loss of $350,000.
Note:
If the fair value of the inventories had increased, the carrying amount of the inventories should
have been increased by the same amount and this gain also recognised in profit or loss (normally
gains on inventories are not recognised until the goods are sold). A loss would have occurred on
the futures contract, which should also have been recognised in profit or loss.
2 Columba
A gain of £3,000 should be recognised in profit or loss.
The ineffective portion of the gain or loss on the hedging instrument should be recognised in profit
or loss. In a cash flow hedge the amount to be recognised in other comprehensive income is the
lower of:
 The cumulative gain/loss on the hedging instrument, ie £20,000; and
 The cumulative change in fair value of the hedged item, ie £17,000
So £17,000. This leaves £3,000 of the increase in the fair value of the cap to be recognised in
profit or loss.
3 Pula
The hedging relationship may be designated either a fair value hedge or a cash flow hedge.
The contract to sell the bulldozer represents a firm commitment with Roadmans, not merely a
proposed transaction, and it is expressed in a currency other than Pula's functional currency. A
hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value
hedge or as a cash flow hedge.

4 Macgorrie
Statement (a) is false.
Macgorrie has only attempted to protect itself against price increases relating to 90 tonnes of the
silver it needs to purchase. IAS 39.AG107A permits the hedged item to be designated as the
hedged amount of the exposure in determining effectiveness. The unhedged 20 tonnes can
therefore be ignored. Hedge effectiveness is reduced as the forward contract is not perfectly
matched against the underlying commodity price.
Statement (b) is true.
The change in value of the derivative per tonne is £2,835/90 = £31.50.
The effective element is (£31.50 change in derivative value per tonne/£35 change in spot price per
tonne)% = 90%, which falls within the specified range. C
H
A
P
T
E
R


The futures contract was intended to protect the company from a fall in oil prices (which would have
reduced the profit when the oil was eventually sold). However, oil prices have actually risen, so that the
company has made a loss on the contract.
(a) Without hedge accounting
The futures contract is a derivative and therefore should be remeasured to fair value under IAS 39.
The loss on the futures contract should be recognised in profit or loss:
Dr Profit or loss (40,000  [£24 – £22]) £80,000
(b) With hedge accounting
The loss on the futures contract should be recognised in profit or loss, as before.
There is an increase in the fair value of the inventories:
£
Fair value at 31 December 20X3 (40,000  £22.25) 890,000
Fair value at 1 December 20X3 = cost (800,000)
Gain 90,000
The gain should also be recognised in profit or loss and adjusted against the carrying amount of
the inventories:
Dr Inventory £90,000
The net effect on profit or loss is a gain of £10,000, compared with a loss of £80,000 without
hedging.
Note: The hedge is highly effective: 80,000/90,000 = 89% which is within the 80% – 125% range.

Yes. The inventories may be hedged for changes in fair value due to changes in the copper price
because the change in fair value of inventories will affect profit or loss when the inventories are sold or
their carrying amount is written down. The adjusted carrying amount becomes the cost basis for the
purpose of applying the lower of cost and net realisable value test under IAS 2.
The hedging instrument used in a fair value hedge of inventories may alternatively qualify as a cash flow
hedge of the future sale of the inventory.

The hedge is fully effective as the gain on the hedging instrument is less than the loss on the cash flows
and the gain of £8,800 is therefore all recognised in other comprehensive income (IAS 39 para 95-96).
The double entry is:
DEBIT Hedging instrument (SOFP) £8,800
CREDIT Other comprehensive income £8,800

No. A cash flow hedge is defined a hedge of the exposure to variability in cash flows attributable to a
particular risk. In this case, the issued debt instrument does not give rise to any exposure to volatility in
cash flows since the interest is calculated at a fixed rate.

The entity may designate the swap as a fair value hedge of the debt instrument, but it cannot designate
the swap as a cash flow hedge of the future cash outflows of the debt instrument.

No. The FRA does not qualify as a cash flow hedge of the cash flow relating to the fixed rate assets,
because they do not have a cash flow exposure.
The entity could, however, designate the FRA as a hedge of the fair value exposure that exists before the
cash flows are remitted.

IAS 39 allows both of these two methods.
C
If the hedge is treated as a fair value hedge, the gain or loss on the fair value remeasurement of the H
hedging instrument and the gain or loss on the fair value remeasurement of hedged item for the A
hedged risk should be recognised immediately in profit or loss. P
T
If the hedge is treated as a cash flow hedge, the portion of the gain or loss on remeasuring the forward E
contract that is an effective hedge should be recognised in other comprehensive income. The amount R
should be reclassified in profit or loss in the same period or periods during which the hedged item (the
liability) affects profits or loss, ie when the liability is remeasured for changes in foreign exchange rates.
Therefore, if the hedge is effective, the gain or loss on the derivative is released to profit or loss in the 7
same periods during which the liability is measured, not when the payment occurs.

The entity does have this choice.
If the entity designates the foreign exchange contract as a fair value hedge, the gain or loss from
remeasuring the forward exchange contract at fair value is recognised immediately in profit or loss and
the gain or loss on remeasuring the receivable is also recognised in profit or loss.
If the entity designates the foreign exchange contract as a cash flow hedge of the foreign currency risk
associated with the collection of the receivable, the portion of the gain or loss that is determined to be
an effective hedge should be recognised in other comprehensive income, and the ineffective portion in
profit or loss. The amount held in equity should be reclassified to profit or loss in the same period or
periods during which changes in the measurement of the receivable affect profit or loss.

Bruntal is hedging the volatility of the future cash inflow from selling the gold jewellery. The futures
contracts can be accounted for as a cash flow hedge in respect of those inflows, providing the criteria
for hedge accounting are met.
The gain on the forward contract should be calculated as:
£
Forward value of contract at 31.10.X1 (24,000 × £388) 9,312,000
Forward value of contract at 30.9.X2 (24,000 × £352) 8,448,000
Gain on contract 864,000
The change in the fair value of the expected future cash flows on the hedged item (which is not
recognised in the financial statements) should be calculated as:
£
At 31.10.X1 9,938,000
At 30.9.X2 9,186,000
752,000
As this change in fair value is less than the gain on the forward contract, the hedge is not fully effective
and only £752,000 of the gain on the forward should be recognised in other comprehensive income.
The remainder should be recognised in profit or loss:

Dr Financial asset (Forward a/c) £864,000
Cr Other comprehensive income £752,000
Note that the hedge is still highly effective (and hence hedge accounting should continue to be used):
£752,000/£864,000 = 87% which is within the 80% – 125% range.
Note: Bruntal could also have accounted for this transaction as a fair value hedge, if, at inception, its
documented objective of the hedge had been to hedge the fair value of its inventories.

The forward qualifies for hedge accounting if it meets the following conditions:
 It is designated as a hedge on entering into the contract (including documentation of company's
strategy)
 It is expected to be highly effective during its whole life (ie gains/losses on the hedging instrument
vs losses/gains on the hedged item or vice versa fall within the ratio 80% to 125% – this is likely to
be the case with a foreign currency forward contract)
 The hedge effectiveness can be reliably measured.
Foreign currency hedges of firm commitments may be accounted for as either a cash flow hedge or a
fair value hedge.
The machine is not yet recognised as an asset, so if the contract is classed as a cash flow hedge, any
gain or loss on the hedging instrument is split into two components:
 The effective portion of the hedge (which matches the change in expected cash flow) is recognised
initially in other comprehensive income (and held in reserves). It is reclassified to profit or loss
either when the asset is recognised (adjusting the asset base and future depreciation) or when the
cash flow is recognised in profit or loss (eg by depreciation). Both options therefore apply the
accruals concept.
 The ineffective portion of the hedge is recognised in profit or loss immediately as it has not hedged
anything.
If the contract is classed as a fair value hedge, all gains and losses on the hedging instrument must be
recognised immediately in profit or loss. However, in order to match those against the asset hedged, the
gain or loss on the fair value of the asset hedged is also recognised in profit or loss (and as an asset or
liability in the statement of financial position). This is arguably less transparent as it results in part of the
asset value (the change in fair value) being recognised in the statement of financial position before the
purchase actually occurs. It is for this reason that IAS 39 allows a foreign currency forward contract to
be accounted for as a cash flow hedge.
(Tutorial note: Gearing will be different depending on whether the forward contract is accounted for as
a cash flow hedge or a fair value hedge {and whether a gain or loss on the hedging instrument occurs}.
Gearing will be less volatile if a fair value hedge is used because the change in fair value of the hedged
asset is also recognised, offsetting gains or losses on the hedging instrument; for the cash flow hedge
this is not the case until the asset is purchased {and recognised}.)

CHAPTER 8
Employee benefits
Introduction
Topic List
1 Objectives and scope of IAS 19 Employee Benefits
2 Short-term employee benefits
3 Post-employment benefits overview
4 Defined contribution plans
5 Defined benefit plans – recognition and measurement
6 Defined benefit plans – other matters
7 Defined benefit plans – disclosure
8 Other long-term employee benefits
9 Termination benefits
10 IAS 19 Employee Benefits and UK GAAP
11 Reasons for 2011 revision of IAS 19
Technical reference
259
Introduction
 Distinguish between a defined contribution and defined benefit plan in accordance with
IAS 19 Employee Benefits
 Demonstrate an understanding and application of the recognition and measurement
criteria for defined contribution and defined benefit plans
 Demonstrate an understanding and application of the recognition and measurement
criteria for short-term and other long-term benefits and termination benefits
 Demonstrate and apply knowledge of the key disclosure requirements of IAS 19
 Apply knowledge and understanding of IAS 19 in particular circumstances through

calculations

1 Objectives and scope of IAS 19 Employee Benefits
Section overview
 IAS 19 considers the following employee benefits:
– Short-term employee benefits
– Post-employment benefits
– Other long-term employee benefits
– Termination benefits
IAS 19 should be applied by all entities in accounting for the provision of all employee benefits, except
those benefits which are equity-based and to which IFRS 2 applies. The Standard applies regardless of
whether the benefits have been provided as part of a formal contract or an informal arrangement.
Employee benefits are all forms of consideration, for example cash bonuses, retirement benefits and
private health care, given to an employee by an entity in exchange for the employee's services.
A number of accounting issues arise due to:
 The valuation problems linked to some forms of employee benefits; and
 The timing of benefits, which may not always be provided in the same period as the one in which
the employee's services are provided.
IAS 19 is structured by considering the following employee benefits:
C
 Short-term employee benefits; such as wages, salaries, bonuses and paid holidays
H
 Post-employment benefits; such as pensions and post-retirement health cover A
 Other long-term employee benefits; such as sabbatical and long-service leave P
 Termination benefits; such as redundancy and severance pay T
E
R
2 Short-term employee benefits

8
Section overview
 Short-term employee benefits are those that fall within 12 months from the end of the period in
which the employees provide their services. The required accounting treatment is to recognise the
benefits to be paid in exchange for the employee's services in the period on an accruals basis.
2.1 All short-term benefits
Definition
Short-term employee benefits: Short-term employee benefits are employee benefits (other than
termination benefits) that fall due within 12 months from the end of the period in which the employees
provide their services.
Short-term employee benefits include:

 Wages, salaries and social security contributions;
 Short-term absences where the employee continues to be paid, for example paid annual vacation,
paid sick leave and paid maternity/paternity leave. To fall within the definition, the absences should
be expected to occur within 12 months of the end of the period in which the employee services
were provided;
 Profit-sharing and bonuses payable within 12 months of the end of the period; and
 Non-monetary benefits, for example private medical care, company cars and housing.
Employee benefits 261

The application of the accruals concept in relation to liabilities means that a short-term benefit should
therefore be recognised as an employee provides his services to the entity on which the benefits are
payable. The benefit will normally be treated as an expense, and a liability should be recognised for any
unpaid balance at the year-end.
2.2 Short-term compensated absences
Definition
Short-term compensated absences: Compensated absences are periods of absence from work for
which the employee receives some form of payment and which are expected to occur within 12 months
of the end of the period in which the employee renders the services.
Examples of short-term compensated absences are paid annual vacation and paid sick leave.
Short-term compensated absences fall into two categories:
 Accumulating absences. These are benefits, such as paid annual vacation, that accrue over an
employee's period of service and can be potentially carried forward and used in future periods; and
 Non-accumulating absences. These are benefits that an employee is entitled to, but are not
normally capable of being carried forward to the following period if they are unused during the
period, for example paid sick leave, maternity leave and compensated absences for jury service.
The cost of providing compensation for accumulating absences should be recognised as an expense as
the employee provides the services on which the entitlement to such benefits accrues. Where an
employee has an unused entitlement at the end of the reporting period and the entity expects to
provide the benefit, a liability should be created.
The cost of providing compensation for non-accumulating absences should be expensed as the
absences occur.
Worked example: Paid vacation

An entity has five employees and each is entitled to 20 days' paid vacation per year, at a rate of £50 per
day. Unused vacation is carried forward to the following year.
At the year end, four of the employees have used their full holiday entitlement; the remaining one has
four days holiday to carry forward.
All five employees work for the entity throughout the year and are therefore entitled to their 20 days of
vacation.
Requirement
How should the expense be recognised in the financial statements?
Solution
An expense should be recognised as part of staff costs for:
5 employees × 20 days × £50 = £5,000
Four of the employees use their complete entitlement for the year and the other, having used 16 days is
permitted to carry forward the remaining four days to the following period. A liability will be recognised
at the period end for:
1 employee × 4 days × £50 = £200

2.3 Profit-sharing and bonus plans
An entity should recognise an expense and a corresponding liability for the cost of providing profit-
sharing arrangements and bonus payments when:
 The entity has a present legal or constructive obligation. The legal obligation arises when payment
is part of an employee's employment contract. The constructive obligation arises where past
performance has led to the expectation that benefits will be payable in the current period.
 A reliable estimate of the obligation can be made.
Worked example: Bonus plan

An entity has a contractual agreement to pay a total of 4% of its net profit each year as a bonus. The
bonus is divided between the employees who are with the entity at its year end. The following data is
relevant:
Net profit: £120,000
Average employees 5
Employees at start of year 6
Employees at end of year 4
Requirement
How should the expense be recognised?
Solution
C
An expense should be recognised for the year in which the profits were made and therefore the H
employees' services were provided, for: A
P
£120,000 × 4% = £4,800 T
E
Each of the four employees remaining with the entity at the year end is entitled to £1,200. A liability of R
£4,800 should be recognised if the bonuses remain unpaid at the year end.
8
Conditions may be attached to such bonus payments; commonly, the employee must still be in the
entity's employment when the bonus becomes payable. An estimate should be made based on the
expectation of the level of bonuses that will ultimately be paid. IAS 19 sets out that a reliable estimate
for bonus or profit-sharing arrangements can be made only when:
 There are formal terms setting out determination of the amount of the benefit;
 The amount payable is determined by the entity before the financial statements are authorised for
issue; or
 Past practice provides clear evidence of the amount of a constructive obligation.
Worked example: Annual bonus

An entity with a 30 June year end has a past practice of paying an annual bonus to employees, although
it has no contractual obligation to do so. Its practice is to appropriate 4% of its pre-tax profits, before
charging the bonus, to a bonus pool and pay it to those employees who remain in employment on the
following 30 September.
The total bonus is allocated to employees in proportion to their 30 June salaries, and amounts due to
those leaving over the next three months are retrieved from the bonus pool for the benefit of the entity.
Past experience is that employees with salaries representing 8% of annual salaries leave employment by
30 September. The entity's pre-tax profits for the year ended 30 June 20X5 were £4 million.
Requirement
How should the bonus be recognised in the financial statements?

Solution
The bonus to be recognised as an expense in the year ended 30 June 20X5 is:
£4m × 4% × (100 – 8)% = £147,200.
3 Post-employment benefits overview
Section overview
 Post-employment benefits are employee benefits which are payable after the completion of
employment.
These can be in the form of either:
– Defined contribution schemes where the future pension depends on the value of the fund.
– Defined benefit schemes where the future pension depends on the final salary and years
worked.
Definition
Post-employment benefits: Post-employment benefits are employee benefits (other than termination
benefits) which are payable after the completion of employment. The benefit plans may have been set
up under formal or informal arrangements.
Post-employment benefits include retirement benefits such as:

 Pensions
 Continued private medical care
 Post-employment life assurance
There are two main types of post-employment benefit schemes:
 Defined contribution schemes (money purchase schemes)
 Defined benefit schemes (final salary schemes)
These two alternative schemes are discussed in more detail below.
A pension scheme will normally be held in the form of a trust separate from the sponsoring employer.
Although the directors of the sponsoring company may also be trustees of the pension scheme, the
sponsoring company and the pension scheme are separate legal entities that are accounted for
separately. IAS 19 covers accounting for the pension scheme in the sponsoring company's accounts.
3.1 Defined contribution plans

Characteristics of a defined contribution plan are:
 Contributions into the plan are fixed, normally at a percentage of an employee's salary
 The amount of pension paid to retirees is not guaranteed and will depend upon the size of the
plan, which in turn depends upon the performance of the pension fund investments
Variables – returns on investments
Time
defined (therefore)
contributions variable
benefits

Risk associated with defined contribution schemes
Contributions are usually paid into the plan by both the employer and the employee. The expectation is
that the investments made will grow through capital appreciation and the reinvestment of returns and
that on a member's retirement, the plan should have grown to be sufficient to provide the anticipated
benefits.
If the investments have not performed as anticipated, the size of the plan will be smaller than initially
anticipated and therefore there will be insufficient assets to meet the expected benefits. This
insufficiency of assets is described as the investment risk and is carried by the employee.
The other main risk with retirement plans is that a given amount of annual benefit will cost more than
expected if, for example, life expectancy has increased markedly by the time benefits come to be drawn;
this is described as the actuarial risk and, in the case of defined contribution plans, this is also carried by
the employee.
Definitions
Investment risk: This is defined as the risk that there will be insufficient funds in the plan to meet the
expected benefits.
Actuarial risk: This is the risk that the actuarial assumptions such as those on employee turnover, life
expectancy or future salaries vary significantly from what actually happens.
3.2 Defined benefit plans C

H
These are defined by IAS 19 as all plans other than defined contribution plans. A
P
Characteristics of a defined benefit plan are: T
E
 The amount of pension paid to retirees is defined by reference to factors such as length of service R
and salary levels (ie it is guaranteed)
 Contributions into the plan are therefore variable depending upon how the plan is performing in
relation to the expected future obligation (ie if there is a shortfall, contributions will increase and 8
vice versa)
Variables – returns on investments, mortality rates, etc
Time
(therefore) defined
variable benefits
contributions
Contribution levels
The actuary advises the company on contributions necessary to produce the defined benefits ('the
funding plan'). It cannot be certain in advance that contributions plus returns on investments will equal
benefits to be paid.
Formal actuarial valuations will be performed (eg every three years) to reveal any surplus or deficit on
the scheme at a given date. Contributions may be varied as a result; for example, the actuary may
recommend a contribution holiday (a period during which no contributions are made) to eliminate a
surplus.
Risk associated with defined benefit schemes
As the employer is obliged to make up any shortfall in the plan, it is effectively underwriting the
investment and actuarial risk associated with the plan. Thus in a defined benefit plan, the employer
carries both the investment and the actuarial risk.

3.2.1 Types of defined benefit plans
There are two types of defined benefit plan:
 Funded plans: these plans are set up as separate legal entities and are managed independently,
often by trustees. Contributions paid by the employer and employee are paid into the separate
legal entity. The assets held within the separate legal entities are effectively ring-fenced for the
payments of benefits. Funded plans, illustrated diagrammatically below, represent the most
common arrangement.
The
company
Pays
contributions
Separate legal
The
entity under
pension
trustees
scheme
Pays Receives pension

contributions and other benefits
on retirement
The
employee
 Unfunded plans: these plans are held within employer legal entities and are managed by the
employers' management teams. Assets may be allocated towards the satisfaction of retirement
benefit obligations, although these assets are not ring-fenced for the payment of benefits and
remain the assets of the employer entity. In the UK and the US, unfunded plans are common in the
public sector but rare in the private sector. Unfunded plans are, however, the normal method of
pension provision in many European countries (eg Germany and France) and also in Japan.
3.2.2 Plans with promised returns on contributions

IAS 19 gives a number of examples of plans that would be deemed to be defined benefit plans even
though on the face of it these may appear to be defined contribution. Examples include circumstances
where an entity's obligation is not limited to an agreed level of contributions through either a legal or a
constructive obligation ie through an entity's past practices. Examples include:
 Where there is a guaranteed level of return on contributions made or on the assets of the plan;
In practical terms this means that the employee benefits from the upside potential on the
investment but has a level of protection from downside risk.
 Where a plan's level of benefits is not linked solely to the amount of contributions made into the
plan; or
 Where informal practices have led to the entity having a constructive obligation to provide
additional benefits under a plan. A past practice of increasing benefits over and above the level due
from the plan, to protect the retired person against inflation for example, would create a
constructive obligation, even if the entity has no legal requirement to increase benefits.
Worked example: Defined contribution or defined benefit?

Scenario 1 – Entity ABC has a separately constituted retirement benefit plan for its employees which sets
out that both ABC and its employees contribute 7% of annual salaries into the plan; contributions in
respect of an individual employee create a right to a specified proportion of the plan assets, which on
retirement is then used to buy the employee an annuity.
This is a defined contribution plan, because there appears to be no obligation on the part of ABC, other
than to pay its annual 7% contribution.

Scenario 2 – Entity DEF has a separately constituted retirement benefit plan for its employees; the plan
is the same as the ABC plan, set out above, except that DEF has a contractual obligation to top-up the
plan assets if the return (calculated according to the rules) on these assets in any year is below 5%.
This is a defined benefit plan, because DEF has provided a guarantee over and above its obligation to
make contributions.
Scenario 3 – Entity GHI has a separately constituted retirement benefit plan for its employees; the plan
is the same as the ABC plan, set out above. For some years GHI has made additional payments directly
to retired ex-employees if the increase in the general price index exceeds 7% in any year. Such
payments are at the discretion of GHI.
This is a defined benefit plan, because over and above its obligation to make contributions GHI has a
past practice of increasing benefits in payment over and above the level due from the plan. This creates
a constructive obligation that the entity will continue to do so.
4 Defined contribution plans
Section overview
 Accounting for defined contribution plans is straightforward as the obligation is determined by the
amount paid into the plan in each period.
C
H
4.1 Recognition and measurement A
P
Contributions into a defined contribution plan by an employer are made in return for services provided T
by an employee during the period. The employer has no further obligation for the value of the assets of E
the plan or the benefits payable. R
 The entity should recognise contributions payable as an expense in the period in which the
employee provides services (except to the extent that labour costs may be included within the cost 8
of assets).
 A liability should be recognised where contributions arise in relation to an employee's service, but
remain unpaid at the period end.
In the unusual situation where contributions are not payable during the period (or within 12 months of
the end of the period) in which the employee provides his or her services on which they accrue, the
amount recognised should be discounted, to reflect the time value of money.
 Any excess contributions paid should be recognised as an asset (prepaid expenses) but only to the
extent that the prepayment will lead to a reduction in future payments or a cash refund.
Worked example: Defined contribution plan

Mouse Co agrees to contribute 5% of employees' total remuneration into a post-employment plan each
period.
In the year ended 31 December 20X9, the company paid total salaries of £10.5 million. A bonus of
£3 million based on the income for the period was paid to the employees in March 20Y0.
The company had paid £510,000 into the plan by 31 December 20X9.
Requirement
Calculate the total expense for post-employment benefits for the year and the accrual which will appear
in the statement of financial position at 31 December 20X9.

Solution
£
Salaries 10,500,000
Bonus 3,000,000
13,500,000 × 5% = £675,000
£ £
Dr Staff costs expense 675,000
Cr Cash 510,000
Cr Accruals 165,000
4.2 Disclosure requirements

Where an entity operates a defined contribution plan during the period, it should disclose:
 The amount that has been recognised as an expense during the period in relation in relation to the
plan
 A description of the plan
5 Defined benefit plans – recognition and measurement
Section overview
 The accounting treatment for defined benefit plans is more complex than that applied to defined
contribution plans:
– The value of the pension plan is recognised in the sponsoring employer's statement of
financial position.
– Movements in the value of the pension plan are broken down into constituent parts and
accounted for separately.
5.1 The problem

As we have seen, contributions to defined benefit schemes will vary depending on whether the actuary
assesses the value of the plan to be adequate to meet future obligations.
In some instances there will be a shortfall, in which case the actuary will advise increased contributions.
In other instances there may be a surplus, in which case the actuary may recommend a contributions
holiday. Contributions will therefore vary substantially from year to year.
For this reason, it is inappropriate to apply the accounting treatment for defined contribution schemes
and expense contributions through profit or loss.
5.2 Introduction to accounting for defined benefit plans

IAS 19 instead requires that the defined benefit plan is recognised in the sponsoring entity's statement
of financial position as either a liability or asset depending on whether the plan is in deficit or surplus.
The value of the pension plan is calculated in its simplest form as:
£
Present value of the defined benefit obligation at the reporting date X
Fair value of plan assets at the reporting date (X)
Plan deficit/surplus X/(X)

5.2.1 Present value of the defined benefit obligation
Definition
Defined benefit obligation: The defined benefit obligation is the present value of all expected future
payments required to settle the obligation resulting from employee service in the current and prior
periods.
Expected future payments

Expected future payments are based upon a number of assumptions and estimates, such as:
 The final benefits payable under the plan (often dependent on future salaries as benefits are often
quoted as a percentage of the employee's final salary), and
 The number of members who will draw benefits (this will in turn depend on employee turnover
and mortality rates).
Discounting to present value
Once determined, the expected future benefits should be discounted to present value (including those
which may become payable within 12 months) using a discount rate determined by reference to:
 Market yields on high-quality fixed-rate corporate bonds at the reporting date, or where there is no
market in such bonds
 Market yields on government bonds C
H
The corporate or government bonds should be denominated in the same currency as the defined A
benefit obligation, and be for a similar term. P
T
Note: The examples of discount rates used in this chapter are merely to illustrate relevant calculations E
and may therefore be rather higher than would currently be found in practice. R
Performance of valuations
IAS 19 encourages the use of a qualified actuary to measure the defined benefit obligation. This is not, 8
however, a requirement.
Frequency of valuations
Valuations are not required at each reporting date, however they should be carried out sufficiently
regularly to ensure that amounts recognised are not materially different from those which would be
recognised if they were valued at the reporting date.
5.2.2 Fair value of plan assets
Definition
Plan assets: Plan assets are defined as those assets held by a long-term benefit fund and those insurance
policies which are held by an entity, where the fund/entity is legally separate from the employer and
assets/policies can only be used to fund employee benefits.
Investments owned by the employer which have been earmarked for employee benefits but which the
employer could use for different purposes are not plan assets.

Definition
Fair value: Fair value is the price that would be received to sell an asset in an orderly transaction
between market participants at the measurement date. (IFRS 13)
Guidance on fair value is given in IFRS 13 Fair Value Measurement (see Chapter 2, Section 2 under IFRS
13, fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets
and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date.
IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient
data are available. Entities should maximise the use of relevant observable inputs and minimise the use
of unobservable inputs.
5.3 Actuarial assumptions

Actuarial assumptions are needed to estimate the size of the future (post-employment) benefits that
will be payable under a defined benefits scheme. The main categories of actuarial assumptions are as
follows.
(a) Demographic assumptions are about mortality rates before and after retirement, the rate of
employee turnover, early retirement, claim rates under medical plans for former employees, and so
on.
(b) Financial assumptions include future salary levels (allowing for seniority and promotion as well as
inflation) and the future rate of increase in medical costs (not just inflationary cost rises, but also
cost rises specific to medical treatments and to medical treatments required given the expectations
of longer average life expectancy).
The standard requires actuarial assumptions to be neither too cautious nor too imprudent: they should
be 'unbiased'. They should also be based on 'market expectations' at the year end, over the period
during which the obligations will be settled.
5.4 Accounting for the movement in defined benefit plans

Both the present value of the defined benefit obligation and the fair value of plan assets, and therefore
the overall plan surplus or deficit will change from year to year. This movement is broken down into its
constituent parts and each is accounted for separately.
The opening and closing obligation and plan assets can be reconciled as follows:
PV of defined
benefit obligation FV of plan assets
£ £
B/f at start of year (advised by actuary) (X) X
Retirement benefits paid out X (X)
Contributions paid into plan X
Interest on plan assets X
Interest cost on obligation (X)
Current service cost (X)
____ __ ___
(X) X
Gains/losses on remeasurement(Balancing figure) X/(X) X/(X)
C/f at end of year (advised by actuary) (X) X
5.5 Outline of the method

There is a four-step method for recognising and measuring the expenses and liability of a defined
benefit pension plan.
An outline of the method used by an employer to account for the expenses and obligation of a
defined benefit plan is given below. The stages will be explained in more detail later.

Step 1 Measure the deficit or surplus:
(a) An actuarial technique (the Projected Unit Credit Method), should be used to
make a reliable estimate of the amount of future benefits employees have earned
from service in relation to the current and prior years. The entity must determine
how much benefit should be attributed to service performed by employees in the
current period, and in prior periods. Assumptions include, for example,
assumptions about employee turnover, mortality rates, future increases in salaries
(if these will affect the eventual size of future benefits such as pension payments).
(b) The benefit should be discounted to arrive at the present value of the defined
benefit obligation and the current service cost.
(c) The fair value of any plan assets should be deducted from the present value of
the defined benefit obligation.
Step 2 The surplus or deficit measured in Step 1 may have to be adjusted if a net benefit
asset has to be restricted by the asset ceiling.
Step 3 Determine the amounts to be recognised in profit or loss:
(a) Current service cost
(b) Any past service cost and gain or loss on settlement
(c) Net interest on the net defined benefit liability (asset)
Step 4 Determine the re-measurements of the net defined benefit liability (asset), to be
recognised in other comprehensive income (items that will not be reclassified to
profit or loss): C
H
(a) Actuarial gains and losses A
(b) Return on plan assets (excluding amounts included in net interest on the net P
T
defined benefit liability (asset)) E
(c) Any change in the effect of the asset ceiling (excluding amounts included in net R
interest on the net defined benefit liability (asset))
5.5.1 Retirement benefits paid out 8
During an accounting year, some of the plan assets will be paid out to retirees, thus discharging part of
the benefit obligation. This is accounted for by:
DR PV of defined benefit obligation X
CR FV of plan assets X
Note that there is no cash entry as the pension plan itself rather than the sponsoring employer pays the
money out.
5.5.2 Contributions paid into plan

Contributions will be made into the plan as advised by the actuary. This is accounted for by:
DR FV of plan assets X
CR Cash X
5.5.3 Return on plan assets
Definition
The return on plan assets is defined as interest, dividends and other revenue derived from plan assets
together with realised and unrealised gains or losses on the plan assets, less any costs of administering
the plan and less any tax payable by the plan itself.

Accounting for the return on plan assets is explained in more detail below
5.6 The statement of financial position

In the statement of financial position, the amount recognised as a defined benefit liability (which may
be a negative amount, ie an asset) should be the following.
(a) The present value of the defined obligation at the year end, minus
(b) The fair value of the assets of the plan as at the year-end (if there are any) out of which the
future obligations to current and past employees will be directly settled.
The earlier parts of this section have looked at the recognition and measurement of the defined benefit
obligation. Now we will look at issues relating to the assets held in the plan.
5.7 Plan assets

Plan assets are:
(a) Assets such as stocks and shares, held by a fund that is legally separate from the reporting entity,
which exists solely to pay employee benefits.
(b) Insurance policies, issued by an insurer that is not a related party, the proceeds of which can only
be used to pay employee benefits.
Investments which may be used for purposes other than to pay employee benefits are not plan assets.
The standard requires that the plan assets are measured at fair value, as 'the price that would be
received to sell an asset in an orderly transaction between market participants at the measurement date'.
You may spot that this definition is slightly different to the revised definition in accordance with IFRS 13
Fair value measurement (see Chapter 2). The two standards were being updated around the same time
so the definitions are currently out of step but this should make no difference to the practicalities you
will have to deal with in questions, where the fair value is normally stated in the scenario information.
IAS 19 includes the following specific requirements:
(a) The plan assets should exclude any contributions due from the employer but not yet paid.
(b) Plan assets are reduced by any liabilities of the fund that do not relate to employee benefits, such
as trade and other payables.
5.8 The statement of profit or loss and other comprehensive income

All of the gains and losses that affect the plan obligation and plan asset must be recognised. The
components of defined benefit cost must be recognised as follows in the statement of profit or loss
and other comprehensive income:
Component Recognised in
Profit or loss
(a) Service cost
Profit or loss
(b) Net interest on the net defined benefit liability
Other comprehensive income (not
(c) Re-measurements of the net defined benefit
reclassified to profit or loss)
liability
5.9 Service costs
These comprise:
(a) Current service cost, this is the increase in the present value of the defined benefit obligation
resulting from employee services during the period. The measurement and recognition of this cost
was introduced in Section 5.5.
(b) Past service cost, which is the change in the obligation relating to service in prior periods. This
results from amendments or curtailments to the pension plan, and
(c) Any gain or loss on settlement.
The detail relating to points (b)and (c) above will be covered in a later section. First, we will continue
with the basic elements of accounting for defined benefit pension costs.

5.10 Net interest on the net defined benefit liability (asset)
In Section 5.5 we looked at the recognition and measurement of the defined benefit obligation. This
figure is the discounted present value of the future benefits payable. Every year the discount must be
'unwound', increasing the present value of the obligation as time passes through an interest charge.
5.10.1 Interest calculation

IAS 19 requires that the interest should be calculated on the net defined benefit liability (asset). This
means that the amount recognised in profit or loss is the net of the interest charge on the obligation
and the interest income recognised on the assets.
The calculation is as follows:
Net defined benefit

liability/(asset) × Discount rate
The net defined benefit liability/(asset) should be measured as at the start of the accounting period,
taking account of changes during the period as a result of contributions paid into the scheme and
benefits paid out.
Many exam questions include the assumption that all payments into and out of the scheme take place
at the end of the year, so that the interest calculations can be based on the opening balances.
C
5.10.2 Discount rate H
The discount rate adopted should be determined by reference to market yields on high quality fixed- A
P
rate corporate bonds. In the absence of a 'deep' market in such bonds, the yields on comparable T
government bonds should be used as reference instead. The maturity of the corporate bonds that are E
used to determine a discount rate should have a term to maturity that is consistent with the expected R
maturity of the post-employment benefit obligations, although a single weighted average discount rate
is sufficient.
8
The guidelines comment that there may be some difficulty in obtaining a reliable yield for long-term
maturities, say 30 or 40 years from now. This should not, however, be a significant problem: the
present value of obligations payable in many years' time will be relatively small and unlikely to be a
significant proportion of the total defined benefit obligation. The total obligation is therefore unlikely to
be sensitive to errors in the assumption about the discount rate for long-term maturities (beyond the
maturities of long-term corporate or government bonds).
Worked example: Interest cost

In 20X8, an employee leaves a company after working there for 24 years. The employee chooses to
leave his accrued benefits in the pension scheme until he retires in seven years' time (he now works for
another company).
At the time of his departure, the actuary calculates that it is necessary at that date to have a fund of
£296,000 to pay the expected pensions to the ex-employee when he retires.
At the start of the year, the yield on high quality corporate debt was 8%, and remained the same
throughout the year and the following year.
Requirement
Calculate the interest cost to be debited to profit or loss in Years 1 and 2.
Solution
£
Year 1: Discounted cost b/f 296,000
Interest cost (profit or loss) (8% × £296,000) 23,680
Obligation c/f (Statement of financial position) 319,680

Year 2: Interest cost (profit or loss)(8% × £319,680) 25,574
Obligation c/f (Statement of financial position) 345,254
5.11 Re-measurements of the net defined benefit liability

Re-measurements of the net defined benefit liability/(asset) comprise:
(a) Actuarial gains and losses;
(b) The return on plan assets, (excluding amounts included in net interest on the net defined benefit
liability/(asset)); and
(c) Any change in the effect of the asset ceiling, (excluding amounts included in net interest on the net
defined benefit liability/(asset)).
The gains and losses relating to points (a) and (b) above will arise in every defined benefit scheme so we
will look at these in this section. The asset ceiling is a complication that is not relevant in every case, so it
is dealt with separately, later in the chapter.
5.11.1 Actuarial gains and losses

Actuarial gains and losses arise for several reasons, and IAS 19 requires these to be recognised, in full
in other comprehensive income.
At the end of each accounting period, a new valuation, using updated assumptions, should be carried
out on the obligation. Actuarial gains or losses arise because of the following.
 Actual events (eg employee turnover, salary increases) differ from the actuarial assumptions that
were made to estimate the defined benefit obligations
 The effect of changes to assumptions concerning benefit payment options
 Estimates are revised (eg different assumptions are made about future employee turnover, salary
rises, mortality rates, and so on)
 The effect of changes to the discount rate
Actuarial gains and losses are recognised in other comprehensive income. They are not reclassified to
profit or loss under the 2011 revision to IAS 1 (see Chapter 1).
5.11.2 Return on plan assets

The return on plan assets must be calculated.
A new valuation of the plan assets is carried out at each period end, using current fair values. Any
difference between the new value, and what has been recognised up to that date (normally the opening
balance, interest, and any cash payments into or out of the plan) is treated as a 're-measurement' and
recognised in other comprehensive income.
Worked example: Remeasurement of the net defined benefit liability

At 1 January 20X2 the fair value of the assets of a defined benefit plan were valued at £1,100,000 and
the present value of the defined benefit obligation was £1,250,000. On 31 December 20X2, the plan
received contributions from the employer of £490,000 and paid out benefits of £190,000.
The current service cost for the year was £360,000 and a discount rate of 6% is to be applied to the net
liability/(asset).
After these transactions, the fair value of the plan's assets at 31 December 20X2 was £1.5m. The present
value of the defined benefit obligation was £1,553,600.
Requirement
Calculate the gains or losses on remeasurement through OCI and the return on plan assets and illustrate
how this pension plan will be treated in the statement of profit or loss and other comprehensive income
and statement of financial position for the year ended 31 December 20X2.

Solution
It is always useful to set up a working reconciling the assets and obligation:

Assets Obligation
£ £
Fair value/present value at 1/1/X2 1,100,000 1,250,000
Interest (1,100,000 × 6%)/(1,250,000 × 6%) 66,000 75,000
Current service cost 360,000
Contributions received 490,000
Benefits paid (190,000) (190,000)
Return on plan assets excluding amounts in net interest 34,000 –
(balancing figure) (OCI)
Loss on re-measurement (balancing figure) (OCI) – 58,600
1,500,000 1,553,600
The following accounting treatment is required.
(a) In the statement of profit or loss and other comprehensive income, the following amounts will
be recognised
In profit or loss:
£
Net interest on net defined benefit liability (75,000 – 66,000) 9,000
In other comprehensive income (34,000 – 58,600) 24,600

C
H
(b) In the statement of financial position, the net defined benefit liability of £53,600 (1,553,600 – A
1,500,000) will be recognised. P
T
E
R
5.12 Section overview

The recognition and measurement of defined benefit plan costs are complex issues. 8
 Learn and understand the definitions of the various elements of a defined benefit pension plan
 Learn the outline of the method of accounting (see Paragraph 5.5)
 Learn the recognition method for the:
– Statement of financial position
– Statement of profit or loss and other comprehensive income
6 Defined benefit plans: other matters
Section overview
 We have now covered the basics of accounting for defined benefit plans. This section looks at t
the special circumstances of:
– Past service costs
– Curtailments
– Settlements
– Asset ceiling test
6.1 Past service cost and gains and losses on settlement

In Paragraph 5.9 we identified that the total service cost may comprise not only the current service costs
but other items, past service cost and gains and losses on settlement. This section explain these issues
and their accounting treatment.

6.1.1 Past service cost
Past service cost is the change in the present value of the defined benefit obligation resulting from a
plan amendment or curtailment.
A plan amendment arises when an entity either introduces a defined benefits plan or changes the
benefits payable under an existing plan. As a result, the entity has taken on additional obligations that
it has not hitherto provided for. For example, an employer might decide to introduce a medical benefits
scheme for former employees. This will create a new defined benefit obligation, that has not yet been
provided for.
A curtailment occurs when an entity significantly reduces the number of employees covered by a
plan. This could result from an isolated event, such as closing a plant, discontinuing an operation or the
termination or suspension of a plan.
Past service costs can be either positive (if the changes increase the obligation) or negative (if the
change reduces the obligation).
6.1.2 Gains and losses on settlement

A settlement occurs either when an employer enters into a transaction to eliminate part or all of its
post-employment benefit obligations (other than a payment of benefits to or on behalf of employees
under the terms of the plan and included in the actuarial assumptions).
A curtailment and settlement might happen together, for example when an employer brings a defined
benefit plan to an end by settling the obligation with a one-off lump sum payment and then scrapping
the plan.
The gain or losses on a settlement is the difference between:
(a) The present value of the defined benefit obligation being settled, as valued on the date of the
settlement; and
(b) The settlement price, including any plan assets transferred and any payments made by the
entity directly in connection with the settlement.
6.1.3 Accounting for past service cost and gains and losses on settlement
An entity should remeasure the obligation (and the related plan assets, if any) using current actuarial
assumptions, before determining past service cost or a gain or loss on settlement.
The rules for recognition for these items are as follows.
Past service costs are recognised at the earlier of the following dates:
(a) When the plan amendment or curtailment occurs, and

(b) When the entity recognises related restructuring costs (in accordance with IAS 37, see Chapter 9)
or termination benefits.
6.2 Asset ceiling test

When we looked at the recognition of the net defined benefit liability/(asset) in the statement of
financial position at the beginning of Section 5 the term 'asset ceiling' was mentioned. This term relates
to a threshold established by IAS 19 to ensure that any defined benefit asset (ie a pension surplus) is
carried at no more than its recoverable amount. In simple terms, this means that any net asset is
restricted to the amount of cash savings that will be available to the entity in future.
6.3 Net defined benefit assets

A net defined benefit asset may arise if the plan has been overfunded or if actuarial gains have arisen.
This meets the definition of an asset (as stated in the Conceptual Framework) because all of the following
apply.
(a) The entity controls a resource (the ability to use the surplus to generate future benefits).

(b) That control is the result of past events (contributions paid by the entity and service rendered
by the employee).
(c) Future benefits are available to the entity in the form of a reduction in future contributions or a
cash refund, either directly or indirectly to another plan in deficit.
The asset ceiling is the present value of those future benefits. The discount rate used is the same as
that used to calculate the net interest on the net defined benefit liability/(asset). The net defined benefit
asset would be reduced to the asset ceiling threshold. Any related write down would be treated as a re-
measurement and recognised in other comprehensive income.
If the asset ceiling adjustment was needed in a subsequent year, the changes in its value would be
treated as follows:
(a) Interest (as it is a discounted amount) recognised in profit or loss as part of the net interest
amount
(b) Other changes recognised in profit or loss.
6.4 Other issues
6.4.1 Multiple plans and offsetting

Where a sponsoring employer runs more than one defined benefit scheme, each must be accounted for
separately and a plan deficit in one cannot be set off against a plan surplus in another unless there is a
legal right of offset and the entity intends to settle on a net basis.
C
6.4.2 Projected unit credit method H
A
The projected unit credit method is the method required by IAS 19 to be used in determining the P
present value of the defined benefit obligation and current service cost. T
E
This method sees each period of service giving rise to an additional unit of benefit entitlement (ie for R
each extra year worked by an employee, their pension increases).
Each of these units is measured separately and the total of all units to date (both current year and
previous years) is the final obligation under the plan. 8
The total of the current year units is the current service cost.
Attribution of benefit to period of service
In order to apply the projected unit credit method, a unit, or amount of future benefit, must be
attributed to each period of service.
Worked example: Projected unit credit method 1

A defined benefit plan provides a lump-sum benefit of £100 per year of service payable on retirement.
Requirement
How is this benefit attributed to periods of service and how is the resulting current service cost and
defined benefit obligation calculated?
Solution
A benefit of £100 is attributed to each year.
The current service cost = the present value of £100
The present value of the defined benefit obligation = the present value of £100 x number of years of
service to reporting date.

Worked example: Projected unit credit method 2
A company operates a defined benefit scheme that pays a lump sum benefit equal to £500 for each year
of service.
An employee joins the company at the beginning of Year 1 and is due to retire after five years of service.
For the sake of simplicity ignore the possibility of the employee leaving the company before the
expected date.
The discount rate is 10%.
Requirement
Calculate the current service cost to be debited to profit or loss in Years 1 to 5, and the present value of
the defined benefit obligation in each of these years.
Solution
Year 1 2 3 4 5
£ ££££
Current year benefit 500 500 500 500 500
Current service cost 500 500 500 500
(1.1) 4 (1.1)3 (1.1)2 1.1 0
= 342 = 376 = 413 = 455 500
PV of defined benefit obligation 342 376 × 2 413 × 3 455 × 4 500 × 5
= 752 =1,239 =1,820 = 2,500
Note:
Previously we have said that the present value of the obligation moves from year to year due to:
 Payments out to retirees
 The unwinding of one year's discount
 The current service cost
This can be applied to year 2 as follows:
£
PV of defined benefit obligation b/f 342
Unwinding of discount (342  0%) 34
Current service cost 376
PV of defined benefit obligation c/f 752
6.5 Suggested approach

The suggested approach to defined benefit schemes is to deal with the change in the obligation and
asset in the following order.
Step Item Recognition

1 Record opening figures:
 Asset
 Obligation
2 Interest cost on obligation DEBIT Interest cost (P/L)
 Based on discount rate and PV (x%  b/d obligation)
obligation at start of period. CREDIT PV defined benefit obligation (SOFP)
 Should also reflect any changes in
obligation during period.

Step Item Recognition
3 Interest on plan assets DEBIT Plan assets (SOFP)
 Based on discount rate and asset CREDIT Interest cost (P/L)
value at start of period. (x%  b/d assets)
 Technically, this interest is also time
apportioned on contributions less
benefits paid in the period.
4 Current service cost
 Increase in the present value of the DEBIT Current service cost (P/L)
obligation resulting from employee CREDIT PV defined benefit obligation (SOFP)
service in the current period.
5 Contributions DEBIT Plan assets (SOFP)
 As advised by actuary. CREDIT Company cash
6 Benefits DEBIT PV defined benefit obligation (SOFP)
 Actual pension payments made. CREDIT Plan assets (SOFP)
7 Past service cost Positive (increase in obligation):
 Increase/decrease in PV obligation as DEBIT Past service cost (P/L)
a result of introduction or CREDIT PV defined benefit obligation (SOFP)
improvement of benefits.
Negative (decrease in obligation):
DEBIT PV defined benefit obligation (SOFP) C
CREDIT Past service cost (P/L) H
A
P
8 Gains and losses on settlement Gain T
E
 Difference between the value of the DEBIT PV defined benefit obligation (SOFP) R
obligation being settled and the CREDIT Service cost (P/L)
settlement price.
Loss
8
DEBIT Service cost (P/L)
CREDIT PV defined benefit obligation (SOFP)
9 Re-measurements: actuarial gains and Gain
losses DEBIT PV defined benefit obligation (SOFP)
 Arising from annual valuations of CREDIT Other comprehensive income
obligation.
Loss
 On obligation, differences between
actuarial assumptions and actual DEBIT Other comprehensive income
experience during the period, or CREDIT PV defined benefit obligation (SOFP)
changes in actuarial assumptions.
10 Re-measurements: return on assets Gain

(excluding amounts in net-interest) DEBIT FV plan assets (SOFP)
 Arising from annual valuations of CREDIT Other comprehensive income
plan assets
Loss
DEBIT Other comprehensive income
CREDIT FV plan assets (SOFP)
11 Disclose in accordance with the See comprehensive question.
standard

Interactive question 1: Defined benefit plan 1 [Difficulty level: Intermediate]
For the sake of simplicity and clarity, all transactions are assumed to occur at the year end.
The following data applies to the post employment defined benefit compensation scheme of BCD Co.
Discount rate: 10% (each year)
Present value of obligation at start of 20X2: £1m
Market value of plan assets at start of 20X2: £1m
The following figures are relevant.
20X2 20X3 20X4
£'000 £'000 £'000
Current service cost 140 150 150
Benefits paid out 120 140 150
Contributions paid by entity 110 120 120
Present value of obligation at year end 1,200 1,650 1,700
Fair value of plan assets at year end 1,250 1,450 1,610
Additional information:
(1) At the end of 20X3, a division of the company was sold. As a result of this, a large number of the
employees of that division opted to transfer their accumulated pension entitlement to their new
employer's plan. Assets with a fair value of £48,000 were transferred to the other company's plan
and the actuary has calculated that the reduction in BCD's defined benefit liability is £50,000. The
year-end valuations in the table above were carried out before this transfer was recorded.
(2) At the end of 20X4, a decision was taken to make a one-off additional payment to former
employees currently receiving pensions from the plan. This was announced to the former
employees before the year end. This payment was not allowed for in the original terms of the
scheme. The actuarial valuation of the obligation in the table above includes the additional liability
of £40,000 relating to this additional payment.
Requirement
Show how the reporting entity should account for this defined benefit plan in each of years 20X2, 20X3
and 20X4.

Peters operates a defined benefit pension plan for its employees. At 1 January 20X5 the fair value of the
pension plan assets was £5,200,000 and the present value of the plan liabilities was £5,800,000.
The actuary estimates that the current and past service costs for the year ended 31 December 20X5 are
£900,000 and £180,000 respectively. The past service cost is caused by an increase in pension benefits.
The plan liabilities at 1 January and 31 December 20X5 correctly reflect the impact of this increase.
The yield on high-quality corporate bonds is estimated at 8%.and the expected return on plan assets at
5%.
The pension plan paid £480,000 to retired members in the year to 31 December 20X5. Peters paid
£1,460,000 in contributions to the pension plan and this included £180,000 in respect of past service
costs.
At 31 December 20X5 the fair value of the pension plan assets is £6,800,000 and the present value of
the plan liabilities is £7,000,000.
In accordance with IAS 19 Employee Benefits (revised 2011), Peters recognises gains and losses on
remeasurement of the defined benefit asset/liability in other comprehensive income in the period in
which they occur.

Requirement
Calculate the actuarial gains or losses on pension plan assets and liabilities that will be included in other
comprehensive income for the year ended 31 December 20X5. (Round all figures to the nearest £000).

The defined benefit pension plan of Leadworth plc was formed on 1 January 20X3. The following details
relate to the scheme at 31 December 20X3.
£m
Present value of obligation 208
Fair value of plan assets 200
Current service cost for the year 176
Contributions paid 160
Interest cost on obligation for the year 32
Interest on plan assets for the year 16
The directors are aware that IAS 19 has been revised and are unsure how to treat any gain or loss on
remeasurement of the plan asset or liability.
Requirement
Show how the defined benefit pension plan should be dealt with in the financial statements for the year
ended 31 December 20X3. C
H
See Answer at the end of this chapter. A
P
T
E
R
Baseline plc has a defined benefit pension scheme and wishes to recognise the full deficit in its
statement of financial position. 8
Requirement
Using the information below, prepare extracts from the statement of financial position and the
statement of comprehensive income, together with a reconciliation of scheme movements for the year
ended 31 January 20X8. Ignore taxation.
1 The opening scheme assets were £3.6m on 1 February 20X7 and scheme liabilities at this date
were £4.3m.
2 Company contributions to the scheme during the year amounted to £550,000.
3 Pensions paid to former employees amounted to £330,000 in the year.
4 The yield on high quality corporate bonds was 8%, and the actual return on plan assets was
£295,000.
5 During the year, five staff were made redundant, and an extra £58,000 in total was added to the
value of their pensions.
6 Current service costs as provided by the actuary are £275,000.
7 The actuary valued the plan liabilities at 31 January 20X8 as £4.54m.

7 Defined benefit plans – disclosure
Section overview
 The disclosure requirements for defined benefit plans are extensive and detailed in order to enable
users to understand the plan and the nature and extent of the entity's commitment.
Detailed disclosure requirements are set out in IAS 19 in relation to defined benefit plans, to provide
users of the financial statements with information that enables an evaluation of the nature of the plan
and the financial effect of any changes in the plan during the period.
Amended requirements for disclosures include a description of the plan, a reconciliation of the fair value
of plan assets from the opening to closing position, the actual return on plan assets, a reconciliation of
movements in the present value of the defined benefit obligation during the period, an analysis of the
total expense recognised in profit or loss, and the principal actuarial assumptions made.
Additional disclosures set out in the amendment to IAS 19 include:
 An analysis of the defined benefit obligation between amounts relating to unfunded and funded plans;
 A reconciliation of the present value of the defined benefit obligation between the opening and
closing statement of financial position, separately identifying each component in the reconciliation;
 A reconciliation of the present value of the defined benefit obligation and the fair value of the plan
assets to the pension asset or liability recognised in the statement of financial position. The
reconciliation should specifically highlight the net actuarial gains and losses recognised in the
statement of financial position, the amount of the pension asset which has not been recognised in
accordance with IAS 19, and the fair value of any reimbursements separately recognised as assets;
 A breakdown of plan assets for the entity's own financial instruments, for example an equity
interest in the employing entity held by the pension plan and any property occupied by the entity
or other assets used by the entity;
 For each major category of plan assets the percentage or amount that it represents of the total fair
value of plan assets;
 A narrative description of the basis used to determine the expected rate of return on plan assets;
 The effect of a one percentage point increase or decrease in the assumed medical cost trend rate
on amounts recognised during the period, such as service cost and the pension obligation relating
to medical costs;
 Amounts for the current annual period and the previous four annual periods of the present value of
the defined benefit obligation, fair value of plan assets and the resulting pension surplus or deficit,
and experience adjustments on the plan liabilities and assets in percentage or value terms; and
 An estimate of the level of future contributions to be made in the following reporting period.
8 Other long-term employee benefits
Section overview
 The accounting treatment for other long-term employee benefits is a simplified version of that
adopted for defined benefit plans.
Definition
Other long-term employee benefits are defined as employee benefits (other than post-retirement
benefit plans and termination benefits) which do not fall due wholly within 12 months after the end of
the period in which the employees render the service.

Examples of other long-term employee benefits include long-term disability benefits and paid
sabbatical leave.
Although such long-term benefits have many of the attributes of a defined benefit pension plan, they
are not subject to the same level of uncertainty. Furthermore, the introduction of such benefits or
changes to these benefits rarely causes a material amount of past service cost. As a consequence, the
accounting treatment adopted is a simplified version of that for a defined benefit plan. The only
difference is that:
 Actuarial gains and losses
 Any past service costs
are recognised immediately in profit or loss (ie no corridor method is allowed).
9 Termination benefits
Section overview
 Termination benefits are recognised as an expense when the entity is committed to either:
– Terminate the employment before normal retirement date or
– Provide termination benefits in order to encourage voluntary redundancy
Definition C
H
Termination benefits: are employee benefits payable on the termination of employment, through A
voluntary redundancy or as a result of a decision made by the employer to terminate employment P
before the normal retirement date. T
E
R
Where voluntary redundancy has been offered, the entity should measure the benefits based on an
expected level of take-up. If, however, there is uncertainty about the number of employees who will 8
accept the offer, then there may be a contingent liability, requiring disclosure under IAS 37 Provisions,
An entity should recognise a termination benefit when it has made a firm commitment to end the
employment. Such a commitment will exist where, for example, the entity has a detailed formal plan for
the termination and it cannot realistically withdraw from that commitment.
Where termination benefits fall due more than twelve months after the reporting date they should be
discounted.
Worked example: Termination benefits

The directors of an entity met on 23 July 20X3 to discuss the need to decrease costs by reducing the
number of employees. On 17 August 20X3 they met again to agree a plan. On 6 September 20X3 other
members of the management team were informed of the plan. On 7 October 20X3 the plan was
announced to the employees affected and implementation of the formalised plan began.
Requirement
When should the entity recognise the liability?
Solution
The entity should only recognise the liability for the termination benefits when it is demonstrably
committed to terminate the employment of those affected. This occurred on 7 October 20X3 when the
formal plan was announced and it is at this date that there is no realistic chance of withdrawal.

10 IAS 19 Employee Benefits and UK GAAP
Section overview
 IFRS compared to UK GAAP.
 IAS 19 allows a similar immediate recognition approach to actuarial gains and losses to FRS 17.
 Deferred tax balances are netted off the net pension scheme asset/liability under FRS 17. Under IAS
19 they must be shown separately.
 The scope of IAS 19 is wider and covers different types of employee compensation.
11 Reasons for 2011 revision of IAS 19

Section overview
 IAS 19 was amended in June 2011.
In June 2011, the IASB published a revised version of IAS 19 Employee Benefits. The revised standard is
now examinable. It is also useful for you to be aware of the changes made – in particular, the abolition
of the 'corridor method' in order to see the current rules in perspective.
11.1 Criticisms of previous treatment

The purpose of the revision was to improve accounting in the short-term for employee benefits in the
light of criticisms of the current IAS 19 by users and preparers of financial statements, including the US
SEC and the EU's European Financial Reporting Advisory Group (that approves IFRS for use in the EU). In
the long term, the IASB intends to produce a common IASB-FASB standard, but recognises that this will
take many years to complete.
Accounting for employee benefits, particularly retirement benefits, had been seen as problematic in the
following respects:
(a) Income treatment. It has been argued that the complexity of the presentation makes the
treatment hard to understand and the splitting up of the various components is arbitrary.
(b) Fair value and volatility. The fair value of plan assets may be volatile, and values in the statement
of financial position may fluctuate. However, not all those fluctuations are recognised in the
(c) Fair value and economic reality. Fair value, normally market value, is used to value plan assets.
This may not reflect economic reality, because fair values fluctuate in the short term, while pension
scheme assets and liabilities are held for the long term. It could be argued that plan assets should
be valued on an actuarial basis instead.
(d) Problems in determining the discount rate used in measuring the defined benefit obligation.
Guidance is contradictory.
11.2 Main changes
The main changes were as follows.
(a) Actuarial gains and losses
(i) The revised standard requires actuarial gains and losses to be recognised in the period
incurred.
(ii) The previous standard permitted a range of choices for the recognition of actuarial gains and
losses:
(1) Immediate recognition in other comprehensive income (as now) was permitted.
(2) Deferral of actuarial gains and losses was permitted through what was known as the
'corridor' method. The 'corridor' was defined as the higher of 10% of the opening plan
assets or 10% of the opening plan obligation. If the accumulated actuarial gains and
losses brought forward exceeded the corridor, the excess would then be divided by the

average remaining service lives of employees in the scheme and this amount recognised
in profit or loss. The balance of unrecognised gains and losses was carried on the
(3) Actuarial gains and losses could also be recognised in profit or loss on any other
systematic basis, subject to the 'corridor' amount as a minimum.
(iii) The changes will improve comparability between companies and will also eliminate some of
the anomalies where the effect of unrecognised actuarial gains and losses (and unrecognised
past service costs (see point (d) below) could turn a deficit into a surplus on the statement of
financial position.
(b) Re-measurements
(i) The revised standard introduced the term 're-measurements'. This is made up of the actuarial
gains and losses on the defined benefit obligation, the difference between actual investment
returns and the return implied by the net interest cost and the effect of the asset ceiling. Re-
measurements are recognised immediately in other comprehensive income and not
reclassified to profit or loss.
(ii) This reduces diversity of presentation that was possible under the previous standard.
(c) Net interest cost
(i) The revised standard requires interest to be calculated on both the plan assets and plan
obligation at the same rate and the net interest to be recognised in the statement of profit or
loss and other comprehensive income. The rationale for this is the view that the net defined
benefit liability/(asset) is equivalent to an amount owed by the company to the plan.
C
(ii) The difference under the previous standard was that an 'Expected return on assets' was H
calculated, based on assumptions about the long term rates of return on the particular classes A
P
of asset held within the plan.
T
(d) Past service costs E
R
(i) The revised standard requires all past service costs to be recognised in the period of plan
amendment.
8
(ii) The previous standard made a distinction between past service costs that were vested (all past
service costs related to former employees and those that related to current employees and not
subject to any condition relating to further service) and those that were not vested (relating
to current employees and where the entitlement was subject to further service). Only vested
past service costs were recognised in profit or loss, and unvested benefits were deferred, and
spread over remaining service lives.
11.3 Effective date and transition issues

The amendments to IAS 19 are effective for annual periods beginning on or after January 1, 2013. Earlier
application is permitted.
Retrospective application is required in accordance with IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors, with two exceptions:
(a) When benefit costs are included in the carrying amount of assets outside the scope of IAS 19 (eg
inventories), these assets do not need to be adjusted on adoption.
(b) In financial statements for periods beginning before January 1, 2014, comparative information does
not need to be presented for the disclosures related to the sensitivity of the defined benefit
obligation.
On making the transition to the amended standard, entities currently using the corridor method may
be obliged to recognise a larger liability (or a smaller asset) in the statement of financial position. This
could affect compliance with debt covenants and impair their ability to pay dividends.
A further implication for the future is that there will be greater volatility in the statement of financial
position and in other comprehensive income as a result of immediate recognition of actuarial gains and
losses. On the other hand, profit or loss will no longer be affected by amortising actuarial gains and
losses.

Summary
Employee benefits
Short-term Post-employment Other long-term Termination

benefits benefits benefits benefits
Same principles as Recognise only if

Accruals Defined Defined defined benefit plans firm commitment
basis contribution benefit except all gains/losses to pay
are recognised in
profit or loss
Payable within 12
Disclosure Recognition months of
reporting date
Yes No
- Amount Contributions an
recognised as expense, and
expense - Unpaid contributions Accruals Benefits
- A description a liability basis discounted
of the plan - Excess contributions
an asset if these will
reduce future liability Disclosure Recognition
See next page

Profit or loss Statement of
financial position
Current service cost
Present value
Net interest of the defined
benefit obligation
Past service cost at reporting date
LESS
Other
comprehensive Fair value of
income plan assets
Remeasurement
gains/loss

Disclosure
Narrative Components Defined benefit Reconciliation Other Standards

disclosure of total expense obligation
IAS 24
- Description of the plan Opening and IAS 37
Arising IAS 1
- Actuarial assumptions closing balances
from
Funded Unfunded
Plan assets plans plans
Actual return Fair value of plan assets Present value of Fair value of
on plan assets - For each category of defined benefit plan assets
entity's own obligation
instruments
- For property or asset
used by entity
Reconciliation of above C
- By main categories to assets and liabilities H
of instruments in A
in statement of
percentage terms P
financial position
T
E
R

Self-test
1 Employee benefits
Under which category of employee benefits should the following items be accounted for according
to IAS 19 Employee Benefits?
(a) Paid annual leave
(b) Lump sum benefit of 1% of the final salary for each year of service
(c) Actuarial gains
2 Lampard
The Lampard company operates two major benefit plans on behalf of its employees under which
the amounts of benefit payable depend on a number of factors, the most important of which is
length of service. The plans are:
(a) Plan Deben, a post-retirement defined benefit plan.
(b) Plan Limen, a long-term disability benefits plan.
Changes to the terms of these plans coming into effect from 31 December 20X7 will result in past
service cost attributable to unvested benefits, to the extent of £500,000 on Plan Deben and
£220,000 on Plan Limen. Within each plan the average period until benefits become vested is five
years. There are no past service costs brought forward on either plan.
Requirement
Under IAS 19 Employee Benefits, what is the total amount of past service costs which must be
recognised by Lampard in the year ended 31 December 20X7?
3 Tiger
The Tiger company operates a post-retirement defined benefit plan under which post-retirement
benefits are payable to ex-employees and their partners.
For all the years this plan has been in operation, Tiger has used the market yield on its own
corporate bonds as the rate at which it has discounted its defined obligation, because the yield on
its own bonds has been the same as that on high quality corporate bonds. In the current year Tiger
has experienced a sharp downgrading in its credit rating, such that the yield on its own bonds at
the year end is 8% while that on high quality corporate bonds is 6%. Tiger is proposing to use the
yield on its own bonds as the discount rate, to reflect the greater risk.
Requirement
Indicate whether Tiger's approach is correct according to IAS 19 Employee Benefits.
4 An entity's defined benefit liability at 31 December 20X4 and 20X5 is measured as follows.
20X4 20X5
£ £
Defined benefit obligation 950,000 1,150,000
The discount rates used for calculating the defined benefit obligation were 6.5% at 31 December
20X4, and 6% at 31 December 20X5.
Requirements
(a) Calculate the interest cost to be charged to profit or loss for 20X5.
(b) How should the discount factor that is used to discount post-employment benefit obligations
be determined?
(c) What elements should the discount rate specifically not reflect according to IAS 19?
5 Straw Holdings plc
John Cork, financial director of Straw Holdings plc, your audit client, has recently written to you for
advice on pension scheme accounting.
The company's defined benefit pension scheme has net assets valued at £20.2 million. Scheme
assets of £19.4 million at the beginning of the year were expected to grow by 10% during the year

and to be enhanced by a cash contribution to the scheme of £0.4 million greater than payments to
pensioners.
Based on these figures Cork has prepared the following reconciliation.
Assets at 31 December 20X1
£m
Opening scheme net assets 19.40
Add interest on assets @ 10% 1.94
Net contributions and interest costs 0.40
Less actuarial deficit (balancing figure) (1.54)
Closing scheme net assets 20.20
The deficit of £1.54 million has come as a surprise to Cork. He is unsure how to treat this deficit in
the financial statements and concerned about the impact it will have on the company's profits.
Requirements
(a) Explain the impact of the actuarial valuation of the scheme's assets and the resultant deficit on
the financial statements of Straw Holdings plc for the year ended 31 December 20X1.
(b) Identify TWO benefits to Straw Holdings plc of moving from a defined benefit to a defined
contribution scheme.
C
H
A
P
T
E
R

Technical reference
IAS 19.4
Four categories of employee benefits
 Short-term employee benefits
 Post-employment benefits
 Other long-term employee benefits
 Termination benefits
IAS 19.7, 19.8
Short-term employee benefits
 Wages, salaries and social security contributions falling due within 12 months
of employee service
 Short-term compensated absences such as vacation entitlement and paid sick
leave
 Profit-sharing and bonuses
 Non-monetary benefits
IAS 19.10
Accounting for short-term employee benefits
 Short-term employee benefits are recognised as an expense and a
corresponding liability and are accounted for on an undiscounted basis
Short-term compensated absences

 Entitlements to compensated absences fall into two categories IAS 19.12, 19.13
– Accumulating
ie those that are carried forward if not used in current period
– Non-accumulating
ie those that cannot be carried forward and lapse after the current period
 An accrual shall be made in respect of unused entitlement for compensated IAS 19.14
absences
Profit sharing and bonus plan

 An entity shall recognise the expected cost of profit-sharing and bonus IAS 19.17
payments only when:
– Entity has present legal or constructive obligation to make payments
– Reliable estimate of these can be made
Post-employment benefits
 Classified as either: IAS 19.25, 19.26,
19.27
– Defined contribution plans
Where entity's legal or constructive obligation is limited to the amount it
agrees to contribute to the fund and consequently bears no actuarial or
investment risk
– Defined benefit plans
Where entity provides agreed benefits and bears both actuarial and
investment risk

IAS 19.7
Multi-employer plans
 Defined contribution or defined benefit plans that:
– Pool assets contributed by entities not under common control
– Provide benefits to employees of more than one entity with benefits
determined without regard to the identity of the entity.
 Defined benefit plans that share risks between entities under common control IAS 19.34
are not multi-employer plans
Recognition and measurement of defined contribution plans

 Recognise as a liability and expense unless another Standard allows inclusion IAS 19.44
in asset (eg IAS 2 or IAS 16)
 Disclose expense and required disclosure under IAS 24 IAS 19.46, 19.47
Recognition and measurement of defined benefit plans

 Entity underwriting both investment and actuarial risk. IAS 19.50
 Accounting involves following steps: IAS 19.50
– Using actuarial techniques make reliable estimate of the amount of

benefit employees earned in current and prior periods
– Discount benefit using projected unit credit method
– Determine fair value of plan assets
C
– Determine total amount of remeasurement gains and losses and amount
H
to be recognised A
– Where plan introduced or changed determine resulting past service cost P
– Where plan has been curtailed or settled calculate resulting gain or loss T
E
Defined benefit scheme R
 Recognised in statement of financial position as the net of: IAS 19.54
– Present value of defined benefit obligation at reporting date plus 8

– Fair value at the reporting date of plan assets
 Recognised in profit or loss IAS 19.61
– Current service cost

– Net interest on the net defined benefit liability (asset)
– Past service cost
– Effect of curtailments or settlements
 Recognised other comprehensive income IAS 19.61
– Actuarial gains and losses

– Returns on plan assets (excluding amounts in net interest)
– Past service cost recognised
– Effect of curtailments or settlements
Actuarial assumptions
 Shall be unbiased and mutually compatible IAS 19.72
– Demographic assumptions
– Financial assumptions
IAS 19.78
Discount rate
 Rate used to discount post-employment obligations shall be determined by
reference to market yields at reporting date on high quality corporate bonds
Actuarial gains and losses

 Gains and losses on remeasurement of plan assets and liabilities must be IAS 19.93 B
recognised in other comprehensive income (not reclassified to profit or loss) in
the period in which they occur.

Past service cost
 Arises when entity introduces defined benefit plan or changes benefit under IAS 19.97
an existing defined benefit plan
 Entity shall recognise past service cost as an expense on a straight line basis IAS 19.96
over the average period until the benefits become vested
 Fair value of plan assets when no market price is available, the fair value of IAS 19.102
plan assets is estimated
IAS 19.104A
Reimbursements
 An entity shall recognise its right to re-imbursement as a separate asset only
when it is virtually certain that another party will reimburse some or all of the
expenditure required to settle a defined benefit obligation
IAS 19.108
Business combinations
 In a business combination (see IFRS 3 Business Combinations) an entity shall
recognise assets and liabilities arising post-employments at the
– Present value of the obligation, less
– Fair value of any plan assets
 The present value of the obligation includes all of the following even if not
recognised by acquiree:
– All actuarial gains and losses
– Past service cost before acquisition date
– Amounts not recognised under transitional provisions
Other long-term employee benefits
 Examples include sabbatical leave and long-term disability benefits IAS 19.126
 Amount recognised as a liability is the net of the following: IAS 19.128
– Present value of the defined benefit obligation at the reporting date

minus
– The fair value of plan assets at the reporting date
 Amount recognised in profit or loss is as for defined benefit schemes except IAS 19.127
that:
– Actuarial gains and losses, and
– Past service costs are recognised immediately
Termination benefits
 Termination benefits are recognised as an expense when the entity is IAS 19.133
committed to
– Terminate the employment before normal retirement date, or
– Provide termination benefits as a result of an offer for voluntary
redundancy
 Where termination benefits fall due more than 12 months after the reporting IAS 19.139
date they shall be discounted

1 Employee benefits
(a) Short-term employee benefits
(b) Defined benefit plans
(c) Defined benefit plans
IAS 19.9 highlights paid annual leave as a short term benefit.
The actuarial gains and the lump sum benefit relate to defined benefit plans (per IAS 19.24-27 and 54).
2 Lampard
£720,000(£500,000 + 2£20,000)
Under IAS 19 Employee Benefits (revised 2011), past service cost attributable to all benefits, whether
vested or not within a post-retirement defined benefit plan must be recognised immediately in
profit or loss. Similarly past service cost attributable to all benefits, whether vested or not, within a
long-term disability benefits plan must be recognised immediately in profit or loss, so the full
£720,000 must be recognised.
3 Tiger
Tiger should not be using 8% as its discount rate.
C
Under IAS 19.78 the yield on high quality corporate bonds must be used as the discount rate for H
the defined benefit obligation. (Using a higher rate would result in a lower obligation, which would A
not reflect greater risk.) P
T
4 (a) The interest cost for 20X5 is calculated by multiplying the defined benefit obligation at the E
start of the period by the discount rate at the start of the period, so: R
£950,000 × 6.5% = £61,750.

(b) The discount factor should be determined by reference to high quality corporate bonds with 8
similar currency and maturity as the benefit obligations.
Where no market in corporate bonds exists the discount rate should be determined by
reference to government debt.
Where there is no deep market in corporate bonds with sufficiently long maturities the
Standard requires the use of current market rates of appropriate term to discount short-term
payments and the estimation of the rate for longer maturities by extrapolating current market
rates on the yield curves.
(c) The discount rate should not reflect:
 Investment risk
 Actuarial risk
 Specific risk relating to the entity's business

5 Straw Holdings plc
(a) Impact of actuarial valuation
The plan assets are less than expected by £1.54 million, this being a remeasurement loss loss.
Under IAS 19 Employee benefits (revised 2011), such losses must be recognised in other
comprehensive income in the period in which they occur. This would result in the net
actuarial difference (the £1.54 million loss on the assets combined with any actuarial gain or
loss on the obligation) being disclosed as other comprehensive income and debited directly to
reserves. There would therefore be no direct impact on profit or loss.
(b) Two benefits of move to defined contribution scheme
(i) Defined contribution schemes are easier for the company to administer and manage. A
fixed level of contributions is paid in monthly instalments for each employee. The risk
resulting from the variable returns achieved by funds invested is then borne by the
employee. This risk is borne by the employer with a defined benefit scheme.
(ii) Defined contribution schemes are easier to account for.
Contributions are charged to profit or loss on a systematic basis.
Provided the company is not in arrears on contributions, the monthly double entry
required is therefore:
£ £
Dr Staff costs X
Cr Cash X


The actuarial gain or loss is established as a balancing figure in the calculations, as follows.
Present value of obligation
20X2 20X3 20X4
£'000 £'000 £'000
PV of obligation at start of year 1,000 1,200 1,600
Interest cost (10%) 100 120 160
Past service cost 40
Benefits paid (120) (140) (150)
Settlements (50)
Actuarial (gain)/loss on obligation: balancing figure 80 320 (100)
PV of obligation at end of year 1,200 1,600 * 1,700
*(1,650 – 50)
Market value of plan assets
20X2 20X3 20X4
£'000 £'000 £'000
C
Market value of plan assets at start of year 1,000 1,250 1,402
H
Interest on plan assets (10%) 100 125 140 A
Contributions 110 120 120 P
Benefits paid (120) (140) (150) T
Settlements – (48) – E
Gain on remeasurement through OCI: balancing 160 95 98 R
figure
Market value of plan assets at year end 1,250 1,402* 1,610
*(1,450 – 48) 8
In the statement of financial position, the liability that is recognised is calculated as follows.
20X2 20X3 20X4
£'000 £'000 £'000
Present value of obligation 1,200 1,600 1,700
Market value of plan assets 1,250 1,402 1,610
Liability/(asset) in statement of financial position (50) 198 90
The following will be recognised in profit or loss for the year:
20X2 20X3 20X4
£'000 £'000 £'000
Past service cost – – 40
Net interest on defined benefit liability (asset) – (5) 20
Gain on settlement of defined benefit liability – (2) –
Expense recognised in profit or loss 140 143 210
The following re-measurements will be recognised in other comprehensive income for the year:
20X2 20X3 20X4
£'000 £'000 £'000
Actuarial (gain)/loss on obligation 80 320 (100)
Return on plan assets (excluding amounts in net- (160) (95) (98)
interest)

Gains or losses on plan assets
£'000
Fair value of plan assets at 1.1.20X5 5,200
Expected return on plan assets (8%  £5,200) 416
Contributions 1,460
Benefits paid (480)
Remeasurement gain to OCI (balancing figure) 204
Fair value of plan assets at 31.12.20X5 6,800
Gains or losses on obligation

£'000
Present value of obligation at 1.1.20X5 5,800
Past service cost 180
Interest cost (8%  £5,800) 464
Benefits paid (480)
Remeasurement gain to OCI (balancing figure) 136
Present value of obligation at 31.12.20X5 7,000

The defined benefit pension plan is treated in accordance with IAS 19 Employee Benefits, as revised in
2011.
The pension plan has a deficit of liabilities over assets.
£m
Fair value of plan assets 200
Less: present value of obligation (208)
(8)
The deficit is reported as a liability in the statement of financial position.

Profit or loss for the year includes:
£m
Net interest on net defined benefit liability (32 – 16) 16
192
The company is required by the revised IAS 19 to recognise the £24,000,000 remeasurement gain (see
working) immediately in other comprehensive income.
WORKING
PV of FV of plan
obligation assets
£m £m
b/f Nil Nil
Contributions paid 160
Interest on plan assets 16
Interest cost on obligation 32
Actuarial difference (bal fig) – 24
c/f 208 200

Statement of financial position extract £'000

Non-current liabilities (4,115 – 4,540) 425
Statement of comprehensive income – extract £'000

Net interest on net defined benefit liability ( 344 – 388) 56
Interest cost (4,300 × 5.2%) 224
Curtailment cost 58
389
Actuarial gain on obligation 107
Return on plan assets (excluding amounts in net interest 7
£'000
Reconciliation of pension plan movement
Plan deficit at 1 Feb 20X7 (3,600 – 4,300) (700)
Company contributions 550
Profit or loss total (389)
Other comprehensive income total (107 + 7) 114
Plan deficit at 31 Jan 20X8 (4,115 – 4,540) (425)
£'000
Changes in the present value of the defined benefit obligation
Defined benefit obligation at 1 Feb 20X7 4,300 C
H
Interest cost @ 8% 344 A
Pensions paid (330) P
Curtailment 58 T
Current service cost 275 E
Actuarial gain (residual) (107) R
Defined benefit obligation at 31 Jan 20X8 4,540
Changes in the fair value of plan assets 8

Fair value of plan assets at 1 Feb 20X7 3,600
Contributions 550
Pensions paid (330)
Interest on plan assets 8%  3,600 288
Remeasurement gain (295 – 288) 7
Fair value of plan assets at 31 Jan 20X8 (residual) 4,115

CHAPTER 9
Share-based payment
Introduction
Topic List
1 Background
2 Objective and scope of IFRS 2 Share-based Payment
3 Share-based transaction terminology
4 Equity-settled share-based payment transactions
5 Cash-settled share-based payment transactions
6 Share-based payment with a choice of settlement
7 Group and treasury share transactions
8 Disclosure
9 UK GAAP comparison
10 Distributable profits and purchase of own shares
Technical reference
299
Introduction
 Demonstrate an understanding and be able to apply the reporting requirements for share-
based payment transactions with third parties and with employees
 Apply knowledge and understanding of IFRS 2 in particular circumstances through basic
calculations
 Demonstrate and apply knowledge of the key disclosure requirements of IFRS 2
 Evaluate and apply appropriate financial reporting treatments of IFRS 2 to given scenarios
 Advise on and develop appropriate remuneration and reward packages for staff and
executives

1 Background
Section overview
 Companies frequently pay for goods and services provided to them in the form of shares or share
options. This raises the issue of how such payments should be accounted for, and in particular
whether they should be expensed in profit or loss.
1.1 Introduction
Share-based payment occurs when an entity purchases goods or services from another party such as a
supplier or employee and rather than paying directly in cash, settles the amount owing in shares, share
options or future cash amounts linked to the value of shares. This is common:
 In e-businesses which do not tend to be profitable in early years and are cash poor.
 Within all sectors where a large part of the remuneration of directors is provided in the form of
shares or options. Employees may also be granted share options.
1.2 The accounting problem

Pre-IFRS 2
Prior to the publication of IFRS 2 there appeared to be an anomaly to the extent that if a company paid
its employees in cash, an expense was recognised in profit or loss, but if the payment was in share
options, no expense was recognised.
IFRS 2 requirements
As will be seen throughout the chapter, IFRS 2 requires an expense to be recognised in profit or loss in
relation to share-based payments.
The publication of IFRS 2 in 2004, and introduction of this requirement to recognise an expense caused
huge controversy with opposition especially strong among hi-tech companies. The arguments over
expensing share-based payments polarised opinion, especially in the US.
 The main argument against recording an expense was that no cash changes hands as part of such
transactions, and therefore there is no true expense. C
H
 The main argument for was that share-based payments are simply another form of compensation A
that should go into the calculation of earnings for the sake of transparency for investors and the P
business community. T
E
Practical application of IFRS 2 R
In practice, the implementation of IFRS 2 has resulted in earnings being reduced, sometimes
significantly. It is generally agreed that as a result of this Standard companies focus more on the
9
earnings effect of different rewards policies.
Following the adoption of IFRS 2, some companies have admitted that they are re-evaluating the use of
share options as part of employee remuneration.
Illustration: GlaxoSmithKline plc

The effect of IFRS 2 on reported performance can be substantial even in mature businesses.
GlaxoSmithKline plc (GSK), a company listed on both the London and New York stock exchanges,
operating in the pharmaceutical industry adopted IFRS 2 in 2004 and restated its 2003 results. In line
with IFRS 2, GSK recognised a charge of £226 million in 2006 (£236m in 2005 and £333m in 2004).
The IFRS 2 adjustment to restate pre-tax profits for 2003 was £369m which represented 5.8% of pre-tax
profits.
Following the restatement of the 2003 results to reflect IFRS 2, there appears to be a trend towards a
reduction in share-based compensation as a percentage of pre-tax profits.
Share-based payment 301

2006 2005 2004 2003
£m £m £m £m
Profit before tax 7,799 6,732 6,119 6,335
Share-based compensation 226 236 333 369
% % % %
Share-based compensation as a % of pre-tax profits 2.9 3.5 5.4 5.8
2 Objective and scope of IFRS 2 Share-based Payment
Section overview
 A share-based payment transaction is one in which the entity transfers equity instruments, such as
shares or share options, in exchange for goods and services supplied by employees or third
parties.
2.1 Transactions within the scope of IFRS 2

IFRS 2 applies to all share-based payment transactions. The Standard recognises and addresses three
types of transactions according to the method of settlement.
 Equity-settled share-based payment transactions
The entity receives goods or services in exchange for equity instruments of the entity (including
shares or share options).
 Cash-settled share-based payment transactions
The entity receives goods or services in exchange for amounts of cash that are based on the price
(or value) of the entity's shares or other equity instruments of the entity.
 Transactions with a choice of settlement
The entity receives goods or services and either the entity or the supplier has a choice as to
whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments.
IFRS 2 requires an entity to recognise share-based payment transactions in its financial statements.
Transactions in which an entity receives goods or services as consideration for equity instruments of the
entity (including shares or share options) are share-based payment transactions. Such transactions give
rise to expenses (or, if applicable, assets) that should be measured at fair value.
IFRS 2 was amended in June 2009 to address situations in those parts of the world where, for public
policy or other reasons, companies give their shares or rights to shares to individuals, organisations or
groups that have not provided goods or services to the company. An example is the issue of shares to a
charitable organisation for less than fair value, where the benefits are more intangible than usual goods
or services.
Note that the requirements of IFRS 13 Fair Value Measurement (see Chapter 2) do not apply to share-
based payment transactions within the scope of IFRS 2.
2.1.1 Share-based payments among group entities

Payment for goods or services received by an entity within a group may be made in the form of
granting equity instruments of the parent company, or equity instruments of another group company.
IFRS 2.3 states that this type of transaction qualifies as a share-based payment transaction within the
scope of IFRS 2.
In 2009, the standard was amended to clarify that it applies to the following arrangements:
 Where the entity's suppliers (including employees) will receive cash payments that are linked to the
price of the equity instruments of the entity

 Where the entity's suppliers (including employees) will receive cash payments that are linked to the
price of the equity instruments of the entity's parent
Under either arrangement, the entity's parent had an obligation to make the required cash payments to
the entity's suppliers. The entity itself did not have any obligation to make such payments. IFRS 2 applies
to arrangements such as those described above even if the entity that receives goods or services from its
suppliers has no obligation to make the required share-based cash payments.
2.2 Transactions outside the scope of IFRS 2

The following are outside the scope of IFRS 2:
 Transactions with employees and others in their capacity as a holder of equity instruments of the
entity (for example, where an employee receives additional shares in a rights issue to all
shareholders)
 The issue of equity instruments in exchange for control of another entity in a business
combination
 Contracts to buy or sell non-financial items that may be settled net in shares or rights to shares are
outside the scope of IFRS 2 and are addressed by IAS 32 Financial Instruments: Presentation and IAS
39 Financial Instruments: Recognition and Measurement
Worked example: Transactions within and outside the scope of IFRS 2

Scenario 1 – Entity A grants share warrants and its own equity to its external consultants. The warrants
become exercisable once an initial public offering (IPO) is made and on condition that the consultants
continue to provide agreed services to Entity A until the date the IPO is made.
This transaction is a share-based payment within the scope of IFRS 2.
Scenario 2 – Entity B buys back some of its own shares from employees in their capacity as shareholders
for the market value of those shares.
This transaction is a simple purchase of treasury shares and is outside the scope of IFRS 2, being
governed instead by IAS32.
Scenario 3 – Entity C buys back some of its own shares but pays an amount in excess of their market
value only to shareholders who are employees.
The excess over market value to employees only would be considered as a compensation expense C
H
within the scope of IFRS 2. A
Scenario 4 – Entity D enters into a contract to buy a commodity for use in its business for cash, at a P
T
price equal to the value of 1,000 shares of Entity D at the date the commodity is delivered. Although E
Entity D can settle the contract net, it does not intend to do so, nor does it have a past practice of doing R
so.
This transaction is within the scope of IFRS 2 as it meets the definition of a cash-settled share-based
payment transaction. Entity D will be acquiring goods in exchange for a payment, the amount of which 9
will be based on the value of its shares.
If, however, Entity D has a practice of settling these contracts net, or did not intend to take physical
delivery, then the forward contract would be within the scope of IAS 32 and IAS 39 and outside the
scope of IFRS 2.
3 Share-based transaction terminology
Section overview
 Share-based transactions are agreed between an entity and counterparty at the grant date; the
counterparty becomes entitled to the payment at the vesting date.

Before considering the accounting treatment of share-based payment transactions, it is important to
understand the terminology used within the topic.
Vesting period
Year 1 Year 2 Year 3
Grant date Vesting date
Definitions
Grant date: The date at which the entity and other party agree to the share-based payment
arrangement. At this date the entity agrees to pay cash, other assets or equity instruments to the other
party, provided that specified vesting conditions, if any, are met. If the agreement is subject to
shareholder approval, then the approval date becomes the grant date.
Vesting conditions: The conditions that must be satisfied for the other party to become entitled to
receive the share-based payment.
Vesting period: The period during which the vesting conditions are to be satisfied.
Vesting date: The date on which all vesting conditions have been met and the employee / third party
becomes entitled to the share-based payment.
In some cases the grant date and vesting date are the same. This is the case where vesting conditions
are met immediately and therefore there is no vesting period.
3.1 Vesting conditions

IFRS 2 recognises two types of vesting conditions:
Non-market based vesting conditions
These are conditions other than those relating to the market value of the entity's shares. Examples
include vesting dependent on:
 The employee completing a minimum period of service (also referred to as a service condition)
 Achievement of minimum sales or earnings target
 Achievement of a specific increase in profit or earnings per share
 Successful completion of a flotation
 Completion of a particular project
Market based vesting conditions
Market-based performance or vesting conditions are conditions linked to the market price of the shares in
some way. Examples include vesting dependent on achieving:
 A minimum increase in the share price of the entity
 A minimum increase in shareholder return
 A specified target share price relative to an index of market prices
The definition of vesting conditions is:
 Restricted to service conditions and performance conditions, and
 Excludes other features such as a requirement for employees to make regular contributions into a
savings scheme.

4 Equity-settled share-based payment transactions
Section overview
 Where payment for goods or services is in the form of shares or share options, the fair value of the
transaction is recognised in profit or loss, spread over the vesting period.
4.1 Introduction
If goods or services are received in exchange for shares or share options, the transaction is accounted for
by:
£ £
DR Expense/Asset X
CR Equity X
IFRS 2 does not stipulate which equity account the credit entry is made to. It is normal practice to credit
a separate component of equity, although an increasing number of UK companies are crediting retained
earnings.
We must next consider:
1 Measurement of the total expense taken to profit or loss
2 When this expense should be recorded.
4.2 Measurement
When considering the total expense to profit or loss, the basic principle is that equity-settled share-
based transactions are measured at fair value.
Definition
Fair value: The amount for which an asset could be exchanged, a liability settled, or an equity
instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length
transaction.
(Note that this definition is still applicable, rather than the definition in IFRS 13, because IFRS 13 does
not apply to transactions within the scope of IFRS 2.) C
H
A
P
Fair value will depend upon who the transaction is with: T
E
 There is a rebuttable presumption that the fair value of goods/services received from a third party R
can be measured reliably.
 It is not normally possible to measure services received when the shares or share options form part
9
of the remuneration package of employees.

Transaction with third parties Transaction with employees
Can the fair value of goods / services

be measured reliably?
no
yes
Measure at fair value of the goods / Measure at the fair value of the equity
services on the date they were received instruments granted at grant date
= direct method = indirect method
4.3 Allocation of expense to financial years

Immediate vesting
Where the instruments granted vest immediately, ie the recipient party becomes entitled to them
immediately, then the transaction is accounted for in full on the grant date.
Vesting period exists
Where entitlement to the instruments granted is conditional on vesting conditions, and these are to be
met over a specified vesting period, the expense is spread over the vesting period.
4.4 Transactions with third parties (non-employees)

Applying the rules seen in the sections above, transactions with third parties are normally
 Measured at the fair value of goods / services received
 Recorded when the goods / services are received
Worked example: Third party transactions – direct method

Entity A has been paying Entity B, a corporate finance consultancy, in cash at the rate of £600 per hour
for advice. Entity B is proposing to increase its fees by 5% per annum. Entity A is experiencing cash-flow
pressures, so it has persuaded Entity B to accept payment in the form of shares with effect from 1 July
20X5. The initial arrangement is for two years with Entity A agreeing to issue 6,000 of its shares to Entity
B every six months in exchange for Entity B providing 300 hours of advice evenly over the six-month
period.
Requirement
What is the expense in profit or loss and the corresponding increase in equity?
Solution
The services received and the shares issued by Entity A are measured at the fair value of the services
received. For the first year, the hourly rate will be measured at that originally proposed by Entity B,
105% of £600. Entity B plans to increase that rate by another 5% for the second year.
The expense in profit or loss and the increase in equity associated with these arrangements will be:
£
July – December 20X5 300 × £630 189,000
January – December 20X6 (300 × £630) + (300 × £630 × 1.05) 387,450
January – June 20X7 300 × £630 × 1.05 198,450

4.5 Transactions with employees
Applying the rules seen in the sections above, transactions with employees are normally
 Measured at the fair value of equity instruments granted at grant date
 Spread over the vesting period (often a specified period of employment)
Worked example: Employee transactions – indirect method

A company provides each of 10 key employees with 1,000 share options on 1 January 20X7. Each
option has a fair value of £9 at the grant date, £11 on 1 January 20X8, £14 on 1 January 20X9 and £12
The options do not vest until 31 December 20X9 and are dependent on continued employment. All 10
employees are expected to remain with the company.
Requirement
What are the accounting entries to be recorded in each of the years 20X7, 20X8 and 20X9?
Solution
The changes in the value of equity instruments after grant date do not affect the charge to profit or loss
for equity-settled transactions.
Based on the fair value at grant date, the remuneration expense is calculated as follows.
Number of employees  number of equity instruments  fair value of equity instruments at grant date
= 10 × 1,000 × £9 = £90,000
The remuneration expense should be recognised over the vesting period of three years. An amount of
£30,000 should be recognised for each of the three years 20X7, 20X8 and 20X9 in profit or loss with a
corresponding credit to equity.
Interactive question 1: Employee transactions [Difficulty level: Easy]

An entity provides each of its employees with 10 share options at 1 July 20X5, but the options do not
vest until 30 June 20X7. The share options may be exercised after vesting date provided that the
employees remain in the entity's employment. C
H
The fair value of the share options is £20 on grant date and there are 1,500 employees in the entity's A
employment at 1 July 20X5. P
T
Requirement E
R
How should the entity account for the transaction if all employees remain in the entity's employment?
9
4.5.1 Immediate vesting

Some share-based transactions with employees vest immediately. In this case, it is assumed that the
relevant services have already been received and so the transaction is recognised on the grant date.
Worked example: Share options vest immediately

An entity issues 10 share options to each of its employees on 1 July 20X5. The share options vest
immediately and there is a two-year period over which the employees may exercise the share options.
Employees are entitled to exercise the options regardless of whether or not they remain in the entity's
employment during the period of exercise. The fair value of the share options is £10 on grant date and
there are 1,500 employees in the entity's employment at 1 July 20X5.

Requirement
How should the transaction be accounted for?
Solution
The total fair value for the share options issued at grant date is:
£10 x 1,500 employees × 10 options = £150,000
The entity should therefore charge £150,000 to profit or loss as employee remuneration on 1 July 20X5
and the same amount will be recognised as part of equity on that date.
4.6 The impact of different types of vesting conditions

As we have seen earlier, vesting conditions may be:
 Non-market based ie not relating to the market value of the entity's shares
 Market based ie linked to the market price of the entity's shares in some way
4.6.1 Non-market based vesting conditions

 These conditions are taken into account when determining the expense which must be taken to
profit or loss in each year of the vesting period.
 Only the number of shares or share options expected to vest will be accounted for.
 At each period end (including interim periods), the number expected to vest should be revised as
necessary.
 On the vesting date, the entity should revise the estimate to equal the number of shares or share
options that do actually vest.
Worked example: Non-market based vesting conditions

On 1 January 20X1 an entity grants 100 share options to each of its 400 employees. Each grant is
conditional upon the employee working for the entity until 31 December 20X3. The fair value of each
share option at the grant date is £20.
During 20X1 20 employees leave and the entity estimates that a total of 20% of the employees will
leave during the three-year period.
During 20X2 a further 25 employees leave and the entity now estimates that 25% of its employees will
leave during the three-year period.
During 20X3 a further 10 employees leave.
Requirement
Calculate the remuneration expense that will be recognised in respect of the share-based payment
transaction for each of the three years ended 31 December 20X3.
Solution
IFRS 2 requires the entity to recognise the remuneration expense, based on the fair value of the share
options granted, as the services are received during the three-year vesting period.
In 20X1 and 20X2 the entity estimates the number of options expected to vest (by estimating the
number of employees likely to leave) and bases the amount that it recognises for the year on this
estimate.
In 20X3 it recognises an amount based on the number of options that actually vest. A total of 55
employees left during the three-year period and therefore 34,500 options (400 – 55)  100 vested.

The amount recognised as an expense for each of the three years is calculated as follows.
Cumulative
expense Expense for
at year-end year
£ £
20X1 100 options x 400 employees  80%  £20  1/3 213,333 213,333
20X2 100 options x 400 employees  75%  £20  2/3 400,000 186,667
20X3 34,500  £20 x 3/3 690,000 290,000
Interactive question 2: Non-market based vesting conditions [Difficulty level: Easy]

On 1 January 20X3 an entity grants 500 share options to each of its 400 employees. The only condition
attached to the grant is that the employees should continue to work for the entity until 31 December
20X6. Ten employees leave during the year, and it is expected that a further ten will leave each year.
The market price of each option was £10 at 1 January 20X3 and £12 at 31 December 20X3.
Requirement
Show how this transaction will be reflected in the financial statements for the year ended 31 December
20X3.
Worked example: Non-market based vesting conditions

On 1 January 20X4 an entity granted options over 10,000 of its shares to Sally, one of its senior
employees. One of the conditions of the share option scheme was that Sally must work for the entity for
three years. Sally continued to be employed by the entity during 20X4, 20X5 and 20X6.
A second condition for vesting is that the costs for which Sally is responsible should reduce by 10% per
annum compound over the three-year period. At the date of grant, the fair value of each share option
was estimated at £21.
At 31 December 20X4 Sally's costs had reduced by 15% and therefore it was estimated that the
performance condition would be achieved. C
H
Due to a particularly tough year of trading for the year ended 31 December 20X5 Sally had only A
P
reduced costs by 3% and it was thought at that time that she would not meet the cost reduction target
T
by 31 December 20X6. E
R
At 31 December 20X6, the end of the performance period, Sally did meet the overall cost reduction
target of 10% per annum compound.
Requirement 9
How should the transaction be recognised?
Solution
The cost reduction target is a non-market performance condition which is taken into account in
estimating whether the options will vest. The expense recognised in profit or loss in each of the three
years is:
Cumulative Charge in the year
£ £
20X4 (10,000  £21)/3 years 70,000 70,000
20X5 Assumed performance would not be achieved 0 (70,000)
20X6 10,000  £21 210,000 210,000

4.6.2 Market-based vesting conditions
 These conditions are taken into account when calculating the fair value of the equity instruments at
the grant date.
 They are not taken into account when estimating the number of shares or share options likely to
vest at each period end.
 If the shares or share options do not vest, any amount recognised in the financial statements will
remain.
4.6.3 Market and non-market based vesting conditions

Where equity instruments are granted with both market and non-market vesting conditions, paragraph
21 of IFRS 2 requires an entity to recognise an expense irrespective of whether market conditions are
satisfied, provided all other vesting conditions are satisfied.
In summary, where market and non-market conditions co-exist, it makes no difference whether the
market conditions are achieved. The possibility that the target share price may not be achieved has
already been taken into account when estimating the fair value of the options at grant date. Therefore,
the amounts recognised as an expense in each year will be the same regardless of what share price has
been achieved.
Worked example: Market and non-market vesting conditions

On 1 January 20X4 an entity granted options over 10,000 of its shares to Jeremy, one of its senior
employees. One of the conditions of the share option scheme was that Jeremy must work for the entity
for three years. Jeremy continued to be employed by the entity during 20X4, 20X5 and 20X6. A second
condition for vesting is that the share price increases at 25% per annum compound over the three-year
period. At the date of grant the fair value of each share option was estimated at £18 taking into account
the estimated probability that the necessary share price growth would be achieved at 25%.
During the year ended 31 December 20X4 the share price rose by 30% and by 26% per annum
compound over the two years to 31 December 20X5. For the three years to 31 December 20X6 the
increase was 24% per annum compound.
Requirement
How should the transaction be recognised?
Solution
Jeremy satisfied the service requirement but the share price growth condition was not met. The share
price growth is a market condition and is taken into account in estimating the fair value of the options at
grant date. No adjustment should be made if there are changes from that estimated in relation to the market
condition. There is no write-back of expenses previously charged, even though the shares do not vest.
The expense recognised in profit or loss in each of the three years is one third of 10,000 × £18 =
£60,000.
Interactive question 3: Market and non-market performance conditions

Company B issued 100 share options to certain employees, that will vest once revenues reach
£1 billion and its share price equals £50. The employee will have to be employed with Company B at
the time the share options vest in order to receive the options. The share options had a fair value of £20
at the grant date and will expire in 10 years.
Requirement
How should the expense be recorded under each of the following different scenarios?
 All options vest

 Revenues have reached £1 billion, all employees are still employed and the share price is £49
 The share price has reached £50, all employees are still employed but revenues have not yet
reached £1 billion
 Revenues have reached £1 billion, the share price has reached £50 and half of the employees who
received options left the company prior to the vesting date
4.7 Other issues

4.7.1 Transactions during the year
Where the grant date arises mid year, the calculation of the amount charged to profit or loss must be
pro-rated to reflect that fact.
Worked example: Options issued during the year

Yarex plc is proposing to award share options to directors and senior employees during the accounting
year ending 31 December 20X6.
The proposal is to issue 100,000 options to each of the 50 directors and senior managers on 1
November 20X6.
The exercise price of the options would be £5 per share. The scheme participants will need to have been
with the company for at least three years before being able to exercise their options.
It is estimated that 75% of the current directors and senior managers will remain with the company for
three years or more.
1 November 20X6 Average 20X6 31 December 20X6
£ £ £
Price per share 5.00 5.50 5.80 (estimated)
Fair value of each option 2.00 2.40 3.80 (estimated)
Requirement
Show how the proposed scheme would be reflected in the financial statements on 31 December 20X6
and 31 December 20X7. Ignore taxation.
C
H
A
Solution P
T
The three-year service condition specified by the options contract is a non-market vesting condition
E
which should be taken into account when estimating the number of options which will vest at the end R
of each period. Therefore the proportion of directors expected to remain with the company is relevant
in determining the remuneration charge arising from the options.
The fair value for the options used is the fair value at the grant date ie the fair value of £2 on 1 9
November 20X6.
The remuneration expense in respect of the options for the year ended 31 December 20X6 is calculated
as follows:
Fair value of options expected to vest at grant date:
(75%  50 employees) × 100,000 options × £2 = £7,500,000
Annual charge to profit or loss therefore £7.5 million/3 years = £2.5 million
Charge to profit or loss for y/e 31 December 20X6 = £2.5 million × 2/12 months = £416,667
The accounting entry for the year ending 31 December 20X6 is:
£ £
DR Remuneration expense 416,667
CR Equity 416,667

In 20X7 the remuneration charge is for the whole year. Assuming there is no change in the estimated
retention rate for employees, the accounting entry is:
£ £
DR Remuneration expense 2,500,000
CR Equity 2,500,000
4.7.2 Vested options not exercised

If, after the vesting date, options are not exercised or the equity instrument is forfeited, there will be no
impact on the financial statements. This is because the holder of the equity instrument has effectively
made that decision as an investor.
The services for which the equity instrument remunerated were received by the entity and the financial
statements reflect the substance of this transaction. IFRS 2 does, however, permit a transfer to be made
between reserves in such circumstances to avoid an amount remaining in a separate equity reserve
where no equity instrument will be issued.
4.7.3 Variable vesting date

Where the vesting date is variable depending upon non-market based vesting conditions, the
calculation of the amount expensed in profit or loss must be based upon the best estimate of when
vesting will occur.
Interactive question 4: Variable vesting date [Difficulty level: Intermediate]

At the beginning of Year 1, Kingsley grants 100 shares each to 500 employees, conditional upon the
employees remaining in the entity's employ during the vesting period. The shares will vest at the end of
Year 1 if the entity's earnings increase by more than 18%; at the end of Year 2 if the entity's earnings
increase by more than an average of 13% per year over the two-year period; and at the end of Year 3 if
the entity's earnings increase by more than an average of 10% per year over the three-year period. The
shares have a fair value of £30 per share at the start of Year 1, which equals the share price at grant
date. No dividends are expected to be paid over the three-year period.
By the end of Year 1, the entity's earnings have increased by 14%, and 30 employees have left. The
entity expects that earnings will continue to increase at a similar rate in Year 2, and therefore expects
that the shares will vest at the end of Year 2. The entity expects, on the basis of a weighted average
probability, that a further 30 employees will leave during Year 2, and therefore expects that 440
employees will vest in 100 shares at the end of Year 2.
By the end of Year 2, the entity's earnings have increased by only 10% and therefore the shares do not
vest at the end of Year 2. 28 employees have left during the year. The entity expects that a further 25
employees will leave during Year 3, and that the entity's earnings will increase by more than 6%,
thereby achieving the average of 10% per year.
By the end of Year 3, 23 employees have left and the entity's earnings had increased by 8%, resulting in
an average increase of 10.64% per year. Therefore 419 employees received 100 shares at the end of
Year 3.
Requirement
Show the expense and equity figures which will appear in the financial statements in each of the three
years.
4.7.4 Modifications and re-pricing

Equity instruments may be modified before they vest.
Eg A downturn in the equity market may mean that the original option exercise price set is no longer
attractive. Therefore the exercise price is reduced (the option is 're-priced') to make it valuable again.

Such modifications will often affect the fair value of the instrument and therefore the amount
The accounting treatment of modifications and re-pricing is:
 Continue to recognise the original fair value of the instrument in the normal way (even where the
modification has reduced the fair value).
 Recognise any increase in fair value at the modification date (or any increase in the number of
instruments granted as a result of modification) spread over the period between the modification
date and vesting date.
 If modification occurs after the vesting date, then the additional fair value must be recognised
immediately unless there is, for example, an additional service period, in which case the difference
is spread over this period.
Worked example: Re-pricing of share options

An entity granted 1,000 share options at an exercise price of £50 to each of its 30 key management
personnel on 1 January 20X4. The options only vest if the managers were still employed on 31
December 20X7. The fair value of the share options was estimated at £20 and the entity estimated that
the options would vest with 20 managers. This estimate was confirmed on 31 December 20X4.
The entity's share price collapsed early in 20X5. On 1 July 20X5 the entity modified the share options
scheme by reducing the exercise price to £15. It estimated that the fair value of an option was £2
immediately before the price reduction and £11 immediately after. It retained its estimate that options
would vest with 20 managers.
Requirement
How should the modification be recognised?
Solution
The total cost to the entity of the original option scheme was:
1,000 shares × 20 managers × £20 = £400,000
This was being recognised at the rate of £100,000 each year.
The cost of the modification is:
1,000  20 managers × (£11 – £2) = £180,000 C
H
This additional cost should be recognised over 30 months, being the remaining period up to vesting, so A
£6,000 a month. P
T
The total cost to the entity in the year ended 31 December 20X5 is: E
R
£100,000 + (£6,000 × 6) = £136,000.
9
Interactive question 5: Re-pricing of share options [Difficulty level: Intermediate]
At the beginning of Year 1, an entity grants 100 share options to each of its 500 employees. Each grant
is conditional upon the employee remaining in service over the next three years. The entity estimates
that the fair value of each option is £15. On the basis of a weighted average probability, the entity
estimates that 100 employees will leave during the three-year period and therefore forfeit their rights to
the share options.
During the first year 40 employees leave. By the end of the first year, the entity's share price has
dropped, and the entity reprices its share options. The repriced share options vest at the end of Year 3.
The entity estimates that a further 70 employees will leave during Years 2 and 3, and hence the total
expected employee departures over the three-year vesting period is 110 employees. During Year 2 a
further 35 employees leave, and the entity estimates that a further 30 employees will leave during Year
3, to bring the total expected employee departures over the three-year vesting period to 105
employees. During Year 3, a total of 28 employees leave, and hence a total of 103 employees ceased

employment during the vesting period. For the remaining 397 employees, the share options vested at
the end of Year 3.
The entity estimates that, at the date of repricing, the fair value of each of the original share options
granted (ie before taking into account the repricing) is £5 and that the fair value of each repriced share
option is £8.
Requirement
What are the amounts that should be recognised in the financial statements for Years 1 to 3?
4.7.5 Cancellations and settlements

An entity may settle or cancel an equity instrument during the vesting period. Where this is the case, the
correct accounting treatment is:
 To immediately charge any remaining fair value of the instrument that has not been recognised in
profit or loss (the cancellation or settlement accelerates the charge and does not avoid it).
 Any amount paid to the employees by the entity on settlement should be treated as a buyback of
shares and should be recognised as a deduction from equity. If the amount of any such payment is
in excess of the fair value of the equity instrument granted, the excess should be recognised
immediately in profit or loss.
Worked example: Cancellation

An entity granted 2,000 share options at an exercise price of £18 to each of its 25 key management
personnel on 1 January 20X4. The options only vest if the managers are still employed by the entity on
31 December 20X6. The fair value of the options was estimated at £33 and the entity estimated that the
options would vest with 23 managers. This estimate was confirmed on 31 December 20X4.
In 20X5 the entity decided to base all incentive schemes around the achievement of performance
targets and to abolish the existing scheme for which the only vesting condition was being employed
over a particular period. The scheme was cancelled on 30 June 20X5 when the fair value of the options
was £60 and the market price of the entity's shares was £70. Compensation was paid to the 24
managers in employment at that date, at the rate of £63 per option.
Requirement
How should the entity recognise the cancellation?
Solution
The original cost to the entity for the share option scheme was:
2,000 shares × 23 managers × £33 = £1,518,000
This was being recognised at the rate of £506,000 in each of the three years.
At 30 June 20X5 the entity should recognise a cost based on the amount of options it had vested on
that date. The total cost is:
2,000 × 24 managers × £33 = £1,584,000
After deducting the amount recognised in 20X4, the 20X5 charge to profit or loss is £1,078,000.
The compensation paid is:
2,000 × 24 × £63 = £3,024,000
Of this, the amount attributable to the fair value of the options cancelled is:
2,000  24  £60 (the fair value of the option, not of the underlying share) = £2,880,000
This is deducted from equity as a share buyback. The remaining £144,000 (£3,024,000 less £2,880,000)
is charged to profit or loss.

4.7.6 Cancellation and reissuance
Where an entity has been through a capital restructuring or there has been a significant downturn in the
equity market through external factors, an alternative to repricing the share options is to cancel them
and issue new options based on revised terms. The end result is essentially the same as an entity
modifying the original options and therefore should be recognised in the same way.
4.7.7 Cancellation by parties other than the entity

As well as the entity, two other parties may cancel an equity instrument:
 Cancellations by the counterparty (eg the employee)
 Cancellations by a third party (eg a shareholder)
Cancellations by the employee must be treated in the same way as cancellations by the employer,
resulting in an accelerated charge to profit or loss of the unamortised balance of the options
granted.
4.7.8 Repurchase after vesting

Where equity instruments are repurchased by an employing entity following vesting, this is similar to
the entity providing the employee with cash remuneration in the first instance. The reporting therefore
reflects this with the payment being recognised as a deduction from equity. The charge recognised in
profit or loss will remain, as this reflects the services for which the employee has been remunerated. If
the payment made is in excess of the fair value of the instruments granted, then this is recognised
immediately in profit or loss reflecting that this is payment for additional services beyond what was
originally agreed.
4.8 Determining the fair value of equity instruments granted

Where a transaction is measured by reference to the fair value of the equity instruments granted, fair
value is based on market prices where available.
If market prices are not available, the entity should estimate the fair value of the equity instruments
granted using a suitable valuation technique. These techniques are covered at Professional level and in
your Business Analysis Study Manual.
4.8.1 Calculating fair value

C
Share options granted to employees do not generally have a readily obtainable market price because H
the conditions attached to the options usually make them different from other options that an entity A
P
may trade on the open market.
T
Where there is no readily obtainable market price an entity should use an option pricing model to E
R
calculate fair value. The type of option-pricing model should reflect the nature of the options. Employee
options often have long lives and are generally exercisable between the vesting date and the end of the
life of the option; the model used should allow for such circumstances.
9
All option-pricing models take into account a number of factors as set out below.
 The exercise price of the option – a known amount.
 The life of the option – although the maximum life of the option is a known quantity, this input
requires an estimate of the expected life of the individual option. Employee options, for example,
are typically exercised soon after vesting date, as this is generally the only way that an employee
can crystallise any gain.
 The current price of the underlying shares – this is generally a known amount (the listed market
value of the shares).
 The expected volatility of the share price – volatility is typically expressed in annualised terms for
ease of comparability. The expected annualised volatility of a share is expressed in terms of the
compounded annual rate of return that is expected to arise approximately two-thirds of the time.
Volatility (also discussed in detail in your Business Analysis Study Manual) is a measure of the
amount by which a share price is expected to fluctuate during a period. For example, a share

worth £100 with a volatility of 40% would suggest that it will be worth between £60 and £140
approximately two-thirds of the time between the grant date and the exercise of the options.
 The dividend expected on the shares – this should only be included where the employee is not
entitled to dividends on the underlying options granted.
 The risk-free interest rate for the life of the option – this is typically 'the implied yield currently
available on zero-coupon government issues of the country in whose currency the exercise price is
expressed'.
Factors which are typically used to assess volatility include the historical volatility of the entity's share
price and the length of time that the shares have been publicly traded.
4.8.2 Which valuation model?

The determination of an appropriate model for the valuation of share-based payment transactions is an
accounting policy choice and should be applied consistently to similar types of transactions.
In choosing an appropriate model the key question is whether the model used to estimate fair value
represents the economics of the instruments and whether the inputs represent the attributes being
measured.
The Black-Scholes model
The Black-Scholes-Merton formula (normally referred to as the Black-Scholes model) is a popular model
and one that is easy to use. However, the model is based on the assumption that options are not
exercised before the end of their lives and therefore may not be suitable for valuing employee share
options. Where such options have a relatively short life and the period after vesting is short, the Black-
Scholes model may provide a reasonable approximation of fair value.
Strengths
 Formula required to calculate fair value is relatively straightforward and can be easily used in
spreadsheets.
 Its wide use enhances comparability.
Weaknesses
The inputs and assumptions of the Black-Scholes model are designed to cover the entire period the
option is outstanding. Because of this feature the model is described as a 'closed form solution'.
 The model cannot therefore be adjusted to take into account anticipated changes in market
conditions or incorporate different values for variables (such as volatility) over the term of the
option as perceived at the grant date. The Black-Scholes model assumes constant volatility and
cannot therefore be adjusted to take into account the empirical observation that the implied
volatility of a share option changes as the intrinsic value of the option changes.
 The model cannot take into account the possibility of early exercise. This is less of an issue when
options have to be exercised on or shortly after vesting.
The Binomial model
The Binomial model applies the same principles as decision tree analysis to the pricing of an option.
Based on the relative probabilities of each path, an expected outcome is estimated.
In contrast to the Black-Scholes model, the Binomial model can incorporate different values for the
variables over the term of the option. Therefore it is described as an 'open form solution' and it can be
adjusted to take into account changes in market conditions and the input variables.
Strengths
 The Binomial model is generally accepted as a more flexible alternative to the Black-Scholes model.
 The inputs into the model are more suitable for an option with a longer term.
Weaknesses
 In practice, the application of the model is more complex than the Black-Scholes model. Whereas
the Black-Scholes model allows the value of an option to be calculated using a relatively simple

spreadsheet, the Binomial model requires a more complex spreadsheet or program to calculate the
option value.
 The calculation of the probabilities of particular price movements is highly subjective.
Monte-Carlo simulation
Monte-Carlo simulation extends the Binomial model by undertaking thousands of simulations of
potential future outcomes for key assumptions and calculating the option value under each scenario.
Monte-Carlo models can incorporate very complex performance conditions and exercise patterns. They
are generally considered the best type of model for valuing employee share-based payments although
they are also affected by the subjectivity of probabilities.
Section overview
 The credit entry in respect of a cash-settled share-based payment transaction is reported as a
liability.
 The fair value of the liability should be re-measured at each reporting date until settled. Changes
in the fair value are recognised in profit or loss.
5.1 Introduction
Cash-settled share-based payment transactions are transactions where the amount of cash paid for
goods and services is based on the value of an entity's equity instruments.
Examples of this type of transaction include:
 Share appreciation rights (SARs): the employees become entitled to a future cash payment (rather
than an equity instrument), based on the increase in the entity's share price from a specified level
over a specified period of time; or
 An entity might grant to its employees a right to receive a future cash payment by granting to
them a right to shares that are redeemable.
C
H
5.2 Accounting treatment A
P
If goods or services are received in exchange for cash amounts linked to the value of shares, the T
transaction is accounted for by: E
£ £ R
DR Expense/Asset X
CR Liability X
9
Allocation of expense to financial years
The expense should be recognised as services are provided. For example, if share appreciation rights do
not vest until the employees have completed a specified period of service, the entity should recognise
the services received and the related liability, over that period.
Measurement
The goods or services acquired and the liability incurred are measured at the fair value of the liability.
The entity should remeasure the fair value of the liability at each reporting date and at the date of
settlement. Any changes in fair value are recognised in profit or loss for the period.
Vesting conditions
Vesting conditions should be taken into account in a similar way as for equity-settled transactions when
determining the number of rights to payment that will vest.

Worked example: cash-settled share-based payment transaction
On 1 January 20X1 an entity grants 100 cash share appreciation rights (SARs) to each of its 500
employees, on condition that the employees continue to work for the entity until 31 December 20X3.
During 20X1 35 employees leave. The entity estimates that a further 60 will leave during 20X2 and
20X3.
During 20X2 40 employees leave and the entity estimates that a further 25 will leave during 20X3.
During 20X3 22 employees leave.
At 31 December 20X3 150 employees exercise their SARs. Another 140 employees exercise their SARs at
31 December 20X4 and the remaining 113 employees exercise their SARs at the end of 20X5.
The fair values of the SARs for each year in which a liability exists are shown below, together with the
intrinsic values at the dates of exercise.
Fair value Intrinsic
value
£ £
20X1 14.40
20X2 15.50
20X3 18.20 15.00
20X4 21.40 20.00
20X5 25.00
Requirement
Calculate the amount to be recognised in profit or loss for each of the five years ended 31 December
20X5 and the liability to be recognised in the statement of financial position at 31 December for each of
the five years.
Solution
For the three years to the vesting date of 31 December 20X3 the expense is based on the entity's
estimate of the number of SARs that will actually vest (as for an equity-settled transaction). However, the
fair value of the liability is remeasured at each year-end.
The intrinsic value of the SARs at the date of exercise is the amount of cash actually paid.
Liability Expense for
at year end year
£ £ £
20X1 Expected to vest (500 – 95):
405 × 100 × £14.40 × 1/3 194,400 194,400
20X2 Expected to vest (500 – 100):
400 × 100 × £15.50 × 2/3 413,333 218,933
20X3 Exercised:
150 × 100 × £15.00 225,000
Not yet exercised (500 – 97 – 150):
253 × 100 × £18.20 460,460 47,127
272,127
20X4 Exercised:
140 × 100 × £20.00 280,000
Not yet exercised (253 – 140):
113 × 100 × £21.40 241,820 (218,640)
61,360
20X5 Exercised:
113 × 100 × £25.00 282,500
Nil (241,820)
40,680
787,500

Interactive question 6: Share-based payment [Difficulty level: Intermediate]
J&B granted 200 options on its £1 ordinary shares to each of its 800 employees on 1 January 20X1.
Each grant is conditional upon the employee being employed by J&B until 31 December 20X3.
J&B estimated at 1 January 20X1 that:
 The fair value of each option was £4 (before adjustment for the possibility of forfeiture).
 Approximately 50 employees would leave during 20X1, 40 during 20X2 and 30 during 20X3
thereby forfeiting their rights to receive the options. The departures were expected to be evenly
spread within each year.
The exercise price of the options was £1.50 and the market value of a J&B share on 1 January 20X1 was £3.
In the event, only 40 employees left during 20X1 (and the estimate of total departures was revised
down to 95 at 31 December 20X1), 20 during 20X2 (and the estimate of total departures was revised to
70 at 31 December 20X2) and none left during 20X3. The departures were spread evenly during each
year.
Requirements
The directors of J&B have asked you to illustrate how the scheme is accounted for under IFRS 2 Share-
based Payment.
(a) Show the double entries for the charge to profit or loss for employee services over the three years
and for the share issue, assuming all employees entitled to benefit from the scheme exercised their
rights and the shares were issued on 31 December 20X3.
(b) Explain how your solution would differ had J&B offered its employees cash, based on the share
value rather than share options.
See Answers at the end of this chapter.
6 Share-based payment with a choice of settlement
Section overview
C
 Accounting for share-based transactions with a choice of settlement depends on which party has H
the choice. A
P
– Where the counterparty has a choice of settlement, a liability component and an equity T
component are identified. E
R
– Where the entity has a choice of settlement, the whole transaction is treated either as cash-
settled or as equity-settled, depending on whether the entity has an obligation to settle in
cash. 9
6.1 Counterparty has the choice

Where the counterparty or recipient, rather than the issuing entity has the right to choose the form
settlement will take, IFRS 2 regards the transaction as a compound financial instrument to which split
accounting must be applied.
This means that the entity has issued an instrument with a debt component in so far as the recipient
may demand cash and an equity component to the extent that the recipient may demand settlement in
equity instruments.

The entity has issued
a compound financial instrument
Debt component Equity component
As for cash-settled Measured as the residual

transaction fair value at grant date
IFRS 2 requires that the value of the debt component is established first. The equity component is then
measured as the residual between that amount and the value of the instrument as a whole. In this
respect IFRS 2 applies similar principles to IAS 32 Financial Instruments: Presentation where the value of
the debt components is established first. However, the method used to value the constituent parts of
the compound instrument in IFRS 2 differs from that of IAS 32.
Fair value of goods Fair value of Equity component

or service debt component (residual)
For transactions in which the fair value of goods or services is measured directly (that is normally where
the recipient is not an employee of the company), the fair value of the equity component is measured as
the difference between the fair value of the goods or services required and the fair value of the debt
component.
For other transactions including those with employees where the fair value of the goods or services is
measured indirectly by reference to the fair value of the equity instruments granted, the fair value of the
compound instrument is estimated as a whole.
The debt and equity components must then be valued separately. Normally transactions are structured
in such a way that the fair value of each alternative settlement is the same.
Worked example: Choice of settlement

On 1 January 20X4 an entity grants an employee a right under which she can, if she is still employed on
31 December 20X6, elect to receive either 8,000 shares or cash to the value, on that date, of 7,000
shares.
The market price of the entity's shares is £21 at the date of grant, £27 at the end of 20X4, £33 at the
end of 20X5 and £42 at the end of 20X6, at which time the employee elects to receive the shares. The
entity estimates the fair value of the share route to be £19.
Requirement
Show the accounting treatment.
Solution
This arrangement results in a compound financial instrument.
The fair value of the cash route is:
7,000 × £21 = £147,000
The fair value of the share route is:
8,000 × £19 = £152,000
The fair value of the equity component is therefore:
£5,000 (£152,000 less £147,000)

The share-based payment is recognised as follows:
Liabilities Equity Expense
£ £ £
20X4 1/3 × 7,000 × £27 63,000 63,000
£5,000 × 1/3 1,667 1,667
20X5 2/3 × 7,000 × £33 154,000 91,000

£5,000 × 1/3 1,667 1,667
20X6 7,000 × £42 294,000 140,000

£5,000 × 1/3 1,667 1,667
As the employee elects to receive shares rather than cash, £294,000 is transferred from liabilities to
equity at the end of 20X6. The balance on equity is £299,000.
6.2 Entity has the choice

Where the entity may choose what form the settlement will take, it should recognise a liability to the
extent that it has a present obligation to deliver cash. Such circumstances arise where, for example, the
entity is prohibited from issuing shares or where it has a stated policy, or past practice, of issuing cash
rather than shares. Where a present obligation exists, the entity should record the transaction as if it is a
cash-settled share-based payment transaction. If no present obligation exists, the entity should treat the
transaction as if it was purely an equity-settled transaction. On settlement, if the transaction was treated
as an equity-settled transaction and cash was paid, the cash should be treated as if it was a repurchase
of the equity instrument by a deduction against equity.
Interactive question 7: Share-based payment [Difficulty level: Exam standard]

Woodley plc is one of your assurance clients, and has asked you to advise on how to apply IFRS 2 to its
new share option scheme. The company's reporting period is to 31 December.
The scheme is open to all 450 employees and all options are granted on 1 January 20X7. The fair value
of each option is £15 on 1 January 20X7. The company estimates that this fair value will rise by
approximately £5 per year. Each employee is given 100 options.
The vesting of the share option depends on achieving two independent targets. The first target is that
the share price must have increased by a total of at least 10% in order for the options to vest.
The second target is that shares can vest when profits increase by 15% in any year, or by an average of C
12% in any two years. The scheme will be cancelled after four years. H
A
In 20X7, profits increase by 10% and the share price has risen by 5%. The shares do not vest, but at
P
31 December 20X7 the forecast increase in profits for 20X8 is 14%, and the forecast increase in share T
price for 20X8 is 5%. It is therefore anticipated the shares will vest in 20X8. E
R
30 employees leave in 20X7 and it is estimated that a further 25 will leave before the options vest.
In 20X8, profits increase by 13% so the shares do not vest, although the share price target has now
been achieved. 15 employees left during the year and it is anticipated that a further 26 will leave before 9
the scheme is expected to vest in 20X9 (forecast profit increase for 20X9 is 12%).
In 20X9, profits increased by the forecast 12%, so the options vest. 390 employees ultimately received
their options.
Requirements
(a) Explain the principles of how this scheme should be measured and recognised. Calculate the IFRS 2
expense and set out the double entries required for 20X7, 20X8 and 20X9.
(b) Describe how your answer would be different if in 20Y0, 100 employees allowed their vested share
options to lapse.
(c) How would your answer to (a) be different if the actual increase in profits for the year to
31 December 20X9 was 10%, and, at that date, it was forecast that profits for 20Y0 were to
increase by 15%, but the actual increase achieved in 20Y0 was 9%? If the targets related to share
price and not profits, describe how to account for failing to meet the targets set.

7 Group and treasury share transactions
Section overview
 IFRS 2 was amended in June 2009 to incorporate the requirements of IFRIC 11 (now withdrawn)
on group and treasury share transactions.
7.1 Background
IFRS 2 gives guidance on group and treasury shares in three circumstances:
 Where an entity grants rights to its own equity instruments to employees, and then either chooses
or is required to buy those equity instruments from another party, in order to satisfy its obligations
to its employees under the share-based payment arrangement
 Where a parent company grants rights to its equity instruments to employees of its subsidiary
 Where a subsidiary grants rights to equity instruments of its parent to its employees

7.2.1 Entity chooses or is required to purchase its own shares
These transactions should always be accounted for as equity-settled share-based payment transactions
under IFRS 2.
7.2.2 Parent grants rights to its equity instruments to employees of its subsidiary
Assuming the transaction is accounted for as equity-settled in the consolidated financial statements, the
subsidiary must measure the services received using the requirements for equity-settled transactions in
IFRS 2, and must recognise a corresponding increase in equity as a contribution from the parent.
7.2.3 Subsidiary grants rights to equity instruments of its parent to its employees
The subsidiary accounts for the transaction as a cash-settled share-based payment transaction.
Therefore, in the subsidiary's individual financial statements, the accounting treatment of transactions in
which a subsidiary's employees are granted rights to equity instruments of its parent would differ,
depending on whether the parent or the subsidiary granted those rights to the subsidiary's employees.
This is because IFRIC 11 concluded that, in the former situation, the subsidiary has not incurred a
liability to transfer cash or other assets of the entity to its employees, whereas it has incurred such a
liability in the latter situation (being a liability to transfer equity instruments of its parent).
7.2.4 In June 2009, IFRIC 11 was withdrawn and incorporated into IFRS 2.
8 Disclosure
Section overview
 The disclosures of IFRS 2 are extensive and require the analysis of share-based payments made
during the year, their impact on earnings and the financial position of the company and the basis
on which fair values were calculated.
8.1 Nature and extent of share-based payment arrangements in the period

 A description of each type of share-based payment arrangement that existed at any time during
the period, including the general terms and conditions of each arrangement.

The disclosure requirements of IFRS 2 are designed to enable the user of financial statements to
understand:
– The nature and extent of share-based payment arrangements that existed during the period
– The basis upon which fair value was measured
– The impact of share-based transactions on earnings and financial position
 The number and weighted average exercise prices of share options for each of the following
groups of options.
– Outstanding at the beginning of the period
– Granted during the period
– Forfeited during the period
– Exercised during the period (plus the weighted average share price at the time of exercise)
– Expired during the period
– Outstanding at the end of the period
– Exercisable at the end of the period
 For share options exercised during the period, the weighted average share price at the date of
exercise.
 For share options outstanding at the end of the period, the range of exercise prices and weighted
average remaining contractual life.
8.2 Disclosable transactions under IAS 24

Share-based payments in respect of key management personnel and related parties have to be disclosed
in accordance with IAS 24 Related Party Disclosures.
8.3 Basis of fair value measurement

IFRS 2 requires disclosure of information that enables users of the financial statements to understand
how the fair value of the goods or services received, or the fair value of the equity instruments granted,
during the period was determined.
For equity instruments the disclosure of fair value methodology applies to both:
 New instruments issued during the reporting period
 Existing instruments modified during the reporting period
The entity must disclose the option pricing model used and the inputs to that model. These will include C
at least: H
A
 The weighted average share price P
 The exercise price T
E
 The expected volatility of the share price
R
 The life of the option
 The expected dividends on the underlying share
 The risk-free interest rate over the life of the option 9
 The method used and the assumptions made to incorporate the effect of early exercise
8.4 Impact on earnings and financial position

Entities should also disclose information that enables users of the financial statements to understand the
effect of share-based payment transactions on the entity's profit or loss for the period and on its
financial position.
 The total expense recognised for the period arising from share-based payment transactions,
including separate disclosure of that portion of the total expense that arises from transactions
accounted for as equity-settled share-based payment transactions.
 For liabilities arising from share-based payment transactions:
– The total carrying amount at the end of the period
– The total intrinsic value at the end of the period of liabilities for which the counterparty's
right to cash or other assets had vested by the end of the period

The disclosure requirements of IFRS 2 are illustrated by an example below.
8.5 Model disclosures

(Note that comparative figures have been omitted from the disclosure).
Share options are granted to both directors and employees, with the exercise price always set at the
market price at the date of grant. Conditions of the options typically include sales growth and cost-
reduction targets over a three-year period from the date of grant. Options which vest are exercisable
over the subsequent four years.
For the year the number and weighted average exercise prices were as follows.
Average
Options exercise price
£
At start of year 163,000 2.00
Granted 50,000 3.00
Forfeited (8,000) –
Exercised (30,000) 1.80
Expired (6,000) –
At end of year 169,000 2.40
Details of the 169,000 outstanding options are as follows:
 The range of exercise prices is £1.50 to £3.00 and the weighted average remaining life is 5.1 years
 72,000 are currently exercisable
The weighted average share price at the date the 30,000 options were exercised during the year was
£2.95.
The fair value of the options granted, all of which were granted on 18 June, was £5.60, based upon the
Black-Scholes model. The key inputs to that model were a weighted average share price of £3.50, an
exercise price of £3.00, expected volatility (based on historic volatility) of 28% and a risk-free interest
rate of 4% per annum.
The total expense for share options recognised in the year was £280,000.
8.6 Impact of share-based payments on Earnings per Share (EPS)

IAS 33 Earnings per Share requires that for calculating diluted EPS all dilutive options need to be taken
into account. Employee share options with fixed terms and non-vested ordinary shares are treated as
options outstanding on grant date even though they may not have vested on the date the diluted EPS is
calculated. All awards which do not specify performance criteria are treated as options.
Employee share options contingent on performance related conditions are treated as contingently
issuable shares and are dealt with in detail in Chapter 14.
9 UK GAAP comparison
Section overview
 FRS 20 issued by the ASB in April 2004 is identical to IFRS 2, with the exception of the deferred
implementation for unlisted entities.
9.1 IFRS 2 Share-based payment and UK GAAP

The ASB issued FRS 20 Share-based Payment in April 2004 the requirements of which are identical to
those of IFRS 2 except that implementation by unlisted entities is deferred by one year to accounting
periods commencing on or after 1 January 2006 as opposed to 1 January 2005 for IFRS 2.

IFRS UK GAAP
IFRS 2 Share-based Payment FRS 20 Share-based Payment

ESOP (Employee SIC 12 requires the sponsoring entity UITF 38 requires assets and liabilities
share ownership to consolidate the trust and not of an employee share ownership
plan) effectively aggregate into its financial statements plan (ESOP) to be recognised in the
controlled by the as in UK GAAP sponsoring company's financial
entity statements where the sponsoring
company has de facto control of
those assets and liabilities.
Entity's own shares Shown as a deduction from equity as Shown as a deduction from
held through ESOP required by IAS 32 shareholders' funds.
10 Distributable profits and purchase of own shares
Section overview
 Various rules have been created to ensure that dividends are only paid out of available profits.
Definition
A dividend is an amount payable to shareholders from profits or other distributable reserves.
10.1 Power to declare dividends

A company may only pay dividends out of profits available for the purpose.
The power to declare a dividend is given by the articles which often include the following rules.
Rules related to the power to declare a dividend
The company in general meeting may declare dividends. C

H
No dividend may exceed the amount recommended by the directors who have an implied power A
in their discretion to set aside profits as reserves. P
T
The directors may declare such interim dividends as they consider justified. E
R
Dividends are normally declared payable on the paid up amount of share capital. For example a
£1 share which is fully paid will carry entitlement to twice as much dividend as a £1 share 50p paid.
9
A dividend may be paid otherwise than in cash.
Dividends may be paid by cheque or warrant sent through the post to the shareholder at his
registered address. If shares are held jointly, payment of dividend is made to the first-named joint
holder on the register.
Listed companies generally pay two dividends a year; an interim dividend based on interim profit
figures, and a final dividend based on the annual accounts and approved at the AGM.
A dividend becomes a debt when it is declared and due for payment. A shareholder is not entitled to
a dividend unless it is declared in accordance with the procedure prescribed by the articles and the
declared date for payment has arrived.
This is so even if the member holds preference shares carrying a priority entitlement to receive a
specified amount of dividend on a specified date in the year. The directors may decide to withhold
profits and cannot be compelled to recommend a dividend.

If the articles refer to 'payment' of dividends this means payment in cash. A power to pay dividends in
specie (otherwise than in cash) is not implied but may be expressly created. Scrip dividends are
dividends paid by the issue of additional shares.
Any provision of the articles for the declaration and payment of dividends is subject to the overriding
rule that no dividend may be paid except out of profits distributable by law.
10.2 Distributable profits
Section overview
 Distributable profits may be defined as 'accumulated realised profits ... less accumulated realised
losses'. 'Accumulated' means that any losses of previous years must be included in reckoning the
current distributable surplus. 'Realised' profits are determined in accordance with generally
accepted accounting principles.
Definition
Profits available for distribution are accumulated realised profits (which have not been distributed or
capitalised) less accumulated realised losses (which have not been previously written off in a reduction
or reorganisation of capital).
The word 'accumulated' requires that any losses of previous years must be included in reckoning the
current distributable surplus.
A profit or loss is deemed to be realised if it is treated as realised in accordance with generally accepted
accounting principles. Hence, financial reporting and accounting standards in issue, plus generally
accepted accounting principles (GAAP), should be taken into account when determining realised profits
and losses.
Depreciation must be treated as a realised loss, and debited against profit, in determining the amount
of distributable profit remaining.
However, a revalued asset will have depreciation charged on its historical cost and the increase in the
value in the asset. The Companies Act allows the depreciation provision on the valuation increase to be
treated also as a realised profit.
Effectively there is a cancelling out, and at the end only depreciation that relates to historical cost
will affect dividends.
Illustration: Depreciation charge

Suppose that an asset purchased for £20,000 has a 10 year life. Provision is made for depreciation on a
straight line basis. This means the annual depreciation charge of £2,000 must be deducted in reckoning
the company's realised profit less realised loss.
Suppose now that after five years the asset is revalued to £50,000 and in consequence the annual
depreciation charge is raised to £10,000 (over each of the five remaining years of the asset's life).
The effect of the Act is that £8,000 of this amount may be reclassified as a realised profit. The net effect
is that realised profits are reduced by only £2,000 in respect of depreciation, as before.
If, on a general revaluation of all fixed assets, it appears that there is a diminution in value of any one or
more assets, then any related provision(s) need not be treated as a realised loss.
The Act states that if a company shows development expenditure as an asset in its accounts it must
usually be treated as a realised loss in the year it occurs. However it can be carried forward in special
circumstances (generally taken to mean in accordance with accounting standards).

10.3 Dividends of public companies
Section overview
 A public company may only make a distribution if its net assets are, at the time, not less than
the aggregate of its called-up share capital and undistributable reserves. It may only pay a
dividend which will leave its net assets at not less than that aggregate amount.
A public company may only make a distribution if its net assets are, at the time, not less than the
aggregate of its called-up share capital and undistributable reserves. The dividend which it may pay
is limited to such amount as will leave its net assets at not less than that aggregate amount.
Undistributable reserves are defined as:
(a) Share premium account
(b) Capital redemption reserve
(c) Any surplus of accumulated unrealised profits over accumulated unrealised losses (known as a
revaluation reserve). However a deficit of accumulated unrealised profits compared with
accumulated unrealised losses must be treated as a realised loss.
(d) Any reserve which the company is prohibited from distributing by statute or by its constitution or
any law.
Worked example: permissible dividend

Suppose that a public company has an issued share capital (fully paid) of £800,000 and £200,000 on
share premium account (which is an undistributable reserve). If its assets less liabilities are less than £1
million it may not pay a dividend. If however its net assets are say £1,250,000 it may pay a dividend but
only of such amount as will leave net assets of £1 million or more, so its maximum permissible dividend
is £250,000.
The dividend rules apply to every form of distribution of assets except the following
 The issue of bonus shares whether fully or partly paid
 The redemption or purchase of the company's shares out of capital or profits
 A reduction of share capital C
H
 A distribution of assets to members in a winding up A
P
You must appreciate how the rules relating to public companies in this area are more stringent than the
T
rules for private companies. E
R
Interactive question 8: Main rules [Difficulty level: Intermediate]

What are the main rules affecting a company's ability to distribute its profits as dividends? 9
10.4 Relevant accounts
Section overview
 The profits available for distribution are generally determined from the last annual accounts to be
prepared.
Whether a company has profits from which to pay a dividend is determined by reference to its 'relevant
accounts', which are generally the last annual accounts to be prepared.
If the auditor has qualified their report on the accounts they must also state in writing whether, in their
opinion, the subject matter of their qualification is material in determining whether the dividend may

be paid. This statement must have been circulated to the members (for a private company) or
considered at a general meeting (for a public company).
A company may produce interim accounts if the latest annual accounts do not disclose a sufficient
distributable profit to cover the proposed dividend. It may also produce initial accounts if it proposes to
pay a dividend during its first accounting reference period or before its first accounts are laid before the
company in general meeting. These accounts may be unaudited, but they must suffice to permit a
proper judgement to be made of amounts of any of the relevant items.
If a public company has to produce initial or interim accounts, which is unusual, they must be full
accounts such as the company is required to produce as final accounts at the end of the year. They need
not be audited. However the auditors must, in the case of initial accounts, satisfy themselves that the
accounts have been 'properly prepared' to comply with the Act. A copy of any such accounts of a public
company (with any auditors' statement) must be delivered to the Registrar for filing.
10.5 Infringement of dividend rules

In certain situations the directors and members may be liable to make good to the company the
amount of an unlawful dividend.
If a dividend is paid otherwise than out of distributable profits the company, the directors and the
shareholders may be involved in making good the unlawful distribution.
The directors are held responsible since they either recommend to members in general meeting that a
dividend should be declared or they declare interim dividends.
(a) The directors are liable if they declare a dividend which they know is paid out of capital.
(b) The directors are liable if, without preparing any accounts, they declare or recommend a
dividend which proves to be paid out of capital. It is their duty to satisfy themselves that profits are
available.
(c) The directors are liable if they make some mistake of law or interpretation of the constitution
which leads them to recommend or declare an unlawful dividend. However in such cases the
directors may well be entitled to relief as their acts were performed 'honestly and reasonably'.
The directors may however honestly rely on proper accounts which disclose an apparent distributable
profit out of which the dividend can properly be paid. They are not liable if it later appears that the
assumptions or estimates used in preparing the accounts, although reasonable at the time, were in fact
unsound.
The position of members is as follows.
 A member may obtain an injunction to restrain a company from paying an unlawful dividend.
 Members voting in general meeting cannot authorise the payment of an unlawful dividend nor
release the directors from their liability to pay it back.
 The company can recover from members an unlawful dividend if the members knew or had
reasonable grounds to believe that it was unlawful.
 If the directors have to make good to the company an unlawful dividend they may claim
indemnity from members who at the time of receipt knew of the irregularity.
 Members knowingly receiving an unlawful dividend may not bring an action against the directors.
If an unlawful dividend is paid by reason of error in the accounts the company may be unable to claim
against either the directors or the members. The company might then have a claim against its auditors
if the undiscovered mistake was due to negligence on their part.
Re London & General Bank (No 2) 1895
The facts: The auditor had drawn the attention of the directors to the fact that certain loans to
associated companies were likely to prove irrecoverable. The directors refused to make any provision for
these potential losses. They persuaded the auditor to confine his comments in his audit report to the
uninformative statement that the value of assets shown in the statement of financial position 'is
dependent on realisation'. A dividend was paid in reliance on the apparent profits shown in the
accounts. The company went into liquidation and the liquidator claimed from the auditor compensation

for loss of capital due to his failure to report clearly to members what he well knew affecting the
reliability of the accounts.
Decision: The auditor has a duty to report what he knows of the true financial position: otherwise his
audit is 'an idle farce'. He had failed in this duty and was liable.
10.6 Purchase of own shares
Section overview
 You must be able to carry out simple calculations showing the amounts to be transferred to the
capital redemption reserve on purchase or redemption of own shares and how the amount of
any premium on redemption would be treated.
Any limited company is permitted without restriction to cancel unissued shares and in that way to
reduce its authorised share capital. That change does not alter its financial position.
Three factors need to be in place to give effect to a reduction of a company's issued share capital.
ARTICLES OF + SPECIAL + COURT

ASSOCIATION RESOLUTION ORDER
These must contain the A special resolution must Must be confirmed by
necessary authority. be passed. the court.
Articles usually contain the necessary power. If not, the company in general meeting would first pass a
special resolution to alter the articles appropriately and then proceed, as the second item on the agenda
of the meeting, to pass a special resolution to reduce the capital.
There are three basic methods of reducing share capital specified.
(a) Extinguish or reduce liability on partly paid shares. A company may have issued £1 (nominal)
shares 75p paid up. The outstanding liability of 25p per share may be eliminated altogether by
reducing each share to 75p (nominal) fully paid or some intermediate figure, eg 80p (nominal)
75p paid. Nothing is returned to the shareholders but the company gives up a claim against them
for money which it could call up whenever needed.
(b) Cancel paid up share capital which has been lost or which is no longer represented by
available assets. Suppose that the issued shares are £1 (nominal) fully paid but the net assets now C
represent a value of only 50p per share. The difference is probably matched by a debit balance on H
A
retained earnings (or provision for fall in value of assets). The company could reduce the nominal
P
value of its £1 shares to 50p (or some intermediate figure) and apply the amount to write off the T
debit balance or provision wholly or in part. It would then be able to resume payment of dividends E
out of future profits without being obliged to make good past losses. The resources of the R
company are not reduced by this procedure of part cancellation of nominal value of shares but it
avoids having to rebuild lost capital by retaining profits.
9
(c) Pay off part of the paid up share capital out of surplus assets. The company might repay to
shareholders, say, 30p in cash per £1 share by reducing the nominal value of the share to 70p. This
reduces the assets of the company by 30p per share.
10.7 Share premium account

Whenever a company obtains for its shares a consideration in excess of their nominal value, it must
transfer the excess to a share premium account. The general rule is that the share premium account is
subject to the same restriction as share capital. However, a bonus issue can be made using the
share premium account (reducing share premium in order to increase issued share capital).
Following the decision in Shearer v Bercain 1980, there is an exemption from the general rules on setting
up a share premium account, in certain circumstances where new shares are issued as consideration for
the acquisition of shares in another company.

The other permitted uses of share premium are to pay:
(a) Capital expenses such as preliminary expenses of forming the company.
(b) Discount on the issue of shares or debentures.
(c) Premium (if any) paid on redemption of debentures.
Private companies (but not public companies) may also use a share premium account in purchasing or
redeeming their own shares out of capital.
10.8 Practical reasons for purchase or redemption

Companies may wish to repurchase or redeem their issued shares for a variety of reasons.
(a) The company may have surplus funds for which it cannot identify sufficient attractive business
opportunities.
(b) A reduction in the number of issued shares helps to improve earnings per share (EPS) and return
on capital employed (ROCE).
(c) Dividend payments may be reduced, allowing the cash to be used for other purposes:
 Funding operating activities
 Capital expenditure
 Repayment of debt
(d) The remaining shareholders' holdings will proportionately increase. Hence, even if the overall total
dividends might not increase, some shareholders could receive more cash individually.
(e) Problem or dissident shareholders in private companies can be paid off and leave the company
without spreading the membership of the company beyond the existing shareholders.
(f) It provides a potential exit route for venture capitalists who intend to be involved in the business
for a limited period.
(g) It provides an escape route for entrepreneurs who have taken their companies to market to take
them back into private ownership, eg Virgin, Amstrad and Harvey Nichols.
10.9 Purchase or redemption by a company of its own shares

There is a general prohibition against any voluntary acquisition by a company of its own shares, but
that prohibition is subject to exceptions.
A company may:
(a) Purchase its own shares in compliance with an order of the court.
(b) Issue redeemable shares and then redeem them.
(c) Purchase its own shares under certain specified procedures.
(d) Forfeit or accept the surrender of its shares.
These restrictions relate to the purchase of shares: there is no objection to accepting a gift.
The conditions for the issue and redemption of redeemable shares are set out in the Companies Act
2006.
(a) The articles must give authority for the issue of redeemable shares. Articles do usually provide for it,
but if they do not, the articles must be altered before the shares are issued.
(b) Redeemable shares may only be issued if at the time of issue the company also has issued shares which
are not redeemable: a company's capital may not consist entirely of redeemable shares: s 684.
(c) Redeemable shares may only be redeemed if they are fully paid.
(d) The terms of redemption must provide for payment on redemption.
(e) The shares may be redeemed out of distributable profits, or the proceeds of a new issue of shares,
or capital (if it is a private company) in accordance with the relevant rules:
(f) Any premium payable on redemption must be provided out of distributable profits subject to an
exception described below.

The CA 2006 provides regulations which prevent companies from redeeming shares except by
transferring a sum equal to the nominal value of shares redeemed from distributable profit reserves to a
non-distributable 'capital redemption reserve'. This reduction in distributable reserves is an example of
the capitalisation of profits, where previously distributable profits become undistributable.
The purpose of these regulations is to prevent companies from reducing their share capital
investment so as to put creditors of the company at risk.
Note: Following IAS 32, redeemable preference shares are no longer classified as equity, they are
classified as financial liabilities.
Worked example: Capitalisation of profits

Suppose, for example, that Muffin Ltd decided to repurchase and cancel £100,000 of its ordinary share
capital. A statement of financial position of the company is currently as follows.
£
Assets
Cash 100,000
Other assets 300,000
400,000
Equity and liabilities
Ordinary shares 130,000
Retained earnings 150,000
Trade payables 120,000
400,000
Now if Muffin Ltd were able to repurchase the shares without making any transfer from the retained
earnings to a capital redemption reserve, the effect of the share redemption on the statement of
financial position would be as follows.
Net assets £
Non-cash assets 300,000
Less trade payables 120,000
180,000
Equity
180,000
C
In this example, the company would still be able to pay dividends out of profits of up to £150,000. If it H
did, the creditors of the company would be highly vulnerable, financing £120,000 out of a total of A
£150,000 assets of the company. P
T
The regulations in the Act are intended to prevent such extreme situations arising. On repurchase of the E
shares, Muffin Ltd would have been required to transfer £100,000 from its retained earnings to a R
non-distributable reserve, called a capital redemption reserve. The effect of the redemption of shares on
the statement of financial position would have been:
9
Net assets £ £
Non-cash assets 300,000
Less trade payables 120,000
180,000
Equity
Reserves
Distributable (retained earnings) 50,000
Non-distributable (capital redemption reserve) 100,000
150,000
180,000
The maximum distributable profits are now £50,000. If Muffin Ltd paid all these as a dividend, there
would still be £250,000 of assets left in the company, just over half of which would be financed by
non-distributable equity capital.

When a company redeems some shares, or purchases some of its own shares, they should be
redeemed:
(a) Out of distributable profits, or
(b) Out of the proceeds of a new issue of shares
and if there is any premium on redemption, the premium must be paid out of distributable profits,
except that if the shares were issued at a premium, then any premium payable on their redemption may
be paid out of the proceeds of a new share issue made for the purpose, up to an amount equal to the
lesser of:
(a) The aggregate premiums received on issue of the shares
(b) The balance on the share premium account (including premium on issue of the new shares)
Worked example: Repurchase of shares

A numerical example might help to clarify this point. Suppose that Just Desserts Ltd intends to
repurchase 10,000 shares of £1 each at a premium of 5 pence per share. The redemption may be
financed out of:
(a) Distributable profits (10,000  £1.05 = £10,500).
(b) The proceeds of a new share issue (say, by issuing 10,000 new £1 shares at par). The premium of
£500 must be paid out of distributable profits.
(c) Combination of a new share issue and distributable profits.
(d) Out of the proceeds of a new share issue where the shares to be repurchased were issued at a
premium. For example, if the shares had been issued at a premium of 3p per share, then (assuming
that the balance on the share premium account after the new share issue was at least £300) £300
of the premium on redemption could be debited to the share premium account and only £200
need be debited to distributable profits.
(a) Where a company purchases its own shares wholly out of distributable profits, it must transfer to
the capital redemption reserve an amount equal to the nominal value of the shares repurchased.
In example (a) above the accounting entries would be:
£ £
DEBIT Share capital account 10,000
Retained earnings (premium on redemption) 500
CREDIT Cash 10,500
DEBIT Retained earnings 10,000
CREDIT Capital redemption reserve 10,000
(b) Where a company redeems shares or purchases its shares wholly or partly out of the proceeds of a
new share issue, it must transfer to the capital redemption reserve an amount by which the
nominal value of the shares redeemed exceeds the aggregate proceeds from the new issue (ie
nominal value of new shares issued plus share premium).
(i) In example (b) the accounting entries would be:

£ £
DEBIT Share capital account (redeemed shares) 10,000
Retained earnings (premium) 500
CREDIT Cash (redemption of shares) 10,500
DEBIT Cash (from new issue) 10,000
CREDIT Share capital account 10,000
No credit to the capital redemption reserve is necessary because there is no decrease in the
creditors' buffer.

(ii) If the redemption in the same example were made by issuing 5,000 new £1 shares at par, and
paying £5,500 out of distributable profits:
£ £
Retained earnings (premium) 500
DEBIT Retained earnings 5,000
CREDIT Capital redemption reserve 5,000
(iii) In the example (d) above (assuming a new issue of 10,000 £1 shares at a premium of 8p per
share) the accounting entries would be:
£ £
Share premium account 800
Retained earnings 200
No capital redemption reserve is required, as in (i) above. The redemption is financed entirely
by a new issue of shares.
10.10 Commercial reasons for altering capital structure

These include the following.
 Greater security of finance.
 Better image for third parties.
 A 'neater' statement of financial position.
 Borrowing repaid sooner.
 Cost of borrowing reduced. C
H
A
Interactive question 9: Krumpet plc [Difficulty level: Intermediate] P
T
Set out below is the summarised statement of financial position of Krumpet plc at 30 June 20X5. E
£'000 R
Net assets 520
Equity
Called up share capital £1 ordinary shares 300 9
520
On 1 July 20X5 Krumpet plc purchased and cancelled 50,000 of its ordinary shares at £1.50 each.
The shares were originally issued at a premium of 20p. The redemption was partly financed by the issue
at par of 5,000 new shares of £1 each.
Requirement
Prepare the summarised statement of financial position of Krumpet plc at 1 July 20X5 immediately after
the above transactions have been effected.

Summary
Share-based payment
Cash settled Transactions

Equity settled
transaction in which either
transactions
party can choose
DR Expense DR Expense
CR Equity CR Liabilities
Fair value of
Not with with liability Who has
employee employee re-measured choice of
If fair at each settlement?
Measure
Measure reporting date
value of at fair value
at fair value
goods or of equity
of goods/
services instrument Entity Counterparty
services
cannot be granted
reliably
measured Treat as Treat as a
equity-settled compound
instrument
Which settlement Which

method has a method was
higher fair value? chosen?
Cash Equity
method method Cash Equity
method method
The amount of
The payment The payment The balance
payment equal
is deducted is applied to of the liability
to the fair value
from equity settle the is transferred
of the equity
liability in full to equity
instrument that
would otherwise
have been issued The excess
is deducted of the fair value
from equity. of the equity
The excess over instrument
this amount is issued over the
recognised as amount of cash
an expense that would
otherwise have
been paid
No further is recognised
accounting is as an expense
required

Vesting
conditions
Market based Non-market

based
Examples
- Remain in
Examples employment for a
achieve target specified service
- Share price period
- Shareholder return - Achieve profit targets
- Price index - Achieve earnings per
share targets
- Achieve flotation
- Complete a particular
project
Accounting Accounting
treatment treatment
Include in determining Ignore in determining

the fair value at the the fair value at the
grant date, and do grant date and
not revise vesting revise vesting
estimate each period estimates each
period
C
H
A
P
T
E
R

Modifications to
equity instrument granted
Is the modification
beneficial?
Yes No
Increase Increase in
Decrease in Decrease in
in fair number of
fair value of number of
value of equity
equity instruments
equity instruments
instruments granted
instruments granted
Less likely
to vest
Amortise
the incremental Ignore the Treat as
fair value modification cancellation
over vesting
period
AND
Revise
vesting
estimates

Self-test
1 Which are the three types of share-based transactions covered by IFRS 2?
2 Which of the following transactions are not within the definition of a share-based payment under IFRS
2?
(a) Employee share ownership plans (ESOPs)
(b) Transfers of equity instruments of the parent of the reporting entity to third parties that have
supplied goods or services to the reporting entity
(c) The acquisition of property, plant and equipment as part of a business combination
(d) Share appreciation rights (SARs)
(e) The raising of funds through a rights issue to all shareholders including those who are
employees
(f) Cash bonus to employees dependent on share price performance
(g) Employee share purchase plans
(h) Remuneration in non-equity shares
3 BCN Co grants 1,000 share options to each of its 300 staff to be exercised in two years' time at a
price of £6.10. The current fair value of the option is £1.40 and the expected fair value in two
years' time is £2.40 (adjusted for the possibility of forfeiture in both cases). Under IFRS 2 Share-
based Payment, how much expense would be recognised in profit or loss at the date of issue of the
options?
4 On 1 January 20X3 an entity grants 250 share options to each of its 200 employees. The only
condition attached to the grant is that the employees should continue to work for the entity until
31 December 20X6. Five employees leave during the year.
The market price of each option was £12 at 1 January 20X3 and £15 at 31 December 20X3.
Requirement
Show how this transaction will be reflected in the financial statements for the year ended
31 December 20X3.
5 On 1 July 20X4 company A granted 20 executives options to buy up to 10,000 shares each. The C
options only vest if the executives are still in the service of the company on 1 July 20X6. H
It is estimated that 90% of the executives will remain with the company for the duration of the A
vesting period and exercise their options in full. P
T
The following information is relevant. E
R
 The exercise price of the option is £20 per share
 The market value of each share was £15 on 1 July 20X4 and £18 on 30 June 20X5. It is £19
9
on 20 July 20X5, when the draft financial statements for the year to 30 June 20X5 are being
reviewed
 The market value of the option is £3 on 1 July 20X4, £3.20 on 30 June 20X5, and £2.50 on
20 July 20X5
Requirement
How should the transaction be accounted for in the financial statements for the year to 30 June
20X5?
6 An entity grants 100 share options on its £1 shares to each of its 500 employees on 1 January
20X5. Each grant is conditional upon the employee working for the entity over the next three
years. The fair value of each share option as at 1 January 20X5 is £15.
On the basis of a weighted average probability, the entity estimates on 1 January 20X5 that 20% of
employees will leave during the three-year period and therefore forfeit their rights to share options.

Requirement
Show the accounting entries which will be required over the three-year period in the event of the
following:
 20 employees leave during 20X5 and the estimate of total employee departures over the
three-year period is revised to 15% (75 employees)
 22 employees leave during 20X6 and the estimate of total employee departures over the
three-year period is revised to 12% (60 employees)
 15 employees leave during 20X7, so a total of 57 employees left and forfeited their rights to
share options. A total of 44,300 share options (443 employees × 100 options) vested at the
end of 20X7
7 On 1 January 20X4 an entity grants 100 cash share appreciation rights (SARs) to each of its 500
employees on condition that the employees remain in its employ for the next two years. The SARs
vest on 31 December 20X5 and may be exercised at any time up to 31 December 20X6. The fair
value of each SAR at the grant date is £7.40.
No. of
employees Estimated Intrinsic
exercising Outstanding further Fair value of value* (ie
Year ended Leavers rights SARs leavers SARs cash paid)
£ £
31 December 20X4 50 – 450 60 8.00
31 December 20X5 50 100 300 – 8.50 8.10
31 December 20X6 – 300 – – – 9.00
* Intrinsic value is the fair value of the shares less the exercise price
Requirement
Show the expense and liability which will appear in the financial statements in each of the three
years.
8 ZZX plc
ZZX plc has provided a share incentive scheme to a number of its employees on 1 January 20X4.
This allows for a cash payment to be made to the individuals concerned equal to the share price at
the end of a three-year period subject to the following conditions.
1 Vesting will be after three years
2 The share price must exceed £2
3 The employee must be with the company on 31 December 20X6530
Each scheme issued will result in payment, subject to the conditions outlined, equal to the value of
10 shares at the end of the three-year period if the conditions are satisfied. The payments, once
earned, are irrevocable.
The finance director has been issued 20 such schemes.
The share prices over the next three years were as follows.
31 December 20X4 £2.20
Requirements
(a) Prepare the journal entries for the transactions of the share incentives issued to the finance
director.
(b) Assuming that on 1 January 20X4 nine other individuals were also granted equivalent rights to
the finance director and that on 1 January 20X5, two of those individuals left the company,
prepare the journal entries for the transactions relating to the incentive schemes.

9 Kapping
The directors of Kapping are adopting IFRS for the first time and are reviewing the impact of IFRS 2
Share-based Payment on the financial statements for the year ended 31 May 20X7. They require
you to:
(a) Explain why share options, although having no cost to the company, should be reflected as
an expense in profit or loss.
(b) Discuss whether the expense arising from share options under IFRS 2 actually meets the
definition of an expense under the IASB's Conceptual Framework.
(c) Explain the impact of IFRS 2 on earnings per share, given that an expense is shown in profit or
loss and the impact of share options is recognised in the diluted earnings per share
calculation.
(d) Briefly discuss whether the requirements of IFRS 2 should lead them to reconsider their
remuneration policies.
C
H
A
P
T
E
R

Technical reference
1 Three specific types of transactions

 Equity-settled share-based payment IFRS 2.2(a)
 Cash-settled share-based payment IFRS 2.2(b)
 Share-based payment transactions with a cash alternative IFRS 2.2(c)
2 Transactions excluded from scope

 Transactions with employees in their capacity as shareholders IFRS 2.4
 Issues of shares in a business combination IFRS 2.5
 Contracts that may be settled net in shares or rights to shares IFRS 2.6
3 Recognition
 Goods or services received in share-based transaction to be recognised as IFRS 2.8
expenses or assets
 Entity shall recognise corresponding increase in equity for equity-settled IFRS 2.7
transaction or a liability for cash-settled transactions
4 Equity-settled share-based transactions

 Goods or services received and corresponding increase in equity shall be IFRS 2.10
measured as fair value of goods or services received (direct method)
 If fair value of goods or services cannot be measured reliably, then measure at IFRS 2.10
fair value of instruments granted
 For transactions with third parties there is a presumption that the fair value of IFRS 2.13
the goods or services can be estimated reliably
 Fair value shall be measured at the date entity obtains the goods or IFRS 2.13
counterparty renders service
 If equity instruments vest immediately entity will recognise services received IFRS 2.14
and corresponding increase in equity immediately
 If equity instruments will be received in future, services and increase in equity IFRS 2.15
will be recognised during vesting period
 Fair value of equity instruments granted to be based on market prices if IFRS 2.16
available
 If market prices are not available a generally acceptable valuation technique IFRS 2.17
should be used
 Non-market vesting conditions shall be taken into account by adjusting the IFRS 2.19
number of equity instruments included in the measurement of the transactions
at each reporting date
 For non-market vesting conditions the amount ultimately recognised will be the IFRS 2.19, 2.20
number of equity instruments that actually vest
 For grants of equity instruments with market conditions the entity shall IFRS 2.21
recognise the goods or services from counterparty who satisfies all the other
vesting conditions irrespective of whether market conditions are satisfied
 Market conditions will be part of fair value at grant date. This should not be IFRS 2.21
revised at each reporting date and where options do not vest the charge should
not be reversed

 If vested equity instruments are forfeited, entity shall make no adjustment to IFRS 2.23
total equity except a transfer from one equity component to another

 Goods or services acquired should be measured at fair value of liability IFRS 2.30
 Liability should be re-measured at each reporting date IFRS 2.30
6 Share-based payment transaction with cash alternative

 If counterparty has right to choose then entity has granted a compound IFRS 2.34
financial instrument with debt component and equity component
 For counterparties other than employees, the equity component is measured as IFRS 2.35
the difference between the fair value of the goods or services received and the
fair value of the debt component (the counterparty's right to demand payment
in cash)
 For transactions with employees, the entity shall measure the fair value of the IFRS 2.36, 2.37,
debt component and the fair value of the equity component separately and 2.38
account for the debt component as a cash-settled transaction and the equity
component as an equity-settled transaction
 At the date of settlement the entity shall remeasure the liability to its fair value IFRS 2.39
 Where equity instruments are paid instead of cash, the liability shall be IFRS 2.39
transferred to equity
 Where entity pays cash on settlement rather than equity, the payment is IFRS 2.40
applied to the liability. The equity components previously recognised will
remain in equity and entity can make a transfer from one component of equity
to another
 Where entity has the choice of settlement, if present obligation exists to deliver IFRS 2.41
cash, it should recognise and treat as cash-settled share-based payment
transactions
 If no present obligation exists to pay cash, entity should treat transaction as an IFRS 2.43
equity-settled transaction. On settlement if cash was paid, cash should be
treated as repurchase of equity by a deduction against equity
C
H
A
P
T
E
R

1 (a) Equity-settled share-based payment transactions

(b) Cash-settled share-based payment transactions
(c) Transactions with a choice of settlement
2 The following transactions are not within the definition of a share-based payment under IFRS 2
(c) The acquisition of property, plant and equipment as part of a business combination
This is within the scope of IFRS 3 Business Combinations.
(e) The raising of funds through a rights issue to all shareholders including those who are
employees
IFRS 2 does not apply to transactions with employees in their capacity as shareholders.
(h) Remuneration in non-equity shares
Payment in non-equity shares does not fall within the scope of IFRS 2 since it is a transaction
in which the entity receives goods and services in return for a financial liability.
3 No expense is recognised at the issue date of the options, but the expected benefit is accrued as a
cost over the life of the option:
300 employees × 1,000 options × £1.40 = £420,000
This is spread equally over the two-year period to vesting, resulting in an annual charge to profit or
loss of £210,000.
This would not be adjusted for any changes in expected benefit due to changes in expected share
price as the value is measured at grant date, but is adjusted for the numbers of employees entitled
to options at each reporting date.
4 The remuneration expense for the year is based on the fair value of the options granted at the
grant date (1 January 20X3). As five of the 200 employees left during the year it is reasonable to
assume that 20 employees will leave during the four-year vesting period and that therefore 45,000
options (250  180) will actually vest.
Staff costs (45,000 × £12)/4 years £135,000
Equity £135,000
5 IFRS 2 requires that share-based transactions made in return for goods or services are recognised in
the financial statements. The granting of options to the senior executives is a share-based payment
under IFRS 2 and will need to be recognised as a remuneration expense. The amount to be
charged as an expense is measured at the fair value of the goods or services provided as
consideration for the share-based payment or at the fair value of the share-based payment,
whichever can be more reliably measured.
In the case of employee share options, the market value of the options on the day these are
granted is used as this can be measured more reliably. The market value of the share options at the
day these were granted, 1 July 20X4 was £3 each.
The exercise price for the option at £20 per share is above the market price on the date of issue on
1 July 20X4. This, however, does not mean that the option has zero market value. It has no intrinsic
value, but it has what is referred to as time value relating to expectations of a share price increase
over time.
The options vest at the end of the two-year period. The company expects that 90% of the options
will vest as it is estimated that 90% of the executives will remain in employment for the two-year
period and thus be able to exercise their options in full.

The remuneration expense will be 10,000 × £3  20 × 90% = £540,000 and as this vests over a
two-year period, the entry to income for the current year to 30 June 20X5 will relate to half that
amount: 1/2  £540,000 = £270,000
£ £
DR Share-based payment remuneration expense 270,000
CR Equity share-based payment reserve 270,000
When the shares are issued a transfer will be made from that reserve together with any further
proceeds (if any) of the shares and will be credited to the share capital and share premium
accounts.
6
£
20X5 Equity c/d (500 × 85% × 100 × £15 × 1/3) = 212,500
DR Expenses £212,500
CR Equity £212,500
£
20X6 Equity c/d (500 × 88% × 100 × £15 × 2/3) = 440,000
Less: previously recognised (212,500)
227,500
CR Equity £227,500
£
20X7 Equity c/d (443 × 100 × £15) = 664,500
224,500
CR Equity £224,500
7
£
Expense and liability ((450 – 60) × 100 × £8.00 × 1/2 ) 156,000
Liability c/d (300 × 100 × £8.50) 255,000
Less: b/d liability (156,000) C
99,000 H
Plus: cash paid on exercise of SARs by employees A
P
(100 × 100 × £8.10) 81,000 T
Expense 180,000 E
R
Liability c/d –
Less: b/d liability (255,000)
9
(255,000)
Plus cash paid on exercise of SARs by employees
(300 × 100 × £9.00) 270,000
Expense 15,000
8 ZZX plc
(a) Journal entries for transactions: Finance director
The transactions are settled in cash and hence liabilities are created.
31 December 20X4 £ £
DR Expense 147
CR Liability 147
It is assumed that the current share price is the best estimate of the final share price.
(calculation note: 20  10  £2.20  1/3 )

DR Liability 147
CR Expense 147
Reverses entries for 20X4 as share price is less than minimum
DR Expense 480
CR Liability 480
DR Liability 480
CR Cash 480
(20  10  £2.40  3/3)
(b) Journal entries for transactions: other individuals
DR Expense 1,467
CR Liability 1,467
(calculation note: 20  10  10  £2.20  1/3 )
31 December 20X5: £ £
DR Liability 1,467
CR Expense 1,467
31 December 20X6
DR Expense 3,840
CR Liability 3,840
DR Liability 3,840
CR Cash 3,840
(calculation note: 20  10  8  £2.40  3/3)
9 Kapping
(a) When shares are issued for cash or in a business combination, an accounting entry is needed
to recognise the receipt of cash (or other resources) as consideration for the issue. Share
options (the right to receive shares in future) are also issued in consideration for resources:
services rendered by directors or employees. These resources are consumed by the company
and it would be inconsistent not to recognise an expense.
(b) The Framework defines an expense as a decrease in economic benefits in the form of outflows
of assets or incurrences of liabilities. It is not immediately obvious that employee services meet
the definition of an asset and therefore it can be argued that consumption of those services
does not meet the definition of an expense. However, share options are issued for
consideration in the form of employee services so that arguably there is an asset, although it is
consumed at the same time that it is received. Therefore the recognition of an expense
relating to share-based payment is consistent with the Framework.
(c) It can be argued that to recognise an expense in profit or loss would have the effect of
distorting diluted earnings per share as diluted earnings per share would then take the
expense into account twice. This is not a valid argument. There are two events involved:
issuing the options and consuming the resources (the directors' service) received as
consideration.
The diluted earnings per share calculation only reflects the issue of the options; there is no
adjustment to basic earnings. Recognising an expense reflects the consumption of services.
There is no 'double counting'.
(d) It is true that accounting for share-based payment reduces earnings. However, it improves the
information provided in the financial statements, as these now make users aware of the true
economic consequences of issuing share options as remuneration. The economic
consequences are the reason why share option schemes may be discontinued. IFRS 2 simply
enables management and shareholders to reach an informed decision on the best method of
remuneration, weighing the advantages of granting these and their potential beneficial effect
on motivation and corporate performance against the disadvantages of the impact on
earnings.


Fair value of options granted at grant date: 1,500 employees × 10 options × £20 = £300,000
This should be charged to profit or loss as employee remuneration evenly over the two-year period from
1 July 20X5 to 30 June 20X7.
£150,000 is recognised each year. A corresponding amount will be recognised as part of equity as the
services are recognised.

The remuneration expense for the year is based on the fair value of the options granted at the grant
date (1 January 20X3):
[400 employees – (10 leavers × 4 years)] × 500 options × £10 = £1,800,000.
Therefore, the entity recognises a remuneration expense of £450,000 (£1.8 million/4 years) in profit or
loss and a corresponding increase in equity of the same amount.

The total expense recorded over the expected vesting period would be:
 All options vest: 100 options × £20 = £2,000 total expense
 All vesting conditions are met, except the market-based performance condition: 100 options × £20
= £2,000 total expense
 All vesting conditions are met, except the non-market based performance condition: nil expense
 All vesting conditions are met, except half of the employees who received options left the company
prior to the vesting date: 50 options × £20 = £1,000 total expense.
Paragraph 21 of IFRS 2 states that the grant date fair value of the share-based payment with market- C
based performance conditions that has met all its other vesting conditions should be recognised, H
A
irrespective of whether that market condition is achieved. The company determines the grant date fair P
value of the share-based payment excluding the non-market based performance factor, but including T
the market-based performance factor. E
R

Equity 9
(per statement of
Expense financial position)
£ £
Year 1 660,000 660,000
Year 2 174,000 834,000
Year 3 423,000 1,257,000
WORKINGS
1 Year 1
Equity: (440 employees × 100 options × £30)/2 years £660,000
(using original estimate of two-year period)

2 Year 2
£
Equity c/d [(500 – 30 – 28 – 25) employees  100  £30  2/3] 834,000
(using revised estimate of three-year period)
Previously recognised (660,000)
 expense 174,000
3 Year 3
£
Equity c/d [(500 – 30 – 28 – 23)  100  £30] 1,257,000
Previously recognised (834,000)
 expense 423,000

The incremental value is £3 per share option (£8 – £5). This amount is recognised over the remaining
two years of the vesting period, along with remuneration expense based on the original option value of
£15.
The amounts recognised in Years 1-3 are as follows.
Year £
1 Equity c/d [(500 – 110)  100  £15  1/3] 195,000
Dr Expenses £195,000
Cr Equity £195,000
2 Equity c/d [(500 – 105)  100  ((£15  2/3) + (£3  1/2 ))] 454,250
259,250
Cr Equity £259,250
3 Equity c/d [(500 – 103)  100  (£15 + £3)] 714,600

260,350
Cr Equity £260,350

(a) Accounting entries
31.12.X1 £ £
Dr Staff costs expense 188,000
Cr Equity reserve ((800 – 95)  200  £4  1/3) 188,000
31.12.X2
Dr Staff costs expense (W1) 201,333
Cr Equity reserve 201,333
31.12.X3
Dr Staff costs expense (W2) 202,667
Cr Equity reserve 202,667
Issue of shares:
Dr Cash ((800 – 40 – 20)  200  £1.50) 222,000
Dr Equity reserve 592,000
Cr Share capital (740  200  £1) 148,000
Cr Share premium (balancing figure) 666,000
WORKINGS
1 Equity reserve at 31.12.X2
£
Equity c/d ((800 – 70)  200  £4  2/3) 389,333
 charge 201,333

2 Equity reserve at 31.12.X3
£
Equity c/d ((800 – 40 – 20)  200  £4  3/3) 592,000
 charge 202,667
(b) Cash-settled share-based payment

If J&B had offered cash payments based on the value of the shares at vesting date rather than
options, in each of the three years an accrual would be shown in the statement of financial position
representing the expected amount payable based on the following:
No of employees  Number of  Fair value of each  Cumulative

estimated at the year rights each right at year end proportion
end to be entitled to of vesting
rights at the vesting period
date elapsed
The movement in the accrual would be charged to profit or loss representing further entitlements
received during the year and adjustments to expectations accrued in previous years.
The accrual would continue to be adjusted (resulting in an expense charge) for changes in the fair
value of the rights over the period between when the rights become fully vested and are
subsequently exercised. It would then be reduced for cash payments as the rights are exercised.
Answer to interactive question 7

(a) Explanation
Employee services – no reliable fair value

Use fair value of the equity instrument
Fair value measured at grant date – and not subsequently changed
Expense in P/L over vesting period
If vesting period can vary as a result of non-market conditions,
use best estimate of length of period
Best estimate of number that will vest
Credit entry to equity – separate component or retained earnings
20X7 C
Expense is at fair value £15 H
based on an expected 2-year vesting period A
P
450 employees – 30 leavers – 25 future leavers = 395 employees
T
Expense = 395  100 options  £15  1/2 years E
= £296,250 R
20X8
450 employees – 30 left Year 1 – 15 left Year 2 – 26 future
leavers = 379 employees 9
Expense is now spread over a 3-year vesting period
Expense = £15  379  100  2/3 years £379,000
Less: Recognised in Year 1 £296,250
Year 2 expense £82,750
20X9
390  100  £15  3/3 years = £585,000
Less: Recognised previously £379,000
Expense in Year 3 £206,000
Double entries £
20X7 Dr employment costs 296,250
Cr equity 296,250
Cr equity 82,750
Cr equity 206,000

(b) 20Y0
If employees do not exercise their options, but allow them to lapse, the net expense recognised
does not change. As long as the options vest, an expense will appear in the accounts.
(c) In this case, the options would never vest. In 20X9, the expense would be extended to 20Y0
(effectively a four-year option scheme) before the scheme was cancelled in 20Y0 according to the
initial details of the scheme. If the non-market condition was not achieved in 20Y0, the net
expense recognised is reversed and a credit would appear in profit or loss for 20Y0 to the value of
the previous cumulative expense recognised (in 20X9 this was £585,000). A market condition not
being achieved would never affect the expense being recognised, as the share price movement is
called 'volatility' which is included in the £15 fair value.

Dividends may only be paid by a company out of profits available for the purpose. There is a detailed
code of statutory rules which determines what are distributable profits. The profits which may be
distributed as dividend are accumulated realised profits, so far as not previously utilised by distribution
or capitalisation, less accumulated realised losses, so far as not previously written off in a reduction or
reorganisation of capital duly made.
The word 'accumulated' requires that any losses of previous years must be included in reckoning the
current distributable surplus.
The word 'realised' presents more difficulties. It may prevent the distribution of an increase in the value
of a retained asset at fair value through profit or loss. However, it does not prevent a company from
transferring to retained earnings profit earned on an uncompleted contract, if it is in accordance with
generally accepted accounting principles.
There is no mention here of realised profits and so it would seem that there is no statutory guidance on
this point. Nevertheless, in view of the authority of accounting standards, it is unlikely that profits
determined in accordance with accounting standards would be considered unrealised. A realised capital
loss will reduce realised profits.
The above rules on distributable profits apply to all companies, private or public. A public company is
subject to an additional rule which may diminish but cannot increase its distributable profit as
determined under the above rules.
A public company may only make a distribution if its net assets are, at the time, not less than the
aggregate of its called-up share capital and undistributable reserves. The dividend which it may pay is
limited to such amount as will leave its net assets at not less than that aggregate amount.

Workings for Krumpet
£ £
Cost of redemption (50,000  £1.50) 75,000
Premium on redemption (50,000  50p) 25,000

No premium arises on the new issue.
Distributable profits
Retained earnings before redemption 160,000
Premium on redemption (must come out of distributable
profits, not premium on new issue) (25,000)
135,000
Remainder of redemption costs 50,000
Proceeds of new issue 5,000  £1 (5,000)
Remainder out of distributable profits (45,000)
Balance on retained earnings 90,000
Transfer to capital redemption reserve
Nominal value of shares redeemed 50,000
Proceeds of new issue (5,000)
Balance on CRR 45,000
STATEMENT OF FINANCIAL POSITION OF KRUMPET PLC AS AT 1 JULY 20X5

£'000
Net assets 450
Capital and reserves
Ordinary shares 255
Share premium 60
Capital redemption reserve 45
360
450
C
H
A
P
T
E
R

CHAPTER 10
Groups – revision
Introduction
Topic List
1 Summary and categorisation of investments
2 IFRS 10 Consolidated Financial Statements
3 IFRS 3 (Revised) Business Combinations
4 IFRS 13 Fair Value Measurement (business combination aspects)
5 IAS 28 Investments in Associates and Joint Ventures
6 IFRS 11 Joint Arrangements
7 IFRS 12 Disclosure of Interests in Other Entities
8 Step acquisitions
9 Disposals
10 Statements of cash flows
Technical reference
351
Introduction
Understand and apply the requirements of:
 IFRS 10 Consolidated Financial Statements
 IFRS 3 (Revised) Business Combinations
 IFRS 13 Fair Value Measurement (business combination aspects)
 IAS 28 Investments in Associates and Joint Ventures
 IFRS 11 Joint Arrangements
 IFRS 12 Disclosure of Interests in Other Entities
 Apply knowledge and understanding of IAS 7 Statement of Cash Flows to group situations

1 Summary and categorisation of investments
Section overview
 This chapter revises IFRS 3 Business Combinations, which was covered at Professional Stage. It also
covers the following standards, which are new or revised, although some of the topics to which
they relate were covered at Professional Stage.
– IFRS 13 Fair Value Measurement (business combination aspects)
– IFRS 10 Consolidated Financial Statements
– IAS 28 Investments in Associates and Joint Ventures
– IFRS 11 Joint Arrangements
– IFRS 12 Disclosure of Interests in Other Entities
 It also explains the changes made as a result of the revisions to IFRS 3 and IAS 27 made in 2008.
A summary of the different types of investment and the required accounting for them is as follows.
Investment Criteria Required treatment in group accounts
Subsidiary Control Full consolidation (IFRS 10)

Associate Significant influence Equity accounting (IAS 28)
Joint venture Contractual arrangement Equity accounting (IAS 28), distinguish
from joint operation (IFRS 11)
Investment which is Asset held for accretion of As for single company accounts (per IAS
none of the above wealth 39)
1.1 Investments in subsidiaries

The important point here is control. In most cases, this will involve the parent company owning a
majority of the ordinary shares in the subsidiary (to which normal voting rights are attached). There are
circumstances, however, when the parent may own only a minority of the voting power in the
subsidiary, but the parent still has control.
IFRS 10 Consolidated financial statements, issued in 2011, retains control as the key concept underlying
the parent/subsidiary relationship but it has broadened the definition and clarified its application. This
will be covered in more detail in Section 2 below.
IFRS 10 states that an investor controls an investee if and only if it has all of the following.
(i) Power over the investee

(ii) Exposure, or rights, to variable returns from its involvement with the investee (see Section 2),
and
(iii) The ability to use its power over the investee to affect the amount of the investor's returns (see
Section 2).
C
H
1.2 Investments in associates A
P
The key criterion here is significant influence. This is defined as the 'power to participate', but not to
T
'control' (which would make the investment a subsidiary). E
R
Significant influence is presumed to exist if an investor holds 20% or more of the voting power of the
investee, unless it can be clearly shown that this is not the case.
However, the existence of significant influence can also be evidenced in other ways. 10
 Representation on the board of directors of the investee

 Participation in the policy making process
 Material transactions between investor and investee
Groups – revision 353

 Interchange of management personnel
 Provision of essential technical information
IAS 28 requires the use of the equity method of accounting for investments in associates. This method
will be explained in Section 5.
1.3 Accounting for investments in joint arrangements

IFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification of a
joint arrangement as a joint operation or a joint venture depends upon the rights and obligations of the
parties to the arrangement.
The detail of how to distinguish between joint operations and joint ventures will be considered in
Section 6.
1.3.1 Accounting treatment in group accounts

IFRS 11 requires that a joint operator recognises line-by-line the following in relation to its interest in a
joint operation:
 Its assets, including its share of any jointly held assets
 Its liabilities, including its share of any jointly incurred liabilities
 Its revenue from the sale of its share of the output arising from the joint operation
 Its share of the revenue from the sale of the output by the joint operation, and
 Its expenses, including its share of any expenses incurred jointly.
This treatment is applicable in both the separate and consolidated financial statements of the joint
operator.
In its consolidated financial statements, IFRS 11 requires that a joint venturer recognises its interest in a
joint venture as an investment and accounts for that investment using the equity method in
accordance with IAS 28 Investments in associates and joint ventures unless the entity is exempted from
applying the equity method (see Section 4.2 which is also applicable to joint ventures).
In its separate financial statements, a joint venturer should account for its interest in a joint venture in
accordance with IAS 27 (2011) Separate financial statements, namely:
 At cost, or
 In accordance with IFRS 9 Financial instruments
1.4 Other investments

Investments which do not meet the definitions of any of the above should be accounted for according
to IAS 39 Financial Instruments: Recognition and Measurement.
2 IFRS 10 Consolidated Financial Statements
Section overview
 IFRS 10, issued in 2011, covers the basic definitions and consolidation requirements and the rules
on exemptions from preparing group accounts. The Standard requires a parent to present
consolidated financial statements, consolidating all subsidiaries, both foreign and domestic.
The most important aspect is control.
2.1 Introduction
When a parent issues consolidated financial statements, it should consolidate all subsidiaries, both
foreign and domestic. The first step in any consolidation is to identify the subsidiaries using the
definition as set out in paragraph 1.1 above.
The definition of an asset in the IASB's Framework from earlier studies is given below.

Definition
Consolidated financial statements: The financial statements of a group presented as those of a single
economic entity. (IFRS 10)
You should make sure that you understand the various ways in which control can arise as this is
something that you may be asked to discuss in the context of a scenario in the exam.
2.1.1 Power
Power is defined as existing rights that give the current ability to direct the relevant activities of
the investee. There is no requirement for that power to have been exercised.
Relevant activities may include:
 Selling and purchasing goods or services
 Managing financial assets
 Selecting, acquiring and disposing of assets
 Researching and developing new products and processes
 Determining a funding structure or obtaining funding.
In some cases assessing power is straightforward, for example, where power is obtained directly and
solely from having the majority of voting rights or potential voting rights, and as a result the ability to
direct relevant activities.
In other cases, assessment is more complex and more than one factor must be considered. IFRS 10 gives
the following examples of rights, other than voting or potential voting rights, which individually, or
alone, can give an investor power.
 Rights to appoint, reassign or remove key management personnel who can direct the relevant
activities
 Rights to appoint or remove another entity that directs the relevant activities
 Rights to direct the investee to enter into, or veto changes to transactions for the benefit of the
investor
 Other rights, such as those specified in a management contract.
IFRS 10 suggests that the ability rather than contractual right to achieve the above may also indicate
that an investor has power over an investee.
An investor can have power over an investee even where other entities have significant influence or
other ability to participate in the direction of relevant activities.
2.1.2 Returns
An investor must have exposure, or rights, to variable returns from its involvement with the investee in
order to establish control.
This is the case where the investor's returns from its involvement have the potential to vary as a result of
the investee's performance.
Returns may include:
C
 Dividends H
A
 Remuneration for servicing an investee's assets or liabilities P
T
 Fees and exposure to loss from providing credit support E
R
 Returns as a result of achieving synergies or economies of scale through an investor combining use
of their assets with use of the investee's assets.
10
2.1.3 Link between power and returns
In order to establish control, an investor must be able to use its power to affect its returns from its
involvement with the investee. This is the case even where the investor delegates its decision making
powers to an agent.

2.2 Exemption from preparing group accounts
A parent need not present consolidated financial statements if and only if all of the following hold:
(a) The parent is itself a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the parent not presenting consolidated financial statements.
(b) Its debt or equity instruments are not publicly traded.
(c) It is not in the process of issuing securities in public securities markets.
(d) The ultimate or intermediate parent publishes consolidated financial statements that comply
with International Financial Reporting Standards.
A parent that does not present consolidated financial statements must comply with the IAS 27 rules on
separate financial statements (discussed later in this section).
2.3 Potential voting rights

An entity may own share warrants, share call options, or other similar instruments that are convertible
into ordinary shares in another entity. If these are exercised or converted they may give the entity
voting power or reduce another party's voting power over the financial and operating policies of the
other entity (potential voting rights). The existence and effect of potential voting rights, including
potential voting rights held by another entity, should be considered when assessing whether an entity
has control over another entity (and therefore has a subsidiary). Potential voting rights are considered
only if the rights are substantive (meaning that the holder must have the practical ability to exercise the
right).
In assessing whether potential voting rights give rise to control, the investor should consider the
purpose and design of the instrument. This includes an assessment of the various terms and
conditions of the instrument as well as the investor's apparent expectations, motives and reasons for
agreeing to those terms and conditions.
Worked examples: Control and potential voting rights

(a) Twist holds 40 per cent of the voting rights of Oliver and twelve other investors each hold 5 per
cent of the voting rights Oliver. A shareholder agreement grants Twist the right to appoint, remove
and set the remuneration of management responsible for directing the relevant activities. To
change the agreement, a two-thirds majority vote of the shareholders is required. To date, Twist
has not exercised its rights with regard to the management or activities of Oliver.
Required
Explain whether Twist should consolidate Oliver in accordance with IFRS 10.
(b) Copperfield holds 45 per cent of the voting rights of Spenlow. Murdstone and Steerforth each
hold 26 per cent of the voting rights of Spenlow. The remaining voting rights are held by three
other shareholders, each holding 1 per cent. There are no other arrangements that affect decision-
making.
Required
Explain whether Copperfield should consolidate Spenlow in accordance with IFRS 10.
(c) Scrooge holds 70% of the voting rights of Cratchett. Marley has 30% of the voting rights of
Cratchett. Scrooge also has an option to acquire half of Scrooge's voting rights, which is
exercisable for the next two years, but at a fixed price that is deeply out of the money (and is
expected to remain so for that two-year period).
Would your answer be difference if the option price were in the money?
(d) Traddles and two other investors each hold a third of the voting rights of Barkis. Barkis's business
activity is closely related to that of Traddles. In addition to its equity instruments, Traddles also
holds debt instruments. These are convertible into ordinary shares of Barkis at any time for a fixed
price that is out of the money (but not deeply out of the money). If the debt were converted,
Traddles would hold 60 per cent of the voting rights of Barkis. Traddles would benefit from
realising synergies if the debt instruments were converted into ordinary shares.

Solution
(a) The absolute size of Twist's holding and the relative size of the other shareholdings alone are not
conclusive in determining whether the investor has rights sufficient to give it power. However, the
fact that Twist has a contractual right to appoint, remove and set the remuneration of
management is sufficient to conclude that it has power over Oliver. The fact that Twist has not
exercised this right is not a determining factor when assessing whether Twist has power. In
conclusion, Twist does control Oliver, and should consolidate it.
(b) In this case, the size of Copperfield's voting interest and its size relative to the other shareholdings
are sufficient to conclude that Copperfield does not have power. Only two other investors,
Murdstone and Steerforth would need to co-operate to be able to prevent Copperfield from
directing the relevant activities of the Spenlow.
(c) Scrooge has been exercising its votes and is actively directing the relevant activities of Cratchett. In
such a case, Scrooge is likely to meet the power criterion because it appears to have the current
ability to direct the relevant activities. Although Marley has currently exercisable options to
purchase additional voting rights (that, if exercised, would give it a majority of the voting rights in
Cratchett), the terms and conditions associated with those options are such that the options are
not considered substantive.Thus voting rights even combined with potential voting rights, may not
be the deciding factor.
If the options were in the money, they would be exercised and the additional rights purchased,
giving Scrooge control and making Marley a subsidiary.
(d) Traddles has power over Barkis because it holds voting rights of Barkis together with substantive
potential voting rights that give it the current ability to direct the relevant activities.
2.4 Exclusion of a subsidiary from consolidation

Where a parent controls one or more subsidiaries, IFRS 10 requires that consolidated financial
statements are prepared to include all subsidiaries, both foreign and domestic other than:
 Those held for sale in accordance with IFRS 5
 Those held under such long-term restrictions that control cannot be operated.
The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a common
method used by entities to manipulate their results. If a subsidiary which carries a large amount of debt
can be excluded, then the gearing of the group as a whole will be improved. In other words, this is a
way of taking debt out of the consolidated statement of financial position.
IFRS 10 is clear that a subsidiary should not be excluded from consolidation simply because it is loss
making or its business activities are dissimilar from those of the group as a whole. IFRS 10 rejects the
latter argument: exclusion on these grounds is not justified because better information can be provided
about such subsidiaries by consolidating their results and then giving additional information about the
different business activities of the subsidiary, eg under IFRS 8 Operating segments.
2.5 Other matters

C
Different reporting dates H
A
Where one or more subsidiaries prepare accounts to a different reporting date from the parent and the P
bulk of other subsidiaries in the group: T
E
 The subsidiary may prepare additional statements to the reporting date of the rest of the group, for R
consolidation purposes.
 Or, if this is not possible, the subsidiary's accounts may still be used for consolidation provided that
10
the gap between the reporting dates is three months or less and that adjustments are made for
the effects of significant transactions or other events that occur between that date and the parent's
reporting date.

Uniform accounting policies
Uniform accounting policies should be used and adjustments must be made where the subsidiary's
policies differ from those of the parent.
Date of inclusion/exclusion
The results of subsidiary undertakings are included in the consolidated financial statements from:
(a) The date of 'acquisition', ie the date on which the investor obtains control, to
(b) The date of 'disposal', ie the date when the investor loses control.
Once an investment is no longer a subsidiary, it should be treated as an associate under IAS 28
(if applicable) or as an investment under IAS 39.
Accounting for subsidiaries and associates in the parent's separate financial statements
A parent company will usually produce its own single company financial statements. In these
statements, governed by IAS 27 Separate financial statements, investments in subsidiaries and associates
included in the consolidated financial statements should be either:
 Accounted for at cost, or
 In accordance with IAS 39.
Where subsidiaries are classified as held for sale in accordance with IFRS 5 they should be accounted
for in accordance with IFRS 5.
Non-controlling interest (NCI)
Within the statement of profit or loss and other comprehensive income, profit for the year and total
comprehensive income must be split between the shareholders of the parent and the non-controlling
interest.
IFRS 10 requires an entity to attribute their share of total comprehensive income to the non-controlling
interest, even if this results in a negative (debit) NCI balance.
Acquisitions and disposals which do not result in a change of control
Acquisitions of further shares in an existing subsidiary or disposals of shares by a parent which do not
result in a loss of control are accounted for within shareholders' equity.
No gain or loss is recognised and goodwill is not remeasured.
This is explained further within sections 8 and 9 of this chapter.
Loss of control
Where a parent loses control of a subsidiary:
 Assets, liabilities and the non-controlling interest must be derecognised
 Any interest retained is recognised at fair value at the date of loss of control
 A gain or loss on loss of control is recognised in profit or loss
This is explained further within section 9 of this chapter.
3 IFRS 3 (Revised) Business Combinations
Section overview
 IFRS 3 refers to business combinations as 'transactions or events in which an acquirer obtains
control of one or more businesses'. In a straightforward business combination one entity acquires
another, resulting in a parent subsidiary relationship.
 Business combinations are accounted for using the acquisition method

3.1 The acquisition method
All business combinations should be recognised using the acquisition method which involves the
following steps.
1 Identifying an acquirer – which obtains control of the other entity. If this cannot be established
from shareholdings and other factors listed in IFRS 10 (see section 1.1 above) IFRS 3 provides
additional indicators, such as the fact that the entity with the larger fair value is likely to be the
acquirer.
2 Determining the acquisition date. This is generally the date on which the parent company
(acquirer) transfers consideration and acquires the net assets of the acquiree.
3 Recognising and measuring the identifiable assets acquired, the liabilities assumed and any
non-controlling interest in the acquiree.
4 Recognising and measuring goodwill or a gain from a bargain purchase.
Measurement of the non-controlling interest in step 3 along with the measurement of goodwill in step 4
are covered in more detail in the next section.
Measurement of the identifiable assets and liabilities in step 3 is covered in Section 3.3 of this chapter.
3.2 Calculation of goodwill

IFRS 3 (revised) requires goodwill acquired in a business combination (or a gain on a bargain purchase)
to be measured as:
£
Consideration transferred: Fair value of assets given, liabilities assumed and
equity instruments issued, including contingent amounts X
Non-controlling interest at the acquisition date X
X
Less total fair value of net assets of acquiree (X)
Goodwill / (gain from a bargain purchase) X/(X)
This calculation includes the non-controlling interest and is therefore calculated based on the whole net
assets of the acquiree.
Section 3.3 considers the first two elements of the revised calculation – consideration transferred and
the non-controlling interest – in more detail.
Worked example: Calculation of goodwill 1

On 1 January 20X7, Avon acquired 80% of the equity share capital of Tweed, for a total consideration of
£670,000. The fair value of the net assets of Tweed at this date was £700,000. The non-controlling
interest is measured at £140,000.
What goodwill arises on the acquisition?
Solution
Goodwill is calculated as:
£ C
H
Consideration transferred 670,000 A
Non-controlling interest at the acquisition date 140,000 P
810,000 T
Less: Total fair value of net assets of acquiree (700,000) E
Goodwill 110,000 R
In this example the non-controlling interest is measured as the relevant percentage of Tweed's
acquisition date net assets, ie 20% × £700,000. 10
This means that the goodwill arising is the same as it would be if calculated according to the previous
version of IFRS 3:

£
Cost of combination 670,000
Less: 80% × £700,000 (560,000)
Goodwill 110,000
As we shall see later, this is not always the case, as the non-controlling interest is not necessarily
calculated as a proportion of acquisition date net assets.
3.3 Consideration transferred

Contingent consideration – initial measurement
IFRS 3 (revised) requires the consideration to be measured at the fair value at the acquisition date. This
includes any contingent consideration payable even if, at the date of acquisition, it is not deemed
probable that it will be paid.
Contingent consideration – subsequent measurement
IFRS 3 (revised) requires contingent consideration to be classified as:
 A liability where contingent consideration is cash or shares to a specific value
 Equity where contingent consideration is a specified number of ordinary shares regardless of their
value
Subsequent changes are then dealt with as follows:
(a) If the change is due to additional information obtained that affects the position at the acquisition
date, goodwill should be re-measured.
(b) If the change is due to events which took place after the acquisition date, for example, meeting
earnings targets:
 Where consideration is recorded as a liability (including a provision), any remeasurement is
recorded in profit or loss (so an increase in the liability due to strong performance of the
subsidiary will result in an expense and a decrease in the liability due to underperformance
will result in a gain)
 Where consideration is recorded in equity, remeasurement is not required
The treatment means that group profits are now reduced where good performance of the subsidiary
results in additional payments to the seller.
Acquisition-related costs
These costs do not form part of consideration within the above calculation. Instead, all finders' fees,
legal, accounting, valuation and other professional fees must be expensed through profit or loss.
Costs incurred to issue securities will be dealt with in accordance with IAS 39.
The treatment will therefore reduce goodwill values and profits.
3.4 Non-controlling interest

The standard allows a choice in valuing the non-controlling interest within the goodwill calculation. It
may be measured either:
 As a proportion of the identifiable net assets of the subsidiary at the acquisition date (as in the
example above), or
 At fair value of the equity shares held by the non-controlling interest on the acquisition date.
The choice is available on a transaction by transaction basis.
The proportion of net assets method is used to value the non-controlling interest (NCI) at the
reporting date. It requires identifiable assets to be recognised at the fair values of the individual assets.
Where this method is used to value the non-controlling interest under IFRS 3 (revised), the resulting
goodwill corresponds only to the share of the entity held by the parent company.

The fair value method brings measurement of the non-controlling interest into line with measurement
of consideration and the acquiree's net assets (ie all at fair value). The fair value of the non-controlling
interest (eg the active market prices of the equity shares not held by the acquirer) is likely to exceed the
proportion of net assets attributable to the non-controlling interest, this being by an amount which
represents goodwill attributable to the non-controlling interest. Therefore goodwill on acquisition
calculated using this method will represent 100% of goodwill in the acquiree. Accordingly, this method
is sometimes known as the 'full goodwill' method.
Worked example: Calculation of goodwill 2

The consideration transferred by National plc when it acquired 80,000 of the 100,000 equity shares of
Locale Ltd was £25 million. At the acquisition date the fair value of Locale Ltd's net assets was £21
million and the fair value of the 20,000 equity shares in Locale Ltd not acquired was £5 million.
Calculate the goodwill acquired in the business combination on the basis that the non-controlling
interest in Locale Ltd is measured at:
(a) Its share of identifiable net assets;
(b) Fair value of the non-controlling interest's equity shares.
Solution
(a) (b)
NCI at share NCI at fair
of net assets value
£'000 £'000
Consideration transferred 25,000 25,000
Non-controlling interest – 20% × £21 million/fair value 4,200 5,000
29,200 30,000
Total net assets of acquiree (21,000) (21,000)
Goodwill acquired in business combination 8,200 9,000
As the non-controlling interest is £0.8 million higher when measured at fair value, it follows that
goodwill is also £0.8 million higher.
This amount is the goodwill relating to the non-controlling interest. The calculation of goodwill when
the NCI is valued at fair value could be laid out as:
Group NCI
£'000 £'000
Consideration / fair value 25,000 5,000
Share of net assets 80% / 20% × £21m (16,800) (4,200)
Goodwill 8,200 800
Total (or full) goodwill is £9 million; of this, the parent's share is £8.2 million and the non-controlling
interest's share is £0.8 million.
Note that the goodwill is not split in the same proportion as ownership of the shares:
 National owns 80% of the shares but 91% of goodwill
 The non-controlling interest owns 20% of shares but just 9% of goodwill
This discrepancy is due to the 'control premium' paid by National.
C
H
A
P
Interactive question 1: Calculation of goodwill [Difficulty level: Easy] T
E
On 1 January 20X5, ABC acquired 90% of DEF when the fair value of DEF's net assets was £18 million. R
The consideration was structured as follows.
 Three million ABC ordinary shares to be issued on the acquisition date; and
10
 An additional one million ABC ordinary shares to be issued on 31 December 20X6 if DEF's revenue
increases by 10% in the interim two years.

The market price of ABC ordinary shares is £7 at the acquisition date and has increased to £9 by 31
December 20X6.
ABC incurs professional acquisition fees amounting to £50,000.
It is ABC group policy to value the non-controlling interest using the proportion of net assets method.
Requirement
Calculate the consideration transferred and the goodwill arising on acquisition.
3.4.1 Non-controlling interest – subsequent valuation

Where the non-controlling interest is measured using the proportion of net assets method, the NCI at
the reporting date is calculated as the non-controlling interest's share of the subsidiary's net assets.
Where the non-controlling interest is measured using the fair value method, a consolidation adjustment
is required to recognise the additional goodwill in the consolidated statement of financial position. This
is best achieved using the following calculation:
Non-controlling interest
£ £
Share of net assets (NCI%  net assets at reporting date (W2)) X
Share of goodwill:
NCI at acquisition date at fair value (W3) X
NCI at acquisition date at share of net assets (NCI%  net
assets at acquisition (W2)) (X)
Difference, being goodwill attributable to NCI X
X
Note: the references are to standard consolidation workings:
W2 Net assets of the subsidiary
W3 Goodwill working
Interactive question 2: Non-controlling interest [Difficulty level: Easy]

Robson acquired 75% of the ordinary shares of Ives on 30 June 20X7. At this date Ives had net assets of
£250,000, and the fair value of the 25% of Ives's equity shares not acquired by Robson was £90,000.
Ives uses the fair value (full goodwill) method to measure non-controlling interests.
The abbreviated statement of financial position of Ives at 31 December 20X9 is as follows:
£
Assets 440,000
Share capital 100,000
Liabilities 95,000
440,000
 At acquisition, the fair value of land owned by Ives was £50,000 greater than its carrying amount;
Ives has subsequently sold the land to a third party.
 During the year ended 31 December 20X9, Ives sold goods to Robson, making a profit of £12,000.
Half of these goods are included in Robson's inventory count at the year end.
What is the value of the non-controlling interest in the consolidated statement of financial position at 31
December 20X9?
3.5 Step acquisitions

Under IFRS 3 and IFRS 10, acquisition accounting is only applied to business combinations when control
is achieved.

Where a parent acquires control of a subsidiary in stages (a step acquisition), this means that goodwill is
only calculated once, upon initially achieving control. It is not then recalculated in response to further
acquisitions of shares in the same subsidiary.
Accounting for step acquisitions is covered in further detail within Section 8 of this chapter.
3.6 Assets and liabilities acquired

In the previous section, we discussed the first two elements of the goodwill calculation: consideration
transferred and the non-controlling interest.
This section deals with the third element of goodwill – the net assets acquired.
3.6.1 Recognition
Assets and liabilities existing at the acquisition date, and meeting the Framework definition of an asset
or liability, should be recognised within the goodwill calculation.
 Only those liabilities which exist at the date of acquisition are recognised (so not future operating
losses or reorganisation plans which will be put into effect after control is gained).
 Some assets not recognised by the acquiree in its individual company financial statements may be
recognised by the acquirer in the consolidated financial statements. These include identifiable
intangible assets such as brand names. Identifiable means that these assets are separable or arise
from contractual or other legal rights.
3.6.2 Measurement
The basic requirement of IFRS 3 (revised) is that the identifiable assets and liabilities acquired are
measured at their acquisition-date fair value.
To understand the importance of fair values in the acquisition of a subsidiary consider again the
definition of goodwill.
Definition
Goodwill: Any excess of the cost of the acquisition over the acquirer's interest in the fair value of the
identifiable assets and liabilities acquired as at the date of the exchange transaction.
The statement of financial position of a subsidiary company at the date it is acquired may not be a
guide to the fair value of its net assets. For example, the market value of a freehold building may have
risen greatly since it was acquired, but it may appear in the statement of financial position at historical
cost less accumulated depreciation.
3.6.3 What is fair value

Fair value is defined as follows by IFRS 13 – it is an important definition.
Definition C
H
Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly A
transaction between market at the measurement date (IFRS 13). P
T
E
R
We will look at the requirements of IFRS 3 (revised) and IFRS 13 regarding fair value in more detail in
Section 4. First, let us look at some practical matters. The following example will remind you how to
make a fair value adjustment, using the standard consolidation workings from your Professional Stage
10
studies.

Worked example: Fair value adjustment
P Co acquired 75% of the ordinary shares of S Co on 1 September 20X5. At that date the fair value of S
Co's non-current assets was £23,000 greater than their carrying amount, and the balance of retained
earnings was £21,000. The fair value of the non-controlling interest was £17,000. The statements of
financial position of both companies at 31 August 20X6 are given below. S Co has not incorporated any
revaluation in its financial statements.
P Co values the non-controlling interest using the fair value (full goodwill) method.
P CO STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6
£ £
ASSETS
Non-current assets
Tangible assets 63,000
Investment in S Co at cost 51,000
114,000
Current assets 82,000
Total assets 196,000
Equity
Ordinary shares of £1 each 80,000
176,000
Current liabilities 20,000
Total equity and liabilities 196,000
S CO STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6

£ £
ASSETS
Tangible non-current assets 28,000
Total assets 71,000
Equity
Ordinary shares of £1 each 20,000
61,000
If S Co had revalued its non-current assets at 1 September 20X5, an addition of £3,000 would have
been made to the depreciation expense charged for 20X5/X6.
Requirement
Prepare P Co's consolidated statement of financial position as at 31 August 20X6.
Solution
P CO CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6
£ £
ASSETS
Non-current assets
Tangible non-current assets £(63,000 + 28,000 + 23,000 – 3,000) 111,000
Intangibles – goodwill (W3) 4,000
115,000
Current assets £(82,000+43,000) 125,000
Total assets 240,000
Ordinary share capital 80,000
Retained earnings (W5) 108,750

Equity 188,750
Non-controlling interest (W4) 21,250
210,000
Current liabilities £(20,000+10,000) 30,000
WORKINGS
1 Group structure
P Co
75%
S Co
2 Net assets
Reporting Acquisition Post-
date acquisition
£ £ £
Share capital 20,000 20,000 –
Retained earnings – per question 41,000 21,000 20,000
– additional depreciation (3,000) (3,000)
Fair value adjustment to PPE 23,000 23,000
81,000 64,000 17,000
3 Goodwill
£
Consideration transferred 51,000
Non-controlling interest 17,000
68,000
Less Net assets of acquiree (W2) (64,000)
4,000
4 Non-controlling interest
£ £
S Co (25% × £81,000 (W2)) 20,250
NCI share of goodwill at acquisition
FV of NCI at acquisition 17,000
NCI share of net assets at acquisition (25% × £64,000) (16,000)
1,000
Non-controlling interest 21,250
5 Retained earnings
£
P Co 96,000
S Co (£17,000 (W2)  75%) 12,750
108,750
Remember also that when preparing consolidated financial statements all intra-group balances,
C
transactions, profits and losses need to be eliminated. Where there are provisions for unrealised profit H
and the parent is the seller the adjustment is made against the parent's retained earnings (in the A
retained earnings working). Where the subsidiary is the seller its retained earnings are adjusted (in the P
net assets working) thus ensuring that the non-controlling interest (ie the minority interest) bear their T
E
share of the provision. R
3.7 Impairments and the non-controlling interest

10
A subsidiary is subject to impairment review as a cash generating unit. The recoverable amount of the
subsidiary is compared with its carrying amount to assess whether an impairment has occurred.

Notional grossing up of goodwill
In order to be comparable with the calculated recoverable amount, the carrying amount of the
subsidiary must include 100% of both its net assets and goodwill. Therefore:
 Where the proportion of net assets method is used to measure the NCI, goodwill must be
notionally adjusted so that it represents both the parent and NCI share of goodwill (ie 100% of
goodwill). This involves grossing up the parent's goodwill according to percentage
shareholdings.
 Where fair value is used to measure the NCI, goodwill already represents 100% of goodwill and no
such adjustment is required.
Split of goodwill between the parent and NCI
Where goodwill requires grossing up according to ownership percentages, total goodwill is split in
proportion to these ownership percentages.
Where goodwill does not require grossing up, total goodwill is not necessarily split in proportion to
ownership percentages due to the control premium.
Illustration: Notional goodwill

A acquires 80% of B for £120,000. The net assets at the date of acquisition were £130,000 and the fair
value of the 20% non-controlling interest equity shares was £28,000.
Proportion of net Fair value
assets method method
£ £
Consideration transferred 120,000 120,000
Non-controlling interest (20% × £130,000)/fair value 26,000 28,000
146,000 148,000
Net assets of acquiree (130,000) (130,000)
Goodwill 16,000 18,000
Attributable to:
Parent 16,000 16,000
NCI [£28,000 – (20% × £130,000)] n/a 2,000
For the purposes of an impairment review, the goodwill calculated using the proportion of net assets
method is notionally adjusted as follows:
£
Parent goodwill 16,000
Notional NCI goodwill (20%/80% × £16,000) 4,000
20,000
In other words the notional goodwill attributable to the non-controlling interest calculated here includes
an element of control premium which is not evident when calculating goodwill attributable to the non-
controlling interest using the fair value method.
Allocation of the impairment loss to parent / NCI

IFRS 3 (revised) has amended IAS 36 to require that any impairment loss is allocated 'on the same
basis as that on which profit or loss is allocated'. This is likely to correspond to ownership
percentages.
Therefore in the illustration above, any impairment loss to goodwill is allocated 80% to the parent and
20% to the NCI.
 Where the proportion of net assets method is used and goodwill is notionally calculated for the
NCI, this split corresponds exactly to the split of goodwill. Assuming an impairment of £10,000:

Parent NCI
£ £
Goodwill 16,000 4,000
Impairment (80%/20% × £10,000) (8,000) (2,000)
8,000 2,000
Impairment of goodwill 50% 50%
ie half the total goodwill has been impaired, being half of the parent's goodwill and half of the NCI's
notional goodwill.
 Where the fair value method is used, and there is a control premium, such that the parent and NCI
goodwill are not in proportion, then any impairment is not in proportion to the starting goodwill.
This time assuming an impairment of £9,000:
Parent NCI
£ £
Goodwill 16,000 2,000
Impairment (80%/20% × £9,000) (7,200) (1,800)
8,800 200
Impairment of goodwill 45% 90%
3.8 Restructuring and future losses

An acquirer should not recognise liabilities for future losses or other costs expected to be incurred as
a result of the business combination.
IFRS 3 (revised) explains that a plan to restructure a subsidiary following an acquisition is not a present
obligation of the acquiree at the acquisition date. Neither does it meet the definition of a contingent
liability. Therefore, an acquirer should not recognise a liability for such a restructuring plan as part of
allocating the cost of the combination unless the subsidiary was already committed to the plan before
the acquisition.
This prevents creative accounting. An acquirer cannot set up a provision for restructuring or future
losses of a subsidiary and then release this to profit or loss in subsequent periods in order to reduce
losses or smooth profits.
3.9 Intangible assets

The acquiree may have intangible assets, such as development expenditure. These can be recognised
separately from goodwill only if they are identifiable. An intangible asset is identifiable only if it:
(a) Is separable, ie capable of being separated or divided from the entity and sold, transferred, or
exchanged, either individually or together with a related contract, asset or liability, or
(b) Arises from contractual or other legal rights.
3.10 Contingent liabilities

Contingent liabilities of the acquirer are recognised if their fair value can be measured reliably. A
contingent liability must be recognised even if the outflow is not probable, provided there is a present C
obligation. H
A
This is a departure from the normal rules in IAS 37; contingent liabilities are not normally recognised, P
T
but only disclosed. E
R
After their initial recognition, the acquirer should measure contingent liabilities that are recognised
separately at the higher of:
(a) The amount that would be recognised in accordance with IAS 37 10
(b) The amount initially recognised

3.11 Other exceptions to the recognition or measurement principles
(a) Deferred tax: use IAS 12 values.
(b) Employee benefits: use IAS 19 values.
(c) Indemnification assets: measurement should be consistent with the measurement of the
indemnified item, for example an employee benefit or a contingent liability.
(d) Reacquired rights: value on the basis of the remaining contractual term of the related contract
regardless of whether market participants would consider potential contractual renewals in
determining its fair value.
(e) Share-based payment: use IFRS 2 values.
(f) Assets held for sale: use IFRS 5 values.
3.12 Goodwill arising on the acquisition

Goodwill should be carried in the statement of financial position at cost less any accumulated
impairment losses. The treatment of goodwill was covered in detail in your earlier studies and revised
in Chapter 2.
3.13 Adjustments after the initial accounting is complete

Sometimes the fair values of the acquiree's identifiable assets, liabilities or contingent liabilities or the
cost of the combination can only be measured provisionally by the end of the period in which the
combination takes place. In this situation, the acquirer should account for the combination using
those provisional values. The acquirer should recognise any adjustments to those provisional values
as a result of completing the initial accounting:
(a) Within twelve months of the acquisition date, and
(b) From the acquisition date (ie, retrospectively)
This means that:
(a) The carrying amount of an item that is recognised or adjusted as a result of completing the initial
accounting shall be calculated as if its fair value at the acquisition date had been recognised
from that date.
(b) Goodwill should be adjusted from the acquisition date by an amount equal to the adjustment to
the fair value of the item being recognised or adjusted.
Any further adjustments after the initial accounting is complete should be recognised only to correct
an error in accordance with IAS 8 Accounting policies, changes in accounting estimates and errors. Any
subsequent changes in estimates are dealt with in accordance with IAS 8 (ie, the effect is recognised in
the current and future periods). IAS 8 requires an entity to account for an error correction
retrospectively, and to present financial statements as if the error had never occurred by restating the
comparative information for the prior period(s) in which the error occurred.
3.14 Reverse acquisitions

IFRS 3 also addresses a certain type of acquisition, known as a reverse acquisition or reverse takeover.
This is where Company A acquires ownership of Company B through a share exchange. (For example, a
private entity may arrange to have itself 'acquired' by a smaller public entity as a means of obtaining a
stock exchange listing.) The number of shares issued by Company A as consideration to the
shareholders of Company B is so great that control of the combined entity after the transaction is with
the shareholders of Company B.
In legal terms Company A may be regarded as the parent or continuing entity, but IFRS 3 states that, as it
is the Company B shareholders who control the combined entity, Company B should be treated as the
acquirer. Company B should apply the acquisition method to the assets and liabilities of Company A.

Illustration: Reverse acquisition
On 1 January 20X5, ABC's share capital was 10,000 ordinary shares, quoted on a public exchange, and
the unquoted share capital of DEF was 24,000 ordinary shares. On that date ABC's shares were quoted
at £20. ABC issued 30,000 new shares, and then exchanged them for the entire share capital of DEF.
The fair value of DEF's shares on 1 January 20X5 was agreed by the professional advisors to both ABC
and DEF as £62.
After the acquisition, the relative interests of the two shareholder groups in ABC were as follows.
Shares held % of total
ABC shareholders 10,000 25
DEF shareholders 30,000 75
40,000 100
As the DEF shareholder group control the combined entities, DEF is treated as the acquirer and ABC as
the acquiree.
If DEF had issued enough of its own shares to give ABC shareholders a 25% interest in DEF, it would
have had to issue 8,000 shares (ie 25/75 of 24,000 shares). DEF's share capital would then have been
32,000 (24,000 + 8,000) and the ABC shareholders' interest would have been 8,000 so 25%.
The consideration for the acquisition is £496,000, being 8,000 DEF shares at their agreed fair value of
£62.
4 IFRS 13 Fair Value Measurement (business combination

aspects)
Section overview
 The accounting requirements and disclosures of the fair value exercise are covered by IFRS 3
(revised). IFRS 13 Fair value measurement gives extensive guidance on how the fair value of assets
and liabilities should be established.
 Business combinations are accounted for using the acquisition method
4.1 Fair value

The general rule under the revised IFRS 3 (revised) is that the subsidiary's assets and liabilities must be
measured at fair value except in limited, stated cases. The assets and liabilities must:
(a) Meet the destinations of assets and liabilities in the IASBConceptual Framework.
(b) Be part of what the acquiree (or its former owners) exchanged in the business combination rather
than the result of separate transactions
IFRS 13 Fair Value Measurement (see Chapter 2) provides extensive guidance on how the fair value of
assets and liabilities should be established.
This standard requires that the following are considered in measuring fair value: C
H
(a) The asset or liability being measured A
(b) The principal market (ie that where the most activity takes place) or where there is no principal P
T
market, the most advantageous market (ie that in which the best price could be achieved) in E
which an orderly transaction would take place for the asset or liability R
(c) The highest and best use of the asset or liability and whether it is used on a standalone basis or in
conjunction with other assets or liabilities
10
(d) Assumptions that market participants would use when pricing the asset or liability.
Having considered these factors, IFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that Level 1 inputs are used where possible:

Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date.
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset.
Level 3 Unobservable inputs for the asset.
Illustration: Examples of fair value and business combinations

For non-financial assets, fair value is decided based on the highest and best use of the asset as
determined by a market participant. The following examples, adapted from the illustrative examples to
IFRS 13, demonstrate what is meant by this.
Example: land
Anscome Co has acquired land in a business combination. The land is currently developed for industrial
use as a site for a factory. The current use of land is presumed to be its highest and best use unless
market or other factors suggest a different use. Nearby sites have recently been developed for residential
use as sites for high-rise apartment buildings. On the basis of that development and recent zoning and
other changes to facilitate that development, Anscome determines that the land currently used as a site
for a factory could be developed as a site for residential use (ie for high-rise apartment buildings)
because market participants would take into account the potential to develop the site for residential use
when pricing the land.
How would the highest and best use of the land be determined?
Solution
The highest and best use of the land would be determined by comparing both of the following:
(a) The value of the land as currently developed for industrial use (ie the land would be used in
combination with other assets, such as the factory, or with other assets and liabilities).
(b) The value of the land as a vacant site for residential use, taking into account the costs of
demolishing the factory and other costs (including the uncertainty about whether the entity would
be able to convert the asset to the alternative use) necessary to convert the land to a vacant site (ie
the land is to be used by market participants on a stand-alone basis).
The highest and best use of the land would be determined on the basis of the higher of those values.
Example: Research and development project

Searcher has a research and development (R & D) project in a business combination. Searcher does not
intend to complete the project. If completed, the project would compete with one of its own projects
(to provide the next generation of the entity's commercialised technology). Instead, the entity intends
to hold (ie lock up) the project to prevent its competitors from obtaining access to the technology. In
doing this the project is expected to provide defensive value, principally by improving the prospects for
the entity's own competing technology.
If it could purchase the R & D project, Developer Co would continue to develop the project and that use
would maximise the value of the group of assets or of assets and liabilities in which the project would be
used (ie the asset would be used in combination with other assets or with other assets and liabilities).
Developer Co does not have similar technology.
How would the fair value of the project be measured?
Solution
The fair value of the project would be measured on the basis of the price that would be received in a
current transaction to sell the project, assuming that the R & D would be used with its complementary
assets and the associated liabilities and that those assets and liabilities would be available to Developer
Co.
Example: Decomissioning liability

Deacon assumes a decommissioning liability in a business combination. It is legally required to
dismantle a power station at the end of its useful life, which is estimated to be twenty years.
How would the decommissioning liability be measured?

Solution
Because this is a business combination, Deacon must measure the liability at fair value in accordance
with IFRS 13, rather than using the best estimate measurement required by IAS 37 Provisions, contingent
liabilities and contingent assets.
Deacon will use the expected present value technique to measure the fair value of the decommissioning
liability. If Deacon were contractually committed to transfer its decommissioning liability to a market
participant, it would conclude that a market participant would use all of the following inputs, probability
weighted as appropriate, when estimating the price it would expect to receive.
(a) Labour costs

(b) Allocated overhead costs
(c) The compensation that a market participant would generally receive for undertaking the activity,
including profit on labour and overhead costs and the risk that the actual cash outflows might
differ from those expected
(d) The effect of inflation
(e) The time value of money (risk-free rate)
(f) Non-performance risk, including Deacon's own credit risk
As an example of how the probability adjustment might work, Deacon values labour costs on the basis
of current marketplace wages adjusted for expected future wage increases. It determines that there is a
20% probability that the wage bill will be £15 million, a 30% probability that it will be £25 million and
a 50% probability that it will be £20 million. Expected cash flows will then be (20% × £15m) + (30% ×
£25m) + (50% × £20m) = £20.5m. The probability assessments will be developed on the basis of
Deacon's knowledge of the market and experience of fulfilling obligations of this type.
Interactive question 3: Goodwill on consolidation [Difficulty level: Intermediate]
Tyzo plc prepares its financial statements to 31 December. On 1 September 20X7 Tyzo plc acquired six
million £1 shares in Kono Ltd at £2.00 per share. The purchase was financed by an additional issue of
loan stock at an interest rate of 10%. At that date Kono Ltd produced the following interim financial
Non-current assets £'000
Property, plant and
equipment (Note 1) 16.0
Current assets
Inventories (Note 2) 4.0
Receivables 2.9
Cash and cash equivalents 1.2
8.1
Total assets 24.1
Equity and liabilities
Equity
Share capital (£1 shares) 8.0
Reserves 4.4 C
12.4 H
Non-current liabilities A
Long-term loan (Note 3) 4.0 P
T
E
Current liabilities
R
Trade payables 3.2
Provision for taxation 0.6
Bank overdraft 3.9
10
(7.7)
Total equity and liabilities 24.1

Notes
1 The following information relates to the property, plant and equipment of Kono Ltd at 1
September 20X7.
£m
Gross replacement cost 28.4
Net replacement cost 16.8
Economic value 18.0
Net realisable value 8.0
2 The inventories of Kono Ltd in hand at 1 September 20X7 consisted of raw materials at cost. They
would have cost £4.2 million to replace at 1 September 20X7.
3 The long-term loan of Kono Ltd carries a rate of interest of 10% per annum, payable on 31 August
annually in arrears. The loan is redeemable at par on 31 August 20Y1. The interest cost is
representative of current market rates. The accrued interest payable by Kono Ltd at 31 December
20X7 is included in the trade payables of Kono Ltd at that date.
4 On 1 September 20X7 Tyzo plc took a decision to rationalise the group so as to integrate Kono
Ltd. The costs of the rationalisation were estimated to total £3.0 million and the process was due to
start on 1 March 20X8. No provision for these costs has been made in any of the financial
statements given above.
5 Kono Ltd has disclosed a contingent liability of £200,000 in its interim financial statements relating
to litigation.
6 Tyzo Group values the non-controlling interest using the proportion of net assets method.
Requirement
Compute the goodwill on consolidation of Kono Ltd that will be included in the consolidated financial
statements of Tyzo plc for the year ended 31 December 20X7, explaining your treatment of the items
mentioned above. You should refer to the provisions of relevant accounting standards.
5 IAS 28 Investments in Associates and Joint Ventures
Section overview
 IAS 28 deals with accounting for associates and joint ventures using the equity method.
 An associate exists where there is 'significant influence'.
 The criteria for identifying a joint venture are contained in IFRS 11
 The accounting for associates and joint ventures is identical
IAS 28 does not apply to investments in associates or joint ventures held by venture capital
organisations, mutual funds, unit trusts, and similar entities that are measured at fair value in accordance
with IAS 39.
IAS 28 requires all investments in associates to be accounted for using the equity method, unless the
investment is classified as 'held for sale' in accordance with IFRS 5 in which case it should be accounted
for under IFRS 5.
An investor is exempt from applying the equity method if:
(a) It is a parent exempt from preparing consolidated financial statements under IAS 27 (revised) or
(b) All of the following apply:
(i) The investor is a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been
informed about, and do not object to, the investor not applying the equity method;
(ii) Its securities are not publicly traded;

(iii) It is not in the process of issuing securities in public securities markets; and
(iv) The ultimate or intermediate parent publishes consolidated financial statements that
comply with International Financial Reporting Standards.
IAS 28 does not allow an investment in an associate to be excluded from equity accounting when an
investee operates under severe long-term restrictions that significantly impair its ability to transfer funds
to the investor. Significant influence must be lost before the equity method ceases to be applicable.
The use of the equity method should be discontinued from the date that the investor ceases to have
significant influence.
From that date, the investor shall account for the investment in accordance with IFRS 9 Financial
instruments. The fair value of the retained interest must be regarded as its fair value on initial recognition
as a financial asset under IAS 39.
5.1 Separate financial statements of the investor

If the investor issues consolidated financial statements an investment in an associate should be either:
 Accounted for at cost, or
 In accordance with IAS 39
in its separate financial statements.
If an investor does not issue consolidated financial statements, an investment in an associate should
be included in its separate financial statements using the equity method.
5.2 Application of the equity method: consolidated accounts

The equity method should be applied in the consolidated accounts:
 Statement of financial position includes investment in associate at cost plus (or minus) the
group's share of the associate's post-acquisition profits (or losses) minus any impairments in the
investment to date.
 Profit or loss (statement of profit or loss and other comprehensive income): group share of
associate's profit after tax.
 Other comprehensive income (statement of profit or loss and other comprehensive income):
group share of associate's other comprehensive income after tax.
The investment in the associate will also include any other long-term interests in the associate, for
example preference shares or long-term receivables or loans.
IAS 39 sets out a list of indications that a financial asset (including an associate) may have become
impaired.
Many of the procedures required to apply the equity method are the same as are required for full
consolidation. In particular, fair value adjustments are required and the group share of intra-group
unrealised profits must be excluded.
C
Worked example: Associate H
A
P Co, a company with subsidiaries, acquires 25,000 of the 100,000 £1 ordinary shares in A Co for
P
£60,000 on 1 January 20X8. In the year to 31 December 20X8, A Co earns profits after tax of £24,000, T
from which it declares and pays a dividend of £6,000. E
R
Requirement
How will A Co's results be accounted for in the individual and consolidated accounts of P Co for the year
ended 31 December 20X8? 10

Solution
In the individual accounts of P Co, the investment will be recorded on 1 January 20X8 at cost. Unless
there is an impairment in the value of the investment (see below), this amount will remain in the
individual statement of financial position of P Co permanently. The only entry in P Co's individual
statement of profit or loss and other comprehensive income / income statement will be to record
dividends received. For the year ended 31 December 20X8, P Co will:
Dr Cash (£6,000  25%) £1,500
Cr Income from shares in associated companies £1,500
In the consolidated accounts of P Co equity accounting will be used. Consolidated profit after tax will
include the group's share of A Co's profit after tax (25%  £24,000 = £6,000).
In the consolidated statement of financial position the non-current asset 'Investment in associates' will
be stated at £64,500, being cost of £60,000 plus the group's share of post-acquisition retained profits of
£4,500 ((24,000 – 6,000) × 25%).
5.3 Transactions between a group and its associate

Unlike for subsidiaries, trading transactions are not cancelled out. However, any unrealised profits on
these transactions should be eliminated, but only to the extent of the group's share.
Where the associate sells to the parent/subsidiary the double entry is as follows, where A% is the
parent's holding in the associate, and PURP is the provision for unrealised profit:
Dr Retained earnings of parent PURP  A%
Cr Group inventories/PPE PURP  A%
Where the parent/subsidiary sells to the associate:
Dr Retained earnings of parent/subsidiary PURP  A%
Cr Investment in associate PURP  A%
5.4 Associate's losses

When the equity method is being used and the investor's share of losses of the associate equals or
exceeds its interest in the associate, the investor should discontinue including its share of further losses.
The investment is reported at nil value. After the investor's interest is reduced to nil, additional losses
should only be recognised where the investor has incurred obligations or made payments on behalf of
the associate (for example, if it has guaranteed amounts owed to third parties by the associate).
5.5 Impairment losses

Any impairment loss is recognised in accordance with IAS 36 Impairment of Assets for each associate
individually.
6 IFRS 11 Joint Arrangements
Section overview
 IFRS 11 classes joint arrangements as either joint operations or joint ventures.
 The classification of a joint arrangement as a joint operation or a joint venture depends upon the
rights and obligations of the parties to the arrangement.
 Joint arrangements are often found when each party can contribute in different ways to the
activity. For example, one party may provide finance, another purchases or manufactures goods,
while a third offers its marketing skills.

Joint arrangements are often found when each party can contribute in different ways to the activity.
For example, one party may provide finance, another purchases or manufactures goods, while a third
offers its marketing skills.
6.1 Definitions
The IFRS begins by listing some important definitions.
Definitions
Joint arrangement: An arrangement of which two or more parties have joint control.
Joint control: The contractually agreed sharing of control of an arrangement, which exists only when
decisions about the relevant activities require the unanimous consent of the parties sharing control.
Joint operation: A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the assets and obligations for the liabilities relating to the arrangement.
Joint venture: A joint arrangement whereby the parties that have joint control of the arrangement have
rights to the net assets of the arrangement. (IFRS 11)
6.2 Forms of joint arrangement

IFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification of a joint
arrangement as a joint operation or a joint venture depends upon the rights and obligations of the
parties to the arrangement.
A joint operation is a joint arrangement whereby the parties that have joint control (the joint operators)
have rights to the assets, and obligations for the liabilities, of that joint arrangement. A joint
arrangement that is not structured through a separate entity is always a joint operation.
A joint venture is a joint arrangement whereby the parties that have joint control (the joint venturers)
of the arrangement have rights to the net assets of the arrangement.
A joint arrangement that is structured through a separate entity may be either a joint operation or a
joint venture. In order to ascertain the classification, the parties to the arrangement should assess the
terms of the contractual arrangement together with any other facts or circumstances to assess whether
they have:
 Rights to the assets, and obligations for the liabilities, in relation to the arrangement (indicating a
joint operation)
 Rights to the net assets of the arrangement (indicating a joint venture)
Detailed guidance is provided in the appendices to IFRS 11 in order to help this assessment, giving
consideration to, for example, the wording contained within contractual arrangements.
IFRS 11 summarises the basic issues that underlie the classifications in the following diagram.
C
H
A
P
T
E
R
10

Structure of the joint arrangement
Not structured through a separate Structured through a separate

vehicle vehicle
An entity shall consider:

(i) The legal form of the separate
vehicle
(ii) The terms of the contractual
arrangement; and
(iii) Where relevant, other facts and
circumstances
Joint operation Joint venture
6.2.1 Contractual arrangement

The existence of a contractual agreement distinguishes a joint arrangement from an investment in an
associate. If there is no contractual arrangement, then a joint arrangement does not exist.
Evidence of a contractual arrangement could be in one of several forms.
 Contract between the parties
 Minutes of discussion between the parties
 Incorporation in the articles or by-laws of the joint venture
The contractual arrangement is usually in writing, whatever its form, and it will deal with the following
issues surrounding the joint venture.
 Its activity, duration and reporting obligations
 The appointment of its board of directors (or equivalent) and the voting rights of the parties
 Capital contributions to it by the parties
 How its output, income, expenses or results are shared between the parties
It is the contractual arrangement which establishes joint control over the joint venture, so that no single
party can control the activity of the joint venture on its own.
The terms of the contractual arrangement are key to deciding whether the arrangement is a joint
venture or joint operation. IFRS 11 includes a table of issues to consider and explains the influence of a
range of points that could be included in the contract. The table is summarised below.

Joint operation Joint venture
The terms The parties to the joint arrangement have The parties to the joint
of the rights to the assets, and obligations for the arrangement have rights to the
contractual liabilities, relating to the arrangement. net assets of the arrangement
arrangement (ie it is the separate vehicle,
not the parties, that has rights
to the assets, and obligations
for the liabilities).
Rights to The parties to the joint arrangement share all The assets brought into the
assets interests (eg rights, title or ownership) in the arrangement or subsequently
assets relating to the arrangement in a acquired by the joint
specified proportion (eg in proportion to the arrangement are the
parties' ownership interest in the arrangement arrangement's assets. The
or in proportion to the activity carried out parties have no interests (ie no
through the arrangement that is directly rights, title or ownership) in
attributed to them). the assets of the arrangement.
Obligations The parties share all liabilities, obligations, The joint arrangement is liable
for liabilities costs and expenses in a specified proportion for the debts and obligations
(eg in proportion to their ownership interest of the arrangement.
in the arrangement or in proportion to the
The parties are liable to the
activity carried out through the arrangement
arrangement only to the
that is directly attributed to them).
extent of their respective:
 Investments in the
arrangement, or
 Obligations to contribute
any unpaid or additional
capital to the
arrangement, or
 Both
The parties to the joint arrangement are liable Creditors of the joint
for claims by third parties. arrangement do not have
rights of recourse against any
party.
Revenues, The contractual arrangement establishes the The contractual arrangement
expenses, allocation of revenues and expenses on the establishes each party's share
profit or loss basis of the relative performance of each party in the profit or loss relating to
to the joint arrangement. For example, the the activities of the
contractual arrangement might establish that arrangement.
revenues and expenses are allocated on the
basis of the capacity that each party uses in a
plant operated jointly.
Guarantees The provision of guarantees to third parties, or the commitment by the parties
to provide them, does not, by itself, determine that the joint arrangement is a
joint operation.
C
6.2.2 Section summary H
A
 There are two types of joint arrangement: joint ventures and jointly controlled operations P
T
 A contractual arrangement must exist which establishes joint control E
R
 Joint control is important: one operator must not be able to govern the financial and operating
policies of the joint venture
10

The accounting treatment of joint arrangements depends on whether the arrangement is a joint venture
or joint operation.
6.3.1 Accounting for joint operations

IFRS 11 requires that a joint operator recognises line-by-line the following in relation to its interest in a
joint operation:
(a) Its assets, including its share of any jointly held assets
(b) Its liabilities, including its share of any jointly incurred liabilities
(c) Its revenue from the sale of its share of the output arising from the joint operation
(d) Its share of the revenue from the sale of the output by the joint operation, and
(e) Its expenses, including its share of any expenses incurred jointly.
operator.
Interactive question 4: Joint arrangement [Difficulty level: Intermediate]

Can you think of examples of situations where this type of joint venture might take place?
6.3.2 Joint ventures

IFRS 11 and IAS 28 require joint ventures to be accounted for using the equity method.
Before the recent group accounting standards issued in 2011, the old standard on joint ventures (IAS
31) permitted either equity accounting or proportionate consolidation to be used for joint ventures. The
choice has now been removed. (Proportionate consolidation meant including the investor's share of the
assets, liabilities, income and expenses of the joint venture, line by line.)
The rules for equity accounting are included in IAS 28 Associates and Joint Ventures. These were covered
in your Professional studies and are revised above.
Application of IAS 28 (revised 2011) to joint ventures

The consolidated statement of financial position is prepared by:
 Including the interest in the joint venture at cost plus share of post-acquisition total comprehensive
income
 Including the group share of the post-acquisition total comprehensive income in group reserves
The consolidated statement of profit or loss and other comprehensive income will include:
 The group share of the joint venture's profit or loss
 The group share of the joint venture's other comprehensive income
The use of the equity method should be discontinued from the date on which the joint venturer ceases
to have joint control over, or have significant influence on, a joint venture.
Transactions between a joint venturer and a joint venture

Upstream transactions
A joint venturer may sell or contribute assets to a joint venture so making a profit or loss. Any such
gain or loss should, however, only be recognised to the extent that it reflects the substance of the
transaction.
Therefore:
 Only the gain attributable to the interest of the other joint venturers should be recognised in the

 The full amount of any loss should be recognised when the transaction shows evidence that the
net realisable value of current assets is less than cost, or that there is an impairment loss.
Downstream transactions
When a joint venturer purchases assets from a joint venture, the joint venturer should not recognise its
share of the profit made by the joint venture on the transaction in question until it resells the assets to
an independent third party, ie until the profit is realised.
Losses should be treated in the same way, except losses should be recognised immediately if they
represent a reduction in the net realisable value of current assets, or a permanent decline in the carrying
amount of non-current assets.
6.3.3 Section summary

 Joint operations are accounted for by including the investor's share of assets, liabilities, income
and expenses as per the contractual arrangement
 Joint ventures are accounted for using the equity method as under IAS 28
7 IFRS 12 Disclosure of interests in other entities
Section overview
 IFRS 12 Disclosure of interests in other entities requires disclosure of a reporting entity's interests
in other entities in order to help identify the profit or loss and cash flows available to the reporting
entity and determine the value of a current or future investment in the reporting entity.
7.1 Objective
IFRS 12 was published in 2011. It is effective for annual accounting periods beginning on or after 1
January 2013, but earlier application is permitted.
The objective of the standard is to require entities to disclose information that enables the user of the
financial statements to evaluate the nature of, and risks associated with, interests in other entities, and
the effects of those interests on its financial position, financial performance and cash flows.
This is particularly relevant in light of the financial crisis and recent accounting scandals. The IASB
believes that better information about interests in other entities is necessary to help users to identify the
profit or loss and cash flows available to the reporting entity and to determine the value of a current or
future investment in the reporting entity.
7.2 Scope
IFRS 12 covers disclosures for entities which have interests in:
 Subsidiaries
 Joint arrangements (ie joint operations and joint ventures, see above)
 Associates, and
 Unconsolidated structured entities.
C
H
7.3 Structured entity A
P
T
IFRS 12 defines a structured entity. E
R
Definition
Structured entity: An entity that has been designed so that voting or similar rights are not the 10
dominant factor in deciding who controls the entity, such as when any voting rights relate to
administrative tasks only and the relevant activities are directed by means of contractual arrangements
(IFRS 12)

7.4 Disclosure
IFRS 12 Disclosure of interests in other entities was issued in May 2011 as part of the 'package of five
standards' relating to consolidation. It removes all disclosure requirements from other standards relating
to group accounting and provides guidance applicable to consolidated financial statements.
The standard requires disclosure of:
(a) The significant judgements and assumptions made in determining the nature of an interest in
another entity or arrangement, and in determining the type of joint arrangement in which an
interest is held
(b) Information about interests in subsidiaries, associates, joint arrangements and structured entities
that are not controlled by an investor.
7.4.1 Disclosure of subsidiaries

The following disclosures are required in respect of subsidiaries:
(a) The interest that non-controlling interests have in the group's activities and cash flows, including
the name of relevant subsidiaries, their principal place of business, and the interest and voting
rights of the non-controlling interests
(b) Nature and extent of significant restrictions on an investor's ability to use group assets and liabilities
(c) Nature of the risks associated with an entity's interests in consolidated structured entities, such as
the provision of financial support
(d) Consequences of changes in ownership interest in subsidiary (whether control is lost or not)
7.4.2 Disclosure of associates and joint arrangements

The following disclosures are required in respect of associates and joint arrangements:
(a) Nature, extent and financial effects of an entity's interests in associates or joint arrangements,
including name of the investee, principal place of business, the investor's interest in the investee,
method of accounting for the investee and restrictions on the investee's ability to transfer funds to
the investor
(b) Risks associated with an interest in an associate or joint venture
(c) Summarised financial information, with more detail required for joint ventures than for associates.
8 Step acquisitions
Section overview
 Subsidiaries and associates are consolidated/equity accounted for from the date control/significant
influence is gained.
 In some cases acquisitions may be achieved in stages. These are known as step acquisitions.
A step acquisition occurs when the parent entity acquires control over the subsidiary in stages, achieved
by buying blocks of shares at different times.
Acquisition accounting is only applied when control is achieved.
The date on which control is achieved is the date on which the acquirer should recognise the acquiree's
identifiable net assets and any goodwill acquired (or bargain purchase) in the business combination.
Until control is achieved, any pre-existing interest is accounted for in accordance with
 IAS 39 in the case of investments
 IAS 28 in the case of associates and joint ventures

8.1 Types of business combination achieved in stages
There are three possible types of business combinations achieved in stages:
(a) A previously held investment, say 10% of share capital, with no significant influence (accounted
for under IAS 39) is increased to a controlling holding of 50% or more.
(b) A previously held equity investment, say 35% of share capital, accounted for as an associate
under IAS 28, is increased to a controlling holding of 50% or more.
(c) A controlling holding in a subsidiary is increased, say from 60% to 80%.
The first two transactions are treated in the same way, but the third is not. There is a reason for
this.
8.2 General principle: 'crossing an accounting boundary'

Under IFRS 3 a business combination occurs only when one entity obtains control over another, which
is generally when 50% or more has been acquired. The Deloitte guide: Business Combinations and
Changes in Ownership interests calls this 'crossing an accounting boundary'.
When this happens, the original investment – whether an investment in equity instruments with no
significant influence, or an associate – is treated as if it were disposed of at fair value and re-acquired
at fair value. This previously held interest at fair value, together with any consideration transferred, is
the 'cost' of the combination used in calculating the goodwill.
If the 50% boundary is not crossed, as when a shareholding in an existing subsidiary is increased, the
event is treated as a transaction between owners.
Whenever you cross the 50% boundary, you revalue, and a gain or loss is reported in profit or loss
for the year. If you do not cross the 50% boundary, no gain or loss is reported; instead there is an
adjustment to the parent's equity.
The following diagram, adapted from the Deloitte guide to IFRS 3 revised, may help you visualise the
boundary:
Transactions that trigger remeasurement of and existing interest
IAS 39 IAS 28/IFRS 11 IFRS 10
Acquisition of a
controlling interest in a
10% financial asset
Acquisition of a
40% controlling interest in
an associate or joint
venture
0% 20% 50% 100%

C
Passive Significant Control H
influence/joint A
control P
T
As you will see from the diagram, the third situation in Paragraph 6.1, where an interest in a subsidiary E
is increased from, say, 60% to 80%, does not involve crossing that all-important 50% threshold. R
Likewise, purchases of stakes of up to 50% do not involve crossing the boundary, and therefore do not
trigger a calculation of goodwill.
10

8.3 Achieving control
When control is achieved
 Any previously held equity shareholding should be treated as if it had been disposed of and then
reacquired at fair value at the acquisition date.
 Any gain or loss on remeasurement to fair value should be recognised in profit or loss in the period.
£
Fair value of consideration paid to acquire control X
Non-controlling interest (valued using either fair value or the proportion of net assets X
method)
Fair value of previously held equity interest at acquisition date X
X
Fair value of net assets of acquiree (X)
Goodwill X
8.3.1 Reclassification adjustments on achieving control

One of the consequences of the previously held equity being treated as disposed of is that any
unrealised gains in respect of it become realised at the acquisition date and are accounted for under the
relevant IFRS:
 If the previously held equity was classified as an available-for-sale financial asset, any gains in
respect of it which were previously recognised in other comprehensive income should now be
reclassified from other comprehensive income to profit or loss (IAS 39).
 If the previously held equity was classified as an investment in an equity-accounted associate and a
share of the associate's revaluation surpluses in respect of property, plant and equipment was
recognised, these surpluses should now be transferred within reserves, from the revaluation surplus
to retained earnings in the statement of changes in equity (IAS 16).
Worked example: Control in stages – previous holding an AFS investment

Bath Ltd has 1 million shares in issue. Bristol plc acquired 50,000 shares in Bath Ltd on 1 January 20X6
for £100,000. These shares were classified as available-for-sale financial assets and on 31 December
20X8 their carrying amount was £230,000 and increases in fair value of £130,000 had been recognised
in other comprehensive income and were held in equity. On 1 June 20X9 when the fair value of Bath
Ltd's net assets was £4 million, Bristol plc acquired another 650,000 shares in Bath Ltd for £3.9 million.
On 1 June 20X9 the fair value of the 50,000 shares already held was £250,000.
Requirement
Show the journal entry required in respect of the 50,000 shareholding on 1 June 20X9 and calculate the
goodwill acquired in the business combination on that date assuming that goodwill is valued using the
proportion of net assets method.
Solution
Journal entry
£'000 £'000
DR Investment in Bath Ltd (250,000 – 230,000) 20
DR Other comprehensive income and AFS reserve 130
CR Profit or loss 150
To recognise the gain on the deemed disposal of the shareholding in Bath Ltd existing immediately
prior to control being obtained.

Calculation of goodwill in respect of 70% (5% + 65%) holding in Bath Ltd:
£'000
Non-controlling interest (30% × £4 million) 1,200
Acquisition-date fair value of previously held equity 250
5,350
Net assets acquired (4,000)
Goodwill 1,350
Interactive question 5: Control in stages – previous holding equity accounted

On 31 December 20X7 when the fair value of Feeder Ltd's net assets was £460,000 Lawn plc acquired
40,000 of Feeder Ltd's 100,000 equity shares. The consideration given was shares in Lawn plc valued at
£200,000.
Lawn plc acquired a further 30,000 shares in Feeder Ltd on 31 December 20X8 when the fair value of
Feeder Ltd's net assets was £510,000, the increase being:
(a) £20,000 in respect of a revaluation surplus on freehold land
(b) £30,000 in respect of retained earnings.
The consideration given was shares in Lawn plc valued at £216,000. On 31 December 20X8 the fair
value of the shares in Feeder Ltd previously held by Lawn plc was £236,000.
Requirement
Calculate the gain on the deemed disposal of Lawn plc's previously held equity investment in Feeder Ltd
on 31 December 20X8 and the goodwill acquired in this business combination assuming that the NCI
is valued using the proportion of net assets method.
8.4 Acquisitions that do not result in a change of control

Where an entity increases its investment in an existing subsidiary:
 No gain or loss is recognised
 Goodwill is not remeasured
 The difference between the fair value of consideration paid and the change in the non-controlling
interest is recognised directly in equity attributable to owners of the parent.
Worked example: Acquisitions that do not result in a change of control

On 1 June 20X6, Santander acquired 70% of the equity of Madrid in exchange for £760,000 cash and
100,000 Santander shares. At this date the fair value of the identifiable net assets of Madrid was
£850,000 and the market value of Santander shares was £2.50.
C
On 31 December 20X8, Santander acquired a further 10% of the equity of Madrid at a cost of H
£105,000. On this date the identifiable net assets of Madrid were £970,000. A
P
Santander measures the non-controlling interest using the proportion of net assets method. T
E
Requirement
R
(a) What goodwill is recorded in the consolidated statement of financial position at 31 December
20X8, assuming that there is no impairment?
10
(b) What journal adjustment is required on the acquisition of the further 10% of shares?

Solution
(a) The goodwill included in the statement of financial position at 31 December 20X8 is that goodwill
calculated on the initial acquisition in June 20X6:
£000
Consideration (£760,000 + (100,000 × £2.50)) 1,010
Non-controlling interest (30% × £850,000) 255
1,265
Net assets of acquiree (850)
Goodwill 415
(b) The adjustment required is based on the change in the non-controlling interest at the acquisition
date:
£
NCI on 31 December 20X8 based on old interest (30% × £970,000) 291,000
NCI on 31 December 20X8 based on new interest (20% × £970,000) 194,000
Adjustment required 97,000
Therefore:
Dr Non-controlling interest 97,000
Dr Shareholders' equity (bal fig) 8,000
Cr Cash 105,000
9 Disposals
Section overview
 Subsidiaries and associates are consolidated/equity accounted for until the date control/significant
influence is lost therefore profits need to be time-apportioned.
 A gain on disposal must also be calculated, by reference to the fair value of any interest retained in
the subsidiary or associate.
An entity may sell all or some of its shareholding in another entity. Full disposals of subsidiaries and
associates were covered in FR and are revised here. Other situations which may arise are:
 The sale of shares in a subsidiary such that control is retained
 The sale of shares in a subsidiary such that the subsidiary becomes an associate
 The sale of shares in a subsidiary such that the subsidiary becomes an investment
 The sale of shares in an associate such that the associate becomes an investment
9.1 Crossing an accounting boundary revisited

Under IFRS 3 a gain on disposal occurs only when one entity loses control over another, which is
generally when its holding is decreased to less than 50%. As noted above, the Deloitte guide: Business
Combinations and Changes in Ownership Interests calls this 'crossing an accounting boundary' but in this
case the investment is being reduced, rather than increased as in sections 8.1 and 8.2 above.
On disposal of a controlling interest, any retained shareholding (an associate or trade investment)
is measured at fair value on the date that control is lost. This fair value is used in the calculation of
the gain or loss on disposal, and also becomes the carrying amount for subsequent accounting for the
retained shareholding.
If the 50% boundary is not crossed, as when the shareholding in a subsidiary is reduced, but control is
still retained, the event is treated as a transaction between owners and no gain or loss is recognised.

Whenever you cross the 50% boundary, you revalue, and a gain or loss is reported in profit or loss
for the year. If you do not cross the 50% boundary, no gain or loss is reported; instead there is an
adjustment to the parent's equity.
The following diagram, adapted from the Deloittes guide, may help you visualise the boundary:
Transactions that required remeasurement of a retained interest
IAS 39 IAS 28/IFRS 11 IFRS 10

Loss of control but
retaining financial asset
10% Loss of control but

retaining an associate
40% or joint venture
Loss of significant
10% influence or joint control
but retaining a financial asset
0% 20% 50% 100%
Passive Significant Control
influence/joint
control
The situation where a shareholding in a subsidiary is reduced from say 80% to 60%, that is where
control is retained, does not involve crossing that all-important 50% threshold.
9.2 Disposal of a whole subsidiary or associate – revision

9.2.1 Parent company's accounts
In the parent's individual financial statements the profit or loss on disposal of a subsidiary or
associate holding will be calculated as:
£
Sales proceeds X
Less: Carrying amount (cost in P's own statement of financial position) (X)
Profit (loss) on disposal X/(X)
9.2.2 Group accounts – disposal of subsidiary

Gain or loss on disposal
In the group financial statements the profit or loss on disposal will be calculated as:
£ £
Proceeds X
Less: Amounts recognised prior to disposal:
Net assets of subsidiary X
Goodwill X
Non-controlling interest (X)
(X)
Profit / loss X/(X) C
H
Remember: A
P
 If the disposal is mid year: T
E
– A working will be required to calculate both net assets and the non-controlling interest at the R
disposal date.
– Any dividends declared or paid in the year of disposal and prior to the disposal date must be
10
deducted from the net assets of the subsidiary if they have not already been accounted for.
 Goodwill recognised prior to disposal is original goodwill arising less any impairments to date.

Worked example: Group gain or loss on disposal
Kingdom acquired 80% of Westville on 1 January 20X5 for £280,000 when Westville had share capital
of £100,000 and retained earnings of £188,000. On this date the fair value of the non-controlling
interest was £67,000. Kingdom's policy is to value the non-controlling interest using the fair value (ie full
goodwill) method. Goodwill has suffered no impairment since acquisition.
On 30 June 20X8, Kingdom disposed of its investment in Westville, raising proceeds of £350,000.
The following are extracts from the accounts of Westville for the year ended 31 December 20X8:
£'000
Retained earnings b/f 215
Profit for the year 24
A final dividend for 20X7 of £10,000 was paid on 14 March 20X8. This has not yet been accounted for.
Requirement
What profit or loss on disposal of Westville is reported in the Kingdom group accounts for the year
ended 31 December 20X8?
Solution
£ £
Proceeds 350,000
Less: Amounts recognised prior to disposal
Net assets of Westville (£100,000 + £215,000 + (1/2 × £24,000) - £10,000) 317,000
Goodwill (£280,000 + £67,000) – (£100,000 + £188,000) 59,000
NCI at disposal
Share of net assets (20% x £317,000) (63,400)
Goodwill on acquisition (£67,000 – (20% × £288,000)) (9,400)
(303,200)
Profit on disposal 46,800
Consolidated statement of financial position

The statement of financial position does not include the subsidiary disposed of as it is no longer
controlled at the reporting date.
Consolidated statement of profit or loss and other comprehensive income
 The time-apportioned results of the subsidiary should be consolidated up to the date of disposal
 The non-controlling interest must be time apportioned
 The gain or loss on disposal forms part of the profit or loss for the year.
IFRS 5 Discontinued operations
If the sale represents a discontinued activity per IFRS 5 the consolidated statement of profit or loss and
other comprehensive income will reflect, as one figure, 'Profit for the period from discontinued
operations', being the group profit on disposal plus the subsidiary's profit for the year to disposal.
9.2.3 Group accounts – disposal of associate

In the consolidated financial statements the profit or loss on disposal should be calculated as:
£ £
Proceeds X
Less: Cost of investment X
Share of post-acquisition profits retained by associate at disposal X
Impairment of investment to date (X)
(X)
Profit/(loss) X/(X)

The other effects of disposal are also similar to those of the disposal of a subsidiary:
 There is no holding in the associate at the end of the reporting period, so there is no investment to
recognise in the consolidated statement of financial position.
 The associate's after tax earnings should be included in consolidated profit or loss up to the date of
disposal.
9.3 Part disposal from a subsidiary holding

9.3.1 Subsidiary to subsidiary
Shares may be disposed of such that a subsidiary holding is still retained, eg a 90% holding is reduced
to a 70% holding.
In this case there is no loss of control and therefore
 No gain or loss on disposal is calculated
 No adjustment is made to the carrying value of goodwill
 The difference between the proceeds received and the change in the non-controlling interest is
accounted for in shareholders' equity.
 Consolidate as normal with the NCI calculated by reference to the year end shareholding
 Calculate goodwill as at the original acquisition date
 Record the difference between NCI and proceeds in shareholders' equity as above
 Consolidate the subsidiary's results for the whole year
 Calculate the NCI on a pro-rata basis
Worked example: Part disposal (subsidiary to subsidiary)

Express acquired 90% of Billings in 20X2 when Billings had retained earnings of £250,000. Goodwill
was calculated as £45,000 using the proportion of net assets method to value the non-controlling
interest. Goodwill has been impaired by £5,000 since acquisition.
At 31 December 20X8 the abbreviated statements of financial position of the two entities were as
follows:
Express Billings
£'000 £'000
Non-current assets 2,300 430
Investments 360 –
Current assets 1,750 220
4,410 650
Share capital 1,000 100
Retained earnings b/f 1,190 304
Profit for the year 120 36
Liabilities 2,100 210
C
4,410 650 H
A
Express disposed of a 10% holding in Billings on 31 August 20X8 for £70,000; this has not yet been
P
recorded in Express' individual accounts. T
Requirement E
R
Prepare the consolidated statement of financial position as at 31 December 20X8.
10

Solution
Express Group Statement of Financial Position at 31 December 20X8
£'000
Non-current assets (£2,300,000 + £430,000) 2,730
Goodwill (£45,000 - £5,000) 40
Current assets (£1,750,000 + £220,000 + proceeds £70,000) 2,040
4,810
Share capital 1,000
Non-controlling interest 20% × (£650,000 - £210,000) 88
Liabilities (£2,100,000 + £210,000) 2,310
4,810
WORKINGS
(1) Retained earnings
£'000
Retained earnings of Express (£1,190,000 + £120,000) 1,310.0
Retained earnings of Billings
Acquisition – 31 August 20X8 90% × (£304,000 + (8/12 × £36,000) - £250,000) 70.2
31 August 20X8 – 31 Dec 20X8 (80% × 4/12 × £36,000) 9.6
Impairment of goodwill (5.0)
NCI adjustment on disposal (W2) 27.2
1,412.0
(2) NCI Adjustment on disposal

£'000
Net assets of Billings at disposal: share capital 100
Retained earnings b/f 304
Profit to disposal (£36,000 × 8/12) 24
428
At disposal date:
NCI based on old shareholding (10% × £428,000) 42.8
NCI based on new shareholding (20% × £428,000) 85.6
Adjustment required 42.8
Dr Proceeds £70,000
Cr NCI £42,800
Cr Shareholders' equity (to Working 1) £27,200
9.3.2 Subsidiary to associate

Shares may be disposed of such that an associate holding is still retained, eg a 90% holding is reduced
to a 30% holding.
In this case there is a loss of control, and so a gain or loss on disposal is calculated as:
£ £
Proceeds X
Fair value of interest retained X
X
Less: net assets of subsidiary recognised prior to disposal:
Net assets X
Goodwill X
Non-controlling interest (X)
(X)
Profit / loss X/(X)

Worked example: Part disposal (subsidiary to associate)
Allister Group acquired a 75% holding in Brown in 20X0, which it held until 31 December 20X8 when
two thirds of the investment were sold for £490,000.
At this date the net assets of Brown were £800,000, goodwill arising on acquisition had been fully
impaired and the fair value of a 25% interest in Brown was £220,000.
The non-controlling interest is valued using the proportion of net assets method.
Requirement
What gain or loss arises on the disposal in the Allister Group accounts in the year ended 31 December
20X8?
Solution
£ £
Proceeds 490,000
Fair value of 25% interest retained 220,000
710,000
Less: Amounts recognised prior to disposal
Net assets of Brown 800,000
Goodwill (fully impaired) –
NCI at disposal (25% × £800,000) (200,000)
(600,000)
Gain on disposal 110,000
Note that the disposal triggers remeasurement of the residual interest to fair value. The gain on disposal
could be analysed as:
Realised gain £ £
Proceeds on disposal 490,000
Interest disposed of (50% × £800,000) (400,000)
90,000
Holding gain
Retained interest at fair value 220,000
Retained interest at carrying value (25% × £800,000) (200,000)
20,000
Total gain 110,000
The retained 25% interest in Brown is included in the consolidated statement of financial position at
31 December 20X8 at the fair value of £220,000.

 Equity account by reference to the year end holding. The carrying value of the associate is based
on the fair value of the interest as included within the gain calculation.
 Consolidate results up to the date of disposal based on the pre disposal holding
C
 Equity account for results after the date of disposal based on the post disposal holding H
 Include gain or loss on disposal as calculated above A
P
Reclassification of other comprehensive income T
E
At the date of disposal, amounts recognised in other comprehensive income in relation to the subsidiary R
should be accounted for in the same way as if the parent company had directly disposed of the assets
that they relate to, for example:
 If the subsidiary holds available-for-sale assets, then on disposal, the amounts of other 10
comprehensive income recorded in the consolidated accounts in relation to these are reclassified to
profit or loss (recycled).

 If the subsidiary holds revalued assets, the revaluation surplus previously recognised in consolidated
other comprehensive income should be transferred to group retained earnings.
9.3.3 Subsidiary to investment

Shares may be disposed of such that an investment is still retained, eg a 90% holding is reduced to a
10% holding.
The gain or loss on disposal is calculated as described in section 9.2.2. Therefore at the point of
disposal, the retained interest is measured at fair value.
 The interest retained is initially recorded at fair value (as included within the gain calculation).
 Consolidate results up to the date of disposal based on the pre disposal holding
 Include dividend income after the date of disposal
 Include gain or loss on disposal as calculated above
Reclassification of other comprehensive income
Upon loss of control, other comprehensive income recorded in relation to the subsidiary should again
be accounted for in the same way as if the parent company had directly disposed of the assets that it
relates to.
9.4 Part disposal from an associate holding

9.4.1 Associate to investment
Shares may be disposed of such that an investment is still retained, eg a 40% holding is reduced to a
10% holding.
In this case there is a loss of significant influence, and a gain or loss on disposal is calculated as:
£ £
Proceeds X
Fair value of interest retained X
X
Less: Cost of investment X
Share of post-acquisition profits retained by associate at disposal X
Impairment of investment to date (X)
(X)
Profit/(loss) X/(X)

 The interest retained is initially recorded at fair value (as included within the gain calculation).
 Equity account for results up to the date of disposal based on the pre disposal holding
 Include dividend income after the date of disposal
 Include gain or loss on disposal as calculated above

10 Statements of cash flows
Section overview
 The consolidated statement of cash flows shows the impact of the acquisition and disposal of
subsidiaries and associates.
 Exchange differences arising on the translation of the foreign currency accounts of group
companies will also impact the consolidated statement of cash flows. This is covered in more
detail in Chapter 11.
10.1 Basic statements of cash flows – revision

 A statement of cash flows prepared in accordance with IAS 7 provides information about the
historical changes in an entity's cash and cash equivalents. This information is presented in a
statement that classifies cash flows between operating activities, investing activities and financing
activities.
 Cash, as defined in IAS 7, includes not only cash itself but also any instrument that can be
converted into cash so quickly that it is in effect equivalent to cash.
 'Operating activities' are the principal revenue-generating activities of an entity, together with any
other activities which are not identified as being investing or financing in nature.
 The cash flows from an entity's operating activities can be presented using two methods:
– The direct method, which discloses the major classes of gross cash receipts and payments; or
– The indirect method, where the entity starts with the net profit or loss for the period and
adjusts it for non-cash transactions, deferrals or accruals of income and expenditure and items
that will form part of the entity's investing and financing activities.
 'Investing activities' are acquisitions and disposals of long-term assets and investments, other than
cash and cash equivalents. Examples include: cash paid or received to acquire or sell an item of
property, plant or equipment, a receipt of cash from the sale of a business, and cash advanced as a
loan to another entity.
 'Financing activities' are activities that change the amount and composition of an entity's equity
capital and borrowings. Examples include: cash proceeds from issuing shares, cash paid to repay
debt instruments, and the capital element in a finance lease payment.
 Investing and financing activities that do not impact on cash, for example the conversion of debt
to equity, should not be included in the statement of cash flows.
Interactive question 6: Operating and financing activities

On 1 January 20X5, an entity entered into a 20-year lease for land and buildings. The lease payments
are £910,000 annually in advance, of which £546,000 relates to the land which is classified as being
held under an operating lease and £364,000 to the buildings held under a finance lease.
C
The 20X5 income statement showed a finance charge in respect of the finance lease of £50,000. The H
entity treats interest paid as relating to its operating activities. A
P
Requirement T
E
Show the amounts appearing in the statements of cash flows for 20X5 and 20X6. R

10

10.2 Consolidated statements of cash flows – revision
You should remember from your Professional stage studies that the consolidated statement of cash flows
is put together from the consolidated financial statements themselves. Additional figures over and above
a single company statement of cash flows will be:
 Dividends paid to the non-controlling interest
 Acquisitions/disposals of subsidiaries
 Acquisitions/disposals of associates
10.2.1 Cash flows to the non-controlling interest

The non-controlling interest represents a third party so dividends paid to the non-controlling interest
are reflected as a cash outflow. This payment should be presented separately and classified as 'Cash
flows from financing activities'.
Dividends paid to the non-controlling interest may be calculated using a T account as follows:
NON-CONTROLLING INTEREST
£ £
b/f NCI (CSFP) X
NCI (CIS) X
NCI dividend paid (balancing figure) X
c/f NCI (CSFP) X
X X
10.2.2 Associates
There are two issues to consider with regard to the associate:
1 The aim of the statement of cash flows is to show the cash flows of the parent and any subsidiaries
with third parties, therefore any cash flows between the associate and third parties are
irrelevant. As a result, the group share of profit of the associate must be deducted as an
adjustment in the reconciliation of profit before tax to cash generated from operations. This
is because group profit before tax includes the results of the associate.
2 Dividends received from the associate must be disclosed as a separate cash flow classified as
'Cash flows from investing activities'. The cash receipt can be calculated as follows:
INVESTMENTS IN ASSOCIATES
£ £
b/f Investment in Associate (CSFP) X
Share of profit of Associate (CIS) X Dividend received (balancing figure) X
c/f Investment in Associate (CSFP) X
X X
10.2.3 Acquisitions and disposals of subsidiaries

If a subsidiary is acquired or disposed of during the accounting period the net cash effect of the
purchase or sale transaction should be shown separately under 'Cash flows from investing
activities'. The net cash effect will be the cash purchase price/cash disposal proceeds net of any cash or
cash equivalents acquired or disposed of.
As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item as we saw
above, care must be taken not to double count the effects of the acquisition/disposal when
looking at the movements in individual asset balances.

Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period must
be excluded when comparing group statements of financial position for cash flow calculations as
follows:
Subsidiary acquired in the period Subtract PPE, inventories, payables, receivables etc at the
date of acquisition from the movement on these items.
Subsidiary disposed of in the period Add PPE, inventories, payables, receivables etc at the date
of disposal to the movements on these items.
This would also affect the calculation of the dividend paid to the non-controlling interest. The T
account working is modified as follows:
NON-CONTROLLING INTEREST
£ £
NCI in Subsidiary at disposal X b/f NCI (CSFP) X
NCI dividend paid (balancing X NCI in Subsidiary at acquisition X
figure)
c/f NCI (CSFP) X NCI (CIS) X
X X
10.2.4 Acquisitions and disposals of associates

If an associate is acquired or disposed of during the accounting period the payment or receipt of cash
is classified as investing activities.
C
H
A
P
T
E
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Summary
Group accounts:
and statement of comprehensive income
Subsidiary Associate
Significant
Control
influence
Direct Indirect Potential Loss of

shareholding shareholding voting rights control
Goodwill
Non-controlling Fair value

Consideration
interest of identifiable
assets and
liabilities
Deferred Contingent Fair Proportion

value of net assets

Acquisitions and disposals
Acquisitions Disposals
Step acquisitions
to achieve control Disposal of Part disposal
whole investment
Acquisition not
resulting in change
of control No loss
Loss of
control of control
IAS 7 Statement of cash flows
Classify cash flows as Consolidated cash flows include

- Operating Direct - Dividends to NCI
Indirect - Dividends from associates
- Investing
- Financing - Acquisition/disposal of subsidiaries and associates
Joint arrangements
Joint ventures Joint operations
Joint ventures Line by line recognition

of assets, liabilities,
revenues and expenses
C
H
A
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Self-test
IFRS 3 Business Combinations
1 Burdett
The Burdett Company acquired an 80% interest in The Swain Company for £1,340,000 when the
fair value of Swain's identifiable assets and liabilities was £1,200,000.
Burdett acquired a 60% interest in The Thamin Company for £340,000 when the fair value of
Thamin's identifiable assets and liabilities was £680,000.
Neither Swain nor Thamin had any contingent liabilities at the acquisition date and the above fair
values were the same as the carrying amounts in their financial statements. Annual impairment
reviews have not resulted in any impairment losses being recognised. The Burdett Company values
the non-controlling interest as the proportionate interest in the identifiable net assets at acquisition.
Requirements
Under IFRS 3 Business Combinations, what figures in respect of goodwill and of the excess of assets
and liabilities acquired over the cost of combination should be included in Burdett's consolidated
statement of financial position?
2 Sheliak
The Sheliak Company acquired equipment on 1 January 20X3 at a cost of £1,000,000,
depreciating it over eight years with a nil residual value.
On 1 January 20X6 the Parotia Company acquired 100% of Sheliak and estimated the fair value of
the equipment at £575,000, with a remaining life of five years. This fair value was not incorporated
into Sheliak's books and subsequent depreciation charges continued to be made by reference to
original cost.
Requirement
Under IFRS 3 Business Combinations, and IAS 27 Consolidated and Separate Financial Statements,
what adjustments should be made to the depreciation charge for the year and the SFP carrying
amount in preparing the consolidated financial statements for the year ended 31 December 20X7?
3 Finch
On 1 January 20X6 the Finch Company acquired 85% of the ordinary share capital and 40% of the
irredeemable preference share capital of The Sequoia Company for consideration totalling
£5.1 million. At the acquisition date Sequoia had the following statement of financial position.
£'000
Non-current assets 5,500
8,100
Ordinary shares of £1 1,000
Preference shares of £1 2,500
8,100
Included in non-current assets of Sequoia at the acquisition date was a property with a carrying
amount of £600,000 that had a fair value of £900,000.
Sequoia had been making losses, so Finch created a provision for restructuring of £800,000 under
plans announced on 2 January 20X6.
Sequoia has disclosed in its accounts a contingent liability with a reliably estimated value of
£20,000. Sequoia has not recorded this as a provision as payment is not considered probable.
Finch values the non-controlling interest using the proportion of net assets method.
Requirement
Under IFRS 3 Business Combinations, what goodwill arises at the time of the acquisition of Sequoia?

4 Maackia
On 31 December 20X7 The Maackia Company acquires 65% of the ordinary share capital of the
Sorbus Company for £4.8 million. Sorbus is incorporated in Flatland, which has not adopted IFRS
for its financial statements. At the acquisition date the fair value of a 35% interest in Sorbus is £1.8
million and net assets of Sorbus have a carrying amount of £4.6 million before taking into account
the following.
Included in the net assets of Sorbus is a business that Maackia has put on the market for immediate
sale. This business has a carrying amount of £500,000, a fair value of £760,000 and a value in use
of £810,000. Costs to sell are estimated at £40,000.
Sorbus also has a defined benefit pension plan which has a plan asset of £1.6 million, and an
obligation with present value of £1,280,000. Sorbus has recognised the net plan asset of £320,000
in its statement of financial position. Maackia does not anticipate any reduction in contributions as
a result of acquiring Sorbus.
Requirement
Under IFRS 3 Business Combinations, what (to the nearest £1,000) is the goodwill arising on the
acquisition of Sorbus, assuming that Maackia measures the non-controlling interest using the fair
value method?
5 Gibbston
On 1 May 20X7 The Gibbston Company acquired 70% of the ordinary share capital of The Crum
Company for consideration of £15 million cash payable immediately and £5.5 million payable on 1
May 20X8. Further consideration of £13.3 million cash is payable on 1 May 20Y0 dependent on a
range of contingent future events. The management of Gibbston believe there is a 45% probability
of paying the amount in full.
The equity of Crum had a carrying amount of £20 million at 1 January 20X7. Crum incurred losses
of £3 million evenly over the year ended 31 December 20X7. The carrying amount and fair values
of the assets of Crum are the same except that at the acquisition date the fair value relating to
plant is £9 million higher than carrying amount. The weighted average remaining useful life of the
plant is three years from the acquisition date.
A rate of 10% is to be used in any discount calculations. The non-controlling interest is measured
using the proportion of net assets method.
Requirement
Calculate the following amounts (to the nearest £0.1 million) in accordance with IFRS 3 Business
Combinations, and IAS 27 Consolidated and Separate Financial Statements, that would be included in
the consolidated financial statements of Gibbston for the year ended 31 December 20X7.
(a) Goodwill
(b) Non-controlling interest in profit/loss
(c) Non-controlling interest included in equity
IFRS 11 Joint Arrangements
6 Supermall
This question is based on Illustrative example 2 from IFRS 11.
C
Two real estate companies (the parties) set up a separate vehicle (Supermall) for the purpose of H
A
acquiring and operating a shopping centre. The contractual arrangement between the parties
P
establishes joint control of the activities that are conducted in Supermall. The main feature of T
Supermall's legal form is that the entity, not the parties, has rights to the assets, and obligations for E
the liabilities, relating to the arrangement. These activities include the rental of the retail units, R
managing the car park, maintaining the centre and its equipment, such as lifts, and building the
reputation and customer base for the centre as a whole.
10
The terms of the contractual arrangement are such that:
(a) Supermall owns the shopping centre. The contractual arrangement does not specify that the
parties have rights to the shopping centre.

(b) The parties are not liable in respect of the debts, liabilities or obligations of Supermall. If
Supermall is unable to pay any of its debts or other liabilities or to discharge its obligations to
third parties, the liability of each party to any third party will be limited to the unpaid amount
of that party's capital contribution.
(c) The parties have the right to sell or pledge their interests in Supermall.
(d) Each party receives a share of the income from operating the shopping centre (which is the
rental income net of the operating costs) in accordance with its interest in Supermall.
Requirement
Explain how Supermall should be classified in accordance with IFRS 11 Joint Arrangements.
7 Green and Yellow
Green entered into an agreement with Yellow, a public limited company, on 1 December 20X8.
Each of the companies holds one half of the equity in an entity, Orange, a public limited company,
which operates offshore oil rigs. The contractual arrangement between Green and Yellow
establishes joint control of the activities that are conducted in Orange. The main feature of
Orange's legal form is that Orange, not Green or Yellow, has rights to the assets, and obligations
for the liabilities, relating to the arrangement.
The terms of the contractual arrangement are such that:
(a) Orange owns the oil rigs. The contractual arrangement does not specify that Green and
Yellow have rights to the oil rigs.
(b) Green and Yellow are not liable in respect of the debts, liabilities or obligations of Orange. If
Orange is unable to pay any of its debts or other liabilities or to discharge its obligations to
third parties, the liability of each party to any third party will be limited to the unpaid amount
of that party's capital contribution.
(c) Green and Yellow have the right to sell or pledge their interests in Orange.
(d) Each party receives a share of the income from operating the oil rig in accordance with its
interest in Orange.
Green wants to account for the interest in Orange by using the equity method, and wishes for
advice on the matter.
Green owns a 10% interest in a pipeline, which is used to transport the oil from the offshore oilrig
to a refinery on the land. Green has joint control over the pipeline and has to pay its share of the
maintenance costs. Green has the right to use 10% of the capacity of the pipeline. Green wishes to
show the pipeline as an investment in its financial statements to 30 November 20X9.
Requirement
Discuss how the above arrangements would be accounted for in Green's financial statements.
Step acquisitions
8 Stuhr
On 1 January 20X6 the Stuhr Company acquired 30% of the ordinary share capital of the Bismuth
Company by the issue of one million shares with a fair value of £4.00 each. From that date Stuhr
did not exercise significant influence over Bismuth, and accounted for the investment at fair value
with changes in value included in profit or loss. At 1 January 20X6 the net assets of Bismuth had a
carrying amount of £6.4 million and a fair value of £7.2 million.
On 1 March 20X7, Stuhr bought a further 50% of the ordinary share capital of Bismuth by issuing
a further two million shares with a fair value of £5.00 each. At that date the net assets of Bismuth
had a carrying amount of £7.8 million and a fair value of £8.4 million. The non-controlling interest
had a fair value of £2 million, and the 30% interest already held by Stuhr had a fair value of £3
million.
Stuhr values the non-controlling interest using the full goodwill method.
Requirement
What is the goodwill figure in the consolidated statement of financial position at 31 December
20X7, in accordance with IFRS 3 Business Combinations?

Disposals
9 Fleurie
Fleurie bought 85% of Merlot on 30 June 20X3, providing consideration in the form of £2 million
cash immediately and a further £1.5 million cash conditional upon earnings targets being met.
At acquisition, the net assets of Merlot were £2.2 million and the fair value of the 15% not
purchased was £350,000. Fleurie measures the non-controlling interest using the full goodwill
method.
On 31 December 20X7, as part of a long term strategy, Fleurie sold a 15% stake from its 85%
holding in Merlot, realising proceeds of £560,000. At this date the net assets of Merlot were £3.5
million.
Requirement
What impact does the disposal have on the financial statements of the Fleurie Group?
10 Chianti
Chianti purchased 95% of the 100,000 £1 ordinary share capital of Barolo on 1 January 20X2,
giving rise to goodwill of £70,000. At this date Barolo's retained earnings were £130,000. There
were no other reserves.
On 30 September 20X2, when the net assets of Barolo were £320,000, Chianti disposed of the
majority of its holding in Barolo, retaining just 5% of share capital, with a fair value of £20,000.
Chianti received £340,000 consideration for the sale.
The following information is relevant:
 Goodwill in Barolo has been impaired by £20,000
 In April 20X2, Barolo revalued a plot of land from £50,000 to £75,000. This land was held
with the intention of building a new head office on it
 Since acquisition, Barolo has recognised a net amount of £16,000 gains on AFS investments in
other comprehensive income
 The non-controlling interest is valued using the proportion of net assets method.
Requirement
What is the impact of the disposal on the Chianti Group Statement of profit or loss and other
comprehensive income?
C
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T
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IAS 7 Statement of Cash Flows
11 Porter
The following consolidated financial statements relate to Porter, a public limited company:
PORTER GROUP: STATEMENT OF FINANCIAL POSITION AS AT 31 MAY 20X6
20X6 20X5
£m £m
Non-current assets
Property, plant and equipment 958 812
Goodwill 15 10
Investment in associate 48 39
1,021 861
Current assets
Inventories 154 168
Trade receivables 132 112
Financial assets at fair value through profit or loss 16 0
Cash and cash equivalents 158 48
460 328
1,481 1,189
Equity attributable to owners of the parent
Share capital (£1 ordinary shares) 332 300
Share premium account 212 172
Retained earnings 188 165
Revaluation surplus 101 54
833 691
Non-controlling interests 84 28
917 719
Long-term borrowings 380 320
Deferred tax liability 38 26
418 346
Current liabilities
Trade and other payables 110 98
Interest payable 8 4
Current tax payable 28 22
146 124
1,481 1,189
PORTER GROUP: STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MAY 20X6
£m
Revenue 956
Cost of sales (634)
Gross profit 322
Other income 6
Distribution costs (97)
Administrative expenses (115)
Finance costs (16)
Share of profit of associate 12
Profit before tax 112
Income tax expense (34)
PROFIT FOR THE YEAR 78
Other comprehensive income(items that will not be reclassified to profit or
loss):
Gains on property revaluation 58
Share of other comprehensive income of associate 8
Income tax relating to items of other comprehensive income (17)
Other comprehensive income for the year, net of tax 49
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 127

Profit attributable to: £m
Owners of the parent 68
Non-controlling interests 10
78
Total comprehensive income attributable to:
Owners of the parent 115
Non-controlling interests 12
127
The following information relates to the consolidated financial statements of Porter:
(1) During the period, Porter acquired 60% of a subsidiary. The purchase was effected by issuing
shares of Porter on a 1 for 2 basis, at their market value on that date of £2.25 per share, plus
£26m in cash.
A statement of financial position of the subsidiary, prepared at the acquisition date for
consolidation purposes showed the following position:
£m
Property, plant and equipment 92
Inventories 20
Trade receivables 16
Cash and cash equivalents 8
136
Share capital (£1 shares) 80

Reserves 40
120
Trade payables 12
Income taxes payable 4
136
An impairment test conducted at the year end, resulted in a write-down of goodwill relating
to another wholly owned subsidiary. This was charged to cost of sales.
Group policy is to value non-controlling interests at the date of acquisition at the
proportionate share of the fair value of the acquiree's identifiable assets acquired and liabilities
assumed.
(2) Depreciation charged to the consolidated profit or loss amounted to £44m. There were no
disposals of property, plant and equipment during the year.
(3) Other income represents gains on financial assets at fair value through profit or loss. The
financial assets are investments in quoted shares. They were purchased shortly before the year
end with surplus cash, and were designated at fair through profit loss as they are expected to
be sold after the year end. No dividends have yet been received.
(4) Included in 'trade and other payables' is the £ equivalent of an invoice for 102m shillings for
some equipment purchased from a foreign supplier. The asset was invoiced on 5 March
20X6, but had not been paid for at the year end, 31 May 20X6.
Exchange gains or losses on the transaction have been included in administrative expenses.
C
Relevant exchange rates were as follows: H
Shillings to £1 A
P
5 March 20X6 6.8 T
E
31 May 20X6 6.0 R
10

(5) Movement on retained earnings was as follows:
£m
At 31 May 20X5 165
Total comprehensive income 68
Dividends paid (45)
At 31 May 20X6 188
Requirement
Prepare a consolidated statement of cash flows for Porter for the year ended 31 May 20X6 in
accordance with IAS 7 Statement of Cash Flows, using the indirect method.
Notes to the statement of cash flows are not required.

Technical reference
Basics
 Definitions: control, parent, subsidiary, acquisition date, goodwill. IFRS 3 (App A)
 Acquisition method: acquirer, acquisition date, recognising and measuring IFRS 3.5
assets, liabilities, non-controlling interest and goodwill.
Measurement of identifiable assets acquired

 At fair value IFRS 3.18
 Non-controlling interest measured at fair value or as a proportionate share of IFRS 3.19

the acquiree's net assets
 Exceptions to measurement principles
– Contingent liabilities recognised if fair value measured reliably regardless IFRS 3.23
of probable outcome
– Income taxes in accordance with IAS 12 IFRS 3.24
– Employee benefits in accordance with IAS 19 IFRS 3.26
– Assets held for sale in accordance with IFRS 5 IFRS 3.31
Consideration transferred
 Fair value of assets transferred, liabilities incurred and equity instruments IFRS 3.37
issued
 Contingent consideration accounted for at fair value IFRS 3.39
 Subsequent accounting for contingent consideration IFRS 3.58
 Acquisition related costs IFRS 3.53
Goodwill
 Calculation IFRS 3.32
Bargain purchases
 Reassess identification and measurement of the net assets acquired, the non- IFRS 3.36
controlling interest, if any, and consideration transferred
 Any remaining amount recognised in profit or loss in period the acquisition is IFRS 3.34
made
Business combination achieved in stages (step acquisition) C

H
 Remeasure previously held interest to fair value at acquisition date IFRS 3.42 A
P
Measurement period T
E
 Adjustment to amounts only within 12 months of acquisition date IFRS 3.45 R
 Subsequently: errors accounted for retrospectively, everything else IFRS 3.50

prospectively 10

Disclosures
 Business combinations occurring in the accounting period or after its finish IFRS 3.59
but before financial statements authorised for issue (in the latter case, by way
of note)
IFRS 10 Consolidated Financial Statements
Basic rule
 Parent must prepare CFS to include all subsidiaries IAS 27.12
Exception
 No need for CFS if wholly owned or all non-controlling shareholders have IAS 27.10
been informed of and none have objected to the plan that CFS need not be
prepared
 No exclusion on grounds of dissimilar activities IAS 27.17
IAS 27.13
Control
 Power over the investee
 Exposure or rights to variable returns
 Ability to use its power
 Power is existing rights that give the current ability to direct the relevant
activities of the investiee.
Procedures
 Non-controlling interest shown as a separate figure: IAS 27.18
– In the statement of financial position, within total equity but separately IAS 27.27
from the parent shareholders' equity
– In the statement of profit or loss and other comprehensive income, the
share of the profit after tax
 Accounting dates of group companies to be no more than three months IAS 27.22-23
apart
 Uniform accounting policies across group or adjustments to underlying IAS 27.24-25
values
 Bring in share of new subsidiary's income and expenses: IAS 27.26
– From date of acquisition, on acquisition

– To date of disposal, on disposal
 Changes that do not result in a loss of control accounted for as equity IAS 27.30
transactions
Loss of control
 Calculation of gain IAS 27.34
 Account for amounts in other comprehensive income as if underlying assets IAS 27.35
disposed of
 Retained interest accounted for in accordance with relevant standard based IAS 27.36-37
on fair value
Parent's separate financial statements

 Account for subsidiary on basis of cost and distributions declared IAS 27.38

Disclosures
 Details where own more than 50% but do not consolidate, and vice-versa IAS 27.42
IAS 28 Investments in Associates and Joint Ventures
Definitions
 The investor has significant influence, but not control IAS 28.2
 Significant influence is the power to participate in financial and operating

policy decisions of the investee, but is not control over those policies (if the
investor had control, then under IAS 27 the investee would be its subsidiary)
 Presumptions re less than 20% and 20% or more IAS 28.6
 Can be an associate, even if the subsidiary of another investor

 No significant influence if 'associate' in legal reorganisation etc IAS 28.10
Equity method
IAS 28.38,
 In statement of financial position: non-current asset = cost plus share of post-
IAS 28.11 and
acquisition change in A's net assets
IAS 28.39
IAS 28.11 and

 In income statement: share of A's post-tax profits less any impairment loss
IAS 28.38
 In statement of changes in equity: share of A's changes IAS 28.39
 Use cost method of accounting in investor's separate financial statements IAS 28.35
 Also applies to joint ventures IAS 28.35
Disclosures
 Fair value of associate where there are published price quotations IAS 28.37
 Summarised financial statements of the associate

 Reasons why 20% presumptions overcome, if that be the case
 The investment to be shown as a non-current asset in the statement of IAS 28.38
financial position, at cost plus/minus share of post-acquisition change in
associate's net assets plus long-term financing less impairment losses
 The investor's share of the associate's:

– After-tax profits
– Discontinued operations
– Changes recognised in other comprehensive income should be IAS 28.39
recognised directly in other comprehensive income of investor
– Contingent liabilities IAS 28.40
C
H
Key areas of consolidations A
P
 Control if less than 50% of the voting rights owned IAS 27.13 T
E
 Potential voting rights IAS 27.14-15 R
 Loss of control IAS 27.32-34
 Contingent consideration IFRS 3.39-40,58 10

IFRS 11 Joint Arrangements
Joint ventures
 Definitions *IFRS 11 ??
 Three forms of joint Arrangement IFRS 11 ??
 Contractual arrangement
 Joint ventures
– Equity method
 Joint operations
– What a joint operation is

– Line by line regognition
– Equity method
 Transactions between a venturer and a joint venture
 Disclosures

 Objective of the statement of cash flows
– The statement of cash flows should show the historical changes in cash
and cash equivalents
– Cash comprises cash on hand and demand deposits IAS 7.6
– Cash equivalents are short-term, highly liquid investments that are IAS 7.6
readily convertible to known amounts of cash and which are subject to
an insignificant risk of changes in value
 Presentation of a statement of cash flows Appendix A
– Cash flows should be classified by operating, investing and financing IAS 7.10
activities
– Cash flows from operating activities are primarily derived from the IAS 7.13-14
principal revenue-producing activities of the entity
– Cash flows from investing activities are those related to the acquisition IAS 7.16
or disposal of any non-current assets, or trade investments together with
returns received in cash from investments (ie dividends and interest)
 Financing activities include: IAS 7.17
– Cash proceeds from issuing shares

– Cash proceeds from issuing debentures, loans, notes, bonds, mortgages
and other short or long-term borrowings
– Cash repayments of amounts borrowed
– Dividends paid to shareholders / the non-controlling interest
– Principal repayments of amounts borrowed under finance leases
 Cash flows from operating activities
– There are two methods of presentation allowed:

 Direct method IAS 7.19
 Indirect method IAS 7.20

Consolidated statements of cash flows
 Only cash flows between the group and an associate are reported in the IAS 7.37
group statement of cash flows with respect to associates
 Aggregate cash flows from acquisitions and disposals of subsidiaries IAS 7.39
presented as investing activities
C
H
A
P
T
E
R
10


1 Burdett
Goodwill: £380,000
Excess of assets/liabilities over cost of combination: Nil
Swain Thamin
£000 £000
Consideration transferred 1,340 340
NCI (20% × £1.2m) / (40% × £680,000) 240 272
1,580 612
Net assets of acquiree (1,200) (680)
Goodwill / Gain on bargain purchase 380 (68)
See IFRS 3.32 and 34. The second acquisition resulted in an excess over the cost of combination
which should be recognised immediately in profit.
2 Sheliak
Depreciation charge: decrease by £10,000
Carrying amount: decrease by £30,000
Depreciation charge: Sheliak (£1m / 8 years) £125,000
Parotia (£575,000 / 5 years) £115,000
Decrease £10,000
Carrying amount: Sheliak (£1m × 3/8 years) £375,000
Parotia (£575,000 × 3/5 years) £345,000
Decrease £30,000
Fair value adjustments not reflected in the books must be adjusted for on consolidation. In this
example the depreciation is decreased by the difference between Sheliak's depreciation charge and
Parotia's fair value depreciation calculation. The carrying amount is decreased by the difference
between Sheliak's carrying value at 31 December 20X7 and Parotia's carrying value at 31
December 20X7.
3 Finch
£207,000
£000
Net assets per SFP (£8.1m – £1.3m) 6,800
Fair value adjustment to property 300
Contingent liability (20)
Adjusted net assets 7,080
Net assets is increased by the fair value adjustment of £300,000 and decreased by the contingent
liability, which is recognised in accordance with IFRS 3.23.
Goodwill is therefore calculated as:
£000
Ordinary shares 15% × (£7.08m – £2.5m) 687
Preference shares 60% × £2.5m 1,500
7,287
Net assets of acquiree (7,080)
Goodwill 207

4 Maackia
£1,780,000
£000 £000
Non-controlling interest (fair value) 1,800
6,600
Net assets of acquiree
Draft 4,600
Business held for sale ((£760,000 – £40,000) – £500,000) 220
(4,820)
Goodwill 1,780
In allocating the cost of the business combination to the assets and liabilities acquired, the business
that is on the market for immediate sale should be valued in accordance with IFRS 5 at fair value
less costs to sell (IFRS 3.31).
The defined benefit plan net asset should be recognised in accordance with IAS 19 (IFRS 3.26).
5 Gibbston
(a) £4.9 million
(b) £1.2 million share of loss
(c) £7.2 million
(a)
£000 £000
Consideration transferred: Cash 15,000
Deferred cash (£5.5m/1.1) 5,000
3
Contingent cash (£13.3m/1.1 ) × 45% 4,500
24,500
Non-controlling interest: Net assets at 1 Jan 20X7 20,000
Loss to acquisition (£3m × 4/12) (1,000)
Fair value adjustment 9,000
30% × 28,000 8,400
32,900
Net assets of acquiree (28,000)
Goodwill 4,900
IFRS 3.39 requires contingent consideration capable of reliable measurement to be included at fair
value regardless of whether payment is probable.
The net assets at the acquisition date are those at the start of the year adjusted for the fair value
increase of plant (£9m) less the losses between the start of the year and the acquisition date.
(b) Non-controlling interest share of loss: £m
Loss: Acquisition to 31 December (8/12 × £3m) 2
Extra depreciation (£9m/3 years × 8/12) 2
4 × 30% = £1.2m
(c) Non-controlling interest in SFP
Share of the net assets at the date of acquisition (£28m  8.4
30%)
C
Share of loss since acquisition (part (b)) (1.2)
H
7.2 A
P
IFRS 13 Joint Arrangements T
E
6 Supermall R
Supermall has been set up as a separate vehicle. As such, it could be either a joint operation or
joint venture, so other facts must be considered.
10
There are no facts that suggest that the two real estate companies have rights to substantially all
the benefits of the assets of Supermall nor an obligation for its liabilities.
Each party's liability is limited to any unpaid capital contribution.

As a result, each party has an interest in the net assets of Supermall and should account for it as a
joint venture using the equity method.
in accordance with IFRS 11 Joint arrangements.
7 Green and Yellow

Orange
Green wishes to account for its arrangement with Yellow using the equity method. It can only do
so if the arrangement meets the criteria in IFRS 11 Joint Arrangements for a joint venture.
A joint arrangement is an arrangement, as here, of which two or more parties have joint control.
A joint venture is a joint arrangement whereby the parties that have control of the arrangement
have rights to the net assets of the arrangement.
Orange is a separate vehicle. As such, it could be either a joint operation or joint venture, so other
facts must be considered.
There are no facts that suggest that Green and Yellow have rights to substantially all the benefits of
the assets of Orange nor an obligation for its liabilities.
Each party's liability is limited to any unpaid capital contribution.
As a result, each party has an interest in the net assets of Orange and should account for it as a
joint venture using the equity method.
Pipeline
Since Green has joint control over the pipeline, even though its interest is only 10%, it would not
be appropriate to show the pipeline as an investment. This is a joint arrangement under IFRS 11.
The pipeline is a jointly controlled asset, and it is not structured through a separate vehicle.
Accordingly, the arrangement is a joint operation.
IFRS 11 Joint Arrangements requires that a joint operator recognises line-by-line the following in
relation to its interest in a joint operation:
(i) Its assets, including its share of any jointly held assets
(ii) Its liabilities, including its share of any jointly incurred liabilities
(iii) Its revenue from the sale of its share of the output arising from the joint operation
(iv) Its share of the revenue from the sale of the output by the joint operation, and
(v) Its expenses, including its share of any expenses incurred jointly.
operator.
Step acquisitions
8 Stuhr
£6,600,000
£'000
Non-controlling interest (fair value) 2,000
Fair value of retained interest 3,000
15,000
Fair value of net assets of Bismuth (8,400)
Goodwill 6,600

Disposals
9 Fleurie
There is no loss of control and therefore:
– No gain or loss arises on disposal of the 15% holding in Merlot, and
– There is no change to the carrying value of goodwill.
Instead, the transaction is accounted for in shareholders' equity, with any difference between
proceeds and the change in the non-controlling interest being recognised in retained earnings.
The non-controlling interest prior to disposal is: £
15% × £3.5 million 525,000
Goodwill [£350,000 – (15% × £2.2 million)] 20,000
545,000
As the value of goodwill is not adjusted on disposal when there is no loss of control, this element
does not change when re-calculating the non-controlling interest after disposal:
The non-controlling interest post disposal is: £
30% × £3.5 million 1,050,000
Goodwill [£350,000 – (15% × £2.2 million)] 20,000
1,070,000
The non-controlling interest has therefore increased by £525,000, recorded by:

Dr Cash proceeds £560,000
Cr NCI £525,000
Cr Retained earnings £35,000
10 Chianti
On disposal of Barolo, the consolidated statement of profit or loss and other comprehensive
income will include:
– A gain on disposal of £6,000 (as calculated below)
– £15,200 (being Chianti's share of the gain on AFS investments) which is reclassified into profit
or loss.
The group share of the revaluation surplus recognised by Barolo is not reclassified into profit or loss
but is transferred from the group revaluation reserve to group retained earnings.
£ £
Proceeds 340,000
Fair value of interest retained 20,000
360,000
Net assets 320,000
Goodwill (£70,000 - £20,000) 50,000
NCI (5% × 320,000) (16,000)
(354,000)
Gain on disposal 6,000
C
H
A
P
T
E
R
10

12 Porter
PORTER GROUP
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MAY 20X6
£m £m
Cash flows from operating activities
Profit before taxation 112
Adjustments for:
Depreciation 44
Impairment losses on goodwill (W2) 3
Foreign exchange loss (W8) 2
Investment income – share of profit of associate (12)
Investment income – gains on financial assets at fair value
through profit or loss (6)
Interest expense 16
159
Increase in trade receivables (132 – 112 – 16) (4)
Decrease in inventories (154 – 168 – 20) 34
Decrease in trade payables (110 – 98 – 12 – (W8) 17 PPE payable) (17)
Cash generated from operations 172
Interest paid (W7) (12)
Income taxes paid (W6) (37)
Net cash from operating activities 123
Cash flows from investing activities
Acquisition of subsidiary, net of cash acquired (26 – 8) (18)
Purchase of property, plant and equipment (W1) (25)
Purchase of financial assets (W4) (10)
Dividend received from associate (W3) 11
Net cash used in investing activities (42)
Cash flows from financing activities
Proceeds from issuance of share capital 18
(332 + 212 – 300 – 172 – (80  60%/2  £2.25))
Proceeds from long-term borrowings (380 – 320) 60
Dividend paid (45)
Dividends paid to non-controlling interests (W5) (4)
Net cash from financing activities 29
Net increase in cash and cash equivalents 110
Cash and cash equivalents at the beginning of the year 48
Cash and cash equivalents at the end of the year 158
Workings
1 Additions to property, plant and equipment
PROPERTY, PLANT AND EQUIPMENT
£m £m
b/d 812
Revaluation 58 Depreciation 44
Acquisition of subsidiary 92
Additions on credit (W8) 15
.
. . Additions for cash 25 c/d 958
1,002 1,002

2 Impairment losses on goodwill
GOODWILL
£m £m
b/d 10
.
Acq'n of subsidiary . . Impairment losses 3
[(80  60%/2 × 2.25) + 26 + (120 × 40%)
– 120 net assets] 8 c/d 15
18 18
3 Dividends received from associate

INVESTMENT IN ASSOCIATE
£m £m
b/d 39
.
P/L 12 . . Dividends received 11
OCI 8
c/d 48
59 59
4 Purchase of financial assets

FINANCIAL ASSETS AT FAIR VALUE THROUGH PROFIT OR LOSS
£m £m
b/d 0
P/L 6
.
. . Additions 10
c/d 16
16 16
5 Dividends paid to non-controlling interests

NON-CONTROLLING INTERESTS
£m £m
b/d 28
.
. . Dividends paid 4 TCI 12
c/d 84 Acquisition of subsidiary (120  40%) 48
88 88
6 Income taxes paid

INCOME TAX PAYABLE
£m £m
b/d (deferred tax) 26
b/d (current tax) 22
P/L 34 C
 Income taxes paid 37 OCI 17 H
c/d (deferred tax) 38 Acquisition of subsidiary 4 A
c/d (current tax) 28 P
T
103 103
E
R
10

7 Interest paid
INTEREST PAYABLE
£m £m
b/d 4
P/L 16
 Interest paid 12
c/d 8
20 20
8 Foreign currency transaction

Transactions recorded on: £m £m
1) 5 March DEBIT Property, plant and equipment (102m/6.8) 15
CREDIT Payables 15
2) 31 May Payable = 102m/6.0 = £17m
DEBIT P/L (Admin expenses) 2
CREDIT Payables (17 – 15) 2


Goodwill on acquisition of DEF
£'000
Consideration 3 million shares issued at £7 21,000
1 million additional shares at £7 7,000
Non-controlling interest 10% × £18m 1,800
29,800
Net assets acquired (18,000)

Goodwill 11,800

£99,750
Net assets of Ives
@
@ reporting
acquisition date
£ £
Share capital 100,000 100,000
Retained earnings 150,000 245,000
FV adjustment 50,000 –
PURP in inventory – (6,000)
300,000 339,000
£ £
Share of net assets (25% × 339,000) 84,750
Share of goodwill:
NCI at acquisition date at fair value 90,000
NCI share of net assets at acquisition date (25% × £300,000) (75,000)
15,000
99,750

Goodwill on consolidation of Kono Ltd
£m £m
Consideration (£2.00  6m) 12.0
Share capital 8.0
Pre-acquisition retained earnings 4.4
Fair value adjustments C
Property, plant and equipment (16.8 – 16.0) 0.8 H
Inventories (4.2 – 4.0) 0.2 A
Contingent liability (0.2) P
13.2 T
E
NCI (25%) 3.3 R
15.3
Net assets acquired (13.2)
Goodwill 2.1
10

Notes on treatment
(a) It is assumed that the market value (ie fair value) of the loan stock issued to fund the purchase of
the shares in Kono Ltd is equal to the price of £12.0m. IFRS 3 requires goodwill to be calculated by
comparing the consideration transferred plus the non-controlling interest, valued either at fair
value, or in this case, as a percentage of net assets, with the fair value of the identifiable net assets
of the acquired business or company.
(b) Share capital and pre-acquisition profits represent the book value of the net assets of Kono Ltd at
the date of acquisition. Adjustments are then required to this book value in order to give the fair
value of the net assets at the date of acquisition. For short-term monetary items, fair value is their
carrying value on acquisition.
(c) The fair value of property, plant and equipment should be determined by market value or, if
information on a market price is not available (as is the case here), then by reference to depreciated
replacement cost, reflecting normal business practice. The net replacement cost (ie £16.8m)
represents the gross replacement cost less depreciation based on that amount, and so further
adjustment for extra depreciation is unnecessary.
(d) Raw materials are valued at their replacement cost of £4.2m.
(e) The rationalisation costs cannot be reported in pre-acquisition results under IFRS 3 as they are not a
liability of Kono Ltd at the acquisition date.
(f) The fair value of the loan is the present value of the total amount payable (principal and interest).
The present value of the loan is the same as its par value.
(g) The contingent liability should be included as part of the acquisition net assets of Kono even
though it is not deemed probable and therefore has not been recognised in Kono's individual
accounts. However, the disclosed amount is not necessarily the fair value at which a third party
would assume the liability. If the probability is low, then the fair value is likely to be lower than
£200,000.

IFRS 11 gives examples in the oil, gas and mineral extraction industries. In such industries companies may,
say, jointly control and operate on oil or gas pipeline. Each company transports its own products down the
pipeline and pays an agreed proportion of the expenses of operating the pipeline (perhaps based on
volume). In this case the parties have rights to assets (such as exploration permits and the oil or gas produced
by the activities).
A further example is a property which is jointly controlled, each venturer taking a share of the rental
income and bearing a portion of the expense.

The holding of 40,000 out of Feeder Ltd's 100,000 shares gave Lawn plc significant influence over
Feeder Ltd, so Lawn plc should have used equity accounting. The deemed disposal gain is calculated as:
£'000
Cost of 40,000 shares 200
Share of revaluation surplus over period of ownership (40% × 20) 8
Share of retained earnings over period of ownership (40% × 30) 12
Carrying amount at 31 December 20X8 220
Acquisition-date fair value of previously held equity 236
Gain to be recognised in profit or loss 16
Point to note:
The revaluation gain should not be reclassified to profit or loss, because it would not be so reclassified if
there had been a real disposal of the interest in Feeder Ltd. It should, however, be transferred to
retained earnings in the statement of changes in equity.
Goodwill acquired in the business combination

£'000
Consideration transferred at acquisition date 216
Non-controlling interest – 30% × 510,000 153
Fair value of previously held equity 236
605
Net assets acquired (510)
Goodwill 95

The amounts appearing in the statement of cash flows for operating and financing activities include:
20X5 20X6
£ £
Operating activities
Operating lease payments 546,000 546,000
Interest paid – (payments are made in advance, so there is no interest in the
January 20X5 payment) 50,000
Financing activities
Payments under finance leases 364,000 314,000
C
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10

CHAPTER 11
Foreign currency translation

and hyperinflationary
economies
Introduction
Topic List
1 Objective and scope of IAS 21
2 The functional currency
3 Reporting foreign currency transactions
4 Foreign currency translation of financial statements
5 Foreign currency and consolidation
6 Disclosure
7 Other matters
8 Reporting foreign currency cash flows
9 Reporting in hyperinflationary economies
10 IFRS and UK GAAP comparison
Technical reference
419
Introduction
 Identify an entity's functional currency in accordance with IAS 21 The Effects of Changes in
Foreign Exchange Rates
 Apply knowledge and understanding of IAS 21 in particular circumstances through
calculations
 Demonstrate knowledge of the key disclosure requirements of IAS 21
 Identify and allocate foreign currency cash flows to the main components of a statement
of cash flows
 Demonstrate an understanding of the overall objective of IAS 29 Financial Reporting in
Hyperinflationary Economies

1 Objective and scope of IAS 21 C
H
A
Section overview P
T
 This section provides an overview of the objective, scope and main definitions of IAS 21. E
R
IAS 21 deals with two situations where foreign currency impacts financial statements:
1 An entity which buys or sells goods overseas, priced in a foreign currency 11
A UK company might buy materials from Canada, pay for them in US dollars, then sell its finished
goods in Germany, receiving payment in Euros or some other currency. If the company owes
money in a foreign currency at the end of the accounting year or holds assets bought in a foreign
currency, the assets and related liabilities must be translated into the local currency (in this case
sterling £), in order to be shown in the books of account.
2 The translation of foreign currency subsidiary financial statements prior to consolidation
A UK company might have a subsidiary abroad (ie a foreign entity that it owns), and the subsidiary
will trade in its own local currency. The subsidiary will keep books of account and prepare its
annual financial statements in its own currency. However, at the year end, the parent company
must 'consolidate' the results of the overseas subsidiary into its group accounts. Therefore the
assets and liabilities and the annual profits of the subsidiary must be translated from the foreign
currency into pounds sterling.
If foreign currency exchange rates remained constant, there would be no accounting problem in either
of these situations. However, foreign exchange rates are continually changing, sometimes significantly,
between the start and the end of the accounting year. For example, between September 2007 and
September 2008 the British Pound depreciated by about 16% against the euro. However, the euro has
suffered its own problems since the banking crisis of 2008, resulting in a stronger pound against the
euro at times – particularly during the first half of 2010.
1.1 Objective of IAS 21

An entity may carry on foreign activities in either of the two ways outlined above.
In either case, currency fluctuations will affect the financial position of the entity, when foreign currency
transactions or items are translated into the entity's functional currency.
The objective of IAS 21 is to produce rules that entities should follow in the translation of foreign
currency activities.
1.2 Scope of IAS 21

IAS 21 applies in the following cases.
 In accounting for transactions and balances in foreign currencies except for those derivative
transactions and balances that are within the scope of IAS 39 Financial Instruments: Recognition and
Measurement;
 In translating the results and financial position of foreign operations that are included in the
financial statements of the entity by consolidation, proportionate consolidation or the equity
method; and
 In translating an entity's results and financial position into a presentation currency.
Foreign currency translation and hyperinflationary economies 421

Definitions
Foreign currency: A currency other than the functional currency of the entity.
Functional currency: The currency of the primary economic environment in which the entity operates.
Presentation currency: The currency in which the financial statements are presented.
Exchange rate: The ratio of exchange for two currencies.
Closing rate: The spot exchange rate at the reporting date.
Spot exchange rate: The exchange rate for immediate delivery.
Exchange difference: The difference resulting from translating a given number of units of one currency
into another currency at different exchange rates.
Monetary items: Are units of currency held and assets and liabilities to be received or paid in a fixed or
determinable number of units of currency.
A group: is a parent and all its subsidiaries.
Foreign operations: are defined as any subsidiary, associate, joint venture or branch of a reporting
entity, the activities of which are based or conducted in a country or currency other than those of the
reporting entity.
Net investment in a foreign operation: is the amount of the reporting entity's interest in the net assets
of that operation.
1.3 Summary of approach required by the Standard

For the preparation of financial statements, an entity needs to determine its functional currency. This is
discussed in section 2 below. For group financial statements, there is no requirement for a group
functional currency; each entity within a group can have its own functional currency.
When an entity enters into a transaction denominated in a currency other than its own functional
currency, then it must translate the foreign currency items into its own functional currency according to
IAS 21. This is covered in section 3.
When transactions create assets and liabilities that remain outstanding at the reporting date, then these
items need to be translated into the entity's functional currency following the provisions of IAS 21. This
is discussed in section 3.
Where a reporting entity comprises a number of individual entities, some of them with their own
functional currencies, it is necessary for the constituent entities to translate their results into the
presentation currency of the parent, in order to be included in the reporting entity's financial
statements. This is covered in sections 4 and 5.
Section 6 deals with disclosures for foreign currency transactions.
2 The functional currency

Section overview
 This section defines the functional currency of an entity and discusses the criteria that need to be
met for a currency to be adopted by an entity as its functional currency.
2.1 Determining functional currency

Each entity whether an individual company, a parent of a group, or an operation within a group (such
as a subsidiary, associate or branch) should determine its functional currency and measure its results
and financial position in that currency.
The functional currency is the currency of the primary economic environment in which the entity
operates and it is normally the currency in which the entity primarily generates and expends cash.

Where an entity is registered in a particular national jurisdiction and the majority of its transactions take
place there, that jurisdiction's currency will be the entity's functional currency. In practice, many entities C
operate internationally, with group entities or business divisions located worldwide. In such H
A
circumstances, management will be required to make a reasoned judgement in respect of each
P
entity/division, based on the available facts. T
E
Where the functional currency of an entity is not obvious, an explanation of why a particular currency
R
was identified as being its functional currency would aid users' understanding of the business operations
of the entity.
11
2.2 Indicators of functional currency
Under IAS 21, the management of a company needs to determine the functional currency of the
company by assessing various indicators of the economic environment in which the company operates.
IAS 21 provides primary and secondary indicators for use in the determination of an entity's functional
currency, as summarised below.
Primary indicators
 The currency that mainly influences sales prices for goods and services (often the currency in
which prices are denominated and settled);
 The currency of the country whose competitive forces and regulations mainly determine the
sales prices of its goods and services; and
 The currency that mainly influences labour, material and other costs of providing goods or
services (often the currency in which prices are denominated and settled).
Secondary indicators
 The currency in which funds from financing activities (raising loans and issuing equity) are
generated; and
 The currency in which receipts from operating activities are usually retained.
2.3 Functional currency of foreign operations

In addition to the five indicators mentioned above, four additional factors are considered in determining
the functional currency of a foreign operation and whether its functional currency is the same as that of
the reporting entity.
 Whether the foreign operation carries out its business as though it were an extension of the
reporting entity rather than with a significant degree of autonomy.
 Whether transactions with the parent are a high or a low proportion of the foreign operation's
activities.
 Whether cash flows from the activities of the foreign operation directly affect the cash flows of
the parent and are readily available for remittance to it.
 Whether cash flows from the activities of the foreign operation are sufficient to service existing and
normally expected debt obligations without funds being made available by the reporting entity.
Worked example: Functional currency determination 1

Bogdankur, a small food processing company located in Denmark is trading almost exclusively with
Germany where the currency is the euro. The management of the company needs to decide on the
functional currency of the company, ie whether to use the Danish krone or the euro and is using the
following information (amounts are denominated in krone except as indicated).

Denominated Settled
€ million in € (%) in € (%)
Revenue
Export sales 750 100% 100%
Domestic sales 250 0% 0%
Total revenues 1,000 75% 75%
Materials 450 15%
Energy and gas 80
Staff costs 80
Other production expenses 30
Depreciation 40
Selling, general and administrative expenses 60 16%
Capital expenditure 70
Dividends 180
The main monetary assets and liabilities at 31 December 20X6 were as follows:
Held Expressed
€ million in € (%) in € (%)
Cash 120 90%
Total accounts receivable 140 80%
Trade payables 170 - 0%
Borrowings 400 10%
Requirement
How might the management of the company determine the functional currency?
Solution
The management of the company has decided using the guidance provided by the IFRS to adopt the
Danish krone as its functional currency, based on the fact that whereas the currency that influences sales
prices is the euro, the domestic currency influences costs and financing.
Worked example: Functional currency determination 2

Entity A operates an oil refinery in Nigeria. All of the entity's income is denominated in US dollars, as oil
trades in US dollars globally. About 20% of its operational expenses are dollar denominated salaries and
another 25% is imports of equipment denominated in US dollars. The remaining 55% of the operational
expenses are incurred in Nigeria and are denominated in Naira. Depreciation costs are denominated in
US dollars since the initial investment was in US dollars.
Requirement
What is the appropriate functional currency for Entity A?
Solution
The currency that mainly influences sales prices is the dollar. The currency that mainly influences costs is
not clear, as 55% of the operational costs are in Naira and 45% are in US dollars. Depreciation should
not be taken into account, because it is a non-cash cost, and the economic environment is where an
entity generates and expenses cash.
Since the revenue side is influenced primarily by the US dollar and the cost side is influenced by both
the dollar and the Naira, then management will be justified on the basis of IAS 21 guidance to
determine the US dollar as its functional currency.
2.4 Change of functional currency

An entity's functional currency may change when its business operations change, leading to a different
primary economic environment being identified. This is not a change in accounting policy, but instead
results from a change in circumstances, and therefore the new functional currency should be adopted
prospectively from the date of that change. The new functional currency is applied by retranslating all

items and comparative amounts into the new currency at the date of the change in circumstances. The
carrying amounts of non-monetary items translated into the new currency at the date of change should C
be deemed to be their historical translated amounts. H
A
P
T
Worked example: Change in functional currency
E
An entity commenced trading many years ago in Belgium, using the euro as its functional currency. R
After a number of years the entity started exporting its products to the UK invoicing sales in UK pounds.
Several years later the entity set up a branch in the UK as a small manufacturing function, incurring
expenses and receiving sales proceeds in £ sterling. With a fall in demand in Belgium by the end of 11
20X6 its activity in the UK came to represent 75% of the entity's activity.
Early in 20X7, the entity's management concluded that the UK was now its primary economic
environment, with 1 January 20X8 being the date when the entity's functional currency changed from
the euro to the pound.
The entity's equity and net assets at 31 December 20X7 were €80,000,000 and the exchange rate was
£1: €1.59.
Requirement
How might the change be reflected in the financial statements?
Solution
The entity's equity and net assets were £50,314,465 when the £ sterling became its functional currency.
Where an entity's functional currency has changed as a result of changes in its trading operations during
a period, the entity is required to disclose that the change has arisen, along with the reason for the
change.
2.5 Functional currency of a hyperinflationary economy

If the functional currency is the currency of a hyperinflationary economy, the entity's financial
statements are restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies
(covered later in this chapter). An entity cannot avoid restatement in accordance with IAS 29 by, for
example, adopting as its functional currency a currency other than the functional currency determined
in accordance with IAS 21.
3 Reporting foreign currency transactions
Section overview
 This section deals with the IAS 21 rules governing the initial and subsequent recognition of items
denominated in foreign currency.
Foreign currency transactions are transactions which are denominated in foreign currencies, rather than
in the entity's functional currency. Such transactions arise when the entity:
 Buys or sells goods or services whose price is denominated in a foreign currency;
 Borrows or lends funds where the amounts payable or receivable are denominated in a foreign
currency; or
 Otherwise acquires or disposes of assets or incurs or settles liabilities denominated in a foreign
currency.

Illustration: Foreign currency translation
An entity trades in gold and has a US dollar functional currency as most of its revenues and expenses are
in US dollars. The entity is located in Frankfurt and as a result it also has significant transactions in euros.
It has issued sterling denominated share capital to its UK parent. Transactions with the parent are
denominated in £. Which of the following transactions should management treat as foreign currency
transactions?
 Euro transactions
 US dollar transactions
 Sterling transactions
The euro and sterling transactions are foreign currency transactions. The fact that the entity is located in
Frankfurt, does not preclude it from designating US $ as its functional currency. All transactions which
are not denominated in the entity's functional currency are foreign currency transactions.
3.1 Foreign currency transactions: initial recognition

An entity is required to recognise foreign currency transactions in its functional currency. The entity
should achieve this by translating the foreign currency amount at the spot exchange rate between the
functional currency and the foreign currency at the date on which the transaction took place.
The date of the transaction is the date on which the transaction first met the relevant recognition
criteria.
Illustration: Initial recognition

Albion Ltd is a UK manufacturing company with sterling as its functional currency. The company has
ordered raw materials from a French supplier for €200,000. It recorded the transaction on 1 August
20X6, the date of the supplier's invoice. On that date the exchange rate was £1=€1.72 and the amount
recorded as purchase price is £116,000.
3.1.1 Average rate

Where an entity has a high volume of transactions in foreign currencies, translating each transaction may
be an onerous task, so an average rate may be used. For example, a duty-free shop at Heathrow airport
may receive a large amount of dollars and euros every day and may opt to translate each currency into
sterling using an average weekly rate.
IAS 21 provides no further guidance on how an average rate should be determined, and therefore an
entity should develop a method which is easily implemented with regard to limitations in its accounting
systems. Application of an average monthly rate, based on actual daily rates, would seem a reasonable
approach. Consistent application of the process for determining an appropriate average rate should be
adopted each period.
However, as the average rate is an approximation of the rate of the day of the transaction, an average rate
should not be adopted if exchange rates or underlying transactions fluctuate significantly (eg due to
seasonality), because in this case an average rate is not a good approximation.
Worked example: Use of average exchange rate

An entity, which has sterling as its functional currency, acquires a Ruritanian denominated bond on
1 January 20X1 for RU£1,000. The bond has five years to maturity and carries a variable market rate of
interest which is currently 6%. Interest is accrued on a daily basis for a calendar year. Interest is paid on
31 January in the following calendar year (that is interest for 20X1 will be paid on 31 January 20X2).
Management classifies the bond as held to maturity. The bond is therefore carried at amortised cost.
The interest income and exchange differences are recognised in profit or loss. The exchange rate at the
date of acquisition was RU£1 = £1.5.

At 31 December 20X1, the exchange rate was RU£1 = £2.0. The average rate for the period is RU£1 =
£1.75 (based on average rates published by the Central Bank of Ruritania, which are daily weighted C
average rates). H
A
Requirement P
T
What rate should management use for the translation of interest income that accrues on a daily basis E
when there is a significant fluctuation in the exchange rate? R
Solution
11
Management should use the daily weighted average exchange rate published by the Central Bank of
Ruritania. Interest income accrues evenly through the period and the weighted average rate will
produce the same result as a daily actual rate calculation.
The use of an un-weighted average rate would not be appropriate because exchange rates fluctuate
significantly.
Recognition of interest receivable:
Dr Held to-maturity investment £105 (RU£60  1.75)
Cr Interest income £105
3.1.2 Multiple exchange rates

It may be the case that a country operates a two (or more) rate system, such as one for capital
transactions and another for revenue items. Where more than one exchange rate exists, the rate to be
applied is the one at which the transaction or balance would have been settled if settlement had taken
place at the measurement date. If there is a temporary lack of published exchange rates between two
currencies, the entity should apply the next available exchange rate published.
3.1.3 Suspension of rates

On certain occasions, developing countries experience economic problems that affect the convertibility
of their currency. There is no exchange rate to be used in this case to translate foreign currency
transactions. The Standard requires companies to use the rate on the first subsequent date at which
exchanges could be made.
3.2 Subsequent measurement

A foreign currency transaction may give rise to assets or liabilities that are denominated in a foreign
currency. These assets and liabilities will need to be translated into the entity's functional currency at
each reporting date. How they will be translated depends on whether the assets or liabilities are
monetary or non-monetary items.
3.2.1 Monetary items

The essential feature of a monetary item, as the definition implies, is the right to receive (or an
obligation to deliver) a fixed or determinable number of units of currency. Examples of monetary assets
include:
 Cash and bank balances
 Trade receivables and payables
 Loan receivables and payables
 Foreign currency bonds held as available for sale
 Foreign currency bonds held to maturity
 Pensions and other employee benefits to be paid in cash
 Provisions that are to be settled in cash
 Cash dividends that are recognised as a liability

 A contract to receive (or deliver) a variable number of the entity's own equity instruments or a
variable amount of assets in which the fair value to be received (or delivered) equals a fixed or
determinable number of units of currency
Foreign currency monetary items outstanding at the end of the reporting date shall be translated
using the closing rate. The difference between this amount and the previous carrying amount in
functional currency is an exchange gain or loss (covered in more detail in section 3.3).
3.2.2 Non-monetary items

A non-monetary item does not give the right to receive or create the obligation to deliver a fixed or
determinable number of units of currency. Examples of non-monetary items include:
 Amounts prepaid for goods and services (eg prepaid rent)
 Goodwill
 Intangible assets
 Inventories
 Property, plant and equipment
 Provisions to be settled by the delivery of a non-monetary asset
 Equity instruments that are held as available for sale financial assets
 Equity investments in subsidiaries, associates or joint ventures
Non-monetary items carried at historic cost are translated using the exchange rate at the date of the
transaction when the asset arose (historical rate). They are not subsequently retranslated in the
individual financial statements of the entity. The foreign currency carrying amount is determined
according to appropriate accounting Standards (eg IAS 2 for inventories, IAS 16 for property, plant and
equipment measured at cost).
Non-monetary items carried at fair value are translated using the exchange rate at the date when the
fair value was determined. The foreign currency fair value of a non-monetary asset is determined by
the relevant Standards (eg IAS 16 for property, plant and equipment and IAS 40 for investment
property).
Interactive question 1: Initial recognition [Difficulty level: Intermediate]

A UK company lends €10m to its Portuguese supplier of Port wine to upgrade its production facilities.
At the time of the loan, in July 20X5, the exchange rate was £1 = €2. The loan is repayable on
31 December 20X5. Initially the loan will be translated and recorded in the UK company's financial
statements at £5m. The amount that the company will ultimately receive will depend on the exchange
rate on the date when the loan is repaid.
At 31 December 20X5, the exchange rate was £1 = €2.5.
Requirement
Calculate the exchange gain or loss.
3.2.3 Issues in the measurement of non-monetary assets

 Subsequent depreciation should be translated on the same basis as the asset to which it relates, so
the rate at the date of acquisition for assets carried at cost and at the rate at the last valuation date
for assets carried at revalued amounts. Application of the depreciation method to the translated
amount will achieve this.
 The carrying amount of inventories is the lower of cost and net realisable value in accordance with
IAS 2 Inventories. The carrying amount in the functional currency is determined by comparing:
– The cost, translated at the exchange rate at the date when that amount was determined.
– The net realisable value, translated at the exchange rate at the date when that value was
determined (eg the closing date at the reporting date).

Worked example: Translation of inventory acquired in a foreign currency
C
Entity J's functional currency is the pound sterling. Entity J acquired inventories for $300,000 on 1 July H
20X5 when the exchange rate was $1.5:£1. At 31 December 20X5, its carrying amount is $300,000 and A
its net realisable value has risen to $340,000. The exchange rate at 31 December 20X5 is $1.8:£1. P
T
Requirement E
R
How should management translate the inventory acquired?
Solution 11
Expressed in dollars, the inventory value has gone up, its net realisable amount exceeding its carrying
amount. In sterling, the carrying amount using the acquisition date rate is £200,000 ($300,000/1.5) and
the net realisable amount using the closing rate is £189,000 ($340,000/1.8). Inventory is stated at the
lower of cost and net realisable value in the functional currency and the carrying amount at 31
December 20X5 is £189,000.
Impairment testing of foreign currency non-monetary assets

Similarly in accordance with IAS 36 Impairment of Assets, the carrying amount of an asset for which there
is an indication of impairment, is the lower of:
 The carrying amount, translated at the exchange rate at the date when that amount was
determined.
 The recoverable amount, translated at the exchange rate at the date when that value was
determined (eg the closing rate at the reporting date).
The effect of this comparison may be that an impairment loss is recognised in the functional currency
but would not be recognised in the foreign currency or vice versa.
Worked example: Translation of impaired non-monetary item

An entity whose functional currency is the pound sterling acquired on 30 September 20X4 a non-
depreciable foreign currency asset costing $450,000. The exchange rate on 30 September 20X4 was
$1.5/£1 and the asset was recorded at the date of purchase at £300,000. There are indications that the
non-current asset has been impaired during the year.
At 31 December 20X5, the reporting date, the asset's recoverable amount in foreign currency is
estimated to be $400,000 when £1=$1.25.
Requirement
How should the transaction be recorded?
Solution
Expressed in foreign currency, the asset has a carrying value of $450,000 and a recoverable amount of
$400,000 and is therefore impaired.
However, when it is expressed in sterling, the asset is not impaired, because its recoverable amount
exceeds its carrying amount. In sterling, the carrying amount, using the acquisition date rate, is
£300,000 ($450,000/1.5) and the recoverable amount, using the closing rate, is £320,000
($400,000/1.25). The appreciation of the foreign currency relative to pounds sterling has offset the fall
in the value of the asset due to impairment, therefore no impairment charge is required.

3.2.4 Measurement of financial assets
Initial measurement
Financial assets can be monetary or non-monetary and may be carried at fair value or amortised cost.
Where a financial instrument is denominated in a foreign currency, it is initially recognised at fair value
in the foreign currency and translated into the functional currency at spot rate. The fair value of the
financial instrument is usually the same fair value of the consideration given in the case of an asset or
received in the case of a liability.
Subsequent measurement
At each year end, the foreign currency amount of financial instruments carried at amortised cost is
translated into the functional currency using either the closing rate (if it is a monetary item) or the
historical rate (if it is a non-monetary item). Financial instruments carried at fair value are translated to
the functional currency using the closing spot rate.
Recognition of exchange differences
The entire change in the carrying amount of a non-monetary available-for-sale financial asset, including
the effect of changes in foreign currency rates, is reported as other comprehensive income at the
reporting date.
A change in the carrying amount of monetary available-for-sale financial assets on subsequent
measurements is analysed between the foreign exchange component and the fair value movement. The
foreign exchange component is recognised in profit or loss and the fair value movement is recognised
as other comprehensive income.
The entire change in the carrying amount of financial instruments measured at fair value through profit
or loss, including the effect of changes in foreign currency rates, is recognised in profit or loss.
Worked example: Translation of non-monetary asset

On 1 January 20X5 an entity whose functional currency is the pound sterling purchased a US dollar
denominated equity instrument at its fair value of $500,000. The entity classifies the instrument as
available-for-sale. The exchange rate at acquisition date was $1.9/£. The exchange rates and the fair
value of the instrument denominated in US dollars at different reporting dates are given below.
Equity
instrument
value
$/£1 $
31 December 20X5 1.80 480,000
31 December 20X6 1.60 450,000
Requirement
What is the fair value of the asset at 1 January 20X5, 31 December 20X5 and 31 December 20X6?
Solution
The asset is an AFS equity investment, therefore a non-monetary financial asset. All exchange differences
are reported in OCI.
Exchange Equity Equity Change in fair value

rate instrument instrument recognised as other
$/£1 value($) value(£) comprehensive income
Recognised in Cumulative
the current gains or
period losses
1 January 20X5 1.9 500,000 263,158
31 December 20X5 1.8 480,000 266,667 3,509 3,509
31 December 20X6 1.6 450,000 281,250 14,583 18,092

3.3 Recognition of exchange differences
C
Exchange differences arise: H
A
 On retranslation of a monetary item at the year end P
 When a monetary item is settled in cash (eg a foreign currency payable is paid) T
 Where there is an impairment, revaluation or other fair value change in a non-monetary item E
R
3.3.1 Retranslation of monetary items

Where a monetary item arising from a foreign currency transaction remains outstanding at the reporting 11
date, an exchange difference arises, being the difference between:
 Initially recording the item at the rate ruling at the date of the transaction (or when it was
translated at a previous reporting date), and
 The subsequent retranslation of the monetary item to the rate ruling at the reporting date.
Such exchange differences should be reported as part of the profit or loss for the year.
3.3.2 Settlement of monetary items

Exchange differences arising on the settlement of monetary items (receivables, payables, loans, cash in a
foreign currency) should be recognised in profit or loss in the period in which they arise.
There are two situations to consider.
(a) The transaction is settled in the same period as that in which it occurred: all the exchange
difference is recognised in that period.
(b) The transaction is settled in a subsequent accounting period: an exchange difference is
recognised in each intervening period up to the period of settlement, determined by the change in
exchange rates during that period (as per section 3.3.1). A further exchange difference is
recognised in the period of settlement.
Worked example: Recognition of exchange differences on monetary item settled in

the same period
White Cliffs Co, whose year end is 31 December, buys some goods from Rinka SA of France on
30 September. The invoice value is €40,000 and is due for settlement on 30 November. The exchange
rate moved as follows.
€/£1
30 September 1.60
30 November 1.80
Requirement
State the accounting entries in the books of White Cliffs Co.
Solution
The purchase will be recorded in the books of White Cliffs Co using the rate of exchange ruling on
30 September.
Dr Purchases £25,000
Cr Trade payables £25,000
Being the £ cost of goods purchased for €40,000 (€40,000  €1.60/£1)
On 30 November, White Cliffs must pay €40,000. This will cost €40,000  €1.80/£1 = £22,222 and the
company has therefore made an exchange gain of £25,000 – £22,222 = £2,778.
Dr Trade payables £25,000
Cr Exchange gains: profit or loss £2,778
Cr Cash £22,222

Worked example: Recognition of exchange differences on monetary item settled in a
subsequent accounting period
White Cliffs Co, whose year end is 31 December, buys some goods from Rinka SA of France on 30
September. The invoice value is €40,000 and is due for settlement in equal instalments on 30 November
and 31 January. The exchange rate moved as follows.
€/£1
30 September 1.60
30 November 1.80
31 December 1.90
31 January 1.85
Requirement
State the accounting entries in the books of White Cliffs Co.
Solution
The purchase will be recorded in the books of White Cliffs Co using the rate of exchange ruling on 30
September.
Dr Purchases £25,000
Cr Trade payables £25,000
Being the £ pounds sterling cost of goods purchased for €40,000 (€40,000  €1.60/£1)
On 30 November, White Cliffs must pay €20,000 to settle half the payable (£12,500). This will cost €
20,000  €1.80/£1 = £11,111 and the company has therefore made an exchange gain of £12,500 –
£11,111 = £1,389.
Cr Cash £11,111
On 31 December, the reporting date, the outstanding liability of £12,500 will be recalculated using the
rate applicable at that date: €20,000  €1.90/£1 = £10,526. A further exchange gain of £1,974
(£12,500 - £10,526) has been made and will be recorded as follows.
The total exchange gain of £3,363 will be included in the operating profit for the year ending 31
December.
On 31 January, White Cliffs must pay the second instalment of €20,000 to settle the remaining liability
of £10,526. This will cost the company £10,811 (€20,000  €1.85/£1).
Dr Exchange losses: Profit or loss £285
Cr Cash £10,811
3.3.3 Exceptions to the general rule

As set out above, exchange differences should normally be recognised as part of profit or loss for the
period. This treatment is required in an entity's own financial statements even in respect of differences
on certain monetary amounts receivable from, or payable to, a foreign operation. If the settlement of
these amounts is neither 'planned nor likely to occur', they are in effect part of the entity's net
investment in the foreign operation.
In the following cases the exchange differences on monetary items are not reported in profit or loss
because hedge accounting provisions under IAS 39 overrule the regulations of IAS 21.
 A monetary item designated as a hedge of a net investment in consolidated financial statements. In
this case any exchange difference that forms part of the gain or loss on the hedging instrument is
recognised as other comprehensive income.

 A monetary item designated as a hedging instrument in a cash flow hedge. In this case any
exchange difference that forms part of the gain or loss on the hedging instrument is recognised as C
other comprehensive income. H
A
 Exchange differences arising in respect of monetary items which are part of the net investment are P
recognised in profit or loss in the individual financial statements of the entity or foreign operation T
E
as appropriate. However, in the consolidated statement of financial position the exchange R
differences are recognised in equity. This exemption arises only on consolidation and is dealt with
in the section on consolidation.
11
3.3.4 Non-monetary items
Where a non monetary item (eg inventory or a non-current asset) is recognised at historical cost (and
there is no impairment) then it is translated into the functional currency at the exchange rate on the
date of the transaction. It is not then retranslated at subsequent reporting dates in the individual
financial statements of the entity, and therefore no exchange differences arise.
Exchange differences do however arise on non-monetary items when there has been a change in their
underlying value (eg fair value changes, revaluations or impairments). These are recognised as follows.
(a) When a gain or loss on a non-monetary item is recognised as other comprehensive income (for
example, where property denominated in a foreign currency is revalued) any related exchange
differences should also be recognised as other comprehensive income.
(b) When a gain or loss (eg fair value change) on a non-monetary item is recognised in profit or loss, any
exchange component of that gain or loss is also recognised in profit or loss.
Several examples are given below to highlight the issues that arise in the recognition of exchange
differences on non-monetary items.
Interactive question 2: Rumble plc [Difficulty level: Exam standard]

Rumble plc is a retailer of fine furniture. On 19 October 20X5 Rumble purchased 100 antique tables
from a US supplier for a total of $3,600,000. Rumble has a year end of 31 December 20X5 and uses
sterling as its functional currency.
Exchange rates are as follows.
19 October 20X5 £1 = $1.8
15 December 20X5 £1 = $1.9
20 December 20X5 £1 = $1.95
31 December 20X5 £1 = $2.0
Average rate for 20X5 £1 = $1.6
3 February 20X6 £1 = $2.4
Requirement
Determine, according to IAS 21 The Effects of Changes in Foreign Exchange Rates, the impact of the above
transaction on the profits of Rumble for the year ended 31 December 20X5 and on the statement of
financial position at that date under each of the following alternative assumptions.
Assumption 1 All the tables were sold on 20 December 20X5 and were paid for by Rumble on 15
December 20X5.
Assumption 2 All the tables were sold on 3 February 20X6 and were paid for by Rumble on 15 December
20X5.
Assumption 3 All the tables were sold on 15 December 20X5 and were paid for by Rumble on 3 February
20X6.
Assumption 4 75 of the tables were sold on 15 December 20X5 with the remaining 25 tables being sold
on 3 February 20X6. All the tables were paid for by Rumble on 3 February 20X6.

Worked example: Translation of investment property
An entity whose functional currency is the pound sterling holds an investment property in Singapore.
The investment property is carried at fair value in accordance with IAS 40. The investment property had
a fair value at 31 December 20X2 of S$10,000,000 and S$12,000,000 at 31 December 20X3. The
exchange rates were as follows.
31 December 20X2 £1:S$1.65
31 December 20X3 £1:S$1.63
Requirement
How should management recognise the change in the value of this investment property?
Solution
Management should recognise the investment property at £6,060,606 and £7,361,963 at 31 December
20X2 and 31 December 20X3 respectively.
The change in value is calculated as:
31 December 20X2 (S$10,000,000 /1.65) £6,060,606
31 December 20X3 (S$12,000,000 /1.63) £7,361,963
Increase in fair value £1,301,357
The increase in fair value of £1,301,357 should be recognised in profit or loss as a gain on investment
property.
The investment property is a non-monetary asset. The movement in value attributable to movement in
exchange rates £74,363 ($10,000,000/1.65) – ($10,000,000/1.63) should not be recognised separately
because the asset is non-monetary.
Illustration: Translation of property – revaluations

A UK-based entity with a sterling functional currency has a property located in Spain which was
acquired at a cost of €6m when the exchange rate was £1=€1.5. At the reporting date the property was
revalued to €8m. The exchange rate on the reporting date was £1=€1.6. Ignoring depreciation the
amount that would be recognised as other comprehensive income is:
€ €/£ £
Value at reporting date 8,000,000 1.6 5,000,000
Value at acquisition 6,000,000 1.5 4,000,000
Revaluation surplus recognised in equity 1,000,000
The revaluation surplus may be analysed as follows.

€ €/£ £ £
Change in fair value 2,000,000 1.6 1,250,000
Exchange component of change
6,000,000 1.6 3,750,000
6,000,000 1.5 4,000,000
(250,000)
Revaluation surplus recognised as other
comprehensive income 1,000,000
Interactive question 3: Translation of land: revaluations [Difficulty level: Intermediate]

Entity A, incorporated in Muritania (local currency Muritania lira), is the treasury department of Entity B
which has British pounds as its functional currency. The functional currency of Entity A is also the British
pound, as it is not autonomous from its parent. Entity A's management follows the revaluation model in
IAS 16 and measures its land and buildings at revalued amounts (based on periodic valuations as
necessary but not less frequent than every three years). A piece of land was acquired on 1 June 20X4
and is not depreciated. It has been revalued on 31 December 20X5 and 31 December 20X6 respectively
as follows.

Muritania lira Date Exchange rate £
Cost at acquisition 200,000 Bought on 1 June 20X4 M lira 1 = 260,000 C
£1.3 H
Fair value 250,000 As at 31 December 20X5 M lira 1 = 250,000 A
P
£1.0
T
Fair value 260,000 As at 31 December 20X6 M lira 1 = 312,000 E
£1.2 R
Requirement
How should management translate the land held at fair value in accordance with IAS 16?
11
Worked example: Impairment in non-monetary item

A UK-based entity with a sterling functional currency has a property located in Spain which was
acquired at a cost of €6m when the exchange rate was £1=€1.5. The property is carried at cost. At the
reporting date the recoverable amount of the property as a result of an impairment review amounted to
€5m. The exchange rate at the reporting date was £1=€1.6.
Requirement
Ignoring depreciation, determine the amount of the impairment loss that would be reported in profit or
loss as a result of the impairment.
Solution
€ €/£ £ £
Carrying amount at reporting date 5,000,000 1.6 3,125,000
Historical cost 6,000,000 1.5 4,000,000
Impairment loss recognised in profit or loss ( 875,000)
The impairment loss may be analysed as follows.

Change in value due to impairment 1,000,000 1.6 (625,000)
Exchange component of change
6,000,000 1.6 3,750,000
6,000,000 1.5 4,000,000
(250,000)
Impairment loss recognised in profit or loss (875,000)
Worked example: Translation of financial instruments

Entity A whose functional currency is the pound sterling acquired on 30 September 20X4 two classes of
dollar-denominated financial instruments. (Entity A's accounting year end is 31 December.)
(1) Listed equity instruments for $10 million, classified as available-for-sale
(2) Non-listed equity instruments for $10 million, classified as available-for-sale
At 31 December, management believe that the cost of the unlisted investments is still a reasonable
approximation of their fair value. The fair value of the listed investments has increased to $14.4 million.
How should the relevant requirements of IAS 39 and IAS 32 affect the translation of these financial
instruments into the functional currency at 31 December 20X4?
Exchange rates: 30 September 20X4 $1:£1
31 December 20X4 $1.2:£1

Solution
Management should recognise the financial instruments on 31 December 20X4 as follows.
(1) Listed equity instruments of £12 million. The listed shares are measured at fair value on 31
December 20X4, of $14.4 million and translated using the spot rate at the date of valuation, which
is $1.2:£1. The gain of £2 million ($14.4 million /1.2 – $10 million/1.0) should be recorded as
other comprehensive income.
(2) Non-listed equity instruments of £10 million. As the shares are recorded at their cost of $10 million,
the foreign currency value should be translated to pounds sterling using the spot rate at the date of
the transaction, which was $1:£1.
Illustration: Translation of a branch into the functional currency

An entity based in the UK with the pound sterling as its functional currency operates a branch in
Portugal where the functional currency is the €. As the branch is an extension of the entity, the
functional currency of the branch is also the pound sterling, but as a matter of convenience the branch
records a number of transactions in euros. Assume that the €:£ exchange rates have been as follows.
1 January 20X3 €2.5:£1
1 January 20X4 €2.4:£1
30 June 20X5 €2.1:£1
30 September 20X5 €2.0:£1
31 December 20X5 €2.2:£1
Details of the branch balances at 31 December 20X5 requiring translation and the basis for calculating
their sterling equivalents are as follows. The branch made all its sales on 30 September 20X5, and half of
these were outstanding as trade receivables at the year end. All purchases were made on 30 June 20X5,
and half of these are unpaid at 31 December 20X5.
Item Balance
Basis € Rate £
Plant – acquired on 1 January 20X3
Cost Historical rate 50,000 €2.5:£1 20,000
Accumulated depreciation Historical rate (30,000) €2.5:£1 (12,000)
20,000 8,000
Plant – acquired on 1 January 20X4
Cost Historical rate 30,000 €2.4:£1 12,500
Accumulated depreciation Historical rate (12,000) €2.4:£1 (5,000)
18,000 7,500
Trade receivables Closing rate 50,600 €2.2:£1 23,000
Trade payables Closing rate 25,200 €2.2:£1 11,455
Revenue Actual rate 101,200 €2.0:£1 50,600
Purchases Actual rate 50,400 €2.1:£1 24,000
Depreciation charge for year

– 1 January 20X3 plant Historical rate 10,000 €2.5:£1 4,000
– 1 January 20X4 plant Historical rate 6,000 €2.4:£1 2,500
Note that both the accumulated depreciation and the charge for the year are translated at the rate
ruling when the relevant plant was acquired. Revenue and purchases are translated at the rate ruling
when the transaction occurred, but the receivables and payables relating to them (which will have been
initially recognised at those rates) are monetary items which are retranslated at closing rate at the end of
the year.

4 Foreign currency translation of financial statements C
H
A
Section overview P
T
 This section presents the rules for the translation of financial statements from the functional E
currency to the presentational currency. R
We have discussed in the previous section the requirements of IAS 21 for the translation of foreign 11
currency transactions. In this section we shall discuss the IAS 21 translation requirements when foreign
activities are undertaken through foreign operations whose financial statements are based on a different
functional currency than that of the parent company. More specifically in this section we shall discuss
the appropriate exchange rate that should be used for the translation of the financial statements of the
foreign operation into the reporting entity's presentation currency.
Although an entity is required to translate foreign currency items and transactions into its functional
currency, it does not have to present its financial statements in this currency. Instead, IAS 21 permits an
entity a completely free choice over the currency in which it presents its financial statements. Where the
chosen currency, the entity's presentation currency, is not the entity's functional currency, this fact
should be disclosed in the financial statements, along with an explanation of why a different
presentation currency has been applied.
The financial statements of a foreign operation operating in a hyperinflationary economy must be
adjusted under IAS 29 before they are translated into the parent's reporting currency and then
consolidated. When the economy ceases to be hyperinflationary, and the foreign operation ceases to
apply IAS 29, the amounts restated to the price level at the date the entity ceased to restate its financial
statements should be used as the historical costs for translation purposes.
4.1 Translation to the presentation currency when the functional currency is a

non-hyperinflationary currency
The approach adopted for the translation into a presentation currency is also used for the preparation of
consolidated financial statements where a parent has a foreign subsidiary. The process is set out below.
The following procedures should be followed to translate an entity's financial statements from its
functional currency into a presentation currency.
 Translate all assets and liabilities (both monetary and non monetary) in the current statement of
financial position using the closing rate at the reporting date.
 Translate income and expenditure in the current statement of profit or loss and other
comprehensive income using the exchange rates ruling at the transaction dates. An approximation
to actual rate is normally used, being the average rate.
 Report the exchange differences which arise on translation as other comprehensive income; and
where a foreign subsidiary is not wholly-owned, allocate the relevant portion of the exchange
differences to the non-controlling interest.
Note that the comparative figures are the presentation currency amounts as presented the previous year.
4.1.1 Translation of equity

No guidance is provided as to how amounts in equity should be translated. Using the closing rate would
be consistent with the approach to the translation of assets and liabilities. Translation at historical rates
may seem more appropriate, given the one-off, capital nature of such items such as share capital. As IAS
21 is not explicit in this respect, either approach may be adopted, although an entity should follow a
consistent policy between periods.

4.2 Exchange differences
The exchange differences comprise:
 Differences arising from the translation of the statement of profit or loss and other comprehensive
income at exchange rates at the transaction dates or at average rates and the translation of assets
and liabilities at the closing rate.
 Differences arising on the opening net assets' retranslation at a closing rate that differs from the
previous closing rate.
Resulting exchange differences are reported as other comprehensive income and classified as a
separate component of equity, because such amounts have not resulted from exchange risks to which
the entity is exposed, but purely through changing the currency in which the financial statements are
presented. To report such exchange differences in profit or loss would distort the results from the
trading operations, as shown in the functional currency financial statements, since these differences are
unrelated to the foreign operation's trading performance or financial operation.
Worked example: Translation to presentation currency

XYZ, a UK-based company with sterling as its functional currency, has created a new subsidiary in the
US, on 1 January 20X5 with a share capital of US$55,000 subscribed in cash. The amounts in its 20X5
US dollar functional currency financial statements are shown below.
US $
Statement of profit or loss
Revenue 500,000
Costs (200,000)
Profit 300,000
There was no other comprehensive income.
Initial share capital 55,000
Retained earnings (as above) 300,000
Equity = net assets 355,000
The entity owns no non-current assets (so there are no assets or depreciation charges to be translated at
the rate ruling when the asset was acquired) and all transactions took place on 30 June (so that a single
rate can be used for the statement of profit or loss transactions, rather than the various rates ruling when
the transactions took place).
Assume that the following exchange rates are relevant.
1 January 20X5 £1=US$2.75
30 June 20X5 £1=US$2.5
31 December 20X5 £1=US$2
The entity translates share capital at the rate ruling when the capital was raised.
Requirement
Translate the financial statements of the subsidiary into the pound sterling presentation currency.
Solution
The statement of profit or loss is translated using the actual rate on the transaction date.
US$ Rate £
Revenue 500,000 Actual 200,000
Costs (200,000) Actual (80,000)
Profit 300,000 120,000
Other comprehensive income:

Exchange gain on retranslation 37,500
Total comprehensive income 157,500

The net assets of the subsidiary are translated using the closing rate and the initial share capital using
the opening rate. The statement of financial position is shown below. C
H
Statement of financial position A
US$ Rate £ P
Initial share capital 55,000 Opening 20,000 T
Retained earnings (as above) 300,000 Actual 120,000 E
Exchange differences 37,500 R
Equity = net assets 355,000 Closing 177,500
The exchange gain arising on consolidation has two components: 11

(a) An exchange gain arising on retranslating the opening net assets from the opening rate to the
closing rate
Rate £
Opening net assets = initial share
capital (US$ 55,000) Closing 27,500
Opening 20,000
7,500
(b) A further exchange gain arising from retranslating profits from the actual to the closing rate.
Rate £
Retained earnings (US$ 300,000) Closing rate 150,000
Actual rate (120,000)
30,000
Total exchange differences 37,500
The inclusion of the exchange gain or loss makes the accounting equation balance since:
Closing net assets = Opening net assets + profit (translated at the

(translated at closing (translated at opening actual rate + exchange
rate) rate + exchange difference)
difference)
The calculation of the exchange difference is discussed in more detail in section 5.3.
4.3 Translation when the functional currency is a hyperinflationary currency

Where an entity's functional currency is that of a hyperinflationary economy and it uses a presentation
currency which is different from its functional currency, all the functional currency amounts restated
under IAS 29 Financial Reporting in Hyperinflationary Economies should be translated at the closing rate at
the current reporting date. The one exception is that where the presentation currency used is that of a
non-hyperinflationary economy, the comparative amounts should be as they were presented in the
previous period. There is no IAS 29 adjustment for the effect of hyperinflation in the current period.
Interactive question 4: Translation of a foreign operation [Difficulty level: Intermediate]

A UK-based company, Petra Ltd, set up a foreign subsidiary, Hellenic Marble, in Greece on 30 June
20X6. Petra Ltd subscribed €24,000 for share capital when the exchange rate was €2 = £1. The
subsidiary borrowed €72,000 and bought a non-monetary asset for €96,000. Petra Ltd prepared its
accounts on 31 December 20X6 and by that time the exchange rate had moved to €3 = £1. No activity
was undertaken by the subsidiary during the period and it had no profits or losses.
Requirement
Account for the above transactions.

5 Foreign currency and consolidation
Section overview
 This section deals with the issues arising from consolidating financial statements and in particular,
the treatment of exchange differences and goodwill.
5.1 Translation of a foreign operation

A reporting entity with foreign operations needs to translate the financial statements of those operations
into its own reporting currency before consolidation, proportional consolidation or inclusion through
the equity method. The method of translation described in Section 4 above should be applied to the
financial statements of a foreign operation. The treatment is summarised here.
(a) Statement of profit or loss and other comprehensive income: translate using actual rates. An
average for a period may be used, but not where there is significant fluctuation and the average is
therefore unreliable.
(b) Statement of financial position: translate all assets and liabilities (both monetary and non
monetary) using closing rates.
(c) Exchange differences are reported as other comprehensive income.
5.2 Consolidation
The incorporation of the results and financial position of a foreign operation with those of the reporting
entity follows normal consolidation procedures such as the elimination of intra-group balances and
intra-group transactions of a subsidiary. However, an intra-group monetary asset (or liability) whether
short-term or long-term cannot be eliminated against the corresponding intra-group liability (or asset)
without showing the results of currency fluctuations in the consolidated financial statements. This is
because a monetary item represents a commitment to convert one currency into another and exposes
the reporting entity to a gain or loss through currency fluctuations. Accordingly, in the consolidated
financial statements of the reporting entity, such an exchange difference:
 Continues to be recognised in profit or loss, or
 Is classified as equity until the disposal of the foreign operations, if it is a monetary asset forming
part of the net investment in a foreign operation.
Worked example: Consolidated financial statements

The abridged statements of financial position and profit or loss of Darius Co and its foreign subsidiary,
Xerxes Inc, appear below.

DRAFT STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
C
Darius Co Xerxes Inc
H
£ £ € € A
ASSETS P
Non-current assets T
Plant at cost 600 500 E
Depreciation (250) (200) R
350 300
Investment in Xerxes
100 shares @ £0.25 per share 25 – 11
375 300
Current assets
Inventories 225 200
Receivables 150 100
375 300
750 600
Equity
Ordinary £1/€1 shares 300 100
Retained earnings 300 280
600 380
Long-term loans 50 110
Current liabilities 100 110
750 600
STATEMENTS OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X9

Darius Co Xerxes Inc
£ €
Profit before tax 200 160
Tax (100) (80)
Profit after tax, retained 100 80
The following further information is given.

(a) Darius Co has had its interest in Xerxes Inc since the incorporation of the company.
(b) Depreciation is 8% per annum on cost.
(c) The equity value of Xerxes at 31 December 20X8 was €300.
(d) There have been no loan repayments or movements in non-current assets during the year. The
opening inventory of Xerxes Inc was €120. Assume that inventory turnover times are very short.
(e) Exchange rates: €4 to £1 when Xerxes Inc was incorporated
€2.5 to £1 when Xerxes Inc acquired its long-term assets
€2 to £1 on 31 December 20X8
€1.6 to £1 average rate of exchange year ending 31 December 20X9
€1 to £1 on 31 December 20X9
Requirements
 Prepare the summarised consolidated statement of profit or loss and statement of financial position
of Darius Co using the £ as the presentation currency.
 Calculate the exchange difference and prepare a separate statement of profit or loss and other
comprehensive income showing other comprehensive income.
Solution
Statement of profit or loss of Xerxes for the year ended 31 December 20X9 translated using the
average rate (€1.6 = £1)
£
Tax (50)
Profit after tax, retained 50

Consolidated statement of profit or loss for the year ended 31 December 20X9
£
Profit before tax £(200 + 100) 300
Tax £(100 + 50) (150)
Profit after tax, retained £(100 + 50) 150
The statement of financial position of Xerxes Inc at 31 December 20X9, other than share capital and
reserves, should be translated at the closing rate of €1 = £1.
Summarised statement of financial position of Xerxes in £ at 31 December 20X9
£ £
Non-current assets (carrying amount) 300
Current assets
Inventories 200
Receivables 100
300
600
Non-current liabilities 110
Current liabilities 110
 Equity = 600 – 110 – 110 = 380 380

600
Since Darius Co acquired the whole of the issued share capital on incorporation, the post-acquisition
reserves including exchange differences will be the value of shareholders' funds arrived at above, less the
original cost to Darius Co of £25 (ie €100 at the historic exchange rate of £1:€4). Post-acquisition
increase in equity = £380 – £25 = £355.
Summarised consolidated statement of financial position as at 31 December 20X9
£ £
ASSETS
Non-current assets (NBV) £(350 + 300) 650
Current assets
Inventories £(225 + 200) 425
Receivables £(150 + 100) 250
675
1,325
Equity
Ordinary £1 shares (Darius only) 300
Retained earnings £(300 + 355) 655
955
Non-current liabilities: loans £(50 + 110) 160
Current liabilities £(100 + 110) 210
1,325
Note: It is quite unnecessary to know the amount of the exchange differences when preparing the
consolidated statement of financial position.
Calculation of exchange differences
£
Xerxes' equity interest at 31 December 20X9 380
Equity interest at 1 January 20X9 (€300/2) ((150)
230
Less: retained profit (50)
Exchange gain 180
Statement of profit or loss and other comprehensive income for the year ended 31 December
20X9
£
Profit after tax 150
Exchange difference on translation of foreign operations 180
Total comprehensive income for the year 330

Note: The post-acquisition reserves of Xerxes Inc at the beginning of the year must have been £150 –
£25 = £125 and the post-acquisition reserves of Darius Co must have been £300 – £100 = £200. C
The consolidated post-acquisition reserves must therefore have been £325. H
A
P
T
5.3 Analysis of exchange differences E
R
The exchange differences in the above exercise could be reconciled by splitting them into their
component parts.
The total exchange difference arises from: 11
 Translating income/expense items using an average rate, whereas assets/liabilities are translated
at the closing rate.
 Translating the opening net investment (opening net assets) in the foreign entity at a closing rate
different from the closing rate at which it was previously reported.
Using the opening statement of financial position and translating at opening rate of €2 = £1 and the
closing rate of €1 = £1 will produce the exchange differences as follows.
Exchange
€2 = £1 €1 = £1 difference
£ £ £
Non-current assets at carrying amount 170 340 170
Inventories 60 120 60
Net current monetary liabilities (25) (50) (25)
205 410 205
Equity 150 300 150
Loans 55 110 55
205 410 205
Translating the statement of profit or loss using average rate €1.60 = £1 and the closing rate €1 = £1
gives the following results.
Exchange
•€1.60
• = £1 ••€1 = £1 difference
£ £ £
Profit before tax, depreciation and
increase in inventory values 75 120 45
Increase in inventory values 50 80 30
125 200 75
Depreciation (25) (40) (15)
100 160 60
Tax (50) (80) (30)
Profit after tax, retained 50 80 30
The overall position is then:

£
Gain on non-current assets (£170  depreciation £15) 155
Loss on loan (55)
Gain on inventories (£60 + £30) 90
Loss on net monetary current assets/
liabilities (all other differences) (£45  £30  £25) (10)
Net exchange gain: as above 180

This can be simplified as:
£ £
Opening net assets of €300 at opening rate (€2:£1) 150
at closing rate (€1:£1) 300
150 gain
Retained profits of €80 at average rate (€1.6:£1) 50
at closing rate (€1:£1) 80
30 gain
180 gain

This exchange difference is recorded as other comprehensive income.
 The group share is included within total comprehensive income attributable to the shareholders of
the parent company (and so included in the group reserves calculation).
 The non-controlling interest share is included within total comprehensive income attributable to
the non-controlling interest.
5.4 Goodwill and fair value adjustments

Goodwill arising under IFRS 3 Business Combinations from the acquisition of a foreign operation should
initially be calculated in the functional currency of the subsidiary and then be treated as an asset of the
foreign operation and translated at the closing rate each year. The exchange difference arising is
recorded as other comprehensive income in the consolidated accounts and accumulated in group equity.
The carrying amount of goodwill in the presentation currency is therefore as affected by changes in
exchange rates as any other non-current asset. This may result in goodwill being allocated to an entity
for the purpose of foreign currency translation at a different level from that used for impairment testing,
which should continue to be determined based on IAS 36.
Adjustments made to the fair values of assets and liabilities of a foreign operation under IFRS 3 should be
treated in the same way as goodwill. The adjustments are recognised in the carrying amounts of the
assets and liabilities of the foreign operation in its functional currency. The adjusted carrying amounts
are then translated at the closing rate.
Illustration: Goodwill adjustment

On 31 December 20X4, ABC acquired 80% of DEF for £10 million when the carrying amount of DEF's
identifiable net assets was €8 million. The carrying amounts were the same as fair value except for land
which is not subject to depreciation and had a fair value of €1 million higher than carrying amount. The
carrying amount in DEF's financial statements was not altered.
The €/£ exchange rate was €2.4/£ at 31 December 20X4, and €2.5/£ at 31 December 20X5. The non-
controlling interest is measured using the proportion of net assets method.
The goodwill arising on consolidation was: €000
Non-controlling interest 20% x (€8m + €1m) 1,800
25,800
Net assets of acquiree (€8m + €1m) (9,000)
Goodwill 16,800
The goodwill arising on acquisition is therefore €16.8 million / 2.4 = £7 million. The fair value adjustment
in sterling amounted to €1m/2.4 = £416,667.
At 31 December 20X5, the goodwill is restated to £6.72 million (€16.8m /2.5) and the fair value
adjustment in sterling terms was £400,000 (€1m/2.5).
The requirement in an entity's own financial statements to recognise in profit or loss all exchange
differences in respect of monetary items which are part of an entity's net investment in a foreign
operation was dealt with earlier.
On consolidation, however, the differences should be recognised as other comprehensive income and
recorded in a separate component of equity. This treatment is required because exchange differences
arising from the translation of the operations' net assets will move in the opposite way. If there is an
exchange loss on the net investment, there will be an exchange gain on the net assets, and vice versa.
The two movements should be netted off, rather than one being recognised in profit or loss and the
other as other comprehensive income.

5.5 Net investment in foreign operation
C
When a monetary item is part of the net investment in a foreign operation (ie there is an intra group H
loan outstanding) then the following rules apply on consolidation. A
P
 If the monetary item is denominated in the functional currency of the parent entity the exchange T
difference will be recognised in the profit or loss of the foreign subsidiary. E
R
 If the monetary item is denominated in the functional currency of the subsidiary, exchange
differences will be recognised in the profit or loss of the parent entity.
 When the monetary item is denominated in the functional currency of either entity, on 11
consolidation, the exchange difference will be removed from the consolidated profit or loss and it
will be recognised as other comprehensive income and recorded in equity in the combined
 If, however, the monetary item is denominated in a third currency which is different from either
entity's functional currency, then the translation difference should be recognised as part of profit or
loss. For example, the parent may have a functional currency of US dollars, the foreign operation a
functional currency of euros, and the loan made by the foreign operation may have been
denominated in UK sterling. In this scenario, the exchange difference results in a cash flow
difference and should be recognised as part of the results of the group.
 A separate foreign currency reserve reported as part of equity may have a positive or negative
carrying amount at the reporting date. Negative reserves are permitted under IFRS.
 If the foreign operation is subsequently disposed of, the cumulative exchange differences previously
reported as other comprehensive income and recognised in equity should be reclassified and so
included in the profit or loss on disposal recognised in statement of profit or loss.
Illustration: Exchange changes

Some years ago ABC, whose functional currency is pounds sterling, made a long-term loan of £100,000 to
its wholly-owned subsidiary, DEF, whose functional currency is the euro. At 31 December 20X4, the
exchange rate was £1=€3, and at 31 December 20X5, was £1=€2.5.
At 31 December 20X4, €300,000 (£100,000 × 3) was a payable in DEF's financial statements. ABC carried
the receivable at £100,000, so on consolidation the two amounts cancelled out.
At 31 December 20X5, only €250,000 (£100,000 × 2.5) was a payable in DEF's financial statements, so in
20X5 DEF made an exchange gain of €50,000 in its own financial statements. On consolidation DEF's
payable still cancels out against ABC's £100,000 receivable.
However, on consolidation, the sterling equivalent of DEF's exchange gain (€50,000/2.5 = £20,000) is
eliminated from consolidated profit or loss and shown as part of total exchange differences reported as
other comprehensive income.
5.6 Consolidation when subsidiaries have different reporting dates

Where the reporting date of entities included in the consolidated financial statements of the group are
different, and in accordance with IFRS 10 an earlier set of financial statements is used for consolidation
purposes, there is an issue as to which exchange rate should be used, the one at the date of the earlier
set of financial statements, or the one at the reporting date of the consolidated financial statements.
Under IAS 21, for all subsidiaries, associates and joint ventures which are consolidated or equity
accounted, the relevant exchange rate is that ruling at the date to which the foreign operation's financial
statements were prepared. This reflects the fact that the foreign operation's results are prepared to its
reporting date and exchange differences should be calculated in a consistent way. However, IAS 21 goes
on to state that, where the exchange rate has significantly changed in the period between the foreign
operation's year end and that of the group, an adjustment should be made. This is consistent with the
approach in IFRS 10 for significant events that have happened in this intervening period. The same
approach is used in applying the equity method to associates and joint s in accordance with IAS 28
Investments in Associates and Joint Ventures .

5.7 Intra-group trading transactions
Where normal trading transactions take place between group companies located in different countries,
the transactions give rise to monetary assets or liabilities that may either have been settled during the
year or remaining unsettled at the reporting date.
Illustration: Intra-group trading

A UK-parent company has a wholly-owned subsidiary in the US. During the year ended 31 December
20X5, the US company purchased plant and raw materials to be used in its manufacturing process from
the UK parent. Details of transactions are as follows.
$/£
Purchase plant costing £500,000 on 30 April 20X5 1.48
Paid for plant on 30 September 20X5 1.54
Purchased raw materials costing £300,000 on 31 October 20X5 1.56
Balance of £300,000 outstanding at 31 December 20X5 1.52
Average rate for the year 1.55
The following exchange gains/losses will be recorded in the US subsidiary's statement of profit or loss for
the year ended 31 December 20X5.
$ $
Plant costing £500,000 @ 1.48 740,000
Paid £500,000 @ 1.54 770,000
Exchange loss – settled transaction (30,000)
Raw materials costing £300,000 @ 1.56 468,000

Outstanding £300,000 @ 1.52 456,000
Exchange gains – unsettled transaction 12,000
Net exchange loss recorded in profit or loss (18,000)
5.8 Inter-company dividends

Dividends paid in a foreign currency during a period by a subsidiary to its parent may lead to exchange
differences being reported in the parent's financial statements. This will be the case where the dividend is
recognised at the transaction date, being the date on which the parent recognises the receivable, but
receipt is not until a later date and exchange rates have moved during this period. As with other intra-
group exchange differences, these amounts should not be eliminated on consolidation.
5.9 Disposal of a foreign operation

On the disposal of a foreign operation, the cumulative amount of exchange differences which has been
reported as other comprehensive income and is accumulated in a separate component of equity relating
to the foreign operation, shall be recognised in profit or loss, along with gain or loss on disposal when it
is recognised.
Disposal may occur either through sale, liquidation repayment of share capital or abandonment of all, or
part of, the entity. The payment of the dividend is part of a disposal only if it constitutes a return of the
investment, for example, when the dividend is paid out of pre-acquisition profits. In the case of a partial
disposal, only the proportionate share of the related accumulated exchange difference is included in the
gain or loss. A write-down of the carrying amount of a foreign operation does not constitute a partial
disposal. Accordingly, no part of the deferred foreign exchange gain or loss is recognised in profit or loss at
the time of a write-down.
5.10 Tax effects of exchange differences

When there are tax effects arising from gains or losses on foreign currency transactions and exchange
differences arising on the translation of the financial statements of foreign operations IAS 12 Income
Taxes should be applied.

6 Disclosure C
H
A
Section overview P
T
 This section presents the relevant disclosure requirements. E
R
The disclosure requirements of IAS 21 are not particularly onerous, and assuming that an entity's
functional currency has not changed during the period, and its financial statements are presented in its
functional currency, it is only required to disclose: 11
 The amount of exchange differences reported in profit or loss for the period. This amount should
exclude amounts arising on financial instruments measured at fair value through profit or loss
under IAS 39; and
 The net exchange differences reported in other comprehensive income. This disclosure should
include a reconciliation between the opening and closing amounts.
In addition, when the presentation currency is different from the functional currency, that fact should
be stated and the functional currency should be disclosed. The reason for using a different
presentational currency should also be disclosed.
Where there is a change in the functional currency of either the reporting entity or a significant
foreign operation, that fact and the reason for the change in functional currency should be disclosed.
An entity may present its financial statements or other financial information in a currency that is
different from either its functional currency or its presentation currency. For example, it may convert
selected items only, or it may use a translation method that does not comply with IFRSs in order to deal
with hyperinflation. In this situation the entity must:
 Clearly identify the information as supplementary information to distinguish it from information
that complies with IFRSs;
 Disclose the currency in which the supplementary information is displayed; and
 Disclose the entity's functional currency and the method of translation used to determine the
supplementary information.
For publicity or other purposes, an entity may wish to display its financial statements using a currency
which is neither its functional nor its presentation currency; such information is not presented in
accordance with IFRS, so IAS 21 requires that it should be clearly identified as being supplementary.
7 Other matters
Section overview
 This section discusses a number of other matters such as non-controlling interests and taxation.
7.1 Non-controlling interests

 The figure for non-controlling interests in the statement of financial position will be the
appropriate proportion of the translated share capital and reserves of the subsidiary plus, where the
NCI is valued at fair value, its share of goodwill translated at the closing rate. In addition, it is
necessary to show any dividend declared but not yet paid to the NCI at the reporting date as a
liability. The dividend payable should be translated at the closing rate for this purpose.
 The non-controlling interest in profit or loss will be the appropriate proportion of profits
available for distribution. If the functional currency of the subsidiary is the same as that of the
parent, this profit will be arrived at after charging or crediting the exchange differences.

 The non-controlling interest in total comprehensive income includes the NCI proportion of the
exchange gain or loss on translation of the subsidiary financial statements. It does not, however
include any of the exchange gain or loss arising on the retranslation of goodwill.
Worked example: Consolidated financial statements

Extracts from the summarised accounts of Camrumite Inc are shown below.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3
€
Non-current assets 10,000
Net monetary assets 5,000
15,000
Equity
Ordinary share capital and reserves 15,000
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X3

€
Profit for the year 3,080
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X3

€
Profit for the year 3,080
Dividend paid 1,680
Retained profit 1,400
60% of the issued capital of Camrumite Inc is owned by Bates Co, a company based in the UK.
There have been no movements in long-term assets during the year.
The exchange rate has moved as follows.
1 January 20X3 € 5 = £1
Average for the year ended 31.12.X3 € 7 = £1
31 December 20X3 € 8 = £1
You are required to calculate the figures for the non-controlling interest to be included in the
consolidated accounts of Bates Co.
The non-controlling interest is measured using the proportion of net assets method.
Show the movements on the non-controlling interest accounts during the year.
Solution
Translating the shareholders' funds using the closing rate as at 31 December 20X3 gives €15,000  8 =
£1,875. The non-controlling interest in the statement of financial position will be 40%  £1,875 = £750.
The dividend payable translated at the closing rate is €1,680  8 = £210. The amount payable to the
non-controlling shareholders is 40%  £210 = £84.
The profit after tax translated at the average rate is €3,080  7 = £440. The non-controlling interest in
profit is therefore 40%  £440 = £176.
The non-controlling share of the exchange difference is calculated as:
Opening net assets £ £
€15,000 – €1,400 = €13,600 At opening rate of €5:£1 2,720
At closing rate of €8:£1 1,700 1,020
Profits of €3,080 At average rate of €7:£1 440

At closing rate of €8:£1 385 55
Loss on retranslation of Camrumite's accounts 1,075
NCI share of loss £1,075 × 40% 430

Therefore the non-controlling interest in total comprehensive income is profit of £84 less exchange
losses of £430 = £346 loss C
H
The non-controlling interest can be summarised as follows. A
£ P
Balance at 1 January 20X3 (£2,720 × 40%) 1,088 T
Non-controlling interest in profit for the year 176 E
Non-controlling interest in exchange losses (430) R
834
Balance at 31 December 20X3 750 11
Dividend payable to non-controlling interest 84
834
7.2 Tax effects

The tax effects of gains and losses on foreign currency translations are addressed by IAS 12 Income Taxes
and covered in Chapter 12.
7.3 First time adoption

IFRS 1 First Time Adoption of International Financial Reporting Standards includes an exemption that allows
the cumulative translation difference on the retranslation of subsidiaries' net assets to be set to zero for
all subsidiaries at the date of transition to IFRS.
This means that it does not have to be separately disclosed and recycled in profit or loss when the
subsidiaries are disposed of.
However, translation differences arising from the date of transition would have to be separately
disclosed as other comprehensive income, included in a separate component of equity and reclassified
to profit or loss on the investment's disposal.
In addition, the requirement to retranslate goodwill and fair value adjustments does not have to be
applied retrospectively to business combinations before transition to IFRS.
8 Reporting foreign currency cash flows
Section overview
 This section addresses the treatment of foreign currency cash flows in the statement of cash flows.
Transactions in foreign currency

 Where an entity enters into foreign currency transactions which result in an inflow or outflow of
cash, the entity should translate cash flows into its functional currency at the transaction date.
 Although transactions should be translated at the date that they occurred, for practical reasons IAS
21 permits the use of an average rate where it approximates to actual.
Foreign subsidiaries
A similar approach is required where an entity has a foreign subsidiary. The transactions of the subsidiary
should be translated into the reporting entity's functional currency at the transaction date.
Reporting translation differences
Although the translation of foreign currency amounts does not affect the cash flow of an entity,
translation differences relating to cash and cash equivalents are part of the changes in cash and cash
equivalents during a period. Such amounts should therefore form part of the statement of cash flows.
IAS 7 requires the effect of foreign currency to be reported separately from operating, investing and
financing activities. No specific location for the disclosure is provided; disclosure at the base of the
statement of cash flows would seem an appropriate presentation.

Where an entity adopts the indirect method of calculating cash flows from operating activities and it has
foreign currency amounts which have been settled during the period, no further adjustment is required
at the period end. This is because any foreign exchange difference will already include the amount of
the original foreign currency transaction and the actual settlement figure. An overseas purchase will be
recorded using the purchase date exchange rate and a payable will be recorded. On settlement, any
adjustment to the actual cash flow paid will be recognised in profit or loss as part of the entity's
operating activities.
Unsettled foreign currency amounts in relation to operating activities, such as trade receivables and
payables, are not adjusted at the period end because such amounts are retranslated at the reporting
date and the exchange difference is reported in profit or loss already. Where an entity uses the indirect
method for calculating its operating cash flows, it starts with the profit figure which will include the
retranslation difference, and the movement in the period for receivables and payables will also include a
similar amount. Since the two amounts effectively eliminate each other, no adjustment is required.
Further disclosures
It is important to note the Standard requires disclosure of significant cash and near cash balances that
the entity holds but which are not available to the group as for example, under a situation in which
exchange controls prohibit the conversion of cash transactions or balances.
Worked example: Foreign currency cash flows

On 15 November, an entity imported some plant and equipment costing $400,000 from an overseas
supplier, with $250,000 being paid on 31 December 20X5 and $150,000 being paid on 31 January
20X6.
The $/£ spot exchange rates were as follows.
$/£
15 November 20X5 2.0:1
31 December 20X5 1.9:1
31 January 20X6 1.8:1
Requirement
How should these transactions be reported within the statement of cash flows?
Solution
The purchase will initially be recorded at the rate ruling at the transaction date:
$400,000 / 2.0 = £200,000, with a trade payable of the same amount also being recognised.
At 31 December 20X5, the cash outflow will be recorded at the rate ruling at the transaction date:
$250,000 / 1.9 = £131,579
and the remaining trade payable, being a monetary liability, is translated at the same rate:
$150,000 / 1.9 = £78,947
The plant and equipment, a non-monetary asset, is carried at the historic rate of £200,000.
Only cash flows appear in the statement of cash flows, so £131,579 will be shown within investing
activities.

9 Reporting in hyperinflationary economies C
H
A
P
Section overview T
E
 IAS 29 requires financial statements of entities operating within a hyperinflationary economy to be R
restated in terms of measuring units current at the reporting date.
 Financial statements should be restated based on a measuring unit current at the reporting 11
date
– Monetary assets/liabilities do not need to be restated
– Non-monetary assets/liabilities must be restated by applying a general prices index
– Items of income/expense must be restated
– Gain/loss on net monetary items must be reported in profit or loss
In a hyperinflationary economy, money loses its purchasing power very quickly. Comparisons of
transactions at different points in time, even within the same accounting period, are misleading. It is
therefore considered inappropriate for entities to prepare financial statements without making
adjustments for the fall in the purchasing power of money over time.
IAS 29 Financial Reporting in Hyperinflationary Economies applies to the primary financial statements of
entities (including consolidated accounts and statements of cash flows) whose functional currency is the
currency of a hyperinflationary economy. In this section, we will identify the hyperinflationary currency
as $H.
The Standard does not define a hyperinflationary economy in exact terms, although it indicates the
characteristics of such an economy, for example, where the cumulative inflation rate over three years
approaches or exceeds 100%.
Worked example: Indicators of hyperinflation

What other factors might indicate a hyperinflationary economy?
Solution
These are examples, but the list is not exhaustive.
(a) The population prefers to retain its wealth in non-monetary assets or in a relatively stable foreign
currency. Amounts of local currency held are immediately invested to maintain purchasing power.
(b) The population regards monetary amounts not in terms of the local currency but in terms of a
relatively stable foreign currency. Prices may be quoted in that currency.
(c) Sales/purchases on credit take place at prices that compensate for the expected loss of purchasing
power during the credit period, even if that period is short.
(d) Interest rates, wages and prices are linked to a price index.
The reported value of non-monetary assets, in terms of current measuring units, increases over time.
For example, if a non-current asset is purchased for $H1,000 when the price index is 100, and the price
index subsequently rises to 200, the value of the asset in terms of current measuring units (ignoring
accumulated depreciation) will rise to $H2,000.
In contrast, the value of monetary assets and liabilities, such as a debt for 300 units, is unaffected by
changes in the prices index, because it is an actual money amount payable or receivable. If a customer
owes $H300 when the price index is 100, and the debt is still unpaid when the price index has risen to
150, the customer still owes just $H300. The purchasing power of monetary assets, however, will
decline over time as the general level of prices goes up.

9.1 Requirement to restate financial statements in terms of measuring units
current at the reporting date
In most countries, financial statements are produced on the basis of either:
 Historical cost, except to the extent that some assets (eg property and investments) may be
revalued, or
 Current cost, which reflects the changes in the values of specific assets held by the entity.
In a hyperinflationary economy, neither of these methods of financial reporting are meaningful unless
adjustments are made for the fall in the purchasing power of money. IAS 29 therefore requires that the
primary financial statements of entities in a hyperinflationary economy should be produced by
restating the figures prepared on either a historical cost basis or a current cost basis in terms of
measuring units current at the reporting date.
Definition
Measuring units current at the reporting date: This is a unit of local currency with a purchasing
power as at the reporting date, in terms of a general prices index.
Financial statements that are not restated (ie that are prepared on a historical cost basis or current cost
basis without adjustments) may be presented as additional statements by the entity, but this is
discouraged. The primary financial statements are those that have been restated.
After the assets, liabilities, equity and statement of profit or loss and other comprehensive income of the
entity have been restated, there will be a net gain or loss on monetary assets and liabilities (the 'net
monetary position') and this should be recognised separately in profit or loss for the period.
9.2 Making the adjustments

IAS 29 recognises that the resulting financial statements, after restating all items in terms of measuring
units current at the reporting date, will lack precise accuracy. However, it is more important that
certain procedures and judgements should be applied consistently from year to year.
9.3 Statement of financial position: historical cost

Where the entity produces its accounts on a historical cost basis, the following procedures should be applied.
 Items that are not already expressed in terms of measuring units current at the reporting date
should be restated, using a general prices index, so that they are valued in measuring units
current at the reporting date.
 Monetary assets and liabilities are not restated, because they are already expressed in terms of
measuring units current at the reporting date.
 Assets that are already stated at market value or net realisable value need not be restated,
because they too are already valued in measuring units current at the reporting date.
 Any assets or liabilities linked by agreement to changes in the general level of prices, such as
indexed-linked loans or bonds, should be adjusted in accordance with the terms of the agreement
to establish the amount outstanding as at the reporting date.
 All other non-monetary assets, ie tangible long-term assets, intangible long-term assets (including
accumulated depreciation/amortisation), investments and inventories, should be restated in terms
of measuring units as at the reporting date, by applying a general prices index.
The method of restating these assets should normally be to multiply the original cost of the assets by a
factor: [prices index at reporting date/prices index at date of acquisition of the asset]. For example, if an
item of machinery was purchased for $H2,000 when the prices index was 400 and the prices index at
the reporting date is 1,000, the restated value of the long-term asset (before accumulated depreciation)
would be:
$H2,000  [1,000/400] = $H5,000

If, in the above example, the non-current asset has been held for half its useful life and has no residual
value, the accumulated depreciation would be restated as $H2,500. (The depreciation charge for the C
year should be the amount of depreciation based on historical cost, multiplied by the same factor as H
A
above: 1,000/400).
P
If an asset has been revalued since it was originally purchased (eg a property), it should be restated in T
E
measuring units at the reporting date by applying a factor: (prices index at reporting date/prices index
R
at revaluation date) to the revalued amount of the asset.
If the restated amount of a non-monetary asset exceeds its recoverable amount (ie its net realisable
value or market value), its value should be reduced accordingly. 11
The owners' equity (all components) as at the start of the accounting period should be restated using a
general prices index from the beginning of the period.
9.4 Statement of profit or loss and other comprehensive income: historical

cost
In the statement of profit or loss and other comprehensive income, all amounts of income and expense
should be restated in terms of measuring units current at the reporting date. All amounts therefore
need to be restated by a factor that allows for the change in the prices index since the item of income
or expense was first recorded.
9.5 Gain or loss on net monetary position

In a period of inflation, an entity that holds monetary assets (cash, receivables) will suffer a fall in the
purchasing power of these assets. By the same token, in a period of inflation, the value of monetary
liabilities, such as a bank overdraft or bank loan, declines in terms of current purchasing power.
 If an entity has an excess of monetary assets over monetary liabilities, it will suffer a loss over
time on its net monetary position, in a period of inflation, in terms of measuring units as at 'today's
date'.
 If an entity has an excess of monetary liabilities over monetary assets, it will make a gain on its
net monetary position, in a period of inflation.
10 IFRS and UK GAAP comparison
Section overview
 This section provides a brief comparison of the IFRS and UK GAAP accounting for foreign currency
amounts.
The ASB issued FRS 23 The Effects of Changes in Foreign Exchange Rates in December 2004. FRS 23 which
derives from IAS 21 and replaces SSAP 20 is effective from periods from 1 January 2006. Whereas IAS 21
and SSAP 20 had significant differences, FRS 23 derives from IAS 21 and there are therefore virtually no
differences between IFRS and UK GAAP regarding foreign currency translation.
Similarly there are no examinable differences between IAS 29 and FRS 24 Financial Reporting in
Hyperinflationary Economies.

Summary
IAS 21 The Effects of Changes in Foreign Exchange Rates
Entity financial Group financial

statements statements
Determine functional Goodwill and fair value

currency adjustments on acquisition
- Primary indicators of foreign subsidiary are
- Secondary indicators - Expressed in functional
currency of subsidiary
- Translated at closing rate
Statement of Statement of Statement of

financial position comprehensive income cash flows
Initial recognition Exchange differences on Foreign currency cash flows

- Use spot exchange rate - Monetary items in profit or - Record in entity's
between functional and loss unless net investment functional currency by
foreign currency on date in foreign currency applying exchange rate
of the transaction - Non-monetary items in between functional
other comprehensive currency at date of cash
income or profit according flow
to where gain or loss - Cash flows of foreign
Subsequent reporting recognised subsidiary translated at the
dates - Net investment in foreign exchange rates between
- Monetary items at entity initially in other functional and foreign
closing rate comprehensive income currency at the dates of the
- Non-monetary items at and income statement on cash flows
historic cost at rate of disposal
transaction
- Non-monetary items at
fair value at exchange
rate when fair value
determined
IAS 29 Financial Reporting in Hyperinflationary Economies
Historical cost financial Current cost financial Economies ceasing to Selection and use of
statements statements be hyperinflationary the general price index
- Statement of financial - Statement of financial
position position
- Statement of - Statement of
comprehensive income comprehensive
- Gain or loss on net - Gain or loss on net
monetary position monetary position

Self-test
C
1 What is the difference between conversion and translation of foreign currency amounts? H
A
2 Define 'monetary' items according to IAS 21. P
T
3 How should foreign currency transactions be recognised initially in an individual entity's accounts? E
R
4 What factors must management take into account when determining the functional currency of a
foreign operation?
5 How should goodwill and fair value adjustments be treated on consolidation of a foreign 11
operation?
6 When can an entity's functional currency be changed?
7 Zephyria
The Zephyria Company acquired a foreign subsidiary on 15 August 20X6. Goodwill arising on the
acquisition was N$175,000.
Consolidated financial statements are prepared at the year end of 30 September 20X6 requiring
the translation of all foreign operations' results into the presentation currency of pounds sterling.
The following rates of exchange have been identified:
Historical rate at the date of acquisition N$1.321:£
Closing rate at the reporting date N$1.298:£
Average rate for Zephyria's complete financial year N$1.302:£
Average rate for the period since acquisition N$1.292:£
Requirement
In complying with IAS 21 The Effects of Changes in Foreign Exchange Rates, at what amount should
the goodwill be included in the consolidated financial statements?
8 Cacomistle
The Cacomistle Company operates in the mining industry. It acquired an overseas mining
subsidiary, The Vanbuyten Company, on 10 September 20X7. The functional currency of
Vanbuyten is the N$.
An initial review of the assets of Vanbuyten immediately after the acquisition found that it was
necessary to make a downward fair value adjustment to the carrying amount of one of its mines
amounting to N$225,000, due to adverse geological conditions. The mine had been acquired by
Vanbuyten on 4 October 20X3.
Cacomistle's consolidated financial statements were prepared to 31 December 20X7 and required
translation into the presentation currency which was pounds sterling.
Exchange rates were as follows:
4 October 20X3 N$1.292:£1
10 September 20X7 N$1.321:£1
31 December 20X7 N$1.298:£1
Average rate for 20X7 N$1.302:£1
Requirement
At what amount should the fair value adjustment be recognised in Cacomistle's consolidated
financial statements for the year ending 31 December 20X7 according to IAS 21 The Effects of
Changes in Foreign Exchange Rates?
9 Longspur
The Longspur Company is an aircraft manufacturer and its functional currency is pounds sterling.
Longspur ordered an item of plant from an overseas supplier at an agreed invoiced cost of
N$250,000 on 31 March 20X7.
The equipment was delivered and was available for use on 30 April 20X7. It has a 10-year life span
and no residual value.

31 March 20X7 £1:N$2.10
30 April 20X7 £1:N$2.07
31 December 20X7 £1:N$1.90
Average rate for 20X7 £1:N$2.05
Requirement
At what amount should depreciation on the equipment be recognised in Longspur's financial
statements for the year ending 31 December 20X7 under IAS 21 The Effects of Changes in Foreign
Exchange Rates?
10 Orton
The Orton Company is a retailer of artworks and sculptures. Orton has a year end of 31 December
20X7 and uses pounds sterling as its functional currency. On 28 October 20X7, Orton purchased
10 paintings from a supplier for N$920,000 each, a total of N$9,200,000.
28 October 20X7 £1:N$1.8
19 December 20X7 £1:N$1.9
31 December 20X7 £1:N$2.0
8 February 20X8 £1:N$2.4
Orton sold seven of the paintings for cash on 19 December 20X7 with the remaining three
paintings being sold on 8 February 20X8. All 10 of the paintings were paid for by Orton on 8
February 20X8.
Requirement
What exchange gain arises from the transaction relating to the paintings in Orton's financial
statements for the year ended 31 December 20X7 according to IAS 21 The Effects of Changes in
Foreign Exchange Rates?
11 Alder
On 1 January 20X7 The Alder Company made a loan of £9 million to one of its foreign subsidiaries,
The Culpeo Company. The loan in substance is a part of Alder's net investment in that foreign
operation. The functional currency of Culpeo is the R$.
Alder's consolidated financial statements were prepared to 31 December 20X7 and the
presentation currency is pounds sterling.
1 January 20X7 R$2.0:£1
31 December 20X7 R$1.8:£1
Requirement
How would the exchange gain or loss on the intra-group loan be recognised in the consolidated
financial statements of Alder for the year ending 31 December 20X7 according to IAS 21 The Effects
of Changes in Foreign Exchange Rates?
12 Porcupine
The Porcupine Company has a wholly-owned foreign subsidiary, The Jacktree Company, with net
assets at 1 January 20X7 of N$300 million. Jacktree made a profit for the year ending 31 December
20X7 of N$150 million. The functional currency of Jacktree is the N$.
Porcupine's consolidated financial statements were prepared to 31 December 20X7 and the
presentation currency is pounds sterling.
1 January 20X7 N$2.0:£1
31 December 20X7 N$3.0:£1
Average rate for 20X7 N$2.5:£1

Requirement
C
How would the exchange gain or loss on the investment in Jacktree be recognised in the H
consolidated financial statements of Porcupine for the year ending 31 December 20X7 according A
to IAS 21 The Effects of Changes in Foreign Exchange Rates? P
T
13 Soapstone E
R
On 31 December 20X6 The Soapstone Company acquired 60% of the ordinary shares in The Frew
Company for £700. Soapstone's functional currency is pounds sterling, while Frew's is the R$.
The summarised financial statements of Frew and the £:R$ exchange rates are as follows. 11
31 December 20X6 31 December 20X7

Identifiable assets less liabilities (= equity) R$500 R$730
Exchange rate £2.0:R$1 £3.0:R$1
The carrying amount of Frew's assets and liabilities are the same as their fair values and there has
been no impairment of goodwill.
The average exchange rate during 20X7 was £2.5:R$1. There was no change in Frew's share capital
during the year and it paid no dividends.
Requirement
Determine the following amounts that will appear in Soapstone's consolidated financial statements
for the year ended 31 December 20X7 in accordance with IAS 21 The Effects of Changes in Foreign
Exchange Rates.
(a) The carrying amount at 31 December 20X7 of the goodwill acquired in the business
combination, assuming that the non-controlling interest is valued as a proportion of the net
assets of the entity
(b) Soapstone's share of Frew's profit for the period
(c) The total foreign exchange gain reported as other comprehensive income in 20X7
14 Jupiter
Jupiter plc trades in the UK preparing accounts to 31 March annually.
On 31 December 20X6 Jupiter plc acquired 90% of the issued ordinary capital of Mars Inc which
trades in Intergalatica where the currency is the Gal. At 31 March 20X7 the following statements of
financial position were prepared.
Jupiter plc Mars Inc
£'000 Gal'000
Property, plant and equipment 148,500 197,400
Financial asset investments 85,000 –
Net current assets 212,800 145,500
446,300 342,900
Capital – ordinary £1/1 Gal 300,000 150,000
Retained earnings – At 31 March 20X7 53,300 132,900
353,300 282,900
Long-term loans 93,000 60,000
446,300 342,900
Relevant data is as follows.

(1) The profit of both companies accrues reasonably evenly throughout the year. Jupiter plc and
Mars Inc had retained earnings of £18.9 million and 24.9 million Gal respectively for the year
ended 31 March 20X7.
(2) The parent company's long-term loans include an amount borrowed from a Swiss bank (to
build a new factory). 50.4 million Swiss francs were borrowed on 1 July 20X5 when the
exchange rate was 2.1 francs = £1. The rate at 31 March 20X7 was 2.3 francs = £1. The loan
is recorded at the historic amount received in the statement of financial position.
(3) When finalising the purchase price of Mars Inc it was agreed that non-current assets were
already at fair value but that receivables required a write-down of 50,000,000 Gals. This has

not been adjusted in the books of the subsidiary. These receivables were still outstanding at
31 March 20X7.
(4) The non-current assets of Mars were acquired as follows:
Gal'000
5 May 20X5 100,400
1 February 20X7 97,000
(5) Rates of exchange were as follows:
Gal = £1
5 May 20X5 6.0
31 December 20X6 5.4
1 February 20X7 4.7
31 March 20X7 4.2
Average for the three months to 31 March 20X7 4.8
(6) The company has determined that goodwill at the year end has been impaired by 10% of its
value in Gals. The impairment event arose on 31 March 20X7.
(7) Jupiter measures the non-controlling interest using the proportion of net assets method.
Requirement
Prepare the consolidated statement of financial position of Jupiter group as at 31 March 20X7 in
accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates.
Foreign currency cash flows
15 Cardamom
The Cardamom Company operates in the heavy engineering sector and has the pound sterling as
its functional currency.
On 30 September 20X7 Cardamom imported a crane from an overseas supplier, The Venilia
Company. The total cost of the crane was R$3,000,000. Under the terms of the contract
Cardamom was to pay Venilia R$2,000,000 on 31 October 20X7 and R$1,000,000 on 31 March
20X8. Cardamom does not hedge its foreign currency cash flows.
The R$/£ spot exchange rates were as follows.
R$ / £
30 September 20X7 3.0 : 1
31 October 20X7 2.5 : 1
31 December 20X7 2.2 : 1
31 March 20X8 2.0 : 1
Requirement
What should be the cash outflow in the statement of cash flows of Cardamom for the year ending
31 December 20X7 under Investing Activities in respect of the purchases of the crane, in
accordance with IAS 7 Statement of Cash Flows?
16 Rostock
The Rostock Company operates in Sidonia and its functional currency is the N$. The Sidonian
economy has deteriorated to such an extent that it became necessary for Rostock to apply IAS 29
Financial Reporting in Hyperinflationary Economies, with effect from 1 January 20X7. At that date
Rostock's statement of financial position was summarised as follows.
N$ N$
Property, plant and equipment 27,600 Share capital 8,000
Trade receivables 10,800 Revaluation reserve 7,000
Cash 1,300 Retained earnings 11,300
Trade payables (13,400)
26,300 26,300
The share capital was issued on the date the company was formed, 1 January 20X5. The property,
plant and equipment was acquired on the same date and revalued on 30 September 20X5. The

trade payables were acquired on 30 September 20X6 and the trade receivables on 31 December
20X6. C
H
The general price index of Sidonia has been as follows. A
20X5 20X6 20X7 P
1 January 500 700 900 T
30 September 600 800 E
R
31 December 700 900
Average for the year 580 780
Requirement 11
What amount should be recognised in the statement of financial position of Rostock at 1 January
20X7 in respect of retained earnings after the adjustments required by IAS 29?

Technical reference
Functional currency
 Currency that influences sales prices and costs IAS 21.9
Initial recognition
 Foreign currency transaction to be recorded in functional currency at spot IAS 21.21
exchange rate at date of transaction
Reporting at subsequent reporting dates IAS 21.23
 Foreign currency monetary items using the closing rate

 Foreign currency non-monetary items measured at historical cost in foreign
currency translated at exchange rate at date of transaction
 Foreign currency non-monetary items measured at fair value in foreign currency
translated at exchange rate at date when fair value determined
Recognition of exchange differences

 Exchange differences arising on settlement or translation of monetary items at IAS 21.28
rate different from those at which they were translated on initial recognition
recognised in profit or loss in period in which they arise (unless these arise in
relation to an entity's net investment in a foreign operation – see IAS 21.32
below)
 When gain or loss on a non-monetary item is recognised directly in other IAS 21.30
comprehensive income any exchange component of gain or loss should also be
recognised in other comprehensive income
 Exchange differences arising on a monetary item that forms part of a reporting IAS 21.32
entity's net investment in a foreign operation shall be recognised:
– In profit or loss in the separate financial statements of reporting entity or
the individual financial statements of foreign operation
– In other comprehensive income (a separate component of equity) in the
consolidated financial statements and reclassified from equity to profit or
loss on disposal
Change in functional currency
 Translation procedures to be applied prospectively from date of change IAS 21.35
Use of presentation currency other than the functional currency

 Translation into presentation currency for consolidation IAS 21.38-39
Translation of foreign operation

 Any goodwill arising on the acquisition of a foreign operation and any fair value IAS 21.44
adjustments shall be expressed in the functional currency of the foreign
operation and translated at the closing rate

IAS 7.25-26
C
 Non-cash transactions H
A
IAS 7.43 P
– The statement of cash flows does not record non-cash transactions
T
 Disclosures IAS 7.50 E
R
– Components of cash and cash equivalents Appendix A
– Reconciliation of the amounts in the statement of cash flows with the

equivalent balance in the statement of financial position 11
– Information (together with a commentary) which may be relevant to the
users
 Scope IAS 29.1
 Restatement of financial statements IAS 29.5-10
 Historical cost financial statements
– Statement of financial position IAS 29.11-25
– Statement of profit or loss and other comprehensive income IAS 29.26
– Gain or loss on net monetary position IAS 29.27-28
 Current cost financial statements
– Statement of financial position IAS 29.29
– Statement of profit or loss and other comprehensive income IAS 29.30
– Gain or loss on net monetary position IAS 29.31
 Taxes IAS 29.32
 Statement of cash flows IAS 29.33
 Corresponding figures IAS 29.34
 Consolidated financial statements IAS 29.35
 Selection and use of the general price index IAS 29.37
 Economies ceasing to be hyperinflationary IAS 29.38
 Disclosures IAS 29.39-40

1 (a) Conversion is the process of physically exchanging one currency for another.
(b) Translation is the restatement of the value of one currency in another currency.
2 Money held and assets and liabilities to be received or paid in fixed or determinable amounts of
money.
3 Use the exchange rate at the date of the transaction. An average rate for a period can be used if
the exchange rates did not fluctuate significantly.
4 Primary factors used in the determination of the functional currency include the currency of the
country that influences sales price for goods and services, labour, material and other costs and
whose competitive forces and regulations determine these prices and costs.
Secondary indicators include the currency in which funding and receipts from operating activities
arise.
5 Treat as assets/liabilities of the foreign operation and translate at the closing rate.
6 Only if there is a change to the underlying transactions relevant to the entity.
7 Zephyria
£134,823
Goodwill is translated at the closing rate. Therefore N$175,000/1.298 = £134,823. See IAS 21
IN15 and 57.
8 Cacomistle
£173,344
Because IAS 21.47 treats fair value adjustments to the carrying amount of assets and liabilities
arising on the acquisition of a foreign operation as assets and liabilities of the foreign operation, it
requires them to be translated at the closing rate.
The correct answer is thus N$225,000/1.298 = £173,344.
9 Longspur
£8,052
IAS 21.21 and 22 require that an asset should be recorded initially at the date of the transaction,
which is the date it first qualifies for recognition. For property, plant and equipment this is when
the asset is delivered, which in this case is 30 April 20X7.
The equipment is a non-monetary asset and thus its carrying amount stays at the original
translated value per IAS 21.23(b). Depreciation on a non-monetary asset is charged from when it
becomes available for use and is treated in the same way as the related assets, so there is no
change from the exchange rate at initial recognition. The correct answer is therefore:
(N$250,000/10 years)  8/12 = N$16,667 translated at £1 : N$2.07 = £8,052.
10 Orton
£511,111
Exchange gain = (N$9,200,000/1.8) – (N$9,200,000/2.0) = £511,111
The exchange gain is determined with respect of the value of the trade payable at the year end (as
per IAS 21.23(a) monetary items such as trade payables are translated at the year-end exchange
rate). The N$ has weakened between the date of the transaction and the year end, so the cost of
settling the trade payable in terms of £ has reduced, thereby producing an exchange gain.
There is no gain or loss in respect of the revenue for the paintings sold, which is recorded at the
transaction date rate (IAS 21.21). There is no gain or loss on the paintings held in inventory which

in the year-end statement of financial position are translated at the transaction date rate (IAS
21.23(b)). C
H
11 Alder A
P
The loan would initially be recorded in the financial statements of Culpeo at the rate ruling on the T
transaction date (IAS 21.21), so £9 million  2.0 = R$18m. Under IAS 21.23 the amount payable at E
the year end is £9m  1.8 = R$16.2m. The difference is a gain (ie reduction in a liability) of R$1.8m R
in the financial statements of Culpeo.
This gain will be translated at the closing rate and is equal to £1.0m (R$1.8m/1.8). Since the loan is 11
part of the net investment, it is recognised as a separate component of equity as required by IAS
21.15 and IAS 21.32-33.
12 Porcupine
£60 million loss, recognised in equity
IAS 21.39 and 41 require that exchange differences in translation to the presentation currency are
recognised directly in equity.
£m £m
Net assets at 1 January 20X7 at last year's rate N$300 @ 2.0 150
Net assets at 1 January 20X7 at this year's rate N$300 @ 3.0 100 50 loss
Profit at average rate N$150 @ 2.5 60
Profit at 31 December 20X7 N$150 @ 3.0 50 10 loss
60 loss
13 Soapstone
(a) The goodwill acquired is calculated as: R$
Consideration transferred (£700/2) 350
Non-controlling interest (R$500 × 40%) 200
550
Net assets of acquiree (500)
Goodwill 50
Translated at acquisition (R$50 × 2) = £100
Retranslated at 31 December 20X7 (R$50 × 3) = £150
(b) As there has been no change in Frew's share capital during 20X7, the (R$730 – R$500) =
R$230 increase in equity represents Frew's profit for 20X7. This is translated at the £2.5:R$1
average rate as an approximation to the rates ruling at the date of each transaction, to give
£575, of which Soapstone's 60% share is £345 (IAS 21.39(b)-40).
(c) The amount reported as other comprehensive income is made up of the exchange difference
on the retranslation of Frew's accounts plus the exchange difference on the retranslation of
goodwill:
Retranslation of Frew's accounts
£ £
Net assets at 1 January 20X6 at opening rate R$500 @ 2.0 1,000
Net assets at 1 January 20X6 at closing rate R$500 @ 3.0 1,500 500 gain
Profit at average rate R$230 @ 2.5 575
Profit at closing rate R$230 @ 3.0 690 115 gain
615 gain
Retranslation of goodwill
£150 – £100 = £50 gain (part (a))
The overall exchange gain recognised as other comprehensive income is therefore £615 + £50
= £665.
Of this:
 £615  40% = £246 is attributable to the non-controlling interest
 (£615  60%) + £50 = £419 is attributable to the shareholders of the parent.

14 Jupiter plc
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X7
£'000
Tangible non-current assets (148,500 + 47,000) 195,500
Goodwill (W4) 54,641
Net current assets (212,800 + 22,738) 235,538
485,679
Share capital 300,000
Foreign exchange reserve (W6) 24,451
374,935
Non-controlling interest (W7) 5,545
Long-term loans (90,913 (W3) + 14,286) 105,199
485,679
WORKINGS
(1) Translation of the statement of financial position of Mars Inc
Gal'000 Gal'000 Rate £'000
Tangible non-current assets 197,400 4.2 CR 47,000
Net current assets 145,500
Less Receivables w/d 50,000
95,500 4.2 CR 22,738
292,900 69,738
Share capital 150,000 5.4 HR 27,778
Pre-acquisition reserves (W2) 76,675 5.4 HR 14,199
Post-acquisition reserves (24,900  3/12) 6,225 ß 13,475
(incl exchange differences to date) 232,900 55,452
Long-term liabilities 60,000 4.2 CR 14,286
292,900 69,738
(2) Pre-acquisition reserves

Gal'000
Balance at 31 March 20X7 132,900
Less Earnings post-acquisition (24,900  3/12) (6,225)
Reserves at 31 December 20X6 126,675
Less Write down of receivables (50,000)
Pre-acquisition reserves 76,675
(3) Jupiter plc loans (retranslated at closing rate)

£'000 £'000
Long term liability per SFP 93,000
Revaluation of Swiss Franc loan
SF50.4m / 2.1 24,000
SF50.4m / 2.3 (21,913)
Gain on remeasurement 2,087
Remeasured long term liabilities 90,913
(4) Goodwill
Gal'000 £000
Consideration transferred (£85 million × 5.4) 459,000
(Gal 150m + Gal 76.675m) × 10% 22,668
481,668
Net assets of acquiree (150m + 76.675m) (226,675)
Goodwill 254,993 @HR 5.4 47,221
Impairment (25,499) @CR 4.2 (6,071)
Exchange gain (β) 13,491
Carrying value 229,494 @CR4.2 54,641

Proof of exchange gain: £'000
Initial value of goodwill Gal 254,993,000 @HR 5.4 47,221 C
H
@CR 4.2 60,712
A
Overall exchange gain 13,491 P
T
(5) Consolidated retained earnings E
£'000 R
Jupiter plc 53,300
Share of post acquisition profits in Mars
(90% × Gal 24.9 million × 3/12m) @ AR 4.8 1,168
11
Gain on Swiss Franc loan (W3) 2,087
Impairment of goodwill (W4) (25,499/4.2) (6,071)
50,484
(6) Foreign exchange reserve

£'000
Exchange gain on goodwill (W4) 13,491
Group share of exchange gain on retranslation of subsidiary (W8) 10,960
24,451
(7) Non-controlling interest (from W1)

£'000
10% x (£69,738 - £14,286) 5,545
(8) Exchange difference on retranslation of subsidiary

£'000 £'000
Opening net assets (acquisition) Gal @ HR 5.4 41,977
226,675,000
@ CR 4.2 53,970 Gain 11,993
Retained profits since acquisition
Gal 24.9 million × 3/12 = Gal 6.225 million @ AR 4.8 1,297
@ CR 4.2 1,482 Gain 185
Gain 12,178
Group share £12,178,000 × 90% 10,960
15 Cardamom
£800,000
IAS 7.25 requires cash flows from foreign currency transactions to be recorded by reference to the
exchange rate at the date of the cash flow.
Only the October 20X7 flow falls within the year ended 31 December 20X7, so the outflow is
R$2,000,000 at 2.5 = £800,000
16 Rostock
N$25,700
The only asset requiring adjustment is the PPE, from date of revaluation to 1 January 20X7, so it is
restated to N$41,400 (N$27,600 × 900/600) (IAS 29.18). The other assets and the trade payables
are monetary items which require no adjustment (IAS 29.12). So the restated equity is N$40,100
(N$41,400 – N$27,600 + N$26,300).
At the beginning of the first period of application of IAS 29, share capital is restated from the date
of contribution, the revaluation surplus is eliminated and retained earnings are the balancing figure
(IAS 29.24). Retained earnings are N$25,700 (N$40,100 – N$8,000 × 900/500).


The £ value of the loan is recorded as £4m (€10/2.5). The UK company suffered an exchange loss of
£1m.

Assumption 1: All the tables were sold on 20 December 20X5 and were paid for on 15 December
20X5.
Purchases = $3,600,000 ÷ 1.8 = £2 million
Purchases are recorded at the exchange rate on the date of the original transaction.
Exchange gain on settlement of payable = ($3,600,000 ÷ 1.8) – ($3,600,000 ÷ 1.9) = £105,263
The $ has weakened between the date of the transaction and the date of settlement; so the cost of
settling the trade payable in terms of £s has reduced thereby producing an exchange gain which is
No balances are outstanding as all the inventories have been sold and the trade payable is settled before
the year end.
Assumption 2: All the tables were sold on 3 February 20X6 and were paid for on 15 December
20X5.
Exchange gain on settlement of payable = £105,263
The impact on profit or loss is as for Assumption 1 as the trade payable was settled on the same day.
Inventories = $3,600,000 ÷ 1.8 = £2 million
All the purchases were held in inventory at the year end. As a non-monetary item inventories remain at
their original cost (ie at the exchange rate at the date of the original purchase).
Assumption 3: All the tables were sold on 15 December 20X5 and were paid for on 3 February
20X6.
Profit or loss
Exchange gain on year end retranslation of payable = ($3,600,000 ÷ 1.8) – ($3,600,000 ÷ 2.0) =
£200,000
The exchange gain is now determined with respect to the value of the trade payable at the year end (as
a monetary item trade payables are translated at the year end exchange rate). The $ has weakened
between the date of the transaction and the year end, so the cost of settling the trade payable in terms
of £s has reduced, thereby producing an exchange gain, which is recognised in profit or loss. The
remainder of any exchange gain/loss between the year end and the date of eventual settlement is
recognised in the 20X6 financial statements.

C
Inventories = Nil. All the inventory is sold during the year. H
A
Trade payables = ($3,600,000 ÷ 2.0) = £1,800,000
P
As a monetary item, trade payables are translated at the year end exchange rate. T
E
Assumption 4: 75 of the tables were sold on 15 December 20X5 with the remaining 25 tables sold R
on 3 February 20X6. All the tables were paid for on 3 February 20X6.
11
Exchange gain on year end retranslation of payable = ($3,600,000 ÷ 1.8) – ($3,600,000 ÷ 2.0) =
£200,000
The explanation of the exchange gain is as for Assumption 3.
Inventories = 25% × ($3,600,000 ÷ 1.8) = £500,000
25% of the purchases were still held in inventory at the year end. As a non-monetary item these
inventories remain at their original cost (ie at the exchange rate at the date of the original purchase).

Management should value the land at £312,000 at 31 December 20X6.
The land is initially recognised at its original cost translated at the spot rate between Muritania lira and
the £ (ie £260,000) on acquisition. The value remains unchanged at 31 December 20X4 because
management determined there was no need for a revaluation in this period.
At 31 December 20X5, the land is valued at £250,000, which is the fair value as at 31 December 20X5
translated at the exchange rate on the same date, when the fair value was determined (IAS 21.23).
Entity A recognises a loss of £10,000 profit or loss on 31 December 20X5, because a decrease of the
carrying amount as a result of a revaluation is recognised in profit or loss (IAS 16.40).
At 31 December 20X6, the land is valued at £312,000. Entity A recognises a gain of £10,000 in profit or
loss. The gain of £10,000 is the reversal of the revaluation decrease as at 31 December 20X5.
The revaluation surplus of £52,000 is recognised in equity (IAS 16.39).

Petra Ltd will record its initial investment at £12,000 which is the cost of the shares (€24,000) translated
at the rate of exchange on the acquisition date. The statement of financial position of Hellenic Marble at
31 December 20X6 will be:
Exchange
€'000 rate £'000
Non-monetary asset 96 3 32
Share capital and retained earnings 24 8

Loan 72 3 24
32
The share capital and retained earnings is the balancing item and is reconciled as follows:
Translation of closing equity (€24,000@ €3/£1) £8,000
Translation of opening equity (€24,000@ €2/£1) £12,000
Loss therefore £4,000

CHAPTER 12
Income taxes
Introduction
Topic List
1 Current tax revised
2 Deferred tax – an overview
3 Identification of temporary differences
4 Measurement of deferred tax assets and liabilities
5 Recognition of deferred tax in the financial statements
6 Common scenarios
7 Group scenarios
8 Presentation and disclosure
9 Deferred tax summary
10 UK GAAP comparison – deferred tax
Technical reference
469
Introduction
 Determine the recognition and measurement for income taxes and their inclusion in the
financial statements
 Apply knowledge and understanding of the recognition and measurement of deferred tax
liabilities and deferred tax assets in particular circumstances through calculations
 Demonstrate knowledge of the key disclosure requirements of IAS 12

1 Current tax revised
Section overview
 Current tax is the amount payable to the tax authorities in relation to the trading activities of the
current period.
1.1 Background
Accounting for current tax is ordinarily straightforward. Complexities arise, however, when we consider
the future tax consequences of what is going on in the financial statements now. This is an aspect of tax
called deferred tax, which has not been covered in earlier studies and which we will look at in the next
C
section. IAS 12 Income Taxes covers both current and deferred tax. The parts of this Study Manual H
relating to current tax are fairly brief, as this has been covered at Professional level. A
P
T
1.2 Recognition of current tax liabilities and assets E
R
Current tax is the amount payable to the tax authorities in relation to the current trading activities.
IAS 12 requires any unpaid tax in respect of the current or prior periods to be recognised as a liability.
12
Conversely, any excess tax paid in respect of current or prior periods over what is due should be
recognised as an asset to the extent it is probable that it will be recoverable.
The tax rate to be used in the calculation for determining a current tax asset or liability is the rate that is
expected to apply when the asset is expected to be recovered, or the liability to be paid. These rates
should be based upon tax laws that have already been enacted (are already part of law) or substantively
enacted (have already passed through sufficient parts of the legal process that they are virtually certain
to be enacted) by the reporting date.
1.3 Measurement
Measurement of current tax liabilities (assets) for the current and prior periods is very simple. They are
measured at the amount expected to be paid to (recovered from) the tax authorities. The tax rates
(and tax laws) used should be those enacted (or substantively enacted) by the reporting date.
1.4 Recognition of current tax

Normally, current tax is recognised as income or expense and included in the net profit or loss for the
period. However, where tax arises from a transaction or event which is recognised as other
comprehensive income recognised directly in equity (in the same or a different period) rather than in
profit or loss, then the related tax should also be reported as other comprehensive income or reported
directly in equity. An example of such a situation is where, under IAS 8, an adjustment is made to the
opening balance of retained earnings due to either a change in accounting policy that is applied
retrospectively, or to the correction of a material error. Any related tax is therefore also recognised
directly in equity.
1.5 Presentation
In the statement of financial position, tax assets and liabilities should be shown separately.
Current tax assets and liabilities may be offset, only under the following conditions.
 The entity has a legally enforceable right to set off the recognised amounts.
 The entity intends to settle the amounts on a net basis, or to realise the asset and settle the liability
at the same time.
The tax expense (income) related to the profit or loss from ordinary activities should be shown on the
face of the statement of profit or loss and other comprehensive income as part of profit or loss for the
period. The disclosure requirements of IAS 12 are extensive and we will look at these later in the
chapter.
Income taxes 471

2 Deferred tax – an overview
Section overview
 Deferred tax is an accounting measure used to match the tax effects of transactions with their
accounting impact and thereby produce less distorted results. It is not a tax levied by the
government that needs to be paid.
2.1 Accounting profits v taxable profits

Although accounting profits form the basis for computing taxable profits, on which the tax liability for
the year is calculated, accounting profits and taxable profits are often different for two main reasons:
 Permanent differences
 Temporary differences
2.1.1 Permanent differences

These arise when items of revenue or expense included in the accounting profit are excluded from the
computation of taxable profits.
Eg  Client entertaining expenses are not tax allowable in the UK
 UK companies are not taxed on dividends from other UK companies
Note that IAS 12 does not refer to the term 'permanent differences'; this is a UK GAAP term.
2.1.2 Temporary differences

These arise when items of revenue or expense are included in both accounting profits and taxable
profits, but not in the same accounting period. For example, both depreciation and capital allowances
write off the cost of a non-current asset, however not necessarily at the same rate and over the same
period.
Illustration: Temporary differences 1

A company buys an item of machinery on the first day of the financial year, 1 January 20X0, at a cost of
£100,000 and applies straight line depreciation at a rate of 10%. Capital allowances are available at
20% reducing balance.
y/e 31 December Depreciation (10% SL) Capital allowances (20% RB)
20X0 £10,000 £20,000
20X1 £10,000 £16,000
20X2 £10,000 £12,800
20X3 £10,000 £10,240 and so on
Therefore in 20X0, accounting profits are reduced by £10,000 but taxable profits are reduced by
£20,000, so providing one reason why the tax charge is not equal to the tax rate multiplied by the
accounting profit.
At this point it could be said that the temporary difference is equal to the £10,000 difference between
depreciation and capital allowances.
In the long run, the total taxable profits and total accounting profits will be the same (except for
permanent differences). In other words, temporary differences which originate in one period will reverse
in one or more subsequent periods.
Deferred tax is an accounting adjustment to smooth out the discrepancies between accounting profit
and the tax charge caused by temporary differences.

2.2 Calculating and accounting for deferred tax
In order to calculate deferred tax, the following steps must be taken:
1 Identify temporary differences
2 Apply the tax rate to the temporary differences to calculate deferred tax asset or liability
3 Recognise the resulting deferred tax amount in the financial statements
Identification of temporary differences
Above we have considered temporary differences as being the product of income or expenditure being
recognised in accounting and taxable profit in different periods.
IAS 12, however, requires that a 'net assets approach' rather than an 'income statement approach' is
taken to calculate temporary differences.
C
Applying this approach to the illustration seen above, we would simply compare the carrying amount H
and the tax written down value rather than depreciation and capital allowances in order to calculate the A
temporary difference: P
£ T
E
Carrying amount (£100,000 - £10,000) 90,000 R
Tax written down value (£100,000 - £20,000) 80,000
Temporary difference 10,000
The identification of temporary differences is covered in more detail in section 3. 12
Apply the tax rate to temporary differences to calculate deferred tax asset or liability
The tax rate to be used is not necessarily the current tax rate. It should be the rate which is expected to
apply to the period when the asset is realised or liability settled.
This is covered in more detail in section 4.
Record deferred tax in the financial statements
Depending on the circumstances, a deferred tax asset or liability may arise in the statement of financial
position. The corresponding entry is normally recorded in
 The tax charge in profit or loss, or
 Other comprehensive income
This is covered in more detail in section 5.
3 Identification of temporary differences
Section overview
 Temporary differences are calculated as the difference between the carrying amount of an asset or
liability and its tax base. Temporary differences may be classified as
– Taxable, or
– Deductible
3.1 Calculation of temporary differences

Temporary differences are calculated as the difference between:
 The carrying amount of the asset or liability in the statement of financial position
 The 'tax base' of the asset or liability
3.1.1 Tax base
Definition
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
Income taxes 473

Assets
The tax base of an asset is the value of the asset in the current period for tax purposes. This is either:
 The amount that will be tax deductible in the future against taxable economic benefits when the
carrying amount of the asset is recovered, or
 If those economic benefits are not taxable, the tax base is equal to the carrying amount of the
asset.
Liabilities
 The tax base of a liability is its carrying amount less any amount that will be tax deductible in the
future.
 For revenue received in advance, the tax base of the resulting liability is its carrying amount less
any amount of the revenue that will not be taxable in future periods.
IAS 12 guidance
IAS 12 states that in the following circumstances, the tax base of an asset or liability will be equal to its
carrying amount:
 Accrued expenses that have already been deducted in determining an entity's tax liability for the
current or earlier periods.
 A loan payable that is measured at the amount originally received and this amount is the same as
the amount repayable on final maturity of the loan.
 Accrued income that will never be taxable.
Illustration: Tax base

Current liabilities include accrued fines and penalties with a carrying amount of £100. These fines and
penalties are not deductible for tax purposes.
The tax base of the accrued fines and penalties is £100 (ie equal to the carrying amount because the
amount which will be deducted for tax purposes in a future period is nil).
As the tax base equals the statement of financial position carrying amount there is no temporary
difference and no deferred tax implications.
Worked example: Tax base

Scenario 1 – An entity's current assets include insurance premiums paid in advance of £20,000, for
which a tax deduction will be allowed in future periods.
The tax base of the insurance premiums is £20,000, because the whole carrying amount will be
deductible for tax purposes in future periods.
Scenario 2 – An entity has recognised a current liability of £400,000 in respect of income received in
advance, which will be taxed in future periods.
The tax base of the liability is its £400,000 carrying amount.
Scenario 3 – An entity has recognised a defined benefit liability of £500,000 in respect of a defined
benefit retirement plan, but no tax deduction is allowed until contributions are paid into the plan.
The tax base of the liability is nil, because the whole carrying amount will be deductible for tax purposes
in future periods.
Scenario 4 – Two years ago, an entity recognised a non-current asset at its £1 million cost. Tax
depreciation is allowed on the full cost at 15% per annum on a straight-line basis.
The tax base of the non-current asset is £700,000. 15% of cost has been allowed for tax purposes in
each of the two years, the tax base is therefore the 70% of cost which will be deductible for tax
purposes in future periods.

Interactive question 1: Tax base [Difficulty level: Intermediate]
State the tax base of each of the following items.
(a) Current liabilities include accrued expenses with a carrying amount of £1,000. The related expense
will be deducted for tax purposes on a cash basis.
(b) Current liabilities include interest revenue received in advance, with a carrying amount of £10,000.
The related interest revenue was taxed on a cash basis.
(c) Current assets include prepaid expenses with a carrying amount of £2,000. The related expense
has already been deducted for tax purposes.
(d) A loan payable has a carrying amount of £1m. The repayment of the loan will have no tax
consequences.
C
See Answer at the end of this chapter. H
A
P
T
E
3.2 Types of temporary difference R
IAS 12 makes a distinction between two types of temporary difference:
 Taxable temporary differences 12
 Deductible temporary differences
3.2.1 Taxable temporary differences

 Taxable temporary differences arise where the carrying amount exceeds the tax base.
 They result in a deferred tax liability
Definitions
Taxable temporary differences are temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability
is recovered or settled.
Deferred tax liabilities: are the amounts of income taxes payable in future periods in respect of taxable
temporary differences.
Worked example: Temporary differences

Scenario 1 – An entity recognised a non-current asset at its £1 million cost two years ago. Tax
depreciation is allowed on the full cost at 15% per annum straight line, while accounting depreciation is
at 10% per annum straight-line.
The tax base of the non-current asset is £700,000, but the carrying amount is £800,000. The taxable
temporary difference is therefore the difference of £100,000.
Scenario 2 – An entity has issued £400,000 of debt redeemable in five years, incurring £20,000 of issue
expenses. The issue expenses have been deducted from the liability and are being amortised over the
five-year life of the debt. To date, £5,000 has been amortised, but the whole £20,000 has been allowed
as a tax deduction.
The tax base of the liability is its £400,000 carrying amount less the £nil amount which is deductible for
tax purposes in future periods. The carrying amount is £385,000 and the taxable temporary difference is
therefore the difference of £15,000.
3.2.2 Deductible temporary differences

 Deductible temporary differences arise where the tax base exceeds the carrying amount.
 These result in a deferred tax asset.
Income taxes 475

Definitions
Deductible temporary differences are temporary differences that will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
Deferred tax assets: are the amounts of income taxes recoverable in future periods in respect of:
 Deductible temporary differences
 The carry forward of unused tax losses/unused tax credits
Illustration: Temporary differences 2

A factory was purchased for £4 million and has been given cumulative capital allowances of £1 million.
It therefore has a tax base of £3 million.
Assumption 1 If the carrying amount of the factory in the statement of financial position is £3.5
million, then there is a taxable temporary difference of £500,000. (Note: where
capital allowances claimed are cumulatively greater than accounting depreciation,
this is sometimes referred to as 'accelerated' as the tax allowances have been
awarded sooner than accounting depreciation has been recognised).
Assumption 2 If instead, the carrying amount of the factory in the statement of financial position is
£2 million, then there is a deductible temporary difference of £1 million.
3.3 Temporary differences with no deferred tax impact

A deferred tax liability or asset should be recognised for all taxable and deductible temporary differences
unless they arise from:
 The initial recognition of goodwill, or
 The initial recognition of an asset or liability in a transaction which
– Is not a business combination, and
– At the time of the transaction, affects neither accounting nor taxable profit.
Examples of initial recognition of assets or liabilities with no deferred tax effect
Examples of initial recognition of assets or liabilities in a transaction which does not affect either
accounting or taxable profit at the time of the transaction are:
1 An intangible asset with a finite life which attracts no tax allowances. In this case, taxable profit is
never affected, and amortisation is only charged to accounting profit after the transaction.
2 A non-taxable government grant related to an asset which is deducted in arriving at the carrying
amount of the asset. For tax purposes it is not deducted from the tax base.
Although a deductible temporary difference arises in both cases (on initial recognition in the second
case, and subsequently in the first case), this is not permitted to be recognised as a deferred tax asset as
it would make the financial statements less transparent.
Worked example: Initial recognition

As another example of the principles behind initial recognition, suppose Petros Co intends to use an
asset which cost £10,000 in 20X7 throughout its useful life of five years. Its residual value would then be
nil. The tax rate is 40%. Any capital gain on disposal would not be taxable (and any capital loss not
deductible). Depreciation of the asset is not deductible for tax purposes.
Requirement
State the deferred tax consequences in each of the years 20X7 and 20X8.

Solution
20X7
To recover the carrying amount of the asset, Petros will earn taxable income of £10,000 and pay tax of
£4,000. The resulting deferred tax liability of £4,000 would not be recognised because it results from
the initial recognition of the asset.
20X8
The carrying value of the asset is now £8,000. In earning taxable income of £8,000, Petros will pay tax
of £3,200. Again the resulting deferred tax liability of £3,200 is not recognised, because it results from
the initial recognition of the asset.
C
H
3.4 Summary A
P
The following diagram summarises the calculation and types of temporary difference: T
E
R
Tax treatment
differs from
accounting
12
treatment
Temporary differences
Tax base < Tax base = Tax base >

carrying amount carrying amount carrying amount
Taxable Deductible
No deferred tax
temporary temporary
implications
difference difference
Deferred tax Deferred tax

liability asset
Income taxes 477

Worked example: Tax base of assets
1 A machine cost £100,000. For tax purposes, capital allowances of £30,000 have already been
deducted in the current and prior periods; and the remaining cost will be deductible in future
periods. Assume that revenue generated by using the machine is taxable, any gain on disposal of
the machine will be taxable and any loss on disposal will be deductible for tax purposes. The
carrying amount of the machine for accounting purposes is £82,000.
The tax base of the machine is £70,000 as this remains to be deducted in future periods. There is a
taxable temporary difference of £12,000 (ie £82,000 - £70,000).
2 Interest receivable has a carrying amount of £1,000. The related interest revenue will be taxed on a
cash basis.
The tax base of the interest receivable is nil as the accrual is not recognised for tax purposes. There
is therefore a taxable temporary difference of £1,000.
3 Trade receivables have a carrying amount of £10,000. Assume that the related revenue has already
been included in taxable profit.
The tax base of the trade receivables is £10,000. (Note: the difference between this case and the
previous example is that in this case the amount has been included in both the accounting profit
and the taxable profit for the period, thus there is no future taxable impact.) As the tax base equals
the carrying amount there is no temporary difference and no deferred tax.
4 A loan receivable has a carrying amount of £8,000. The repayment of the loan will have no tax
consequences.
The tax base of the loan is £8,000, as there are no future tax consequences. Thus, as the tax base
equals the carrying value, there is no temporary difference and no deferred tax.
Worked example: Tax base of liabilities

In the following cases show and explain:
(a) The tax base
(b) Temporary differences
1 Current liabilities include accrued expenses with a carrying amount of £1,000. The related expense
will be deducted for tax purposes on a cash basis.
2 Current liabilities include accrued expenses with a carrying amount of £3,000. The related expense
has already been deducted for tax purposes.
3 A loan payable has a carrying amount of £5,000. The repayment of the loan will have no tax
consequences.
4 Current liabilities include interest revenue received in advance, with a carrying amount of £7,000.
The related interest revenue was taxed on a cash basis.
Solution
1 The tax base of the accrued expenses is nil. This is because the expenses have been recognised in
accounting profit, but the tax impact is yet to take effect. There is therefore a deductible temporary
difference of £1,000.
2 The tax base of the accrued expenses is £3,000, ie the carrying value (£3,000) less the amount
which will be deducted for tax purposes in future periods (nil, as relief has already been obtained).
There is no temporary difference, and no deferred tax arises.
3 The tax base of the loan is £5,000, as there are no future tax consequences. Thus, as the tax base
equals the carrying value, there is no temporary difference and no deferred tax.
4 The tax base of the interest received in advance is nil (ie the carrying value (£7,000) less the
amount which will not be taxable in future periods (£7,000, as it has all been charged already)). As
a result there is a deductible temporary difference of £7,000.

4 Measurement of deferred tax assets and liabilities
Section overview
 The tax rate is applied to temporary differences in order to calculate the deferred tax asset or
liability.
The tax rate should be applied to temporary differences in order to calculate deferred tax:
 Taxable temporary differences  tax rate = deferred tax liability
 Deductible temporary differences  tax rate = deferred tax asset
C
H
Worked example: Calculation of deferred tax A
P
A company purchased an asset costing £1,500. At the end of 20X8 the carrying amount is £1,000. The T
cumulative depreciation for tax purposes is £900 and the current tax rate is 25%. E
R
Requirement
Calculate the deferred tax liability for the asset.
12
Solution
The tax base of the asset is £1,500 – £900 = £600.
The carrying amount exceeds the tax base and therefore there is a taxable temporary difference of
£1,000 – £600 = £400. The entity must therefore recognise a deferred tax liability of £400  25% =
£100.
(In order to recover the carrying amount of £1,000, the entity must earn taxable income of £1,000, but
it will only be able to deduct £600 as a taxable expense. The entity must therefore pay income tax of
£400  25% = £100 when the carrying amount of the asset is recovered).
4.1 Tax rate

The tax rates that should be used to calculate deferred tax are the ones that are expected to apply in the
period when the asset is realised or the liability settled. The best estimate of this tax rate is the rate
which has been enacted or substantively enacted by the reporting date.
In the UK 2013 Budget which became the Finance Act 2013 the rate of corporation tax was cut to 23%.
A further reduction to 21% for 2014 has been announced but not yet substantively enacted at the time
of writing.
The Accounting Standards Board (ASB) has stated that substantive enactment occurs when any future
steps in the enactment process will not change the outcome. Specifically, in relation to the UK, the ASB
has stated that this occurs when the House of Commons passes a resolution under the Provisional
Collection of Taxes Act 1968.
Note that the tax rates used in this chapter are assumptions or hypothetical rates rather than real
rates.
Worked example: Tax rate

A Muldovian company enters into a long-term contract to build a motorway in that country. During the
year ended 31 December 20X3, the entity recognises £4 million of income on this contract even though
it is not expected to receive the related cash until the year ending 31 December 20X5.
Under the tax rules of Muldovia companies are charged tax on a cash receipts basis.
Income taxes 479

The tax rate for companies in Muldovia was 30 per cent in the year to 31 December 20X3, but their
government has voted in favour of a reduction to 29 per cent in 20X4. There is currently discussion of
the rate dropping to 28 per cent in 20X5, but as yet there is no agreement.
Requirement
What rate of tax should be used to determine the deferred tax balance?
Solution
A rate of 29% should be used. The rate is that expected to apply when the asset is realised, thus the rate
of 30% in 20X3, when the temporary difference originated, is not relevant. The 28% would be used if it
had been enacted or substantively enacted, but it is only under discussion. Thus, our best estimate of
the rate applying in 20X5, based upon laws already enacted or substantively enacted, is the rate for
20X4 (ie the previous year) of 29%.
4.1.1 Progressive rates of tax

In some countries, different tax rates apply to different levels of taxable income. In this case, an
average rate expected to apply to the taxable profit of the entity in the period in which the temporary
difference is expected to reverse should be identified and used to calculate the temporary difference.
4.1.2 Different rates of tax

Some countries also apply different rates of tax to different types of income eg one rate to profits and
another to gains.
Where this is the case, the tax rate used to calculate the deferred tax amount should reflect the manner in
which the entity expects to recover the carrying amount of assets or settle the carrying amount of
liabilities.
Worked example: Manner of recovery/settlement

Richcard Co has an asset with a carrying amount of £10,000 and a tax base of £6,000. If the asset were
sold, a tax rate of 20% would apply. A tax rate of 30% would apply to other income.
Requirement
State the deferred tax consequences if the entity:
(a) Sells the asset without further use.
(b) Expects to retain the asset and recover its carrying amount through use.
Solution
(a) A deferred tax liability is recognised of £(10,000 – 6,000)  20% = £800.
(b) A deferred tax liability is recognised of £(10,000 – 6,000)  30% = £1,200.
Interactive question 2: Recovery 1 [Difficulty level: Intermediate]

Emida Co has an asset which cost £100,000. In 20X9 the carrying amount was £80,000 and the asset
was revalued to £150,000. No equivalent adjustment was made for tax purposes. Cumulative
depreciation for tax purposes is £30,000 and the tax rate is 30%. If the asset is sold for more than cost,
the cumulative tax depreciation of £30,000 will be included in taxable income but sale proceeds in
excess of cost will not be taxable.
Requirement
State the deferred tax consequences of the above, assuming
(a) That the entity expects to recover the carrying amount through continued use of the asset

(b) That the entity expects to recover the carrying amount of the asset through sale
The manner of recovery may also affect the tax base of an asset or liability. Tax base should be
measured according to the expected manner of recovery or settlement.
Interactive question 3: Recovery 2 [Difficulty level: Intermediate]

The facts are as in Recovery 1 above, except that if the asset is sold for more than cost, the cumulative
tax depreciation will be included in taxable income (taxed at 30%) and the sale proceeds will be taxed
at 40% after deducting an inflation-adjusted cost of £110,000. C
H
Requirement A
State the deferred tax consequences of the above, assuming P
T
(a) That the entity expects to recover the carrying amount through continued use of the asset E
(b) That the entity expects to recover the carrying amount of the asset through sale R

12
4.2 Discounting
IAS 12 states that deferred tax assets and liabilities should not be discounted because the complexities
and difficulties involved will affect reliability. Discounting would require detailed scheduling of the
timing of the reversal of each temporary difference, but this is often impracticable. If discounting were
permitted, this would affect comparability.
Note however that where carrying amounts of assets or liabilities are discounted (eg a pension
obligation), the temporary difference is determined based on a discounted value.
5 Recognition of deferred tax in the financial statements
Section overview
 The deferred tax amount calculated is recorded as a deferred tax balance in the statement of
financial position with a corresponding entry to the tax charge, other comprehensive income or
goodwill.
5.1 Principles of recognition

As with current tax, deferred tax should normally be recognised as income or an expense amount within
the tax charge, and included in the net profit or loss for the period. Only the movement in the deferred
tax asset / liability on the statement of financial position is recorded:
Dr Tax charge X
Cr Deferred tax liability X
or
Dr Deferred tax asset X
Cr Tax charge X
Note that the recognition of a deferred tax asset may be restricted (see section 5.2)
Income taxes 481

Worked example: Deferred tax in the financial statements
An entity purchases a machine for £64,000 at the beginning of the year to 31 December 20X1. It has a
useful life of five years, and on 31 December 20X5 the asset is disposed of at a zero residual value. The
entity uses straight-line depreciation. The accounting year end is 31 December.
Assume that the machine qualifies for capital allowances, at a rate of 20 per cent per annum on a
reducing balance basis.
Assume that the rate of tax is 30 per cent.
Requirement
Show the deferred tax balance in the statement of financial position and the deferred tax charge for
each year of the asset's life.
Solution
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Carrying amount 51,200 38,400 25,600 12,800 0
Tax base 51,200 40,960 32,768 26,214 0
Taxable/(deductible) temporary 0 (2,560) (7,168) (13,414) 0
difference
Opening deferred tax liability/(asset) 0 0 (768) (2,150) (4,024)
Deferred tax expense/(credit) 0 (768) (1,382) (1,874) 4,024
Closing deferred tax liability/(asset) 0 (768) (2,150) (4,024) 0
5.1.1 Exceptions to recognition in profit or loss

 Deferred tax relating to items dealt with as other comprehensive income (such as a revaluation)
should be recognised as tax relating to other comprehensive income within the statement of profit
or loss and other comprehensive income.
 Deferred tax relating to items dealt with directly in equity (such as the correction of an error or
retrospective application of a change in accounting policy) should also be recognised directly in
equity.
 Deferred tax resulting from a business combination is included in the initial cost of goodwill (This
is covered in more detail later in the chapter).
Where it is not possible to determine the amount of current/deferred tax that relates to other
comprehensive income and items credited/charged to equity, such tax amounts should be based on a
reasonable pro rata allocation of the entity's current/deferred tax.
5.1.2 Components of deferred tax

Deferred tax charges will consist of two components:
(a) Deferred tax relating to temporary differences.
(b) Adjustments relating to changes in the carrying amount of deferred tax assets/ liabilities
(where there is no change in temporary differences), eg changes in tax rates/ laws, reassessment of
the recoverability of deferred tax assets, or a change in the expected recovery of an asset.
5.2 Deferred tax assets

A deferred tax asset must satisfy the recognition criteria given in IAS 12. These state that a deferred tax
asset should only be recognised to the extent that it is probable that taxable profit will be available
against which it can be utilised.
This is an application of prudence.

Worked example: Recognition of deferred tax asset
Pargatha Co recognises a liability of £10,000 for accrued product warranty costs on 31 December 20X7.
Assume that these product warranty costs will not be deductible for tax purposes until the entity pays
claims. The tax rate is 25%.
Requirement
State the deferred tax implications of this situation.
Solution
The carrying amount of the liability is (£10,000).
The tax base of the liability is nil (carrying amount of £10,000 less the amount that will be deductible
for tax purposes in respect of the liability in future periods). C
H
When the liability is settled for its carrying amount, the entity's future taxable profit will be reduced by A
£10,000 and so its future tax payments by £10,000  25% = £2,500. P
T
The carrying amount of (£10,000) is less than the tax base of nil and therefore the difference of £10,000 E
R
is a deductible temporary difference.
The entity should therefore recognise a deferred tax asset of £10,000  25% = £2,500 provided that it
is probable that the entity will earn sufficient taxable profits in future periods to benefit from a 12
reduction in tax payments.
5.2.1 Future taxable profits

When can we be sure that sufficient taxable profit will be available against which a deductible
temporary difference can be utilised?
IAS 12 states that this is assumed when:
 There are sufficient taxable temporary differences, and
 The taxable and deductible temporary differences relate to the same entity and same tax authority,
and
 The taxable temporary differences are expected to reverse either
– In the same period as the deductible temporary differences, or
– In periods in which a tax loss arising from the deferred tax asset can be utilised.
Insufficient taxable temporary differences
Where there are insufficient taxable temporary differences, a deferred tax asset may only be recognised
to the extent that:
 It is probable that taxable profits will be sufficient in the same period as the reversal of the
deductible temporary difference (ignoring taxable amounts arising from future deductible
temporary differences).
 Tax planning opportunities exist that will allow the entity to create taxable profit in the appropriate
periods.
If an entity has a history of recent losses, then this is evidence that future taxable profit may not be
available.
5.2.2 Reassessment of unrecognised deferred tax assets

For all unrecognised deferred tax assets, at each reporting date an entity should reassess the availability
of future taxable profits and whether part or all of any unrecognised deferred tax assets should now be
recognised. This may be due to an improvement in trading conditions which is expected to continue.
Income taxes 483

6 Common scenarios
Section overview
 There are a number of common examples which result in a taxable or deductible temporary
difference. This list is not, however exhaustive.
6.1 Taxable temporary differences

6.1.1 Accelerated capital allowances
 These arise when capital allowances for tax purposes are received before deductions for accounting
depreciation are recognised in the statement of financial position (accelerated capital allowances).
 The temporary difference is the difference between the carrying amount of the asset at the
reporting date and its tax written down value (tax base).
 The resulting deferred tax is recognised in profit or loss.
Interactive question 4: Initial recognition [Difficulty level: Intermediate]

Jonquil Co buys equipment for £50,000 at the start of 20X1 and depreciates it on a straight line basis
over its expected useful life of five years. For tax purposes, the equipment is depreciated at 25% per
annum on a straight line basis. Tax losses may be carried back against the taxable profit of the previous
five years. In 20X0, the entity's taxable profit was £25,000. The tax rate is 40%.
Requirement
Assuming nil profits / losses after depreciation in years 20X1 to 20X5, show the current and deferred tax
impact in years 20X1 to 20X5 of the acquisition of the equipment.
6.1.2 Interest revenue

 In some jurisdictions interest revenue may be included in profit or loss on an accruals basis, but
taxed when received.
 The temporary difference is equivalent to the income accrual at the reporting date as the tax base
of the interest receivable is nil.
6.1.3 Development costs

 Development costs may be capitalised for accounting purposes in accordance with IAS 38 while
being deducted from taxable profit in the period incurred (ie they receive immediate tax relief).
 The temporary difference is equivalent to the amount capitalised at the reporting date as the tax base
of the costs is nil since they have already been deducted from taxable profits.
6.1.4 Revaluations to fair value – property, plant and equipment

IFRS permits or requires some assets to be revalued to fair value, eg property, plant and equipment
under IAS 16.
Temporary difference
In some jurisdictions a revaluation will affect taxable profit in the current period. In this case, no
temporary difference arises as both carrying value and the tax base are adjusted.
In other jurisdictions, including the UK, the revaluation does not affect taxable profits in the period of
revaluation and consequently, the tax base of the asset is not adjusted. Hence a temporary difference arises.

This should be provided for in full based on the difference between carrying amount and tax base.
An upward revaluation will therefore give rise to a deferred tax liability, even if:
 The entity does not intend to dispose of the asset
 Tax due on any future gain can be deferred through rollover relief
This is because the revalued amount will be recovered through use which will generate taxable income
in excess of the depreciation allowable for tax purposes in future periods.
Manner of recovery
The carrying amount of a revalued asset may be recovered
 Through sale, or
 Through continued use. C
The manner of recovery may affect the tax rate applicable to the temporary difference, and / or the tax H
A
base of the asset. Interactive questions 2 and 3 within section 4.1.2 of the chapter provide illustrations
P
of this. T
E
Recording deferred tax R
As the underlying revaluation is recognised as other comprehensive income, so the deferred tax thereon
is also recognised as part of tax relating to other comprehensive income. The accounting entry is
therefore: 12
Dr Tax on other comprehensive income X

Non-depreciated revalued assets

SIC 21 Income Taxes – Recovery of Revalued Non-Depreciable Assets requires that deferred tax should be
recognised even where non-current assets are not depreciated (eg land). This is because the carrying
value will ultimately be recovered on disposal.
Worked example: Revaluation

A building in the UK was acquired on 1 January 20X2 at a cost of £500,000. It has been depreciated at a
rate of 2% straight line and has also attracted tax allowances at a rate of 4% straight line. On 31
December 20X6, the building is revalued to £650,000. The tax rate is 30%.
Requirement
What are the deferred tax implications of the revaluation?
Solution
 The carrying amount of the building before the revaluation was £500,000 – (5 × 2% × £500,000) =
£450,000.
 The tax base of the building before the revaluation was £500,000 – (5 × 4% × £500,000) =
£400,000.
 The temporary difference of £50,000 would have resulted in a deferred tax liability of 30% ×
£50,000 = £15,000.
 As a result of the revaluation, the carrying amount of the building is increased to £650,000.
 The tax base does not change.
 The temporary difference therefore increases to £250,000 (£650,000 - £400,000), resulting in a
total deferred tax liability of 30% × £250,000 = £75,000.
 As a result of the revaluation, additional deferred tax of £60,000 must therefore be recognised.
 This could also be calculated by applying the tax rate to the difference between carrying amount of
£450,000 and valuation of £650,000.
Income taxes 485

6.1.5 Revaluations to fair value – other assets
IFRS permit or require certain other assets to be revalued to fair value, for example:
 Certain financial instruments under IAS 39
 Investment properties under IAS 40
Where the revaluation is recognised in profit or loss (eg fair value through profit or loss instruments,
investment properties) and the amount is taxable / allowable for tax, then no deferred tax arises as both
the carrying value and the tax base are adjusted.
Where the revaluation is recognised as other comprehensive income (eg available-for-sale instruments)
and does not therefore impact taxable profits, then the tax base of the asset is not adjusted and
deferred tax arises. This deferred tax is also recognised as other comprehensive income.
6.1.6 Retirement benefit costs

In the financial statements, retirement benefit costs are deducted from accounting profit as the service
is provided by the employee. They are not deducted in determining taxable profit until the entity
pays either retirement benefits or contributions to a fund. Thus a temporary difference may arise.
 A deductible temporary difference arises between the carrying amount of the net defined benefit
liability and its tax base. The tax base is usually nil.
 The deductible temporary difference will normally reverse.
 A deferred tax asset is recognised for this temporary difference to the extent that it is recoverable,
that is sufficient profit will be available against which the deductible temporary difference can be
utilised.
 If there is a net defined benefit asset, for example when there is a surplus in the pension plan, a
taxable temporary difference arises and a deferred tax liability is recognised.
Under IAS 12, both current and deferred tax must be recognised outside profit or loss if the tax relates
to items that are recognised outside profit or loss. This could make things complicated as it interacts
with IAS 19 Employee Benefits.
IAS 19 (revised) requires recognition of remeasurement (actuarial) gains and losses in other
comprehensive income in the period in which they occur.
It may be difficult to determine the amount of current and deferred tax that relates to items recognised
in profit or loss or in other comprehensive income. As an approximation, current and deferred tax are
allocated on an appropriate basis, often pro rata.
Illustration 1: Defined benefit asset with a remeasurement loss

Defined Current Deferred
benefit tax relief tax liability
asset (28%) (28%)
£'000 £'000 £'000
Brought forward 1,000 – (280)
Contributions 600 (168) –
Profit or loss: net pension cost (500) 140 –
OCI: actuarial loss (200) 28 28
(700) 168 28
Carried forward 900 – 252

Illustration 2: Defined benefit liability with a remeasurement loss
Defined Current Deferred
benefit tax relief tax asset
liability (28%) (28%)
£'000 £'000 £'000
Brought forward (2,000) – 560
Contributions 1,200 (336) –
Profit or loss: net pension cost (1,000) 280 –
OCI: actuarial loss (400) 56 56
(1,400) 336 56
Carried forward (2,200) – 616
C
H
A
P
Worked example: Deferred tax and retirement benefits T
Note: Look back to Chapter 8 on employee benefits to refresh your memory of how to account for E
R
pensions. In this example we look at how employee benefits and deferred tax interact.
Operating expenses in the draft accounts for Celia include £405,000 relating to the company's defined
benefit pension scheme. This figure represents the contributions paid into the scheme in the year. No 12
other entries have been made relating to this scheme. The figures included on the draft statement of
financial position represent opening balances as at 1 October 20X5:
£
Pension scheme assets 2,160,000
Pension scheme liabilities (2,530,000)
(370,000)
Deferred tax asset 121,000
(249,000)
After the year end, a report was obtained from an independent actuary. This gave valuations as at 30
September 20X6 of
£
Pension scheme assets 2,090,200
Pension scheme liabilities (2,625,000)
Other information in the report included:

Yield on high quality corporate bonds 10%
Current service cost £374,000
Payment out of scheme relating to employees transferring out £400,000
Reduction in liability relating to transfers £350,000
Pensions paid £220,000
All receipts and payments into and out of the scheme can be assumed to have occurred on 30
September 20X6.
Celia recognises any gains and losses on remeasurement of defined benefit pension plans directly in
other comprehensive income in accordance with IAS 19 (revised 2011).
In the tax regime in which Celia operates, a tax deduction is allowed on payment of pension benefits.
No tax deduction is allowed for contributions made to the scheme. Gains and losses on pension
scheme assets are tax exempt.
Assume that the rate of tax applicable to 20X5, 20X6 and announced for 20X7 is 30%.
Requirements
(i) Explain how each of the above transactions should be treated in the financial statements for the
year ended 30 September 20X6;
(ii) Prepare an extract from the statement of profit or loss and other comprehensive income showing
other comprehensive income for the year ended 30 September 20X6.
Income taxes 487

Solution
Pensions
(i) The contributions paid have been charged to profit or loss in contravention of IAS 19 Employee
Benefits.
Under IAS 19, the following must be done:
 Actuarial valuations of assets and liabilities revised at the year end
 All gains and losses recognised
In profit or loss – Current service cost
– Transfers
– Net interest on net defined benefit liability
In other comprehensive income – Remeasurement gains and losses

Deferred tax must also be recognised. The deferred tax is calculated as the difference between the
IAS 19 net defined benefit liability less its tax base (ie nil as no tax deduction is allowed until the
pension payments are made). IAS 12 Income Taxes requires deferred tax relating to items charged
or credited to other comprehensive income to be recognised in other comprehensive income
hence the amount of the deferred tax movement relating to the losses on remeasurement charged
directly to OCI must be split out and credited directly to OCI.
(ii) Amounts recognised in other comprehensive income (extract)
£
Actuarial loss on defined benefit obligation (W1) (38,000)
Return on plan assets (excluding amounts in net interest (W1) (70,800)
(108,800)
Deferred tax credit relating to actuarial losses on defined benefit plan (W2) 32,640
Other comprehensive income for the year (76,160)
WORKINGS
1 Pension scheme
Pension Pension
scheme scheme
assets liabilities
£ £
At 1 October 20X5 2,160,000 2,530,000
Interest cost on obligation (10%  2,530,000) 253,000
Interest on plan assets (10%  2,160,000) 216,000
Contributions 405,000
Transfers (400,000) (350,000)
Pensions paid (220,000) (220,000)
Loss on remeasurement recognised in OCI (70,800) 38,000
At 30 September 20X6 2,090,200 2,625,000
2 Deferred tax on pension liability

Net pension liability (2,625,000 – 2,090,200) (534,800)
Tax base (no deduction until benefits paid) (0)
(534,800)
Deferred tax asset @ 30% 160,440

Deferred tax asset b/f (121,000)
39,400
Credited to OCI re losses ((70,800 + 38,000) × 30%) (32,640)
Credit to profit or loss for the year 6,800

6.1.7 Dividends receivable from UK and overseas companies
 Dividends received from UK and overseas companies are not taxable on UK companies.
 Overseas dividends are thus a permanent difference and so there is no deferred tax payable. (Previously
dividends received by a UK company from an overseas company were taxable and hence were a
temporary difference.)
6.2 Deductible temporary differences

6.2.1 Tax losses
Where tax losses arise, for example in the UK as trading losses or non-trading loan relationship deficits,
then the manner of recognition of these in the financial statements depends upon how they are
expected to be utilised. C
H
 If losses are carried back to crystallise a refund, then a receivable is recorded in the statement of A
financial position and the corresponding credit is to the current tax charge. P
T
 If losses are carried forward to be used against future profits or gains, then they should be E
recognised as deferred tax assets to the extent that it is probable that future taxable profit will be R
available against which the losses can be used.
Unused tax credits carried forward against taxable profits will also give rise to a deferred tax asset to the
12
extent that profits will exist against which they can be utilised.
Recognition of deferred tax asset
The existence of unused tax losses is strong evidence that future taxable profit may not be available.
The following should be considered before recognising any deferred tax asset:
 Whether an entity has sufficient taxable temporary differences against which the unused tax losses
can be offset
 Whether it is probable that the entity will have taxable profits before the unused tax losses expire
 Whether the tax losses result from identifiable causes which are unlikely to recur
 Whether tax planning opportunities are available to create taxable profit
Group tax relief
Where the acquisition of a subsidiary means that tax losses which previously could not be utilised, can
now be utilised against the profits of the subsidiary, a deferred tax asset may be recognised in the
financial statements of the parent company. This amount is not taken into account in calculating
goodwill arising on acquisition.
6.2.2 Provisions
 A provision is recognised for accounting purposes when there is a present obligation, but it is not
deductible for tax purposes until the expenditure is incurred.
 In this case, the temporary difference is equal to the amount of the provision, since the tax base is
nil.
 Deferred tax is recognised in profit or loss.
6.2.3 Share based payments

Share-based transactions may be tax deductible in some jurisdictions. However, the amount deductible
for tax purposes does not always correspond to the amount that is charged to profit or loss under IFRS
2.
In most cases it is not just the amount but also the timing of the expense allowable for tax purposes that
will differ from that required by IFRS 2.
For example an entity recognises an expense for share options granted under IFRS 2, but does not
receive a tax deduction until the options are exercised. The tax deduction will be based on the share
price on the exercise date and will be measured on the basis of the options' intrinsic value ie the
difference between market price and exercise price at the exercise date. In the case of share-based
employee benefits under IFRS 2 the cost of the services as reflected in the financial statements is
expensed and therefore the carrying amount is nil.
Income taxes 489

The difference between the carrying amount of nil and the tax base of share-based payment expense
received to date is a deferred tax asset, provided the entity has sufficient future taxable profits to utilise
this deferred tax asset.
The deferred tax asset temporary difference is measured as:
£
Carrying amount of share-based payment expense 0
Less: tax base of share-based payment expense (X)
(estimated amount tax authorities will permit as a deduction in future
periods, based on year end information)
Temporary difference (X)
Deferred tax asset at X%
If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the
related cumulative remuneration expense, this indicates that the tax deduction relates also to an equity
item.
The excess is therefore recognised directly in equity. The diagrams below show the accounting for
equity-settled and cash-settled transactions.
Equity-settled transaction
Estimated
future
tax
deduction
Greater Smaller
than than
Cumulative Cumulative
remuneration remuneration
expense expense
The tax benefit The excess over The tax

is record in the cumulative benefit is
profit or loss expense recorded
up to the amount is recorded in profit
of the cumulative in equity or loss
expense
Cash-settled transaction
Estimated All
future Recorded in
tax profit or loss
deduction

Worked example: Deferred tax
On 1 January 20X2, an entity granted 5,000 share options to an employee vesting two years later on
31 December 20X3. The fair value of each option measured at the grant date was £3.
Tax law in the jurisdiction in which the entity operates allows a tax deduction of the intrinsic value of
the options on exercise. The intrinsic value of the share options was £1.20 at 31 December 20X2 and
£3.40 at 31 December 20X3 on which date the options were exercised.
Assume a tax rate of 30%.
Requirement
Show the deferred tax accounting treatment of the above transaction at 31 December 20X2, 31
December 20X3 (before exercise), and on exercise.
C
H
Solution A
31 Dec 20X3 P
31 Dec 20X2 before exercise T
E
£ £ R
Carrying amount of share-based payment expense 0 0
Less: Tax base of share-based payment expense (3,000) (17,000)
(5,000  £1.2 ÷ 2)/(5,000  £3.40)
12
Temporary difference (3,000) (17,000)
Deferred tax asset @ 30% 900 5,100
Deferred tax (Cr profit) (5,100 – 900 – (Working) 600) 900 3,600
Deferred tax (Cr Equity) (Working) 0 600
On exercise, the deferred tax asset is replaced by a current tax asset.
The double entry is: £
Dr deferred tax (profit) 4,500
Dr deferred tax (equity) 600 reversal
Cr deferred tax asset 5,100
Dr current tax asset 5,100
Cr current tax (profit) 4,500
Cr current tax (equity) 600
WORKING £ £
Accounting expense recognised (5,000  £3 ÷ 2)/(5,000  £3) 7,500 15,000
Tax deduction (3,000) (17,000)
Excess temporary difference 0 (2,000)
Excess deferred tax asset to equity @ 30% 0 600
Interactive question 5: Share option scheme and deferred tax

Frost plc has the following share option scheme at 31 May 20X7:
Fair value
of options
Director's Options at grant Exercise Vesting
name Grant date granted date price date
£ £
Edmund 1 June 20X5 40,000 3.00 4.00 6/20X7
Houston
Kieran Bullen 1 June 20X6 120,000 2.50 5.00 6/20X9
The price of the company's shares at 31 May 20X7 is £8 per share and at 31 May 20X6 was £8.50 per
share.
The directors must be working for Frost on the vesting date in order for the options to vest.
No directors have left the company since the issue of the share options and none are expected to leave
before June 20X9. The shares can be exercised on the first day of the month in which they vest.
Income taxes 491

In accordance with IFRS 2 an expense of £60,000 has been charged to profits in the year ended 31 May
20X6 in respect of the share option scheme. The cumulative expense for the two years ended 31 May
20X7 is £220,000.
Tax allowances arise when the options are exercised and the tax allowance is based on the option's
intrinsic value at the exercise date.
Assume a tax rate of 30%.
Requirement
What are the deferred tax implications of the share option scheme?
7 Group scenarios
Section overview
 In relation to business combinations and consolidations, IAS 12 gives examples of circumstances
that give rise to taxable temporary differences and to deductible temporary differences in an
appendix.
 As already mentioned, however, the initial recognition of goodwill has no deferred tax impact.
7.1 Taxable temporary differences

7.1.1 Fair value adjustments on consolidation
IFRS 3 requires assets acquired on acquisition of a subsidiary or associate to be recognised at their fair
value rather than their carrying amount in the individual financial statements of the subsidiary. The fair
value adjustment does not, however, have any impact on taxable profits or the tax base of the asset.
This is much like a revaluation in an individual company's accounts.
Therefore an upwards fair value adjustment made to an asset will result in the carrying value of the asset
exceeding the tax base and so a taxable temporary difference will arise.
The resulting deferred tax liability is recorded in the consolidated accounts by:
Dr Goodwill (group share) X
Worked example: Fair value adjustments

On 1 September 20X8, Hunt acquired 80% of the ordinary share capital of Harrison for consideration
totalling £150,000. At the date of acquisition, Harrison's statement of financial position showed net
assets of £180,000, although the fair value of inventory was assessed to be £10,000 above its carrying
amount.
Requirement
Explain the deferred tax implications, assuming a tax rate of 30%.
Solution
 The carrying amount of the inventory in the group accounts is £10,000 more than its tax base
(being carrying amount in Harrison's own accounts).
 Deferred tax on this temporary difference is 30% x £10,000 = £3,000.
 A deferred tax liability of £3,000 is recognised in the group statement of financial position.
 Goodwill is increased by (£3,000  80%) = £2,400.

7.1.2 Undistributed profits of subsidiaries, branches, associates and joint ventures
 The carrying amount of, for example, a subsidiary in consolidated financial statements is equal to
the group share of the net assets of the subsidiary plus purchased goodwill.
 The tax base is usually equal to the cost of the investment.
 The difference between these two amounts is a temporary difference. It can be calculated as the
parent's share of the subsidiary's post acquisition profits which have not been distributed.
Worked example: Temporary difference in subsidiary holding

Askwith purchased 80% of the ordinary share capital of Embsay for £110,000 when the net assets of
Embsay were £100,000, giving rise to goodwill of £30,000. At 31 December 20X6 the following is
C
relevant:
H
1 Goodwill has not been impaired A
P
2 The net assets of Embsay amount to £120,000
T
Requirement E
R
What temporary difference arises on this investment at 31 December 20X6?
Solution 12
 The tax base of the investment in Embsay is the cost of £110,000. The carrying value is the share
of net assets (80% × £120,000) + goodwill of £30,000 = £126,000.
 The temporary difference is therefore £126,000 - £110,000 = £16,000.
 This is equal to the group share of post acquisition profits: 80% × £20,000 change in net assets
since acquisition.
Recognition of deferred tax

A deferred tax liability should be recognised on the temporary difference unless:
 The parent / investor / venturer is able to control the timing of the reversal of the temporary
difference, and
 It is probable that the temporary difference will not reverse (ie the profits will not be paid out) in
the foreseeable future.
This can be applied to different levels of investment as follows:
 Subsidiary
As a parent company can control the dividend policy of a subsidiary, deferred tax will not arise in
relation to undistributed profits.
 Associate
An investor in an associate does not control that entity and so cannot determine its dividend
policy. Without an agreement requiring that the profits of the associate should not be distributed
in the foreseeable future, therefore, an investor should recognise a deferred tax liability arising from
taxable temporary differences associated with its investment in the associate. Where an investor
cannot determine the exact amount of tax, but only a minimum amount, then the deferred tax
liability should be that amount.
 Joint venture
In a joint venture, the agreement between the parties usually deals with profit sharing. When a
venturer can control the sharing of profits and it is probable that the profits will not be distributed
in the foreseeable future, a deferred liability is not recognised.
Income taxes 493

7.1.3 Changes in foreign exchange rates
Where a foreign operation's taxable profit or tax loss (and therefore the tax base of its non-monetary assets
and liabilities) is determined in a foreign currency, changes in the exchange rate give rise to taxable or
deductible temporary differences.
These relate to the foreign entity's own assets and liabilities, rather than to the reporting entity's
investment in that foreign operation, and so the reporting entity should recognise the resulting deferred
tax liability or asset. The resulting deferred tax is charged or credited to profit or loss.
A deferred tax asset should however only be recognised to the extent that (and only to the extent that)
both these are probable:
(a) That the temporary difference will reverse in the foreseeable future, and
(b) That taxable profit will be available against which the temporary difference can be utilised.
7.2 Deductible temporary differences

7.2.1 Unrealised profits on intra-group trading
 From a tax perspective, one group company selling goods to another group company is taxed on
the resulting profit in the period that the sale is made.
 From an accounting perspective no profit is realised until the recipient group company sells the
goods to a third party outside the group. This may occur in a different accounting period from that
in which the initial group sale is made.
 A temporary difference therefore arises equal to the amount of unrealised intra-group profit. This is
the difference between:
– Tax base, being cost to the recipient company (ie cost to selling company plus unrealised
intra-group profit on sale to the recipient company)
– Carrying value to the group, being the original cost to the selling company, since the intra-
group profit is eliminated on consolidation
 Deferred tax is provided at the receiving company's tax rate.
7.2.2 Fair value adjustments

IFRS 3 requires assets and liabilities acquired on acquisition of a subsidiary or associate to be brought in
at their fair value rather than the carrying amount. The fair value adjustment does not, however, have
any impact on taxable profits or the tax base of the asset.
Therefore a fair value adjustment which increases a recognised liability or creates a new liability will
result in the tax base of the liability exceeding the carrying value and so a deductible temporary
difference will arise.
A deductible temporary difference also arises where an asset's carrying amount is reduced to a fair value
less than its tax base.
The resulting deferred tax asset is recorded in the consolidated accounts by:
Dr Deferred tax asset X
Cr Goodwill X
7.3 Deferred tax assets of an acquired subsidiary

Deferred tax assets of a subsidiary may not satisfy the criteria for recognition when a business
combination is initially accounted for but may be realised subsequently.
These should be recognised as follows:
 If recognised within 12 months of the acquisition date and resulting from new information about
circumstances existing at the acquisition date, the credit entry should be made to goodwill. If the
carrying amount of goodwill is reduced to zero, any further amounts should be recognised in profit
or loss.

 If recognised outside the 12 months 'measurement period' or not resulting from new information
about circumstances existing at the acquisition date, the credit entry should be made to profit or loss.
Interactive question 6: Recognition [Difficulty level: Intermediate]

In 20X2 Jacko Co acquired a subsidiary, Jilly Co, which had deductible temporary differences of £3m.
The tax rate at the date of acquisition was 30%. The resulting deferred tax asset of £0.9m was not
recognised as an identifiable asset in determining the goodwill of £5m resulting from the business
combination. Two years after the acquisition, Jacko Co decided that future taxable profit would
probably be sufficient for the entity to recover the benefit of all the deductible temporary differences.
Requirement
Consider the accounting treatment of the subsequent recognition of the deferred tax asset in 20X4. C
H
A
P
T
E
Worked example: Deferred tax and groups 1 R
In recent years, Morpeth Ltd has made the following acquisitions of other companies:
 On 1 January 20X6, it acquired 90% of the share capital of Skipton, resulting in goodwill of 12
£1.4 million.
 On 1 July 20X6 it acquired the whole of the share capital of Bingley for £6 million. At this date the
fair value of the net assets of Bingley was £4.5 million and their tax base was £4 million.
The following information is relevant to Morpeth Group's year ended 31 December 20X6:
Skipton
1 Skipton has made a provision amounting to £1.8 million in its accounts in respect of litigation. This
is tax allowable only when the cost is actually incurred. The case is expected to be settled within 12
months.
2 Skipton has a number of investments classified as at fair value through profit or loss in accordance
with IAS 39 Financial Instruments: Recognition and Measurement. The remeasurement gains and
losses recognised in profit or loss for accounting purposes are not taxable / tax allowable until such
date as the investments are sold. To date the cumulative unrealised gain is £2.5 million.
3 Skipton has sold goods to Morpeth in the year making a profit of £1 million. A quarter of these
goods remain in Morpeth's inventory at the year end.
Bingley
1 At its acquisition date, Bingley had unrelieved brought forward tax losses of £0.4 million. It was
initially believed that Bingley would have sufficient taxable profits to utilise these losses and a
deferred tax asset was recognised in Bingley's financial statements at acquisition. Subsequent
events have proven that the future taxable profits will not be sufficient to utilise the full brought
forward loss.
2 At acquisition Bingley's retained earnings amounted to £3.5 million. The directors of Morpeth
Group have decided that in each of the next four years to the intended listing date of the group,
they will realise earnings through dividend payments from the subsidiary amounting to £600,000
per annum. Bingley has not declared a dividend for the current year. Tax is payable on remittance
of dividends.
3 £300,000 of the purchase price of Bingley has been allocated to intangible assets. The recognition
and measurement criteria of IFRS 3 and IAS 38 do not appear to have been met, however the
directors believe that the amount is allowable for tax and have calculated the tax charge
accordingly. It is believed that this may be challenged by the tax authorities.
Requirement
What are the deferred tax implications of the above issues for the Morpeth Group?
Income taxes 495

Solution
Acquisitions
Any fair value adjustments made for consolidation purposes will affect the group deferred tax charge for
the year.
A taxable temporary difference will arise where the fair value of an asset exceeds its carrying value, and
the resulting deferred tax liability should be recorded against goodwill.
A deductible temporary difference will arise where the fair value of a liability exceeds its carrying value,
or an asset is revalued downwards. Again the resulting deferred tax amount (an asset) should be
recognised in goodwill.
In addition, it may be possible to recognised deferred tax assets in a group which could not be
recognised by an individual company. This is the case where tax losses brought forward, but not
considered to be an asset, due to lack of available taxable profits to set them against, can now be used
by another group company.
Goodwill
Goodwill arose on both acquisitions. According to IAS 12, however, no provision should be made for
the temporary difference arising on this.
Skipton
1 A deductible temporary difference arises when the provision is first recognised. This results in a
deferred tax asset calculated as £540,000 (30% x £1.8m). The asset may, however, only be
recognised where it is probable that there will be future taxable profits against which the future tax
allowable expense may be set. There is no indication that this is not the case for Skipton.
2 A taxable temporary difference arises where investments are revalued upwards for accounting
purposes but the uplift is not taxable until disposal. In this case the carrying value of the
investments has increased by £2.5 million, and this has been recognised in profit or loss. The tax
base has not, however changed. Therefore, a deferred tax liability should be recognised on the
£2.5 million, and in line with the recognition of the underlying revaluation, this should be
3 This intra-group transaction results in unrealised profits of £250,000 which will be eliminated on
consolidation. The tax on this £250,000 will, however, be included within the group tax charge
(which is comprised of the sum of the individual group companies' tax charges). From the
perspective of the group there is a temporary difference. Deferred tax should be provided on this
difference using the tax rate of Morpeth (the recipient company).
Bingley
1 Unrelieved tax losses give rise to a deferred tax asset only where the losses are regarded as
recoverable. They should be regarded as recoverable only where it is probable that there will be
future taxable profits against which they may be used. It is indicated that the future profits of
Bingley will not be sufficient to realise all of the brought forward loss, and therefore the deferred
tax asset is calculated only on that amount expected to be recovered.
2 Deferred tax is recognised on the unremitted earnings of investments, except where:
(a) The parent is able to control the payment of dividends.
(b) It is unlikely that the earnings will be paid out in the foreseeable future.
Morpeth controls Bingley and is therefore able to control its dividend payments, however it is
indicated that £2.4million will be paid as dividends in the next four years. Therefore a deferred tax
liability related to this amount should be recognised.
3 The directors have assumed that the £300,000 relating to intangible assets will be tax allowable,
and the tax provision has been calculated based on this assumption. However this is not certain,
and extra tax may have to be paid if this amount is not allowable. Therefore a liability for the
additional tax amount should be recognised.

Interactive question 7: Deferred tax and groups [Difficulty level: Intermediate]
Menston, a limited company, has two wholly owned subsidiaries, Burley, another UK company and
Rhydding, which is located in Estomania. The following information is relevant to the year ended 31
August 20X8:
1 Rhydding has made a tax adjusted loss equivalent to £6.5 million. This loss can only be relieved
through carry forward against future profits of Rhydding.
2 During the year Burley has sold goods to Menston for £12 million, based on a 20% mark up. Half
of these goods are still in Menston's stock room at the year end.
3 The tax rate applicable to the group companies based in the UK is 30%; the Estomanian tax rate is
20%.
Requirement C
H
What are the deferred tax implications of these issues? A
P
See Answer at the end of this chapter. T
E
R
8 Presentation and disclosure 12
Section overview
 The detailed presentation and disclosure requirements for deferred tax are given below.
8.1 Disclosure requirements

The tax expense (income) related to profit (or loss) from ordinary activities should be presented on the
face of the statement of profit or loss and other comprehensive income.
The following are the main items that should be disclosed separately:
 Current tax expense (income)
 Any adjustments recognised in the period for current tax of prior periods
 The amount of deferred tax expense (income) relating to temporary differences
 The amount of deferred tax expense (income) relating to changes in tax rates or the imposition of
new taxes
 Prior period deferred tax or current tax adjustments
 The aggregate current and deferred tax relating to items that are charged or credited to equity
 An explanation of the relationship between tax expense (income) and accounting profit which can
be done in either (or both) of the following ways
– A numerical reconciliation between tax expense and the product of accounting profit
multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax
rate(s) is (are) computed; or
– A numerical reconciliation between the average effective tax rate and the applicable tax rate,
disclosing also the basis on which the applicable tax rate is computed.
 An explanation of changes in the applicable tax rate(s) compared to the previous accounting
period
 The amount of deductible temporary differences, unused tax losses, and unused tax credits for
which no deferred tax asset is recognised in the statement of financial position.
Income taxes 497

8.2 The statement of financial position
Tax assets and tax liabilities should be presented separately from other assets and liabilities in the
statement of financial position. Deferred tax assets and liabilities should be distinguished from current
tax assets and liabilities.
Deferred tax assets (liabilities) should not be classified as current assets (liabilities).
There is no requirement in IAS 12 to disclose the tax base of assets and liabilities on which deferred tax
has been calculated.
8.2.1 Offsetting
Where appropriate deferred tax assets and liabilities should be offset in the statement of financial
position.
An entity should offset deferred tax assets and deferred tax liabilities if, and only if:
 The entity has a legally enforceable right to set off current tax assets against current tax liabilities;
and
 The deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same
taxation authority.
There is no requirement in IAS 12 to provide an explanation of assets and liabilities that have been
offset.
8.2.2 Other disclosures

An entity should disclose any tax-related contingent liabilities, and contingent assets, in accordance with
IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Contingent liabilities and contingent assets
may arise, for example, from unresolved disputes with the taxation authorities.
Similarly, where changes in tax rates or tax laws are enacted or announced after the reporting date, an
entity should disclose any significant effect of those changes on its current and deferred tax assets and
liabilities (see IAS 10 Events after the Reporting Period).
9 Deferred tax summary
Section overview
 The calculation and recording of deferred tax can be set out in an eight step process.
The following is a summary of the steps required to calculate and record deferred tax in the financial
statements.
Procedure Comment
Step 1 Determine the carrying amount of each asset and This is merely the carrying value
liability in the statement of financial position. determined by other Standards.
Step 2 Determine the tax base of each asset and This is the amount attributed to each asset
liability. or liability for tax purposes.
Step 3 Determine any temporary differences (these are These will be either:
based on the difference between the figures in  Taxable temporary differences; or
Step 1 and Step 2).  Deductible temporary differences.
Step 4 Determine the deferred tax balance by The tax rate to be used is that expected to
multiplying the tax rate by any temporary apply when the asset is realised or the
differences. liability settled, based upon laws already
enacted or substantively enacted by the
statement of financial position date.

Procedure Comment
Step 5 Recognise deferred tax assets/liabilities in the Apply recognition criteria in IAS 12.
Step 6 Recognise deferred tax, normally in profit or loss This will be the difference between the
(but possibly as other comprehensive income or in opening and closing deferred tax balances
equity or goodwill). in the statement of financial position.
Step 7 Off-set deferred tax assets and liabilities in the Off-set criteria in IAS 12 must be satisfied.
statement of financial position where appropriate.
Step 8 Comply with relevant presentation and disclosure See relevant presentation and disclosure
requirements for deferred tax in IAS 12. requirements sections above.
C
The method described is referred to as the liability method, or full provision method. H
A
 The advantage of this method is that it recognises that each temporary difference at the reporting P
date has an effect on future tax payments, and these are provided for in full. T
E
 The disadvantage of this method is that under certain types of tax system, it gives rise to large R
liabilities that may fall due only far in the future.
12
10 UK GAAP comparison – deferred tax
Section overview
 There are certain key differences between IFRS and UK GAAP in accounting for deferred tax.
The following is a summary of some of the key differences between the IFRS treatment and the UK
GAAP treatment of deferred tax.
Item IAS 12 UK GAAP FRS 19

Underlying concept Based upon taxable temporary Recognised on the basis of timing
differences. differences.
This is derived from a net assets This is derived from a profit and loss
liability approach. account approach being the
differences between taxable profit
and accounting profit.
Revaluations Revaluations on non-monetary Deferred tax should only be provided
assets should always be recognised if:
in determining deferred tax.  The asset is revalued to fair value
with the change reported in the
profit and loss account (income
statement), or
 There is a binding sale
agreement with a tax liability
expected to arise (eg no roll-
over relief).
Fair value Always recognise deferred tax and Do not recognise deferred tax.
adjustments in adjust goodwill.
business
combinations
Income taxes 499

Item IAS 12 UK GAAP FRS 19
Roll-over relief Recognise deferred tax. Do not recognise deferred tax.
Unrealised profit on Use tax rate of buying division. Use tax rate of selling division.
intra-group transfers
of inventory
Unremitted foreign Provide deferred tax unless investor Only provide deferred tax if dividends
profits controls reversal of temporary have been declared or requirement
difference and it is probable it will for profit to be remitted.
not reverse in foreseeable future.
Discounting Discounting is prohibited. Discounting is permitted, but not
required.

Summary
IAS 12
Income tax
Current Deferred
tax tax C
H
A
P
Asset Liability Taxable temporary Deductible T
differences temporary differences E
R
WHERE
Excess Deferred tax Deferred tax
paid liability recognised asset 12
OR
Tax loss Recognised only
c/back Exceptions Deferred tax where probable
recovers tax - initial recognition liabilities relating to that taxable
of previous of goodwill business profit will be
period - initial recognition combinations shall available
of an asset or be recognised unless
liability in a - parent, investor or
transaction which venturer is control
- is not a business reversal of
combination temporary
- at the time of difference
the transaction - probable that
affects neither temporary
accounting profit difference will not
nor taxable reverse in the
profit or loss foreseeable future
Exceptions Deferred tax asset

Transactions that relating to business
arise from initial combinations shall
recognition of a be recognised if
transaction that probable that
- is not a business - temporary
combination and differences will
- at the time of the reverse in the
transaction affects foreseeable future
neither accounting - taxable profit will
profit nor taxable be available to be
profit or loss utilised
Income taxes 501

Self-test
IAS 12 Income Taxes
1 Torcularis
The Torcularis Company has interest receivable which has a carrying amount of £75,000 in its
statement of financial position at 31 December 20X6. The related interest revenue will be taxed on
a cash basis in 20X7.
Torcularis has trade receivables that have a carrying amount of £80,000 in its statement of financial
position at 31 December 20X6. The related revenue has been included in its statement of profit or
loss and other comprehensive income for the year to 31 December 20X6.
Requirement
According to IAS 12 Income Taxes, what is the total tax base of interest receivable and trade
receivables for Torcularis at 31 December 20X6?
2 What will the following situations give rise to as regards to deferred tax, according to IAS 12
Income Taxes?
A Development costs have been capitalised and will be amortised through profit or loss, but
were deducted in determining taxable profit in the period in which they were incurred.
B Accumulated depreciation for a machine in the financial statements is greater than the
cumulative capital allowances up to the reporting date for tax purposes.
C A penalty payable is in the statement of financial position. Penalties are not allowable for tax
purposes.
3 Budapest
On 31 December 20X6, The Budapest Company acquired a 60% stake in the Lisbon Company.
Among Lisbon's identifiable assets at that date was inventory with a carrying amount of £8,000
and a fair value of £12,000. The tax base of the inventory was the same as the carrying amount.
The consideration given by Budapest resulted in the recognition of goodwill acquired in the
business combination.
Income tax is payable by Budapest at 25% and by Lisbon at 20%.
Requirement
Indicate whether the following statements are true or false, in respect of Budapest's consolidated
statement of financial position at 31 December 20X6, in accordance with IAS 12 Income Taxes.
A No deferred tax liability is recognised in respect of the goodwill
B A deferred tax liability of £800 is recognised in respect of the inventory
4 Dipyrone
The Dipyrone Company owns 100% of the Reidfurd Company. During the year ended 31
December 20X7:
(1) Dipyrone sold goods to Reidfurd for £600,000, earning a profit margin of 25%. Reidfurd held
30% of these goods in inventory at the year end.
(2) Reidfurd sold goods to Dipyrone for £800,000, earning a profit margin of 20%. Dipyrone held
25% of these goods in inventory at the year end.
The tax base of the inventory in each company is the same as its carrying amount. The tax rate
applicable to Dipyrone is 26% and that applicable to Reidfurd is 33%.
Requirement
What is the deferred tax asset at 31 December 20X7 in Dipyrone's consolidated statement of
financial position under IAS 12 Income Taxes, and IFRS 10 Consolidated Financial Statements?

5 Rhenium
The Rhenium Company issued £6 million of 8% loan stock at par on 1 April 20X7. Interest is
payable in two instalments on 30 September and 31 March each year.
The company pays income tax at 20% in the year ended 31 December 20X7, but expects to pay at
25% for 20X8 as it will be earning sufficient profits to pay tax at the higher rate.
For tax purposes interest paid and received is dealt with on a cash basis.
Requirement
What is the deferred tax balance at 31 December 20X7, according to IAS 12 Income Taxes?
6 Cacholate
The Cacholate Company acquired a property on 1 January 20X6 for £1.5 million. The useful life of C
the property is 20 years, which is also the period over which tax depreciation is charged. H
A
On 31 December 20X7, the property was revalued to £2.16 million. The tax base remained P
unaltered. T
E
Income tax is payable at 20%. R
Requirement
What is the deferred tax charge for the year ended 31 December 20X7, and where is it charged, 12
under IAS 12 Income Taxes?
7 Spruce
Spruce Company made a taxable loss of £4.7 million in the year ended 31 December 20X7. This
was due to a one-off reorganisation charge in 20X7; prior to that, Spruce made substantial taxable
profits each year.
Assume that tax legislation allows companies to carry back tax losses for one financial year, and
then carry them forward indefinitely.
Spruce's taxable profits are as follows.
Year ended £'000
31 December 20X6 500
31 December 20X8 (estimate) 1,000
31 December 20X9 (estimate) 1,200
31 December 20Y0 and onwards Uncertain
Spruce pays income tax at 25%.
Requirement
What is the deferred tax balance in respect of tax losses in Spruce's statement of financial position
at 31 December 20X7, according to IAS 12 Income Taxes?
8 Bananaquit
At 31 December 20X6, The Bananaquit Company has a taxable temporary difference of £1.5
million in relation to certain non-current assets.
At 31 December 20X7, the carrying amount of those non-current assets is £2.4 million and the tax
base of the assets is £1.0 million.
Tax is payable at 30%.
Requirement
Indicate whether the following statements are true or false, in accordance with IAS 12 Income
Taxes.
A The deferred tax charge through profit or loss for the year is £30,000
B The statement of financial position deferred tax asset at 31 December 20X7 is £420,000
Income taxes 503

9 Antpitta
The Antpitta Company owns 70% of the Chiffchaff Company. During 20X7 Chiffchaff sold goods
to Antpitta at a mark-up above cost. Half of these goods are held in Antpitta's inventories at the
year end. The rate of income tax is 30%.
Requirement
Indicate whether the following statements are true or false according to IAS 12 Income Taxes, and
IFRS 10 Consolidated Financial Statements, when preparing Antpitta's consolidated and Chiffchaff's
individual financial statements for the year ended 31 December 20X7.
A A deferred tax asset arises in the individual statement of financial position of Chiffchaff in
relation to intra-group transactions.
B A deferred tax asset arises in Antpitta's consolidated statement of financial position due to the
intra-group transactions.
10 Parea
In order to maximise its net assets per share, the Parea Company wishes to recognise the minimum
deferred tax liability allowed by IFRS. Parea only pays tax to the Government of Gredonia, at the
rate of 22%.
On 1 January 20X6 Parea acquired some plant and equipment for £30,000. In the financial
statements it is being written off over its useful life of four years on a straight-line basis, even
though tax depreciation is calculated at 27% on a reducing-balance basis.
On 1 January 20X3 Parea acquired a property for £40,000. Both in the financial statements and
under tax legislation it is being written off over 25 years on a straight-line basis. On 31 December
20X7 the property was revalued to £50,000 with no change to its useful life, but this revaluation
had no effect on the tax base or on tax depreciation.
Requirement
Determine the following amounts for the deferred tax liability of Parea in its consolidated financial
statements according to IAS 12 Income Taxes.
(a) The deferred tax liability at 31 December 20X6
(b) The deferred tax liability at 31 December 20X7
(c) The charge or credit for deferred tax in profit or loss for the year ended 31 December 20X7

Technical reference
Tax base of an asset/liability IAS 12.7, IAS 12.8
Current tax
 Unpaid current tax recognised as a liability IAS 12.12
 Benefit relating to tax losses that can be carried back to recover previous IAS 12.13
period current tax recognised as asset
C
Taxable temporary differences H
A
 Deferred tax liability shall be recognised on all taxable temporary IAS 12.15 P
differences except those arising from: T
E
R
– Initial recognition of goodwill
– Initial recognition of an asset or liability in a transaction which:
 Is not a business combination 12
 At the time of the transaction affects neither accounting profit

nor taxable profit (tax loss)
Deductible temporary differences

 Deferred tax asset shall be recognised for all deductible temporary IAS 12.24
differences to the extent that taxable profit will be available to be utilised,
unless asset arises from initial recognition of asset or liability in a
transaction that:
– Is not a business combination, and
– At the time of the transaction affects neither accounting profit nor
taxable profit or loss
Unused tax losses and unused tax credits
 Deferred tax asset may be recognised in respect of unused tax losses and IAS 12.34
unused tax credits to the extent that future taxable profits will be available
Deferred tax assets and liabilities arising from investments in subsidiaries, IAS 12.39, IAS 12.44
branches and associates and investments in joint ventures
Tax rates and manner of recovery

 Measurement of deferred tax at tax rates expected to apply when asset IAS 12.47
realised or liability settled to reflect tax consequences of manner of IAS 12.51
recovery
Discounting
 Deferred tax assets and liabilities shall not be discounted IAS 12.53
Annual review
 Carrying amount of deferred tax asset to be reviewed at each reporting IAS 12.56
date
Income taxes 505

IAS 12 Income Taxes

1 Torcularis
£ Nil and £80,000
IAS 12.7 Examples 2 and 3 show that:
 For interest receivables the tax base is nil
 The tax base for trade receivables is equal to their carrying amount.
2 A Deferred tax liability
B Deferred tax asset
C No deferred tax implications.
'Development costs' lead to a deferred tax liability.
'A penalty payable' has no deferred tax implications.
3 Budapest
A True
B True
Under IAS 12.19 the excess of an asset's fair value over its tax base at the time of a business
combination results in a deferred tax liability. As it arises in Lisbon, the tax rate used is 20% and the
liability is £800 ((£12,000 - £8,000)  20%).
The recognition of a deferred tax liability in relation to the initial recognition of goodwill is
specifically prohibited by IAS 12.15(a).
4 Dipyrone
£25,250
Under IFRS 10, intra-group profits recognised in inventory are eliminated in full and IAS 12 applied
to any temporary differences that result. This profit elimination results in the tax base being higher
than the carrying amount, so deductible temporary differences arise. Deferred tax assets are
measured by reference to the tax rate applying to the entity who currently owns the inventory.
So the deferred tax asset in respect of Dipyrone's eliminated profit is £14,850 (£600,000  25% 
30%  33% tax rate) and in respect of Reidfurd's eliminated profit is £10,400 (£800,000  20% 
25%  26% tax rate), giving a total of £25,250.
5 Rhenium
£30,000 asset
The year-end accrual is £120,000 (£6m  8%  3/12). Because the £120,000 year-end carrying
amount of the accrued interest exceeds its nil tax base, under IAS 12.5 there is a deductible
temporary difference, of £120,000. Under IAS 12.24 a deferred tax asset must be recognised.
The deferred tax asset is the deductible temporary difference multiplied by the tax rate expected to
exist when the tax asset is realised (IAS 12.47). This gives a deferred tax asset of (£120,000  25%)
= £30,000.
6 Cacholate
£162,000
Because the £2.16m year-end carrying amount of the asset exceeds its £1.35m (£1,500,000 
18/20) tax base, under IAS 12.5 there is a taxable temporary difference, of £810,000. Under IAS
12.15 a deferred tax liability must be recognised, of £162,000 (£810,000  20%). As there was no
such liability last year (the carrying amount and the tax base were the same), the charge in the
current year is for the amount of the liability.

Because the revaluation surplus is recognised as other comprehensive income and accumulated in
equity (IAS 12.62), the deferred tax charge is recognised as tax on other comprehensive income
and also accumulated in equity, under IAS 12.61.
7 Spruce
£550,000
A deferred tax asset shall be recognised for the carry forward of unused tax losses to the extent that
future taxable profits will be available for offset (IAS 12.34). The loss incurred in the current year is
a one-off, and the company has a history of making profits and expects to do so over the next two
years. So it is likely that there will be future profits to offset.
£500,000 of the loss will be relieved by carry back, leaving £4,200,000 for carry forward. But the
carry forward is limited to the likely future profits, so £2.2m.
C
At the 25% tax rate, the deferred tax asset is £550,000. H
A
8 Bananaquit P
T
A False E
B False R
The deferred tax figure in profit or loss is the difference between the opening and closing deferred
tax liabilities. At the start of the year the liability was £450,000 (£1.5m  30%). The amount of the 12
change is £30,000, but it is a deferred tax credit, not charge to profit or loss.
At the end of the year the £2.4m carrying amount of the assets exceeds their £1.0m tax base, so
under IAS 12.5 there is a taxable temporary difference, of £1.4m. Under IAS 12.15 a deferred tax
liability (not asset) of £420,000 (£1.4m  30%) must be recognised.
9 Antpitta
A False
B True
There is an unrealised profit relating to inventories still held within the group, which must be
eliminated on consolidation (IFRS 10). But the tax base of the inventories is unchanged, so it is
higher than the carrying amount in the consolidated statement of financial position and there is a
deductible temporary difference (IAS 12.5).
10 Parea
(a) £132
(b) £3,743
(c) £349 credit
At 31 December 20X6 the carrying amount of the plant is £30,000  (1 – 25%) = £22,500,
while the tax base is £30,000  (1 – 27%) = £21,900. The taxable temporary difference is £600
and the deferred tax liability is 22% thereof, £132.
At 31 December 20X7 the carrying amount of the plant is £30,000  (1 – (25% x 2)) =
2
£15,000, while the tax base is £30,000  (1 – 27%) = £15,987, leading to a deductible
temporary difference of £987. A deferred tax asset should be recognised in relation to this.
Before its revaluation, the property's carrying amount is £40,000 – (5 years at 4%) = £32,000
and the tax base is the same. The revaluation to £50,000 creates a taxable temporary difference
of £18,000.
As Parea pays all its tax to a single authority, it must offset deferred tax assets and liabilities
(IAS 12.74). At 31 December 20X7 there is a deferred tax liability of £(-987 + 18,000) =
£17,013  22% = £3,743.
The change in deferred tax liability over the year is £3,743 - £132 = £3,611. Of this, £18,000 
22% = £3,960 relates to the property revaluation and is recognised in other comprehensive
income. This leaves £3,611 - £3,960 = £(349) to be credited to profit or loss (IAS 12.58).
Income taxes 507


(a) The tax base of the accrued expenses is nil.
(b) The tax base of the interest received in advance is nil.
(c) The tax base of the prepaid expenses is nil.
(d) The tax base of the loan is £1m.

The tax base of the asset is £70,000 (£100,000 – £30,000).
(a) Recovery through continued use
Temporary difference of £150,000 – £70,000 = £80,000 is all taxed at 30% resulting in a deferred
tax liability of £24,000.
(If the entity expects to recover the carrying amount by using the asset it must generate taxable
income of £150,000, but will only be able to deduct depreciation of £70,000)
(b) Recovery through sale
If the entity expects to recover the carrying amount by selling the asset immediately for proceeds
of £150,000, the temporary difference is still £80,000. Of this only the £50,000 excess of proceeds
over cost is taxable. Therefore the deferred tax liability will be computed as follows.
Taxable temporary Deferred
difference Tax rate tax liability
£ £
Cumulative tax depreciation 30,000 30% 9,000
Proceeds in excess of cost 50,000 Nil –
Total temporary difference 80,000 9,000

(a) Recovery through continued use
If the entity expects to recover the carrying amount by using the asset, the situation is as in
Recovery 1 above in the same circumstances.
(b) Recovery through sale
If the entity expects to recover the carrying amount by selling the asset immediately for proceeds
of £150,000, the entity will be able to deduct the indexed cost of £110,000. The net profit of
£40,000 will be taxed at 40%. In addition, the cumulative tax depreciation of £30,000 will be
included in taxable income and taxed at 30%. On this basis, the tax base is £80,000 (£110,000 –
£30,000), there is a taxable temporary difference of £70,000 and there is a deferred tax liability of
£25,000 (£40,000  40% plus £30,000  30%).

Jonquil Co will recover the carrying amount of the equipment by using it to manufacture goods for
resale. Therefore, the entity's current tax computation is as follows.
Year
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Taxable income* 10,000 10,000 10,000 10,000 10,000
Depreciation for tax purposes 12,500 12,500 12,500 12,500 0
Taxable profit (tax loss) (2,500) (2,500) (2,500) (2,500) 10,000
Current tax expense (income) at 40% (1,000) (1,000) (1,000) (1,000) 4,000
* ie nil profit plus (£50,000  5) depreciation add-back.

The entity recognises a current tax asset at the end of years 20X1 to 20X4 because it recovers the
benefit of the tax loss against the taxable profit of year 20X0.
The temporary differences associated with the equipment and the resulting deferred tax asset and
liability and deferred tax expense and income are as follows.
Year
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Carrying amount 40,000 30,000 20,000 10,000 0
Tax base 37,500 25,000 12,500 0 0
Taxable temporary difference 2,500 5,000 7,500 10,000 0
Opening deferred tax liability 0 1,000 2,000 3,000 4,000
Deferred tax expense (income): bal fig 1,000 1,000 1,000 1,000 (4,000)
Closing deferred tax liability @ 40% 1,000 2,000 3,000 4,000 0 C
H
The entity recognises the deferred tax liability in years 20X1 to 20X4 because the reversal of the taxable A
temporary difference will create taxable income in subsequent years. The entity's income statement is as P
follows. T
Year E
R
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Income 10,000 10,000 10,000 10,000 10,000
Depreciation (10,000) (10,000) (10,000) (10,000) (10,000) 12
Profit before tax 0 0 0 0 0
Current tax expense (income) (1,000) (1,000) (1,000) (1,000) 4,000
Deferred tax expense (income) 1,000 1,000 1,000 1,000 (4,000)
Total tax expense (income) 0 0 0 0 0
Net profit for the period 0 0 0 0 0

The company will recognise an expense for the consumption of employee services given in
consideration for share options granted, but will not receive a tax deduction until the share options are
actually exercised. Therefore a temporary difference arises and IAS 12 Income Taxes requires the
recognition of deferred tax.
A deferred tax asset (a deductible temporary difference) results from the difference between the tax
base of the services received (a tax deduction in future periods) and the carrying value of zero. IAS 12
requires the measurement of the deductible temporary difference to be based on the intrinsic value of
the options at the year end. This is the difference between the fair value of the share and the exercise
price of the option.
If the amount of the estimated future tax deduction exceeds the amount of the related cumulative
remuneration expense, the tax deduction relates not only to the remuneration expense, but to equity. If
this is the case, the excess should be recognised directly in equity.
Year to 31 May 20X6
Deferred tax asset:
£
Fair value (40,000  £8.50  1/2) 170,000
Exercise price of option (40,000  £4.00  1/2 ) (80,000)
Intrinsic value (estimated tax deduction) 90,000
Tax at 30% 27,000
The cumulative remuneration expense is £60,000, which is less than the estimated tax deduction of
£90,000. Therefore:
 A deferred tax asset of £27,000 is recognised in the statement of financial position.
 There is deferred tax income of £18,000 (60,000  30%).
 The excess of £9,000 (30,000  30%) goes to equity.
Income taxes 509

Year to 31 May 20X7
Deferred tax asset:
£
Fair value
(40,000  £8) 320,000
(120,000  £8  1/3) 320,000
640,000
Exercise price of options
(40,000  £4) (160,000)
(120,000  £5  1/3) (200,000)
Intrinsic value (estimated tax deduction) 280,000
Tax at 30% 84,000
57,000
The cumulative remuneration expense is £220,000, which is less than the estimated tax deduction of
£280,000. Therefore:
 A deferred tax asset of £84,000 is recognised in the statement of financial position at 31 May 20X7
 There is potential deferred tax income of £57,000 for the year ended 31 May 20X7
 Of this, £9,000 (60,000  30%) – (9,000) goes directly to equity
 The remainder (£48,000) is recognised in profit or loss for the year

The entity recognises a deferred tax asset of £0.9m (£3m  30%) and, in profit or loss, deferred tax
income of £0.9m. Goodwill is not adjusted as the recognition does not arise within the measurement
period (ie within the 12 months following the acquisition).

1 An unrelieved tax loss gives rise to a deferred tax asset, however only where there are expected to
be sufficient future taxable profits to utilise the loss.
There is no indication of Rhydding's future profitability, although the extent of the current year
losses suggests that future profits may not be available. If this is the case then no deferred tax asset
should be recognised.
If, however, the current year loss is due to a one-off factor, or there are other reasons why a return
to profitability is expected, then the deferred tax asset may be recognised at 20% × £6.5 million =
£1.3 million.
2 The intra-group sale gives rise to an unrealised year end profit of £12 million × 20/120 × ½ =
£1 million. Consolidated profit and inventory are adjusted for this amount.
This profit has, however, already been taxed in the accounts of Burley. A deductible timing
difference therefore arises which will reverse when the goods are sold outside the group and the
profit is realised. The resulting deferred tax asset is £1 million × 30% = £300,000.
This may be recognised to the extent that it is recoverable.

CHAPTER 13
Industry specific Standards
Introduction
Topic List
1 IAS 40 Investment Property
2 IAS 41 Agriculture
3 IFRS 6 Exploration for and Evaluation of Mineral Resources
4 IFRS 4 Insurance Contracts
5 IAS 26 Accounting and Reporting by Retirement Benefit Plans
Technical reference
511
Introduction
 Understand and apply the requirements of IAS 40 Investment Property
 Understand and apply the requirements of IAS 41 Agriculture
 Understand the nature, application and scope of IFRS 4 Insurance Contracts
 Understand the nature, application and scope of IAS 26 Accounting and Reporting by
Retirement Benefit Plans

Section overview
 An investment property is land or buildings or both that is held by an entity to earn rentals and/or
for its capital appreciation potential.
 Investment properties have been covered at Professional stage and the section below is revision of
that material.
One of the distinguishing characteristics of investment property is that it generates cash flows largely
independent of the other assets held by an entity.
Owner-occupied property is not investment property and is accounted for under IAS 16 Property, Plant
and Equipment.
1.1 Recognition
Investment property should be recognised as an asset when two conditions are met.
 It is probable that the future economic benefits that are associated with the investment property
will flow to the entity.
 The cost of the investment property can be measured reliably.
C
H
1.2 Initial measurement and further aspects of recognition A
P
An investment property should initially be measured at its cost, including transaction costs. T
E
Further aspects of recognition R
Transaction costs Expenses that are directly attributable to the investment property, for example
professional fees and property transfer taxes. Cost does not include activities 13
that, while related to the investment property, are not directly attributable to it.
For example, start up costs, abnormal amounts of wasted resources in
constructing the property, relocation costs, losses incurred before full occupancy
and the normal servicing of the property are not directly attributable.
Self-constructed Property being self-constructed or under development for future use as an
investment investment property qualifies itself as an investment property.
properties
Leases A property interest held under a lease and classified as an investment
property shall be accounted for as if it were a finance lease. The asset is
recognised at the lower of the fair value of the property and the present
value of the minimum lease payments. An equivalent amount is recognised
as a liability.
Entity occupies part If the two portions can be sold separately or leased separately under a
of property and finance lease, each is accounted for as appropriate. If not, entire property is
leases out balance an investment property only if insignificant portion is owner occupied.
Entity supplies An investment property only if the services are insignificant to the
services to the lessee arrangement as a whole.
of the property
Property leased to An investment property in entity's own accounts but owner occupied from
and occupied by group perspective.
parent, subsidiary or
other group company
Industry specific Standards 513

Interactive question 1: Identification of investment property
(a) An entity has a factory that has been shut down due to chemical contamination, worker unrest and
strike. The entity plans to sell this factory.
(b) An entity has purchased a building that it intends to lease out under an operating lease.
(c) An entity has acquired a large-scale office building, with the intention of enjoying its capital
appreciation. Rather than holding it empty, the entity has decided to try to recover its running
costs by renting the space out for periods which run from one week to one year. To make the
building attractive to potential customers, the entity has fitted the space out as small office units,
complete with full-scale telecommunications facilities, and offers reception, cleaning, a loud
speaker system and secretarial services. The expenditure incurred in fitting out the offices has been
a substantial proportion of the value of the building.
(d) An entity acquired a site on 30 April 20X4 with the intention of building office blocks to let. After
receiving planning permission, construction started on 1 September 20X4 and was completed at a
cost of £10 million on 30 March 20X5 at which point the building was ready for occupation.
The building remained vacant for several months and the entity incurred significant operating
losses during this period.
The first leases were signed in July 20X5 and the building was not fully let until 1 September 20X6.
Requirement
Do the buildings referred to in (a) – (d) above meet the definition of investment property?
1.3 Measurement subsequent to initial recognition

Following initial measurement, investment properties are held either:
 At cost less accumulated depreciation (the cost model), or
 Measured at fair value (the fair value model).
Cost model
Where the cost model is adopted, the property should be accounted for in accordance with IAS 16
Property, Plant and Equipment.
Fair value model
 After initial recognition, an entity that chooses the fair value model should measure all of its
investment property at fair value, except in the extremely rare cases where this cannot be
measured reliably. In such cases it should apply the IAS 16 cost model.
 A gain or loss arising from a change in the fair value of an investment property should be
recognised in net profit or loss for the period in which it arises.
 The fair value of investment property should reflect market conditions at the reporting date.
 A change in use of an investment property may lead to a change in classification.
Whatever policy the entity chooses should be applied to all of its investment property.
Interactive question 2: Estimating fair value [Difficulty level: Intermediate]

An entity with a 31 December year-end owns the freehold of an office block standing on a city centre
site on which there are four other similar buildings, none of which are owned by the entity. All the office
buildings were constructed at the same time as the entity's building and the floors in all five buildings
are let out on standard 25-year leases.

Requirement
Which of the following values could be used by the entity as a basis for estimating the fair value of its
office building at 31 December 20X5, according to IAS 40?
(1) The first of the other office buildings changed hands early in 20X5 for £5 million as a result of an
auction which was widely publicised in the professional property press.
(2) The second of the other office buildings changed hands late in 20X5 for £6 million as a result of a
sale to an entity, 55% of whose shares were owned by the seller.
(3) The third of the other office buildings changed hands late in 20X5 for £4.5 million as a result of
sale to a financial institution to which the seller owed £3.5 million. It is understood that the seller
had breached its banking covenants and had to raise cash by the end of 20X5.
(4) The fourth of the other office buildings changed hands late in 20X5 for £5.5 million as a result of a
sale to an overseas institution which was seeking to establish its first foothold in the country's
property market. The offer of the office building was widely publicised in the professional property
press although it is understood that local institutions were only prepared to offer in the region of
£4.9 million.
1.4 Derecognition
 When an investment property is derecognised, a gain or loss on disposal should be recognised in C
profit or loss. The gain or loss should normally be determined as the difference between the net H
disposal proceeds and the carrying amount of the asset. A
P
T
E
Interactive question 3: Disposal of investment property [Difficulty level: Easy] R
An entity purchased an investment property on 1 January 20X3, for a cost of £5.5m. The property has a
useful life of 50 years, with no residual value and at 31 December 20X5 had a fair value of £6.2m.
On 1 January 20X6 the property was sold for net proceeds £6m. 13
Requirement
Calculate the profit or loss on disposal under both the cost and fair value model.
1.5 Transfers following a change in use

A change in use may lead to recognition or de-recognition of an investment property. The following is a
summary of such instances.
Evidence of change in use Accounting treatment
Commencement of owner  Owner occupied property recognised under IAS 16.

occupation  If fair value model was used, treat fair value as deemed cost.
Commencement of  Reclassify as inventory under IAS 2.
development with a view to sale  If fair value model was used, treat fair value as deemed cost.
Development with view to  Continue to hold as an investment property.
continue letting
End of owner occupation with  Transfer to investment properties under IAS 40.
view to let to third parties
 If fair value model to be used, revalue at date of change and
recognise difference as revaluation under IAS 16.

Evidence of change in use Accounting treatment
Property held as inventory now  Transfer to investment properties under IAS 40.
let to a third party
 If fair value model to be used, revalue at date of change and
recognise difference in profit or loss.
Commencement of operating  Transfer from property, plant and equipment to investment
lease to another party property under IAS 40.
Interactive question 4: Change of use [Difficulty level: Intermediate]

An entity with a 31 December year-end purchased an office building, with a useful life of 50 years, for
£5.5 million on 1 January 20X1. The amount attributable to the land was negligible. The entity used the
building as its head office for five years until 31 December 20X5 when the entity moved its head office
to larger premises. The building was reclassified as an investment property and leased out under a five
year lease.
Owing to a change in circumstances the entity took possession of the building five years later on
31 December 20Y0, to use it as its head office once more. At that date the remaining useful life of the
building was confirmed as 40 years.
The fair value of the head office was as follows.
At 31 December 20X5 £6 million
At 31 December 20Y0 £7.5 million
Requirements
How should the changes of use be reflected in the financial statements on the assumption that:
(a) The entity uses the cost model for investment properties.
(b) The entity uses the fair value model for investment properties.
1.6 Summary of disclosure requirements

An entity shall disclose
 Whether it has followed the fair value model or cost model
 Whether property interests held as operating leases are included in investment property
 Criteria for classification as investment property
 Assumptions in determining fair value
 Use of independent professional valuer (encouraged but not required)
 Rental income and expenses
 Any restrictions or obligations
Fair value model – additional disclosures
An entity that adopts this must also disclose a reconciliation of the carrying amount of the investment
property at the beginning and end of the period.
Cost model – additional disclosures
These relate mainly to the depreciation method, rates and useful lives used as well as a reconciliation of
the carrying amount at the beginning and end of the period. In addition, an entity which adopts the
cost model must disclose the fair value of the investment property.

Interactive question 5: Installation of new equipment 1 [Difficulty level: Intermediate]
An entity owns the freehold of an office building which was acquired on 31 December 20X0 for £17
million, £2 million of which was attributable to the land. The freehold is an investment property
measured under the cost model with the building's useful life estimated at 30 years. The building was
fully equipped with an air-conditioning system. No separate value was placed on the air conditioning
unit as this was not something that was required by accounting standards at the time of acquisition.
On 31 December 20X5 the entity replaced the air-conditioning system for £1.2 million, which has an
estimated useful life of 10 years. As no more reliable information was available, it used this cost as an
indication of the cost of the old system.
Requirement
How should the replacement of the air-conditioning be accounted for?
Interactive question 6: Installation of new equipment 2 [Difficulty level: Intermediate]

An entity with a 31 December year-end owns an office building which is recognised as an investment
property. The lift system is an integral part of the office building. The entity uses the fair value model for
measurement of investment properties.
The lift system was purchased on 1 January 20X0 for £400,000 and is being depreciated at 12.5% per
annum on cost. Its carrying amount has been accepted as a reasonable value at which to include it
within the fair value of the office building as a whole. C
Early in December 20X5 a professional valuer determined the fair value of the office building, including H
A
the lift system, to be £3 million. The lift system failed on 28 December 20X5 and was immediately
P
replaced on 31 December 20X5 with a new system costing £600,000. T
Requirement E
R
How should the lift system be recognised?
13
Interactive question 7: Replacement property [Difficulty level: Intermediate]

An entity with a 31 December year-end owns an investment property which it measures using the fair
value model. At 31 December 20X4, the property's carrying amount is £4 million. On 30 June 20X5, an
explosion close to the property causes major damage to the property. In July 20X5, the entity makes a
number of insurance claims as a result, one of which is for the rebuilding cost, estimated at £3.7 million.
Although the property is repairable, the entity decides to sell it in its present state and buy a
replacement property. This decision is made on 30 September 20X5, on which date the damaged
property meets the criteria for classification as held for sale. Its fair value on that date is £350,000 and
the costs to sell are £35,000. The fair value does not change between 30 September 20X5 and 31
December 20X5. The sale is completed in the middle of 20X6 for £375,000, with selling costs of
£40,000.
On 1 March 20X6, the entity acquires a replacement property for £3.8 million.
The entity's insurers contest the claim relating to the building on the basis of an exclusion clause. The
entity disagrees with the insurers' interpretation and in February 20X6 initiates legal proceedings.
Negotiations are protracted and it is not until the end of 20X7 that the insurers agree to settle for £3.9
million.
Requirement
How should the entity recognise these transactions?

Section overview
 IAS 41 sets out the accounting treatment, including presentation and disclosure requirements, for
agricultural activity.
2.1 Definitions
Definitions
Agricultural activity: Agricultural activity is defined as the management of the biological transformation
of biological assets for sale, into agricultural produce, or into additional biological assets.
Agricultural activities include, for example, raising livestock, forestry and cultivating orchards and
plantations.
Biological transformation: A biological transformation comprises the processes of growth,
degeneration, production and procreation that cause qualitative or quantitative changes in a biological
asset.
In its simplest form a biological transformation is the process of growing something such as a crop,
although it also incorporates the production of agricultural produce such as wool and milk.
Biological asset: A biological asset is a living plant or animal.
Agricultural produce: Agricultural produce is the harvested produce of an entity's biological assets.
IAS 41 considers the classification of biological assets and how their characteristics, and hence value,
change over time. The Standard applies to agricultural produce up to the point of harvest, after which
IAS 2 Inventories is applicable. A distinction is made between the two because IAS 41 applies to
biological assets throughout their lives but to agricultural produce only at the point of harvest.
IAS 41 includes a table of examples which clearly sets out three distinct stages involved in the
production of biological assets. Examples include the identification of dairy cattle as the biological asset,
milk the agricultural produce and cheese the product that is processed after the point of harvest.
Another example is wine: vines are the biological asset, grapes the agricultural produce and wine the
end product.
Calves and cows are biological assets as they are living animals whereas beef and milk are agricultural
produce. Apples are agricultural produce whereas the related trees and orchards are biological assets.
Agricultural activities may be quite diverse, but all such activities have similar characteristics as described
below.
Common characteristics of agricultural activities
 Capacity to change – living animals and plants are capable of changing. For example, a sapling
grows into a fruit tree which will bear fruit and a sheep can give birth to a lamb;
 Management of change – the biological transformation relies on some form of management
input, ensuring, for example, the right nutrient levels for plants, providing the right amount of
light or assisting fertilisation; and
 Measurement of change – the changes as a result of the biological transformation are measured
and monitored. Measurement is in relation to both quality and quantity.
Illustration: Agricultural activities

An entity is involved in the production and sale of raw materials for food products, in the sale of fish
reared at its own 'fish farms' and in the sale of fish caught in the Northern seas by ocean-going trawlers.
An analysis of the processes involved is as follows.

Food products raw materials
The entity owns farmland on which it grows annual crops of corn for sale to food manufacturers. The
growing process is aided by the careful application of a range of nutrients, while additives are
administered to the underlying land immediately after harvesting has ended. This is an agricultural
activity; the corn growing each year is the biological transformation; growth is encouraged by
management's activities and the change is monitored, to identify the time at which harvest should
commence.
Fish farming
The entity leases a number of privately-owned lakes into which it puts underwater tanks for the rearing
of fish. This is an agricultural activity, because the fish are grown to the size suitable for sale and their
feed must be provided for them since the amount available naturally in the tanks will be insufficient.
Ocean fishing
The entity owns a number of trawlers. The trawlers go to sea in search of suitable fish. This is not an
agricultural activity. Although there is biological transformation on the part of the fish, there is no
management intervention in the process; neither is there any routine measurement of the amount of
any change which has taken place. The trawlers harvest what the seas yield naturally.
Interactive question 8: Classification [Difficulty level: Easy]

Into which category would the following items be classified according to IAS 41 Agriculture?
(a) Wool C
(b) Vines H
A
(c) Sugar
P
E
R
2.2 Recognition and measurement

13
2.2.1 Recognition criteria
A biological asset or agricultural produce should only be recognised when:
 The entity controls the asset as a result of past events, for example the acquisition of dairy cattle.
The past event is the purchase, and control is obtained as the entity is now the legal owner.
 It is probable that future economic benefits will flow to the entity, for example because the dairy
cattle will produce milk which can be sold or processed into cheese and sold; and
 Fair value, or cost, of the asset can be measured reliably.
2.2.2 Measurement of biological assets

A biological asset should initially be measured at its fair value less estimated costs to sell, such as duty
and commission to brokers or dealers.
Costs to sell
Costs to sell do not include any costs that are necessary to get the asset to a market, for example
transport. These should, however, be deducted in determining fair value.
Fair value
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.' – see Chapter 2 Section 2.
Where an active market exists for a biological asset the quoted price in the market is the appropriate fair
value.
Where an active market does not exist, then fair value may be derived by using:

 The most recent transaction in the market, assuming that similar economic conditions exist at the
time of the transaction and at the reporting date; or
 Market prices for similar assets with appropriate adjustments to reflect differences; or
 Sector-based benchmarks, for example the value of meat per kilogram.
IAS 41 includes the presumption that it will be possible to fair value a biological asset. But if fair value
cannot be measured reliably at the time of initial recognition then the biological asset should be
recognised at cost less accumulated depreciation and impairment cost (ie the decrease in the
recoverable amount of an asset). Fair value should then be used as soon as a reliable measurement can
be made.
At subsequent reporting dates a biological asset should continue to be measured at its fair value. Once a
biological asset has been measured at fair value it is not possible to revert to cost.
2.2.3 Measurement of agricultural produce

Agricultural produce should be measured at its fair value, less estimated costs to sell at the point of
harvest. Subsequent measurement is by reference to IAS 2. It will always be possible to fair value the
agricultural produce since, by its very nature, there must be a market for it.
Interactive question 9: Costs to sell [Difficulty level: Easy]

Which of the following expenses would be classified as costs to sell when valuing biological assets and
agricultural produce?
(a) Commission to brokers
(b) Transfer taxes and duties
(c) Transport costs
(d) Advertising costs
Worked example: Fair value

An entity rears animals to be sold in a local market. The market is 50km away, and transport to market
costs £1 per animal. At the measurement date the open market value is £60. The auctioneers charge a
sales commission of 2% of market value and there is a government levy, based on market value, of 1%
on purchases and 3% on sales.
Requirement
How should the fair value less cost to sell be calculated?
Solution
The fair value less costs to sell is calculated as:
£
Market value 60.00
Transport to market costs (1.00)
Fair value 59.00
Costs to sell
Auctioneers' commission – 2% of £60 (1.20)
Government levy – 3% of £60 (1.80)
Fair value less costs to sell 56.00
2.2.4 Grouping assets

Grouping biological assets, or agricultural produce, according to significant attributes, such as age or
quality, may help to establish fair value. Such groupings should be consistent with attribute groupings
that are used in the market as a basis for pricing, for example, by wine vintage.

Some biological assets are physically attached to land, for example tree plantations, and it is necessary
to value the land and biological assets together as one asset, even though agricultural land is not within
the scope of IAS 41. To obtain the fair value of the biological assets, the fair value of the land element
should be deducted from the combined fair value.
A farmer wishing to value an apple orchard, in circumstances where there is no separate valuation for
the orchard from that for the land on which it is grown, would value it at the combined fair value of the
land and orchard, less the estimated fair value of land.
Land is dealt with under IAS 16 or IAS 40.
2.3 Gains and losses

Gains or losses arising on the initial recognition at fair value of a biological asset and agricultural
produce should be reported directly in profit or loss for the period to which they relate, for example a
gain may arise on the birth of a calf. Subsequent changes in the fair value will also be reported directly
in profit or loss.
Gains or losses on the initial recognition of agricultural produce should also be included in profit or loss
in the period in which they arise. Such gains or losses may arise as a result of harvesting, because the
harvested crop may be worth more than the unharvested crop. In this case a gain would arise.
Worked example: Changes in fair value

A herd of five four-year old animals was held on 1 January 20X3. On 1 July 20X3 a 4.5-year old animal
was purchased. The fair values less estimated costs to sell were as follows.
4 year-old animal at 1 January 20X3 £200 C
H
4.5 year-old animal at 1 July 20X3 £212
A
5 year-old animal at 31 December 20X3 £230 P
T
Requirement
E
Show the reconciliation of the changes in fair value. R
Solution
13
The movement in the fair value less estimated costs to sell of the herd can be reconciled as follows.
£
At 1 January 20X3 (5  £200) 1,000
Purchased 212
Change in fair value (the balancing figure) 168
At 31 December 2003 (6  £230) 1,380
The entity is encouraged to disclose separately the amount of the change in fair value less estimated
costs to sell arising from physical changes and price changes.
If it is not possible to measure biological assets reliably and they are instead recognised at their cost less
depreciation and impairment an explanation should be provided of why it was not possible to establish
fair value. A full reconciliation of movements in the net cost should be presented with an explanation of
the depreciation rate and method used.

3 IFRS 6 Exploration for and Evaluation of Mineral Resources
Section overview
 IFRS 6 Exploration for and Evaluation of Mineral Resources is effective from 1 January 2006 and
essentially deals with two matters.
– Allows entities to use existing accounting policies for exploration and evaluation assets.
– Requires entities to assess exploration and evaluation assets for impairment. The recognition
criteria for impairment are different from IAS 36 but, once impairment is recognised, the
measurement criteria are the same as for IAS 36.
3.1 Scope
The Standard deals with the accounting of expenditures on the exploration for and evaluation of
mineral resources (that is, minerals such as gold, copper, etc, oil, natural gas and similar resources),
except:
 Expenditures incurred before the acquisition of legal rights to explore.
 Expenditures incurred following the assessment of technical and commercial feasibility.
IAS 8 still applies to such industries in helping them determine appropriate accounting policies. Thus,
accounting policies must present information that is relevant to the economic decision needs of users.
Entities may change their policies under IFRS 6 as long as the new information comes closer to meeting
the IAS 8 criterion.
3.2 Measurement at recognition

At recognition, exploration and evaluation assets must be measured at cost.
Entities must determine which expenditures to recognise and apply their policy consistently. Such
expenditure may include acquisition of rights to explore, exploratory drilling, sampling, studies and
activities relating to commercial evaluation.
Expenditure related to the development of mineral resources is outside the scope of IFRS 6. This
comes under IAS 38.
3.3 Measurement after recognition

Entities must apply either the cost model or the revaluation model in IAS 16.
3.4 Changes in accounting policies

These may be made if the change makes the financial statements more relevant to users. IAS 8 criteria
need to be applied.
3.5 Classification and reclassification

Exploration and evaluation assets are classified as tangible or intangible according to the nature of
the assets acquired. The classification must be applied consistently. They should no longer be classified
as such when the technical feasibility and commercial viability of extracting a mineral resource are
demonstrable.
3.6 Impairment
The difficulty with respect to exploratory activities is that future economic benefits are generally very
uncertain and hence forecasting future cash flows, for example, is difficult. IFRS 6 modifies IAS 36 to
state that impairment tests are required:

 When the technical and commercial viability of extraction is demonstrable, at which point IFRS 6 is
no longer relevant to the asset.
 When other facts indicate that the carrying amount exceeds recoverable amounts, such as:
– Exploration rights have expired
– There has been no success in finding commercially viable mineral resources and the entity has
decided to discontinue exploratory activities within a specific area
– Estimates suggest that the carrying amount of assets are unlikely to be recovered in full
following successful development of the mineral resource
In such circumstances, impairment is undertaken in accordance with IAS 36.
3.7 Presentation and disclosure

Exploration and evaluation assets are recorded as tangible or intangible assets, as appropriate. Once
benefits are demonstrable, assets dealt with under IFRS 6 are superseded by other appropriate standards
and are reclassified accordingly.
Disclosure relates to:
 A description of the accounting policies applied
 The amounts relating to assets, liabilities, income and expense, and operating and investing cash
flows arising from exploration for and evaluation of mineral resources
C
H
4 IFRS 4 Insurance Contracts A
P
T
E
Section overview
R
 IFRS 4 represents interim guidance, as the first phase of a bigger project on insurance contracts.
The objective of IFRS 4 is to make limited improvements to accounting practices for insurance
contracts and to require an issuer of insurance contracts to disclose information that identifies and 13
explains amounts arising from such contracts.
4.1 Background
IFRS 4 specifies the financial reporting for insurance contracts by any entity that issues such contracts, or
holds reinsurance contracts. It does not apply to other assets and liabilities held by insurers.
In the past there was a wide range of accounting practices used for insurance contracts and the
practices adopted often differ from those used in other sectors. As a result the IASB embarked on a
substantial project to address the issues surrounding the accounting for insurance contracts. Rather than
issuing one Standard that covered all areas, the IASB decided to tackle the project in two phases.
Interim guidance has been issued in phase one of the project in the form of IFRS 4; it is a stepping stone
to the second phase of the project. IFRS 4 largely focuses on improving the disclosure requirements in
relation to insurance contracts; however, it also includes a number of limited improvements to existing
accounting requirements.
Although IFRS 4 sets out a number of accounting principles as essentially best practice, it does not
require an entity to use these if it currently adopts different accounting practices. An insurance entity is
however prohibited from changing its current accounting policies to a number of specifically identified
practices.

4.2 What is an insurance contract?
Definition
Insurance contracts: are contracts between two parties, where one party, the insurer, agrees to
compensate the other party, the policyholder, if it is adversely affected by an uncertain future event.
An uncertain future event exists where at least one of the following is uncertain at the inception of an
insurance contract:
 The occurrence of an insured event;
 The timing of the event; or
 The level of compensation that will be paid by the insurer if the event occurs (IFRS 4 Appendix B).
Some insurance contracts may offer payments-in-kind rather than compensation payable to the
policyholder directly. For example, an insurance repair contract may pay for a washing machine to be
repaired if it breaks down; the contract will not necessarily pay monetary compensation.
In identifying an insurance contract it is important to make the distinction between financial risk and
insurance risk. A contract that exposes the issuer to financial risk without significant insurance risk does
not meet the definition of an insurance contract.
Definitions
Financial risk is where there is a possible change in a financial or non-financial variable, for example a
specified interest rate, commodity prices, an entity's credit rating or foreign exchange rates.
Insurance risk is defined as being a risk that is not a financial risk. The risk in an insurance contract is
whether an event will occur (rather than arising from a change in something), for example a theft,
damage against property, or product or professional liability.
Examples of insurance contracts

Appendix B to IFRS 4, which forms an integral part of the Standard, includes an extensive list of
examples of insurance contracts including:
 Life insurance and prepaid funeral plans. It is the timing of the event that is uncertain here, for
example certain life cover plans only pay out if death occurs within a specified period of time;
 Disability and medical cover;
 Credit insurance, covering the policyholder for non-recoverable receivables; and
 Travel cover to provide against any loss suffered whilst travelling.
Examples of an insurer taking on insurance risk are:
 An insurance contract issued to a policyholder against the escalation of claims from faulty
motorcycles. The fault was discovered a year ago and the extent of total claims is yet to be
established. This is an insurance contract since the insured event is the discovery of the ultimate
cost of the claims.
 A gas boiler repair service available from a supplier who, for the payment of a fixed fee, will fix the
malfunctioning boiler. This is an insurance contract as it is a payment-in-kind contract, with the
uncertain event being whether the boiler will break down and the policyholder will be adversely
affected.
Examples which are not insurance contracts
It is important to distinguish between insurance contracts and other contracts that are not covered by
IFRS 4 but which might look like insurance contracts. To provide clarification IFRS 4 specifically identifies
a number of areas where its provisions do not apply, for example:
 The provision of product warranties given directly by the manufacturer, dealer or retailer;

 Employers' assets and liabilities in relation to employee benefit plans and obligations under a
defined benefit plan;
 A contractual right, or obligation, that is contingent on the right to use a non-financial item, for
example some licences;
 A finance lease that contains a residual value guaranteed by the lessee, ie a specified value for the
asset at the end of the lease is guaranteed by the lessee;
 Financial guarantees within the scope of IAS 39 Financial Instruments: Recognition and Measurement;
 Contingent consideration that has arisen as a result of a business combination; and
 Insurance contracts that the entity holds as policyholder.
4.3 Recognition and measurement

IFRS 4 exempts an insurer temporarily (during phase one of the IASB's insurance project) from the need
to consider the IASB Framework in selecting accounting policies for insurance contracts where there is no
specific accounting requirement set out in another international Standard (IFRS 4.13, through its
reference to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors). However, IFRS 4
expressly:
 Requires a test for the adequacy of recognised insurance liabilities – referred to as the liability
adequacy test;
 Prohibits provisions for possible claims under contracts that are not in existence at the reporting
date (referred to as catastrophe or equalisation provisions); C
H
 Requires an impairment test for reinsurance assets. An impairment is only recognised where after A
the commencement of a reinsurance contract, an event has occurred that will lead to amounts due P
T
under the contract not being recovered in full, and a reliable estimate of the shortfall can be E
assessed; and R
 Requires an insurer to continue to recognise insurance liabilities in its financial statements until they
are discharged, cancelled or expire, and to present such liabilities without offsetting them against
13
related reinsurance assets.
Liability adequacy test
An insurer recognises its insurance liabilities at each reporting date based on the current estimate of
future contractual cash flows, and related items such as handling costs, arising under the insurance
contracts.
This provision should be reassessed at each reporting date and any identified shortfall should be
recognised immediately as part of profit or loss for the period. This is the so called liability adequacy
test.
The assessment should be based on current estimates for future cash flows under the insurance
contracts issued. If the recognised insurance liability is assessed as being adequate, then IFRS 4 does not
require any further action by the insurer. However, if the liability is found to be inadequate, then the
entire shortfall should be recognised in profit or loss.
The liability adequacy test considers all contractual cash flows under current insurance contracts, and
related costs, such as claims handling costs. Where there are embedded options or guarantees within a
contract, any cash flows arising should also be included in the assessment. Where an entity has deferred
acquisition costs and related intangible assets such as those arising from an insurance based business
combination these should be deducted from the insurance liabilities.
If the accounting policies of an insurer do not demand that a liability adequacy test should be carried
out, as described above, then an assessment is still required of the potential net liability (ie the relevant
insurance liabilities less any related deferred acquisition costs). In these circumstances the insurer is
required to recognise at least the amount that would be required to be recognised as a provision under
the application of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
That is, if the carrying amount of the IAS 37 calculated provision is greater than that recognised, then
the insurer should increase the liabilities as appropriate.

Worked example: Liability adequacy test
An insurance entity writes one-year policies for one of its classes of general insurance business and is
carrying the following amounts for that class in its draft statement of financial position at 31 December
20X5.
Liabilities £m
Provision for claims - discounted value of likely claims for insured
losses occurring up to 31 December 20X5 75
Liability for unearned premiums - proportion of premiums for policies
already written which relates to cover in 20X6 30
Assets
Deferred acquisition costs - proportion of commission and other
business acquisition costs for policies already written which relate
to the unearned premiums 10
The effect of reinsurance is immaterial.
The entity's procedure for calculating the provision for claims is as follows.
 To use past experience to make a range of estimates of amounts ultimately payable to insured
persons in respect of claims for losses occurring by the reporting date and of the timing of the
payments;
 To select the most likely amount and timing as its central estimate;
 To discount the amount by reference to a risk-free rate;
 To use past experience to increase the discounted amount by a risk margin to reflect the inherent
uncertainty in this discounted estimate; and
 To increase the adjusted amount by an estimate, based on past experience and discounted, of the
internal costs (such as employee benefits and accommodation costs) which will be incurred in
handling the loss claims over the period up to their settlement.
The cost of the provision is recognised in profit or loss. As this procedure meets the requirements of
IFRS 4 no further action is necessary.
The entity also estimates on a similar basis the discounted total amount, including claims handling costs,
which will be payable in respect of insured losses arising after the reporting date over the period of
cover which generates the unearned premiums. The estimated amount is £25 million.
As all the policies extend for one year, in 20X6 the whole of the £30 million unearned premiums will
become earned. But in 20X6 the deferred acquisition costs of £10 million will be charged against those
premiums. Against this net income of £20 million, the estimated cost of claims is £25 million. Hence,
there is a premium deficiency of £5 million in 20X6, which should be recognised in profit or loss in
20X5.
4.4 Disclosures
IFRS 4 sets out an overriding requirement that the information to be disclosed in the financial
statements of an insurer 'identifies and explains amounts arising from insurance contracts'.
This information should include the accounting policies adopted and the identification of recognised
assets, liabilities, income and expense arising from insurance contracts.
More generally, the risk management objectives and policies of an entity should be disclosed, since this
will explain how an insurer deals with the uncertainty it is exposed to.
An entity is not generally required to comply with the disclosure requirements in IFRS 4 for comparative
information that relates to annual periods beginning before 1 January 2005. However, comparative
disclosure is required in relation to accounting policies adopted and the identification of recognised
assets, liabilities, income and expense arising from insurance contracts.

Section overview
 IAS 26 applies to the preparation of financial reports by retirement benefit plans which are either
set up as separate entities and run by trustees or held within the employing entity.
5.1 Objectives, scope and definitions of IAS 26

The objective of IAS 26 is to provide useful and consistently produced information on retirement benefit
plans for members of the plans and other interested parties.
IAS 26 should be applied in the preparation of financial reports by retirement benefit plans.
Although it is commonplace for a retirement benefit plan to be set up as a separate legal entity run by
independent trustees, plan assets may be held within the entity employing the plan's members. IAS 26
applies in both sets of circumstances. In the latter case IAS 26 still regards the retirement benefit plan as
a reporting entity separate from the employing entity.
The preparation of a retirement benefit plan's financial report should be in accordance with not only IAS
26 but also all other international Standards to the extent that they are not overridden by IAS 26.
IAS 26 does not cover:
 The preparation of reports to individual participants about their retirement benefit rights; or
 The determination of the cost of retirement benefits in the financial statements of the employer C
having pension plans for its employees and providing other employee benefits. H
A
P
Definition T
Retirement benefit plans: are arrangements whereby an entity provides benefits for its employees on E
R
or after termination of service (either in the form of an annual income or as a lump sum), when such
benefits, or the employer's contributions towards them, can be determined or estimated in advance of
retirement from the provisions of a document or from the entity's practices.
13
There are two main types of retirement benefit plan, both discussed in Chapter 8.
 Defined contribution plans (sometimes called 'money purchase schemes'). These are retirement
plans under which payments into the plan are fixed. Subsequent payments out of the plan to
retired members will therefore be determined by the value of the investments made from the
contributions that have been made into the plan and the investment returns reinvested.
 Defined benefit plans (sometimes called 'final salary schemes'). These are retirement plans under
which the amount that a retired member will receive from the plan during retirement is fixed.
Contributions are paid into the scheme based on an estimate of what will have to be paid out
under the plan.
The diagram following the question below outlines the relevant relationships (it is also relevant to IAS
19).
Interactive question 10: Scope [Difficulty level: Easy]

To which of the following does IAS 26 Accounting and Reporting by Retirement Benefit Plans apply?
(a) The general purpose financial reports of pension schemes
(b) The cost to companies of employee retirement benefits
(c) The financial statements relating to an actuarial business
(d) Reports to individuals of their future retirement benefits

The entity
(ie employer)
Employer's
contributions
(funding)
Pension scheme assets

Investment
(net assets available
returns
for benefits)
Employees' Pensions paid to

contributions retired employees
Employees
(or participants)
5.2 Key concepts

'Funding' represents the employer's contributions paid to the fund in order to meet the future
obligations under the plan for the payment of retirement benefits.
'Participants' are those employees who will benefit under the plan (ie employees and retired
employees).
The 'net assets available for benefits' are the assets less liabilities of the plan that are available to
generate future investment income that will increase the plan's assets. These net assets are calculated
before the deduction of the actuarial assessment of promised retirement benefits.
5.3 Defined contribution plans

A defined contribution plan is where the annual pension payable to retired employees (ie participants) is
based upon the accumulated value of the assets in the employee's fund.
The assets in the pension plan are funded by contributions made into the plan and investment returns
on those assets. Contributions may be made by the employer, the employee or both parties.
Financial report for a defined contribution plan
A financial report prepared for a defined contribution plan should contain:
(1) A statement of the net assets in the plan that are available to meet the benefits payable under the
plan; and
(2) A description of the funding policy of the plan.
The objective of the plan's financial report is to provide information about the plan itself, for example
that it is being run with the members' best interest in mind, and to set out the performance of the
investments in the plan. The performance of the investments will directly affect the retirement benefits
that are paid out under the plan and hence such information will be of particular interest to the
participants of the plan.
A defined contribution plan report will typically include:
 A description of the significant activities for the reporting period, along with details of any changes
that have been made to the plan and the effect of these changes on the plan;
 A description of the plan's membership, terms and conditions;
 Financial statements containing information on the transactions and investment performance for
the period as well as presenting the financial position of the plan at the end of the period; and
 A description of the investment policies.

5.4 Defined benefit plans
Under defined benefit plans the annual pensions payable to retired employees (ie the participants)
are based upon a formula, for example using the number of years' service and the employee's final
salary.
The level of payments ultimately to be paid out of the fund is uncertain as they depend upon such
factors as life expectancy and future investment returns. The expertise of an actuary is used to
estimate these uncertain future events to ensure that based on the assets in the plan and the
expected future contributions to be made, the pension scheme is adequately funded to meet its
future obligations. The future obligations are measured as the actuarial present value of promised
retirement benefits, which is more precisely defined as being the present value of the expected
payments by a retirement benefit plan to existing and past employees, attributable to the service
already rendered.
A related concept is 'vested benefits' which are benefits payable regardless of whether the participants in
the plan continue in the entity's employment.
If the estimated expected obligations payable under a plan exceed the assets (ie there is a deficit), then
the employer may have to make additional contributions to ensure the retirement plan is adequately
funded. If assets exceed obligations (ie there is a surplus), then the employer may be able to reduce its
future contributions payable.
Financial report for a defined benefit plan
A defined benefit plan report should contain a statement showing the net assets that are available for
the payment of benefits, the actuarial present value of promised retirement benefits, identifying which
of these benefits are vested and which are not, and the resulting surplus or deficit in the plan. This C
H
information may alternatively be presented by providing a statement of the net assets of the fund that A
are available to pay future benefits, together with a note disclosing the actuarial present value of P
promised retirement benefits and those benefits which are vested and those which are not. This T
actuarial present value information may be contained in an accompanying actuarial report, rather than E
in the statement of net assets. R
A defined benefit plan's report should provide participants with information about the relationship
between the future obligations under the plan and the resources within the plan that are available to 13
meet those obligations. A typical report will therefore include:
 A description of significant activities for the reporting period along with details of any changes that
have been made to the plan and the effect of the changes on the plan;
 A description of the plan's membership, terms and conditions;
 Financial statements containing information on the transactions and investment performance for
the period as well as presenting the financial position of the plan at the end of the period;
 Actuarial information, including the present value of the promised retirement benefits under the
plan and a description of the significant actuarial assumptions made in making those estimates;
and
 A description of the investment policies.
5.5 All retirement plans

5.5.1 Valuation of assets
Retirement benefit plan investments should be carried at fair value, which for marketable securities is
market value. Where an estimate of fair value is not possible, for example where the plan has total
ownership of another entity, disclosure should be made of the reason why fair value is not used.

5.6 Key requirements
The following summarises the key requirements of IAS 26.
Key requirements Defined Defined All

contribution benefit retirement
plans plans plans
Investments to be carried at fair value wherever Yes

possible
Recognition of the actuarial present value of Yes
promised retirement benefits
A statement of changes in net assets available for Yes
benefits
No requirement for an actuarial report Yes
5.7 Disclosure
The report of all retirement benefit plans should also include the following information.
 A statement of changes in the net assets that are available in the fund to provide future benefits;
and
 A summary of the plan's significant accounting policies.
The statement of changes in the net assets available to provide future benefits should disclose a full
reconciliation showing movements during the period, for example contributions made to the plan split
between employee and employer, investment income, expenses and benefits paid out.
Information should be provided on the plan's funding policy, the basis of valuation for the assets in the
fund and details of significant investments that exceed a 5% threshold of net assets in the fund available
for benefits. Any liabilities that the plan has other than those of the actuarially calculated figure for
future benefits payable and details of any investment in the employing entity should also be disclosed.
General information should be included about the plan, such as the names of the employing entities,
the groups of employees that are members of the plan, the number of participants receiving benefits
under the plan and the nature of the plan, ie defined contribution or defined benefit. If employees
contribute to the plan, this should be disclosed along with an explanation of how the promised benefits
are calculated and details of any termination terms of the plan. If there have been changes in any of the
information disclosed then this fact should be explained.

Summary
IAS 40
Investment Property
Recognition as
investment property?
No Yes
Treat according to Recognise according C

IAS 16 to IAS 40 H
A
P
T
E
R
Subsequent 13
measurement
Initial recognition
- accounting policy
choice
Cost Fair value
model model
At cost - At cost less

Fair value
including - depreciation
IAS 40
transaction costs - impairment para's 33-35
IAS 40 para 20 IAS 40 para 56

Industry specific Standards
IAS 26 Accounting and Reporting

IAS 41 Agriculture
by Retirement Benefit Plans
Biological assets Agricultural produce Defined Defined

- initial recognition at the point of benefit contribution
- subsequent harvest plans plans
measurement at - fair value less point
fair value less of sale costs
point of sale
Actuarial present value of
costs
promised retirement
benefits
Valuation
of plan
assets
IFRS 6 Exploration For and

IFRS 4 Insurance Contracts
Evaluation of Mineral Resources
Recognition of exploration
Unbundle contracts and evaluation assets
into Liability adequacy
- insurance test
After recognition, apply
component (apply - recognise either the cost model
IFRS 4) deficiency in profit or the revaluation model
- deposit or loss
component (apply
IAS 39)

Self-test
IAS 40 Investment Property
1 Which of the following properties fall under the definition of investment property and therefore
within the scope of IAS 40 Investment Property?
(a) Property occupied by an employee paying market rent
(b) A building owned by an entity and leased out under an operating lease
(c) Property being constructed on behalf of third parties
(d) Land held for long-term capital appreciation
2 Boron
The Boron Company is an investment property company. On 31 December 20X6 it purchased a
retirement home as an investment at a cost of £600,000. Legal costs associated with the
acquisition of this property were a further £50,000.
At 31 December 20X7 Boron adopted the fair value model. The fair value of the retirement home
at this date was £700,000 and costs to sell were estimated at £40,000.
Requirement
What amount should appear in the statement of profit or loss and other comprehensive income of
Boron in the year ending 31 December 20X7 in respect of the retirement home under IAS 40
Investment Property?
3 Acimovic
The Acimovic Company is an investment property company. It acquired an industrial investment C
H
property on 31 December 20X6 from The Tyrant Company, a finance house, on a long lease which A
is a finance lease in accordance with IAS 17 Leases. The following information is available. P
T
At 31 December 20X6 20X7 E
£ £ R
Present value of minimum payments under the lease 740,000 720,000
Fair value of the property interest 840,000 875,000
Fair value of the property 790,000 890,000 13
The property has a useful life of 40 years from 31 December 20X6.

Requirement
What amount should appear in the statement of profit or loss and other comprehensive income of
Acimovic in the year ending 31 December 20X7 in respect of the property under IAS 40 Investment
Property?
4 Laburnum
The Laburnum Company is an investment property company. One of its properties is a warehouse
which has the specialist use of storing tropical plants at high temperatures. As a result, the central
heating system is an important and integral part of the warehouse building. Laburnum uses the fair
value model for investment properties.
The central heating system was purchased on 1 January 20X2 for £80,000. It is being depreciated
at 10% per annum on cost and it has been agreed by the valuer that the carrying amount of the
central heating system is a reasonable value at which to include it in the fair value of the entire
warehouse.
In December 20X7 the valuer initially determined the fair value of the warehouse, including the
central heating system, to be £1,250,000. Unfortunately, the central heating system completely
failed on 25 December 20X7 and was immediately scrapped and replaced with a new heating
system costing £140,000 on 31 December 20X7.
Requirement
According to IAS 40 Investment Property, at what value should the warehouse, including the
heating system, be recognised in the financial statements of Laburnum in the year ending 31
December 20X7?

5 Ramshead
On 1 January 20X6 The Ramshead Company acquired an investment property for which it paid
£3.1 million and incurred £100,000 agency and legal costs. The property's useful life was estimated
at 20 years, with no residual value; its fair value at 31 December 20X6 was estimated at £3.45
million and agency and legal costs to dispose of the property at that date were estimated at
£167,500.
On 1 July 20X7 Ramshead decided to dispose of the property. The criteria for being classified as
held for sale were met on that date, when the property's fair value was £3.5 million. Agency and
legal costs to dispose of the property were estimated at £160,000.
On 1 October 20X7 the property was sold for a gross price of £3.7 million, with agency and legal
costs of £165,000 being incurred.
Requirement
Calculate the following amounts in respect of Ramshead's financial statements for the year ended
31 December 20X7 in accordance with IAS 40 Investment Property, and IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations.
(a) The gain or loss arising in 20X6 from the change in carrying amount if the fair value model is
used to account for the property.
(b) The gain or loss on disposal arising in 20X7 if the cost model is used.
(c) The increase or decrease, compared with the cost model, in the gain or loss on disposal
arising in 20X7 if the fair value model is used.
IAS 41 Agriculture
6 Arapawanui
The Arapawanui Company keeps a flock of sheep on its land, selling the milk outputs. The day after
its production, the milk is collected on behalf of the purchasers and revenue from its sale is
recognised.
On 30 June 20X7 300 animals were born, all of which survived and were still owned by
Arapawanui at 31 December 20X7. 10,000 litres of milk were produced in the year to 31
December 20X7.
The following market data is available in respect of the sheep.
Type of animal At 30 June 20X7 At 31 December 20X7
Fair value per animal Fair value per animal
£ £
Newborn 22 23
6 months old 25 26
The animal fair values are based upon transactions prices in the local markets. Auctioneers'
commission is 1.5% of the transaction price and the government sales levy is 0.5% of that price.
The production cost, including overheads, of the milk was £0.08 per litre and the fair values were
£0.13 per litre throughout 20X7 and £0.14 per litre throughout 20X8. Costs to sell were estimated
at 4%.
Requirement
What gain should be recognised in respect of the newborn sheep and the milk in Arapawanui's
financial statements for the year to 31 December 20X7, according to IAS 41 Agriculture?
7 Tepev
The Tepev Company bought a flock of 400 sheep on 1 December 20X7. The cost of each sheep
was £80, which represented fair value at that date. Auctioneers' fees on sale are 5% of fair value,
and the cost of transporting each sheep to market is £4.00. An agricultural levy of £2.00 is payable
on each sheep sold.

At 31 December 20X7 all of the sheep are still held and fair value has increased to £90 per sheep.
No other costs have changed. Tepev has a contract to sell the sheep on 31 March 20X8 for £100
each.
Requirement
What is the carrying amount of the flock in the statement of financial position at 31 December
20X7, according to IAS 41 Agriculture?
8 Saving
The Saving Company bought a flock of 500 sheep on 1 December 20X7. The cost of each sheep
was £95, which represented fair value at that date. Auctioneers' fees on sale are 5% of fair value,
and the cost of transporting each sheep to market is £3.00. An agricultural levy of £2.00 is payable
on each sheep sold.
At 31 December 20X7 all of the sheep are still held and fair value has increased to £107 per sheep.
No other costs have changed. Saving has a contract to sell the sheep on 31 March 20X8 for £119
each.
Requirement
What is the gain arising in relation to the flock between the date of initial recognition as an asset
and 31 December 20X7, according to IAS 41 Agriculture?
9 Monkey
The Monkey Company has the following information in relation to a cattle herd in the year ended
31 December 20X7.
C
£'000 H
Cost of herd acquired on 1 January 20X7 (which equates to fair value) 1,800 A
Auctioneers' sales fees 2% of sale price P
Loan obtained at 8% to finance acquisition of herd 1,500 T
Fair value of herd at 31 December 20X7 2,500 E
R
Transport cost to market 35
Government transfer fee on sales – no fee on purchases 50
Requirement 13
What is the loss arising on initial recognition of the herd as biological assets and the gain arising on
its subsequent remeasurement under IAS 41 Agriculture, in the year ended 31 December 20X7?
10 Blackbuck
The Blackbuck Company has in issue unit-linked contracts which pay benefits measured by
reference to the fair value of the pool of investments supporting the contracts. The terms of the
contracts include the following.
(1) On surrender by the holder or on maturity, the benefits shall be the full fair value of the
relevant proportion of the investment.
(2) In the event of the holder's death prior to surrender or maturity, the benefits shall be 120% of
the full value of the relevant proportion of the investments.
Blackbuck's accounting policies do not otherwise require it to recognise all the obligations under
any deposit component within these contracts.
Blackbuck's financial controller is unclear whether these contracts should be accounted for under
IFRS 4 Insurance Contracts, or under IAS 39 Financial Instruments: Recognition and Measurement.
Requirement
Explain how these contracts should be accounted for.

11 Traore
The Traore Company is organised into a number of divisions operating in different sectors. The
accounting policies applied in two of its divisions prior to the introduction of IFRS 4 Insurance
Contracts are as follows.
Accounting policy (1) In its car breakdown division, Traore offers unlimited amounts of
roadside assistance in exchange for an annual subscription. Although it
has always accepted that this activity is in the nature of offering
insurance against breakdown, it accounts for these subscriptions by
using the stage of completion method under IAS 18 Revenue, and
making relevant provisions for fulfilment costs under IAS 37 Provisions,
Accounting policy (2) In its property structures insurance division, Traore makes a detailed
estimate for the cost of each outstanding claim but adopts the practice
of adding another 20% to the total on a 'just in case' basis.
Requirement
Which of these accounting policies is Traore permitted to continue to use under IFRS 4 Insurance
Contracts?
IAS 26 Accounting and Reporting by Retirement Benefit Plans
12 Answer the following questions in accordance with IAS 26 Accounting and Reporting by Retirement
Benefit Plans.
(a) How should a defined contribution retirement benefit plan carry property, plant and
equipment used in the operation of the fund?
(b) Is a defined contribution retirement benefit plan permitted to use a constant rate redemption
yield to measure any securities with a fixed redemption value which are acquired to match the
obligations of the plan?
(c) Does IAS 26 specify a minimum frequency of actuarial valuations?
IFRS 6 Exploration For and Evaluation of Mineral Resources
13 Give examples of circumstances that would trigger a need to test an evaluation and exploration
asset for impairment.

Technical reference

Definition of investment property IAS 40.5
Definition of fair value IFRS 13.9
Property held by lessee under operating lease may be investment IAS 40.6
property
Fair value model IAS 40.33-35, IAS 40.38
Cost model IAS 40.56
Scope IAS 41.1
Agricultural activity IAS 41.5, 8
– Biological assets
– Agricultural produce at the point of harvest
– Government grants C
H
Recognition and measurement IAS 41.10, 12-13 A
P
Gains and losses IAS 41.26, 28 T
E
Government grants IAS 41.34-35
R
Disclosure IAS 41.40, 41, 46-50, 54-57
3 IFRS 6 Exploration For and Evaluation of Mineral Resources 13
Scope IFRS 6.3-5
Measurement at recognition IFRS 6.8-11
Measurement after recognition IFRS 6.12
Changes in accounting policies IFRS 6.13
Impairment IFRS 6.18
4 IFRS 4 Insurance Contracts

Objective IFRS 4.1
Scope IFRS 4.2-6
Embedded derivatives IFRS 4.7-9
Liability adequacy test IFRS 4.15

Scope IAS 26.1
Definitions IAS 26.8
Defined contribution plans IAS 26.13
Defined benefit plans IAS 26.17-19
Frequency of actuarial valuations IAS 26.27
Financial statement content IAS 26.28-31
All plans:
Valuation of plan assets IAS 26.32
Disclosure IAS 26.34

IAS 40 Investment Property

1 (b) and (d) fall under the definition of investment property
(b) A building owned by an entity and leased out under an operating lease
(d) Land held for long-term capital appreciation
IAS 40.8 and 9 give examples of types of investment property.
2 Boron
£50,000
Under the fair value model IAS 40.33 requires investment properties to be measured at fair value,
while IAS 40.37 requires fair value to be determined excluding transaction costs that may be
incurred on sale or other disposal. IAS 40.35 requires changes in fair value to be recognised in
profit or loss.
IAS 40.20 requires transaction costs, such as legal costs, to be included in the initial measurement.
So the change in fair value is £700,000 – (£600,000 + £50,000) = £50,000.
3 Acimovic
£135,000 income C
H
IAS 40.25 requires that an investment property held under a finance lease should initially be A
recognised according to IAS 17 Leases, which is at the lower of (i) fair value and (ii) present value of P
minimum lease payments, so £740,000. T
E
Subsequent measurement is at fair value, per IAS 40.33. IAS 40.26 requires the subsequent fair R
value to relate to the property interest, not to the underlying property. So the £875,000 fair value
of the property interest should be used.
13
The result is income of £135,000 (ie £875,000 - £740,000).
4 Laburnum
£1,358,000
IAS 40.19 and 68 require derecognition of the carrying amount of the failed system and inclusion
of the replacement.
Thus £1,250,000 – (£80,000 × 4/10) + £140,000 = £1,358,000
5 Ramshead
(a) £250,000 gain
(b) £575,000 gain
(c) £540,000 decrease
(a) Transaction costs should be included in the initial measurement of investment properties (IAS
40.20). Under the fair value model an investment property is subsequently carried at fair value
without any deduction for costs to sell (IAS 40.33 and 5). The gain recognised in profit or loss
is £250,000 (£3.45m – (£3.1m + £0.1m)).
(b) Any asset classified as held for sale is measured in accordance with applicable IFRS
immediately before classification. So if the cost model is used, the carrying amount before
initial classification is cost less depreciation to the date of classification, so £2.96m (£3.2m less
18 months' depreciation at 5% per annum). On initial classification, the property is measured
at the lower of this carrying amount and the £3.34m (£3.5m – £160,000) fair value less costs
to sell (IFRS 5.15) so £2.96m. There is no subsequent depreciation (IFRS 5.25), so the carrying
amount will be the same at the date of disposal. The profit on disposal is net disposal
proceeds less the carrying amount (IAS 40.69), so net sales proceeds of £3.535m (£3.7m –
£165,000) less £2.960m gives a profit on disposal of £575,000.

(c) If the fair value model is used, then the carrying amount immediately before initial
classification will be the £3.5m fair value. The requirement to measure an asset 'held for sale'
at the lower of carrying amount at fair value less costs to sell does not apply to investment
properties measured at fair value (IFRS 5.5) and so the property continues to be measured at
fair value. IAS 40.37 states that costs to sell should not be deducted from fair value, so the
property continues to be measured at £3.5m. Profit on disposal will be net sales proceeds of
£3.535m less £3.5m = £35,000. This is a reduction of £540,000 on the cost model gain.
IAS 41 Agriculture
6 Arapawanui
The newborn sheep are biological assets and should be measured at fair value less costs to sell,
both on initial recognition and at each reporting date (IAS 41.12). The gains on initial recognition
and from a change in this value should be recognised in profit or loss (IAS 41.26). As the animals
are 6 months old at the year-end, the total gain in the year (being the initial gain based on a
newborn fair value of £22 plus the year end change in value by £4 to £26) is £7,644 (300  £26 
(100% – 1.5% – 0.5%)).
The milk is agricultural produce and should be recognised initially under IAS 41 at fair value less
costs to sell (IAS 41.13). (At this point it is taken into inventories and dealt with under IAS 2.) The
gain on initial recognition should be recognised in profit or loss (IAS 41.28). The gain is £1,248
(10,000 litres  £0.13  (100% – 4)).
Total gain is £8,892.
7 Tepev
£33,400
Biological assets should be measured at fair value less costs to sell (IAS 41.12). Costs to sell include
sales commission and regulatory levies but exclude transport to market (IAS 41.14). Transport costs
are in fact deducted from market value in order to reach fair value. In this question fair value of £90
is provided; it is assumed that this is calculated as a market value of £94 less the quoted transport
costs of £4. Contracts to sell agricultural assets at a future date should be ignored (IAS 41.16).
The statement of financial position carrying amount per sheep is:
£
Fair value 90.00
Costs to sell (£90 × 5%) + £2.00 (6.50)
Value per sheep 83.50
For the flock of 400 sheep, the amount is £33,400.

8 Saving
£5,700
Biological assets should be measured at fair value less costs to sell, both on initial recognition and
at each reporting date (IAS 41.12). Costs to sell include sale commission and regulatory levies but
exclude transport to market (IAS 41.14). Transport costs are in fact deducted from market value in
order to reach fair value. Contracts to sell agricultural assets at a future date should be ignored
(IAS 41.16).
£
FV at reporting date (£107 – commission (£107 × 5%) – levy £2.00) 99.65
Initial FV per sheep (£95 – commission (£95 × 5%) – levy £2.00) (88.25)
Gain per sheep 11.40
There is, therefore, a gain on the flock of 500 sheep of £5,700.

9 Monkey
(a) £86,000 loss on initial recognition
(b) £686,000 gain on subsequent measurement

(a)
£'000
Cost of herd 1,800
Recognised at FV – costs to sell (£1.8m – fees (£1.8m × 2%) – Gvnmt fee (1,714)
£50,000)
Initial loss on recognition 86
On acquisition of the herd, the cattle are initially recognised as biological assets at fair value
less costs to sell (IAS 41.27), which in this case is less than cost by the costs to sell which are
immediately deducted (IAS 41.27). Acceptable costs to sell include autioneers' fees and
government transfer fees (IAS 41.14) but exclude transport to market costs (IAS 41.14). The
interest on the loan taken out to finance the acquisition is not a cost to sell (IAS 41.22).
(b) The value is then restated to fair value less costs to sell at each reporting date (IAS 41.12)
£'000
Fair value at 31 December 20X7 2,500
Costs to sell: auctioneers fees (£2.5m × 2%) (50)
Government fees (50)
Carrying value 2,400
Less initial recognition value (1,714)
Gain 686

10 Blackbuck
The extra payable on death prior to surrender/maturity should be accounted for under IFRS 4 and
C
the remainder under IAS 39. H
Given the entity's accounting policies in relation to the recognition of obligations under the deposit A
P
components, IFRS 4.10 requires the insurance component and the deposit component to be T
unbundled; IFRS 4.12 requires the insurance component to be accounted for under IFRS 4 and the E
deposit component under IAS 39. R
11 Traore
The entity is permitted to continue with both policies. 13
IFRS 4.13 disapplies the provisions of IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors, in relation to selection of accounting policies where there is no IFRS. Entities are therefore
only required to change existing policies in the circumstances listed in IFRS 4.14. Accounting policy
(1) is not caught by this paragraph, so its continued use is permitted.
The application of Accounting policy (2) involves the use of excessive prudence. The continued use
of excessive prudence is permitted by IFRS 4.26.
IAS 26 Accounting and Reporting by Retirement Benefit Plans
12 (a) Under IAS 26.33 all types of retirement benefit plan should account for assets used in the
operation of the plan under the applicable Standards. IAS 16 is applicable in this case and
either the cost model or the revaluation model may be used.
(b) All types of retirement plan are permitted by IAS 26.33 to use this method of measuring such
securities.
(c) No minimum frequency of actuarial valuation is specified in IAS 26.27 or elsewhere.
IFRS 6 Exploration For and Evaluation of Mineral Resources
13 (a) The expiration or anticipated expiration in the near future of the period for which the entity
has the right to explore the relevant area, unless the right is expected to be renewed.
(b) The lack of available planned or budgeted expenditure for further exploration and evaluation
of the specific area.
(c) A decision to discontinue evaluation activities in the exploration and specific area when
commercially viable resources have not been identified.


(a) The factory is not an investment property. It should be classified as property held for sale and
accounted for under IFRS 5.
(b) The building would qualify as an investment property under IAS 40 as the entity intends to earn
rentals from it under an operating lease.
(c) The provisions offered over and above the office space itself, fall within what IAS 40 describes as
'ancillary services'. Considering the nature and extent of these services, it would be unlikely that
they could be described as 'insignificant' in relation to the arrangements as a whole. The building
is, in essence, being used for the provision of serviced offices and therefore does not meet the
definition of an investment property.
Although the entity's main objective in acquiring the building is its potential capital appreciation,
the building should be recognised and measured in accordance with IAS 16 rather than IAS 40.
(d) The property should be recognised as an investment property on 30 March 20X5 when the offices
were ready to be occupied. Costs incurred, and consequently operating losses, after this date
should be expensed even though the entity did not start to receive rentals until later in 20X5.
Losses incurred during this 'empty' period are part of the entity's normal business operations and
do not form part of the cost of the investment property.

(1) The £5 million value could be used as a basis of fair value, because the price was agreed between
market participants.
(2) The £6 million value could not be used as a basis of fair value, because the sale transaction cannot
be presumed to be between market participants in an orderly transaction.
(3) The £4.5 million value could not be used as a basis of fair value, because the sale transaction would
appear to have been made by a forced, not willing, seller, and therefore not an orderly transaction.
(4) The £5.5 million value could not be used as a basis of fair value, because the sale transaction would
appear to have been made to a buyer who was not knowledgeable of local market conditions, and
therefore not a market participant in an orderly transaction.

The cost model £m
(a) Net proceeds 6.00
Carrying amount £5,500,000 × 47/50 (5.17)
Profit on sale 0.83
The fair value model £m

(b) Net proceeds 6.0
Fair value (6.2)
Loss on sale (0.2)

The changes of use will be reflected in the financial statements based on whether the entity uses the
cost model or the fair value model for investment properties as follows.

The cost model for investment properties
At 31 December 20X5, the building has a carrying amount of:
£5.5m × 45/50 years = £4.95 million in accordance with IAS 16.
On 1 January 20X6 the property will be recognised as an investment property at its IAS 16 carrying
amount of £4.95 million and will continue to be depreciated over its remaining 45-year life.
At 31 December 20Y0, the building has a carrying amount of:
£4.95m × 40/45 years = £4.4 million in accordance with IAS 40.
On 1 January 20Y1 the property will be recognised as property, plant and equipment at its IAS 40
carrying amount of £4.4 million and will continue to be depreciated over its remaining 40-year life.
The fair value model for investment properties
At 31 December 20X5, the building has a carrying amount of £4.95 million in accordance with IAS 16
(as set out above).
On 1 January 20X6, the property will be recognised as an investment property. However, the property
should be revalued to fair value at 31 December 20X5, and any change in value should be recognised in
accordance with IAS 16.
The property will therefore be recognised at a carrying amount of £6 million and the difference of
£1.05 million should be recognised as a revaluation surplus (other comprehensive income).
During the period between 1 January 20X6 and 31 December 20Y0 the building is measured at fair
value with any gain or loss recognised directly in profit or loss. At the end of 20Y0 the cumulative gain is
C
£1.5 million. H
A
At 31 December 20Y0, the building has a carrying amount of £7.5 million being its fair value and this is
P
the amount that should be recognised as its carrying amount under IAS 16. The carrying amount will be T
depreciated over the building's remaining 40-year useful life. E
R

(1) £1 million is derecognised being the depreciated cost of the replaced system: 13
£1.2 million  (25/30 years)
(2) £1.2 million is capitalised as the cost of the new system and will be depreciated over its estimated
useful life of 10 years

The carrying amount of the failed system should be derecognised:
Carrying amount is £100,000 (£400,000 less six years' depreciation at 12.5%)
and the replacement system should be recognised:
Total carrying amount of the office building is £3,500,000
(£3m – £100,000 + £600,000)

The entity recognises these transactions and events as follows.
20X5
The property continues to be measured under the fair value model on classification as held for sale on
30 September. An impairment of £3.65 million is recognised (£4 million less £350,000).
At 31 December the property is presented as held for sale within current assets at £350,000.

20X6
The replacement property is recognised at a cost of £3.8 million and a loss on disposal is recognised of
£15,000 being (proceeds of £375,000 less selling costs of £40,000 less carrying amount of property of
£350,000).
20X7
The insurance proceeds of £3.9 million are recognised in profit or loss.
Note:
The requirement to measure an asset 'held for sale' and the lower of carrying amount and fair value less
costs to sell does not apply to investment properties measured at fair value (IFRS 5.5). IAS 40.37 states
that costs to sell should not be deducted from fair value.

(a) Wool: Agricultural produce
(b) Vines: Biological assets
(c) Sugar: Products that are the result of processing after harvest

(a) Commission to brokers
(b) Transfer taxes and duties
Commissions to brokers and transfer taxes and duties are recognised costs to sell in the Standard.

(a) IAS 26 applies to the general purpose financial reports of pension schemes.

CHAPTER 14
Earnings per share
Introduction
Topic List
IAS 33 Earnings per Share
1 EPS: overview of material covered in earlier studies
2 Basic EPS: weighted average number of shares
3 Basic EPS: profits attributable to ordinary equity holders
4 Diluted earnings per share
5 Diluted EPS: convertible instruments
6 Diluted EPS: options
7 Diluted EPS: contingently issuable shares
8 Retrospective adjustments and presentation and disclosure
9 IAS 33 Earnings per Share and UK GAAP
Technical reference
545
Introduction
 Calculate basic and diluted EPS figures in situations where there have been a number of
adjustments that will affect EPS calculations during the period
 Demonstrate an understanding of the significance of additional EPS figures and how they
can be calculated to provide a more 'stable' performance measure

1 EPS: overview of material covered in earlier studies
Section overview
 This section reviews the material on basic and diluted earnings per share covered at Professional
level.
Scope
 IAS 33 applies to entities whose ordinary shares are publicly traded or are in the process of being
issued in public markets.
Basic earnings per share
 Basic EPS is calculated as:
Pr ofit / (loss) attributable to ordinary equity holders of the parent

Weighted average number of ordinary shares outs tanding during the period
 Profit attributable to the ordinary equity holders is based on profit after tax after the deduction
of preference dividends and other financing costs in relation to preference shares classified as
equity under IAS 32. Whether an adjustment is needed depends on the type of preference share:
Redeemable preference No adjustment is required as these shares are classified as liabilities and
shares the finance charge relating to them will already have been charged to
profit or loss as part of finance charges.
Irredeemable These shares are classified as equity and the dividend relating to them
preference shares is disclosed in the statement of changes in equity. This dividend must
be deducted from profit for the year to arrive at profit attributable to
the ordinary shareholders.
 The weighted average number of shares should be adjusted for changes in the number of shares
without a corresponding change in resources, for example a bonus issue, by assuming that the
new number of shares had always been in issue.
Shares should generally be included in the weighted average number of shares from the date the
consideration for their issue is receivable.
C
 An entity is required to calculate and present a basic EPS amount based on the profit or loss for the H
period attributable to the ordinary equity holders of the parent entity. If results from 'continuing A
operations' or 'discontinued operations' are reported separately, EPS on these results should also be P
separately reported. T
E
Diluted earnings per share R
 A diluted EPS figure should also be reported by an entity. A dilution is a reduction in the EPS figure
(or increase in a loss per share) that will result from the issue of more equity shares on the 14
conversion of convertible instruments already issued.
 For the purpose of calculating diluted earnings per share, an entity shall adjust profit or loss
attributable to ordinary equity holders of the parent entity, and the weighted average number of
shares outstanding for the effects of all dilutive potential ordinary shares.
Presentation
 Basic and diluted EPS figures for profit or loss from continuing operations should be presented on
the face of the statement of comprehensive income with equal prominence.
 Where changes in ordinary shares occur during the accounting period, an amendment is necessary
to the number of shares used in the EPS calculations. In some situations, the EPS in prior periods
will also have to be adjusted.
 Treasury shares are accounted for as a deduction from shareholders' funds. Since such shares are no
longer available in the market, they are excluded from the weighted average number of ordinary
shares for the purpose of calculating EPS.
Earnings per share 547

Interactive question 1: Adjustment for preference shares [Difficulty level: Easy]
A company has issued £100,000 4% redeemable non-cumulative preference shares. Should the
dividend be subtracted from the reported profit after tax figure for the calculation of EPS?
2 Basic EPS: weighted average number of shares
Section overview
 This section deals with certain adjustments to the number of shares used for the calculation of
basic earnings per share.
IAS 33 requires that a time-weighted average number of shares should be used in the denominator of
the earnings per share calculation. The basic idea of how to calculate such a weighted average has been
covered at Professional level. In this section we deal with issues relating to the treatment of share
repurchases, partly paid shares, bonus and rights issues and the impact of consolidation.
2.1 Calculation of the weighted average number of shares

The use of the weighted average number of ordinary shares outstanding during the period reflects the
possibility that the amount of shareholders' capital varied during the period.
The weighted average number of ordinary shares outstanding during the period is the number of
ordinary shares outstanding at the beginning of the period, adjusted by the number of ordinary shares
bought back or issued during the period multiplied by a time-weighting factor.
2.2 Time weights determination

Shares are usually included in the weighted average number of shares from the date consideration is
receivable (which is generally the date of their issue), for example:
 Ordinary shares issued in exchange for cash are included when cash is receivable.
 Ordinary shares issued on the voluntary reinvestment of dividends on ordinary or preference shares
are included when dividends are reinvested.
 Ordinary shares issued as a result of the conversion of a debt instrument to ordinary shares are
included from the date that interest ceases to accrue.
 Ordinary shares issued in place of interest or principal on other financial instruments are included
from the date that interest ceases to accrue.
 Ordinary shares issued in exchange for the settlement of a liability of the entity are included from
the settlement date.
 Ordinary shares issued as consideration for the acquisition of an asset other than cash are included
as of the date on which the acquisition is recognised.
 Ordinary shares issued for the rendering of services to the entity are included as the services are
rendered.
 Ordinary shares issued as part of the cost of a business combination are included in the weighted
average number of shares from the acquisition date. This is because the acquirer incorporates into
its results the acquiree's profits and losses from that date.
 Ordinary shares that will be issued upon the conversion of a mandatorily convertible instrument are
included in the calculation of basic earnings per share from the date the contract is entered into.
 Contingently issuable shares are included in the calculation of basic earnings per share only from
the date when all necessary conditions for their issue are satisfied. Shares that are issuable solely

after the passage of time are not contingently issuable shares, because the passage of time is a
certainty.
 Outstanding ordinary shares that are contingently returnable (ie subject to recall) are excluded
from the calculation of basic earnings per share until the date the shares are no longer subject to
recall.
Worked example: Weighted average number of ordinary shares

The following information is provided for an entity.
Shares Treasury Shares
issued shares outstanding
1 Jan 20X1 Balance at beginning of year 2,000 300 1,700
31 May 20X1 Issue of new shares for cash 800 – 2,500
1 Dec 20X1 Purchase of treasury shares for cash – 250 2,250
31 Dec 20X1 Balance at year-end 2,800 550 2,250
Requirement
Calculate the weighted average number of shares in issue during the year.
Solution
The calculation can be performed on a cumulative basis:
Weighted
average
1 Jan X1 – 30 May X1 1,700  5/12 708
Share issue 800
31 May X1 – 30 Nov X1 2,500  6/12 1,250
Share purchase (250)
1 Dec X1 – 31 Dec X1 2,250  1/12 188
2,146
or alternatively each issue or recall treated separately:

Weighted
average
1 Jan X1 – 31 Dec X1 1,700 x 12/12 1,700 C
31 May X1 – 31 Dec X1 800 x 7/12 467 H
A
1 Dec X1 – 31 Dec X1 (250) x 1/12 (21)
P
2,146 T
E
R
2.3 Partly paid shares

14
Where ordinary shares are issued but not fully paid, they are treated in the calculation of basic earnings
per share as a fraction of an ordinary share to the extent that they were entitled to participate in
dividends during the period relative to a fully paid ordinary share.
To the extent that partly paid shares are not entitled to participate in dividends during the period they
are treated as the equivalent of warrants or options in the calculation of diluted earnings per share. The
unpaid balance is assumed to represent proceeds used to purchase ordinary shares. The number of
shares included in diluted earnings per share is the difference between the number of shares subscribed
and the number of shares assumed to be purchased.
Worked example: Partly paid shares

At 1 January 20X5 an entity had 900 ordinary shares in issue. It issued 600 new shares at 1 September
20X5, at a subscription price of £4 per share. At the date of issue each shareholder paid £2. The balance
of £2 per share will be paid during 20X6. Each part-paid share will be entitled to dividends in proportion
to the percentage of the issue price paid up on the share. The entity has a year end of 31 December.

Requirement
Calculate the weighted average number of shares for the year ended 31 December 20X5.
Solution
The new shares issued should be included in the calculation of the weighted average number of shares
in proportion to the percentage of the issue price received from the shareholding during the period.
Weighted
Shares Fraction average
issued of period shares
1 January 20X5 – 31 August 20X5 900 8/12 600
Issue of new shares for cash, part paid (2/4 × 600) 300
1 September 20X5 – 31 December 20X5 1,200 4/12 400
Weighted average number of shares 1,000
2.4 The impact of bonus issues and share consolidations on the number of
shares
The weighted average number of ordinary shares outstanding during the period must be adjusted for
events that have changed the number of ordinary shares outstanding without a corresponding change
in resources. These include:
 Bonus issues (capitalisation issues)
 Share consolidation
2.4.1 Bonus issue

In a bonus or capitalisation issue, or a share split, ordinary shares are issued to existing shareholders for
no additional consideration. Therefore, the number of ordinary shares outstanding is increased without
a corresponding increase in resources.
The number of ordinary shares outstanding before the event is adjusted for the proportionate change in
the number of ordinary shares outstanding as if the event had occurred at the beginning of the earliest
period presented. For example, on a two-for-one bonus issue, the number of ordinary shares
outstanding before the issue is multiplied by three to obtain the new total number of ordinary shares, or
by two to obtain the number of additional ordinary shares.
Bonus issue after the reporting date
Where a bonus issue takes place after the reporting date but before the financial statements are
authorised for issue, the number of shares in the EPS calculation is adjusted for the current and prior
periods as though the bonus issue took place during the current year.
Worked example: Bonus issue

The following information is given for an entity.
Profit attributable to ordinary equity holders for y/e 30 September 20X6 £300
Profit attributable to ordinary equity holders for y/e 30 September 20X7 £900
Ordinary shares outstanding until 30 September 20X7 200
Bonus issue 1 October 20X7 two ordinary shares for each ordinary share
outstanding at 30 September 20X7
Requirement
Calculate the basic earnings per share for 20X6 and 20X7.

Solution
The bonus issue arose in the period after the reporting date. It should be treated as if the bonus issue
arose during 20X7, and EPS calculated accordingly:
Additional shares issued 200 × 2 = 400
Basic earnings per share 20X7
£900
= £2.50
(200 + 400)
Basic earnings per share 20X6

£300
= £0.50
(200 + 400)
2.4.2 Share consolidation

A consolidation of ordinary shares generally reduces the number of ordinary shares outstanding without
a corresponding reduction in resources.
Sometimes, however, shares are repurchased at fair value, and in this instance, there is a corresponding
reduction in resources. An example is a share consolidation combined with a special dividend. In this
case, the weighted average number of ordinary shares outstanding for the period is adjusted for the
reduction in the number of ordinary shares from the date the special dividend is recognised.
Worked example: Share consolidation

At the start of its financial year ended 31 December 20X5, an entity had 10 million ordinary shares in
issue. On 30 April 20X5 it issued three million shares in consideration for the acquisition of a majority
holding in another entity. On 31 August 20X5 it went through a share reconstruction by consolidating
the shares in issue, on the basis of one new share for two old shares.
Requirement
Calculate the weighted number of shares in issue for the year to 31 December 20X5.
C
Solution H
The three million new shares issued at the time of the acquisition should be weighted from the date of A
P
issue, but the consolidation should be related back to the start of the financial year (and to the start of
T
any previous years presented as comparative figures). E
R
The calculation of the weighted number of shares in issue is as follows.
Adjusted
Number Weighting number
At 1 January 20X5 10,000,000 14
Effect of consolidation is to halve the number of shares
(since one new share was issued for every two old shares (5,000,000)
held)
5,000,000 12/12 5,000,000
30 April 20X5 issue 3,000,000

Effect of consolidation is to halve the number of shares (1,500,000)
1,500,000 8/12 1,000,000
Weighted average shares in issue 6,000,000

Worked example: Special dividend and share consolidation
A company has issued 20,000 shares with a nominal value of 20p each. At the beginning of 20X7 it
considers whether to launch a share repurchase of 2,000 shares at the current market price of £2 per
share, or pay a special dividend of 20p per share to be followed by a share consolidation of nine new
shares for 10 old shares. The profit after tax for 20X6 and 20X7 is expected to be £4,000 for each year.
Interest rates stand at 5% and the company tax rate is 20%.
Requirement
Calculate the basic EPS for the two alternatives.
Solution
(a) Share repurchase at fair value
20X7 20X6
£ £
Profit for the year 4,000 4,000
Loss of interest as cash
paid out £4,000  0.05  0.80* (160)
Earnings 3,840 4,000
Number of shares outstanding 18,000 20,000
Earnings per share 21.33p 20.00p
(b) Special dividend followed by share consolidation

20X7 20X6
£ £
Loss of interest on cash paid out as dividend
£4,000  0.05  0.80* (160)
Earnings 3,840 4,000
The effect of share consolidation is to leave the total nominal value of outstanding shares the same, but
to reduce the number of shares from 20,000 to 18,000, and raising the market price of a share from £2
to £2.22.
20X7 20X6
Number of shares 18,000 20,000
Earnings per share 21.33p 20.00p
No adjustment to prior year's EPS is made for the share consolidation.
* 0.80 = (1 – tax rate)
2.5 Rights issue

A rights issue is an issue of shares for cash to the existing ordinary equity holders in proportion to their
current shareholdings, at a discount to the current market price.
Because the issue price is below the market price, a rights issue is in effect a combination of an issue at
fair value and a bonus issue.
In order to calculate the weighted average number of shares when there has been a rights issue, an
adjustment factor is required:
Pr e - rights issue price of shares
Adjustment factor =
Theoretical ex - rights price (TERP)
The TERP is the theoretical price at which the shares would trade after the rights issue and takes into
account the diluting effect of the bonus element in the rights issue. It is calculated as:
Total market value of original shares pre rights issue + Proceeds of rights issue
TERP =
Number of shares post rights issue

The adjustment factor is used to increase the number of shares in issue prior to the rights issue for the
bonus element.
Where the rights are to be publicly traded separately from the shares before the exercise date, fair value
for the purposes of this calculation is established at the close of the last day on which the shares are
traded together with the rights.
Worked example: Rights issue

The following information is provided for an entity which is making a rights issue.
20X4 20X5 20X6
Profit attributable to ordinary equity holders of the parent entity £1,100 £1,500 £1,800
Shares outstanding before rights issue: 500 shares

Rights issue: One new share for each five outstanding shares (100 new shares total)
Exercise price: £5.00
Date of rights issue: 1 January 20X5
Last date to exercise rights: 1 March 20X5
Market price of one ordinary share immediately before exercise on 1 March 20X5: £11.00
Reporting date 31 December
Requirement
Calculate the theoretical ex-rights value per share and the basic EPS for each of the years 20X4, 20X5
and 20X6.
Solution
Calculation of theoretical ex-rights value per share
No. Price Total
Pre-rights issue holding 5 £11 £55
Rights share 1 £5 £5
6 £60
C
Therefore TERP = £60/6 = £10 H
A
(The TERP may also be calculated on the basis of all shares in issue, ie £6,000/600 shares)
P
Calculation of adjustment factor T
E
Fair value per share before exercise of rights £11 R
Adjustment factor    1.10
Theoretical ex - rights value per share £10
Calculation of basic earnings per share 14
20X4
20X4 basic EPS as originally £1,100
reported:  £2.20
500 shares
20X4 basic EPS restated for rights £1,100
issue in 20X5 accounts:  £2.00
(500 shares)  (adjustment factor)
Alternatively the restated EPS may be calculated by applying the reciprocal of the adjustment factor to
the basic EPS as originally reported:
£2.20 × 10/11 = £2.00

20X5
Weighted average number of shares:
1 January – 28 February 500 × 11/10 × 2/12 92
Rights issue 100
1 March – 31 December 600 × 10/12 500
592
£1,500
Basic EPS including effects of rights issue:  £2.53
592 shares
20X6
£1,800
Basic EPS:  £3.00
600 shares
Worked example: Cash and rights issue

An entity had 14 million ordinary shares in issue on 1 January 20X4 and 20X5. In its financial year ended
31 December 20X5 it issued further shares, as follows:
 On 1 April 20X5, 4 million shares in consideration for the majority holding in another entity; and
 On 1 July 20X5 a rights issue of one for six at £15 when the market price of the existing shares was
£20. There were 18 million shares in issue at this date, another three million shares were therefore
issued.
A profit of £17 million attributable to the ordinary equity holders was reported for 20X5 and £14 million
for 20X4.
Requirement
Calculate the earnings per share for 20X5 and restate the comparative for 20X4.
Solution
As the shares issued on the acquisition were issued at full fair value, a time apportionment adjustment
over the period they are in issue is required.
The rights issue shares require a time apportionment adjustment and an adjustment for the bonus
element in the rights. The latter adjustment should be applied to the shares issued on 1 April as well as
to those issued earlier. To adjust for the bonus element the theoretical ex-rights fair value per share is
required:
Computation of theoretical ex-rights price (TERP):
No. Price Total
Pre-rights issue holding 6 £20 £120
Rights share 1 £15 £15
7 £135
Therefore TERP = £135/7 = £19.29
The adjustment factor is therefore £20/£19.29

20X4 and earlier EPS figures would be adjusted by dividing the corresponding earnings figure by 1.037.
The weighted number of shares in issue in 20X5 is calculated as:
Adjusted
Number Weighting number
1 January to 31 March 14,000,000 × 20/19.29 3/12 3,628,823
Issue 1 April 4,000,000
1 April to 30 June 18,000,000 × 20/19.29 3/12 4,665,630
Rights issue 1 July 3,000,000
1 July to 31 December 21,000,000 6/12 10,500,000

20X5 earnings per share:
£17m / 18,794,453 shares = £0.90
20X4 restatement – original EPS: £14m ÷ 14m shares = £1.00
£1.00 × 19.29/20.00 = £0.96
3 Basic EPS: profits attributable to ordinary equity holders
Section overview
 In this section we discuss the adjustments that are required to earnings as a result of preference
shares, in order to calculate profits attributable to ordinary shareholders (equity holders).
As we have seen in earlier studies, for the purpose of calculating basic earnings per share, we must
calculate the amounts attributable to ordinary equity holders of the parent entity in respect of profit or
loss.
This is done in two steps:
 First the profit or loss which includes all items of income and expense that are recognised in a
period, including tax expense, dividends on preference shares classified as liabilities or non-
controlling interest is calculated according to IAS 1 Presentation of Financial Statements.
 In the second step the calculated profit or loss is adjusted for the after-tax amounts of preference
dividends, differences arising on the settlement of preference shares, and other similar effects of
preference shares classified as equity under IAS 32 Financial Instruments: Presentation.
3.1 Adjusting earnings for the impact of preference shares

Where an entity has preference shares in issue depending on their terms these will be classified as either:
 Financial liabilities or
 Equity under IAS 32
C
Preference shares classified as equity H
A
Any dividends and other appropriations (for example, amortised premium or discount) is debited P
directly to equity, in the statement of changes in equity. Therefore an adjustment is required to deduct T
these amounts from the profit for the period in order to derive the profit attributable to ordinary E
shareholders (equity holders). R
Preference shares classified as liabilities

Any dividends or other appropriations are treated as finance costs in arriving at profit for the period and 14
no adjustment is required.
In both the above cases the treatment is the same, as in both cases the amounts are deducted from
profit attributable to ordinary shareholders. In the latter case the deduction will already have been made
in arriving at reported profit and loss, however in the former case an adjustment to reported profits is
required.
Cumulative preference shares
Where preference shares are cumulative, the dividends for the period need to be taken into account
irrespective of whether these have been declared or not.
Non-cumulative preference shares
For non-cumulative preference dividends only the amount of dividend declared for the period should be
deducted in arriving at profit or loss attributed to ordinary equity holders.

Interactive question 2: Redeemable preference shares [Difficulty level: Intermediate]
Turaco is a company listed on a recognised stock exchange. Given below is an extract from its
statement of comprehensive income for the year ended 31 December 20X6.
£
Profit before tax 500,000
Tax 150,000
Profit after tax 350,000
The company paid an ordinary dividend of £20,000 and a dividend on its redeemable preference shares
of £70,000.
The company had £100,000 of £0.50 ordinary shares in issue throughout the year and authorised share
capital of 1,000,000 ordinary shares.
Requirement
What should be the basic earnings per share figure for the year according to IAS 33 Earnings per Share?
3.1.1 Other adjustments in respect of preference shares

Increasing rate preference shares
These are preference shares that provide for a low initial dividend to compensate an entity for selling the
preference shares at a discount, or an above-market dividend in later periods to compensate investors
for purchasing preference shares at a premium.
Under IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and
Measurement any original issue discount or premium on increasing rate preference shares is amortised
using the effective interest method and treated as a preference dividend for the purposes of calculating
earnings per share.
In addition, there may be other elements amortised such as transaction costs.
All these elements should be deducted in arriving at the earnings attributed to ordinary equity holders.
Note: the sale of shares at a discount is not allowed by UK Company Law, however it may be permitted
in certain jurisdictions, and is therefore examinable.
Worked example: Increasing rate preference shares

Entity D issued non-convertible, non-redeemable class A cumulative preference shares of £100 par value
on 1 January 20X1. The class A preference shares are entitled to a cumulative annual dividend of £7 per
share starting in 20X4.
At the time of issue, the market rate dividend yield on the class A preference shares was 7 per cent a
year. Thus, Entity D could have expected to receive proceeds of approximately £100 per class A
preference share if the dividend rate of £7 per share had been in effect at the date of issue.
There was, however, to be no dividend paid for the first three years after issue. In consideration of these
dividend payment terms, the class A preference shares were issued at £81.63 per share, ie at a discount
of £18.37 per share. The issue price can be calculated by taking the present value of £100, discounted
at 7 per cent over a three-year period.
Requirement
Calculate the imputed dividends attributable to preference shares that need to be deducted from
earnings to determine the profit or loss attributable to ordinary equity holders.
Solution
Because the shares are classified as equity, the original issue discount is amortised to retained earnings
using the effective interest method and treated as a preference dividend for earnings per share

purposes. To calculate basic earnings per share, the following imputed dividend per class A preference
share is deducted to determine the profit or loss attributable to ordinary equity holders of the parent
entity.
Carrying amount of class A Imputed Carrying amount of class A Dividend

Year preference shares 1 January dividend preference shares 31 December paid
£ £ £ £
20X1 81.63 5.71 87.34 –
20X2 87.34 6.12 93.46 –
20X3 93.46 6.54 100.00 –
Thereafter: 100.00 7.00 107.00 (7.00)
Convertible preference shares

An entity may achieve early conversion of convertible preference shares by improving the original
conversion terms or paying additional consideration.
Where this is the case, then the excess amount transferred as a result of the improvement of conversion
terms is treated as a return to the preference shareholders and so should be deducted in arriving at
earnings attributable to ordinary equity holders.
Deduction = Fair value of ordinary shares - Fair value of ordinary shares
issued / consideration paid issuable under original terms
Worked example: Cumulative convertible preference shares

An entity issued £100,000 2% cumulative convertible preference shares in 20X4 and the shares were
due to be converted in the current year, 20X6.
The convertible shares were converted at the beginning of 20X6 and no dividend was accrued in
respect of the year, although the previous year's dividend was paid immediately prior to conversion. The
terms of conversion were also amended and the revised terms entitled the preference shareholders to a
total additional 100 ordinary shares on conversion with a fair value of £300.
Requirement
If the profit attributable to ordinary equity holders for the year is £150,000 what adjustments need to be
C
made for the purpose of calculating EPS in 20X6? H
A
P
Solution T
E
The excess of the fair value of additional ordinary shares issued on conversion of the convertible R
preference shares over fair values of the ordinary shares to which they would have been entitled under
the original conversion terms is deducted from profit as it is an additional return to the convertible
preference shareholders. 14
£
Profits attributable to the ordinary equity holders 150,000
Fair value of additional ordinary shares
issued on conversion of convertible preference shares (300)
149,700
There is no adjustment in respect of the preference shares as no dividend accrual was made in respect of
the year. The payment of the previous year's cumulative dividend is ignored for EPS purposes as it will
have been adjusted for in the prior year.
Repurchase of preference shares

 Where the fair value of consideration paid to preference shareholders exceeds the carrying value of
the preference shares repurchased, the excess is a return to the preference shareholders and must
be deducted in calculating profits attributable to ordinary equity holders.

 Where the carrying value of preference shares repurchased exceeds the fair value of consideration
paid, the excess is added in calculating profit attributable to ordinary equity holders.
In respect of preference shares that are classified as liabilities, the above adjustments, where these are
relevant, would have already been made in arriving at the profit or loss for the period.
Worked example: Repurchase of preference shares

An entity has issued £100,000 8% non-redeemable non-cumulative preference shares. Half way through
the year, the entity repurchased half of the preference shares at a discount of £1,000. No dividends
were paid on these shares in respect of the amounts repurchased or outstanding at the end of the year.
Requirement
If the profit attributable to ordinary equity holders for the year is £150,000, what adjustments should be
made for the purpose of calculating EPS?
Solution
£
Profit for the year attributed to ordinary equity holders 150,000
Plus discount on repurchasing of preference shares 1,000
151,000
The discount on repurchase of the preference shares has been credited to equity and it must therefore
be adjusted against profit.
Had there been a premium payable on repurchase, the loss on repurchase would have been subtracted
from profit.
No accrual for the dividend on the 8% preference shares is required as these are non-cumulative. Had a
dividend been paid for the year it would have been deducted from profit for the purpose of calculating
basic EPS as the shares are treated as equity and the dividend would have been charged to equity in the
3.2 Participating securities and two-class ordinary shares

The equity of some entities includes:
 Instruments that participate in dividends with ordinary shares according to a predetermined
formula (for example, two for one) with an upper limit on the extent of participation (for example,
up to, but not beyond, a specified amount per share), or
 A class of ordinary shares with a different dividend rate from that of another class of ordinary
shares.
Profit or loss for the period is allocated to the different classes of shares and participating equity
instruments in accordance with their dividend rights or other rights to participate in undistributed
earnings.
To calculate basic earnings per share:
1 Profit or loss attributable to ordinary equity holders of the parent entity is adjusted as previously
discussed.
2 The remaining profit or loss is allocated to ordinary shares and participating equity instruments to
the extent that each instrument shares in earnings as if all of the profit or loss for the period had
been distributed. The total profit or loss allocated to each class of equity instrument is determined
by adding together the amount allocated for dividends and the amount allocated for a
participation feature.
3 The total amount of profit or loss allocated to each class of equity instrument is divided by the
number of outstanding instruments to which the earnings are allocated to determine the earnings
per share for the instrument.

Worked example: Participating equity instruments
The following information is provided for an entity.
Profit attributable to equity holders of the parent entity £100,000
Ordinary shares outstanding 10,000
Non-convertible preference shares 6,000
Non-cumulative annual dividend on preference shares
(before any dividend is paid on ordinary shares) £5.50 per share
After ordinary shares have been paid at a dividend of £2.10 per share, the preference shares participate
in any additional dividends on a 20:80 ratio with ordinary shares.
Dividends on preference shares paid £33,000 (£5.50 per share × 6,000 shares)
Dividends on ordinary shares paid £21,000 (£2.10 per share × 10,000 shares)
Requirement
Calculate the earnings attributable to ordinary shares.
Solution
Basic earnings per share is calculated as follows.
£ £
Profit attributable to equity holders of the parent entity 100,000
Less dividends paid:
Preference 33,000
Ordinary 21,000
(54,000)
Undistributed earnings 46,000
Allocation of undistributed earnings

Let A be the allocation of undistributed earnings per ordinary share and B the allocation per preference
share. That is:
(A × 10,000) + (B × 6,000) = £46,000
As B's entitlement is one quarter that of A's, we can eliminate B from the equation as follows:
(A × 10,000) + (1/4 × A × 6,000) = £46,000
10,000A + 1,500A = £46,000 C
H
11,500A = £46,000 A
P
A = £46,000/11,500 T
E
A = £4.00 R
Therefore B = £1.00
Basic per share amounts 14
per preference per ordinary share
share
Distributed earnings £5.50 £2.10
Undistributed earnings £1.00 £4.00
Totals £6.50 £6.10

4 Diluted earnings per share
Section overview
 This section deals with the adjustments required to earnings in order to take into account the
dilutive impact of potential ordinary shares.
The objective of diluted earnings per share is consistent with that of basic earnings per share; that is, to
provide a measure of the interest of each ordinary share in the performance of an entity taking into
account dilutive potential ordinary shares outstanding during the period.
4.1 Potential ordinary shares

Potential ordinary shares are financial instruments or other contracts that may entitle their holders to
ordinary shares. Potential ordinary shares are:
 Various financial liabilities or equity instruments, including preference shares that are convertible
into ordinary shares.
 Options.
 Warrants.
 Shares that would be issued on satisfaction of certain conditions that result from contractual
arrangements, such as the purchase of a business or other assets.
The conversion of potential ordinary shares will lead in the future to an increase in the weighted average
number of ordinary shares outstanding by the weighted average number of additional ordinary shares
that would have been outstanding assuming the conversion of all dilutive potential ordinary shares.
Conversion may also lead to consequential changes in income or expenses. For example, the reduction
of interest expense related to convertible debt and the resulting increase in profit or reduction in loss
may lead to an increase in the expense related to a non-discretionary employee profit-sharing plan.
For the purpose of calculating diluted earnings per share, profit or loss attributable to ordinary equity
holders of the parent entity is adjusted for any such consequential changes in income or expense.
4.2 Dilutive and antidilutive potential ordinary shares

Potential ordinary shares are dilutive when their conversion to ordinary shares would decrease earnings
per share or increase loss per share from continuing operations.
Potential ordinary shares are antidilutive when their conversion to ordinary shares would increase
earnings per share or decrease loss per share from continuing operations. Antidilution is therefore the
situation where the 'diluted' EPS is greater than the basic EPS (or where there is a lower loss per share).
IAS 33 defines antidilution as follows.
Definition
Antidilution: is an increase in earnings per share or a reduction in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or that
ordinary shares are issued upon the satisfaction of specified conditions.
In computing diluted EPS only potential ordinary shares that are dilutive are considered in the
calculations. The calculation ignores the effects of potential ordinary shares that would have an
antidilutive effect on earnings per share.
Determining whether potential ordinary shares are dilutive or antidilutive
In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of
potential ordinary shares is considered separately rather than in aggregate.

A separate EPS calculation is performed for each potential share issue.
 Those individual EPS which exceed the entity's basic EPS are disregarded as they are antidilutive.
 Those individual EPS which are less than the entity's basic EPS are dilutive and are ranked from
most to least dilutive. Options and warrants are generally included first because they do not affect
the numerator of the calculation. These dilutive factors are added one by one into the DEPS
calculation in order to identify the maximum dilution.
The calculation showing each issue or series of potential ordinary shares being considered separately is
shown in the worked example in Section 5.
4.3 Computation of diluted earnings

For the purpose of calculating diluted earnings per share, the profit or loss attributable to ordinary
equity holders of the parent entity should be adjusted for the after-tax effect of:
 Any dividends or other items related to dilutive potential ordinary shares deducted in arriving at
profit or loss attributable to ordinary equity holders;
 Any interest recognised in the period related to dilutive potential ordinary shares; and
 Any other changes in income or expense that would result from the conversion of the dilutive
potential ordinary shares.
After the potential ordinary shares are converted into ordinary shares, the dividends, interest and any
other expenses associated with the potential ordinary shares will no longer arise. Instead, the new
ordinary shares are entitled to participate in profit or loss attributable to ordinary equity holders of the
parent entity. The expenses associated with potential ordinary shares include transaction costs and
discounts accounted for in accordance with the effective interest method.
4.4 Calculation of the number of shares

In the calculation of diluted earnings per share, the number of ordinary shares in the denominator is the
weighted average number of ordinary shares calculated for the basic earnings per share plus the
weighted average number of ordinary shares that would be issued on the conversion of all the dilutive
potential ordinary shares into ordinary shares. That is:
Number of shares in diluted = Number of shares in basic + Dilutive potential ordinary
earnings per share earnings per share shares C
H
 Dilutive potential ordinary shares shall be deemed to have been converted into ordinary shares at A
P
the beginning of the period or, if later, the date of the issue of the potential ordinary shares (ie
T
where the convertible instruments or options are issued during the current period). E
R
 Potential ordinary shares are weighted for the period they are outstanding.
 Potential ordinary shares that are cancelled or allowed to lapse during the period are included in
the calculation of diluted earnings per share only for the portion of the period during which they 14
are outstanding.
 Potential ordinary shares that are converted into ordinary shares during the period are included in
the calculation of diluted earnings per share from the beginning of the period to the date of
conversion. From the date of conversion, the resulting ordinary shares are included in both basic
and diluted earnings per share.
 The number of ordinary shares that would be issued on conversion of dilutive potential ordinary
shares is determined from the terms of the potential ordinary shares. When more than one basis of
conversion exists, the calculation assumes the most advantageous conversion rate or exercise
price from the standpoint of the holder of the potential ordinary shares.

5 Diluted EPS: convertible instruments
Section overview
 This section deals with the impact of convertible instruments on the diluted earnings per share.
5.1 Convertible instruments

Convertible instruments, such as convertible loan stock or convertible preference shares impact both the
profit or loss attributed to ordinary equity holders, and the number of ordinary shares, on conversion.
Where this has a dilutive effect, the instrument should be taken into account when calculating DEPS.
Indicators that convertible instruments are antidilutive
Convertible preference shares are antidilutive whenever the amount of the dividend on such shares
declared in, or accumulated for, the current period per ordinary share obtainable on conversion exceeds
basic earnings per share.
Similarly, convertible debt is antidilutive whenever its interest (net of tax and other changes in income
or expense) per ordinary share obtainable on conversion exceeds basic earnings per share.
Worked example: Convertible loan stock 1

On 1 January 20X5 entity A had in issue:
 24 million ordinary shares of £1 nominal value each.
 £8 million of 8% convertible loan stock. These were issued on 1 January 20X5 and are convertible
at any time from 1 January 20X8. The conversion terms are one ordinary share for each £2 nominal
of loan stock.
The split accounting required for compound financial instruments per IAS 32 resulted in a liability
element for the loan stock of £7 million and an effective interest rate of 10%.
After charging income tax at 20%, the entity reported profit attributable to the ordinary equity holders
of £15 million for its year ended 31 December 20X5.
Requirement
Calculate the basic and diluted earnings per share for 20X5.
Solution
Basic EPS
£15m / 24m shares = £0.63
Diluted EPS
To calculate the diluted earnings per share we need to consider the impact on both earnings and
number of shares.
Impact on earnings: On conversion, after tax earnings attributed to ordinary shareholders should
be increased by the reduction in the interest charge payable to loan
holders.
Taking tax into account, the interest saved will be:
£7m  0.1  (1- 0.2) = £0.56m
Therefore diluted earnings = £15m + £0.56m = £15.56m
Impact on number of On conversion the number of ordinary shares will increase by £8m/2 = 4
shares: million shares, raising the number of ordinary shares after conversion to 28
million ordinary shares.
Therefore DEPS = £15.56m/28 million shares = £0.56

Interactive question 3: Test of dilution [Difficulty level: Intermediate]
The issued share capital of Entity A at 31 December 20X5 was 2,000,000 ordinary shares of £1 each. On
1 January 20X6, Entity A issued £1,500,000 of 7% convertible loan stock for cash at par. (Ignore the
requirement to split the value of a compound financial instrument.) Each £100 nominal of the loan
stock may be converted into 140 ordinary shares at any time after 1 January 20X9.
The profit before interest and taxation for the year ended 31 December 20X6 amounted to £1,050,000
and arose exclusively from continuing operations. The rate of tax is 30 per cent.
Requirement
Test whether the potential shares are dilutive.
Worked example: Convertible loan stock 2

On 1 January 20X5 Entity A had in issue:
 20 million ordinary shares
 £11 million of 6.5% convertible loan stock, convertible at any time from 1 January 20X7. The
conversion terms are one ordinary share for each £2 nominal of loan stock, the 1 January carrying
amount of the liability component is £10 million and the effective interest rate is 9%.
 £9 million of 6.75% convertible loan stock, convertible at any time from 1 January 20X8. The
 £12.6 million of 9% convertible loan stock, convertible at any time from 1 January 20X9. The
The entity reported profit attributable to the ordinary equity holders of £4 million for its year ended
31 December 20X5.
Requirement
Ignoring taxes, calculate the diluted earnings per share.
C
H
Solution A
P
The incremental earnings per share for each type of potential ordinary shares is shown below. T
E
Increase in Increase in Earnings per R
earnings number of additional
(interest saved) shares share
£ £ 14
£11 million of 6.5% convertible loan stock
£10m  9% convertible loan stock 900,000
1 ordinary share for £2 nominal of loan
stock 5,500,000 0.16
£9 million of 6.75% convertible loan stock
£8m  8% convertible loan stock 640,000
stock 4,500,000 0.14
£12.6 million of 9% convertible loan stock
£12m  12% convertible loan stock 1,440,000
stock 2,100,000 0.69

The earnings per share can be calculated adjusting both the earnings and the number of shares for each
type of potential shares, and the results are shown below. Each issue of potential ordinary shares is
added to the calculation at a time, taking the most dilutive factor first.
Earnings Number of Earnings per
£ shares share
£
Shares already in issue 4,000,000 20,000,000 0.20
Including 6.75% convertible loan stock 4,640,000 24,500,000 0.189
Including 6.5% convertible loan stock 5,540,000 30,000,000 0.185
Including 9% convertible loan stock 6,980,000 32,100,000 0.217
The diluted earnings per share will be £0.185. The 9% convertible loan stock is antidilutive since it increases
earnings per share, and it will not be taken into account in calculating diluted earnings per share.
5.2 Testing for dilution

In some cases some convertible preference shares are redeemed or converted in a period, and others
remain outstanding.
Where this occurs, any excess consideration paid on redemption or conversion is attributed to those
shares which have been redeemed or converted.
Outstanding convertible preference shares are therefore tested for dilution as normal and without
regard to this excess.
6 Diluted EPS: options
Section overview
 This section deals with the impact of options on diluted earnings per share.
Definition
Options and warrants: are financial instruments that give the holder the right to purchase ordinary
shares.
6.1 Options, warrants and their equivalents

Options and warrants are dilutive when they would result in the issue of ordinary shares for less than the
average market price of ordinary shares during the period (ie when they are 'in the money').
To calculate DEPS where there are options or warrants, the potential ordinary shares at less than average
market price are treated as consisting of two elements:
 A contract to issue some shares at average market price. These shares are assumed to be fairly
priced and to be neither dilutive nor antidilutive. They are ignored in the calculation of diluted
earnings per share.
 A contract to issue the remaining ordinary shares for no consideration These shares are dilutive
and are added to the number of ordinary shares outstanding in the calculation of diluted earnings
per share.

Average market price of ordinary shares
 Theoretically every market transaction for an entity's ordinary shares could be included in the
determination of the average market price. It is however adequate to use a simple average of
weekly or monthly prices.
 Generally, closing market prices are adequate for calculating the average market price. When prices
fluctuate widely, however, an average of the high and low prices usually produces a more
representative price.
 The method used to calculate the average market price must be used consistently unless it is no
longer representative because of changed conditions. For example, an entity that uses closing
market prices to calculate the average market price for several years of relatively stable prices might
change to an average of high and low prices if prices start fluctuating greatly and the closing
market prices no longer produce a representative average price.
Worked example: Share options and diluted earnings per share

The following information is provided about a company.
Profit attributable to ordinary equity holders of the parent entity for year 20X6 £1,200,000
Weighted average number of ordinary shares outstanding during year 20X6 500,000
Average market price of one ordinary share during year 20X6 £20
Weighted average number of shares under option during year 20X6 100,000
Exercise price for shares under option during year 20X6 £15
Requirement
Calculate the basic and diluted earnings per share.
Solution
Earnings Shares Per share
£ £
Basic EPS
Profit attributable to ordinary equity holders of the
parent entity for year 20X6 1,200,000
Weighted average shares outstanding during year 20X6 500,000
Basic earnings per share 2.40
DEPS C
Weighted average number of shares under option 100,000 H
Issued at full market price (£15 × 100,000)/£20 75,000 A
Issued at nil consideration (100,000 – 75,000) 25,000 P
T
E
Number of equity shares for basic EPS 500,000 R
Number of dilutive shares under option 25,000

Adjusted number of shares 525,000
14
Diluted EPS (£1,200,000/525,000 shares) 2.29
Interactive question 4: Diluted earnings per share [Difficulty level: Intermediate]

At 31 December 20X6, the issued share capital of Entity A consisted of 3,000,000 ordinary shares of 20p
each. Entity A has granted options that give holders the right to subscribe for ordinary shares between
20X8 and 20X9 at 50p each. Options outstanding at 31 December 20X7 were 600,000. There were no
grants, exercises or lapses of options during the year. The profit after tax attributable to ordinary equity
holders for the year ended 31 December 20X7 amounted to £900,000 arising from continuing
operations. The average market price of one ordinary share during year 20X7 was £1.50.
Requirement
Calculate the diluted earnings per share for 20X7.

6.2 Employee share options
The most common type of option that leads to earnings dilution is an employee share option granted
by a company to its employees.
Employee share options give the right to the holder to acquire shares in the company at a price that is
fixed when the options are issued.
Employee share options can normally be exercised after a certain time, eg once the employee has
completed a period of service and within a certain period, eg over a period of five years after they
become exercisable.
Employee share options that can be exercised are vested options, whereas options that cannot yet be
exercised are unvested options.
Worked example: Vested options

The profit attributable to the ordinary equity holders of an entity for the year ended 31 December 20X5
was £30 million and the weighted average number of its ordinary shares in issue was 60 million. Its basic
earnings per share was £0.50.
In addition, there was a weighted average of five million shares under options which had vested (ie were
able to be exercised). The exercise price for the options was £21 and the average market price per share
over the year was £30.
Requirement
Calculate the diluted EPS.
Solution
The amount to be received on exercise is £21  5m = £105m
The number of shares issued at average market price is: £105m / £30 = 3.5m
The number of 'free' shares is: 5m issued – 3.5m issued at average market price = 1.5m
Diluted earnings per share:
£30m / (60m + 1.5m) = £0.49
Where shares are unvested, the amount still to be recognised in profit or loss before the vesting date
must be taken into account when calculating the number of 'free' shares.
Worked example: Unvested options

Assume the same information as in above example, except that:
 The options have not yet vested; and
 The amount to be recognised in relation to these options in the entity's profit or loss over future
accounting periods up to date of vesting, as calculated according to IFRS 2, is £15m.
Requirement
Calculate the diluted EPS.
Solution
The amount to be recognised in profit or loss is reduced to a per share amount: £15m / 5m = £3
This is added to the exercise price: £21 + £3 = £24
The amount to be received on exercise: £24  5m = £120m
The number of shares issued at average market price: £120m / £30 = 4m
The number of 'free' shares: 5m – 4m = 1m
Diluted earnings per share: £30m / (60m + 1m) = £0.49

Employee share options with fixed or determinable terms and non-vested ordinary shares are treated as
options in the calculation of diluted earnings per share, even though they may be contingent
on vesting. They are treated as outstanding on the grant date.
Performance-based employee share options are treated as contingently issuable shares (section 7)
because their issue is contingent upon satisfying specified conditions in addition to the passage of time.
7 Diluted EPS: contingently issuable shares
Section overview
 This section deals with the impact of contingently issuable shares on the number of ordinary
shares used in the calculation of diluted earnings per share.
7.1 Contingently issuable shares

The consideration for acquisitions of other entities may partly be in the form of shares which will only be
issued if certain targets are met in the future. The additional consideration is contingent consideration
and the additional shares are described as contingently issuable.
Contingently issuable shares may also arise where senior staff members are issued shares as a
performance reward.
 Until the shares are issued (if indeed they ever are), they should not be taken into account when
calculating basic EPS.
 They should be taken into account when calculating diluted EPS if and only if the conditions
leading to their issue have been satisfied. For these purposes the end of the accounting period is
treated as the end of the contingency period.
 Contingently issuable shares are included from the beginning of the period (or from the date of the
contingent share agreement, if later).
Worked example: Contingently issuable shares

was £20 million and the weighted average number of its ordinary shares in issue was 16 million. Basic C
earnings per share was therefore £1.25. H
A
Under an agreement relating to a business combination, two million additional shares were to be issued P
if the share price on 30 June 20X6 was £8 or above. On 31 December 20X5 the share price was £9. T
Assuming the end of the reporting period was the end of the contingency period, the condition would E
R
have been met.
Requirement
14
Determine the diluted EPS.
Solution
As the two million additional shares do not result in additional resources for the entity, they are brought
into the diluted earnings per share calculation from the start of the 20X5 reporting period. The diluted
earnings per share is therefore:
Diluted earnings per share = £20m / (16m + 2m) = £1.11

7.2 Conditions for issue
Contingently issuable shares are included within the calculation of DEPS where
 The shares have not yet been issued
 The relevant performance criteria have been met
Future earnings
Achieving or maintaining a specified level of earnings for a particular period may be the condition for
contingent issue.
In this case, if the effect is dilutive, the calculation of DEPS is based on the number of ordinary shares
that would be issued if the amount of earnings at the end of the reporting period were the amount of
earnings at the end of the contingency period.
Market price of shares
The number of ordinary shares contingently issuable may depend on the future market price of the
ordinary shares.
In this case, if the effect is dilutive, the calculation of DEPS is based on the number of ordinary shares
that would be issued if the market price at the end of the reporting period were the market price at the
end of the contingency period.
If the condition is based on an average of market prices over a period of time that extends beyond the
end of the reporting period, the average for the period of time that has lapsed is used.
Future earnings and market price of shares
The number of ordinary shares contingently issuable may depend on future earnings and future prices
of the ordinary shares.
In such cases, the number of ordinary shares included in the DEPS calculation is based on both
conditions (ie earnings to date and the current market price at the end of the reporting period).
Contingently issuable ordinary shares are not included in the diluted earnings per share calculation
unless both conditions are met.
Other conditions
In other cases, the number of ordinary shares contingently issuable may depend on a condition other
than earnings or market price (for example, the opening of a specific number of retail stores).
In this case, the contingently issuable ordinary shares are included in the calculation of diluted earnings
per share according to the status at the end of the reporting period.
Cumulative targets
Note that where performance criteria involve a cumulative target, no dilution is accounted for until the
cumulative target has been met. For example, where the issue of shares is dependent upon average
profits of £300,000 over four years, the cumulative target is £1,200,000. No dilution is accounted for
until this cumulative target is met.
Worked example: Cumulative targets

A manufacturer has in issue 3,000,000 ordinary shares at 1 January 20X7. It agreed to issue 500,000
shares to its staff if factory output averages 100,000 units per annum over the period from 1 January
20X7 to 31 December 20X9. The shares are to be issued on 1 January 20Y0.
Results for the three periods are:
Units produced Profits
20X7 120,000 £780,000
20X8 99,000 £655,000
20X9 105,000 £745,000
Requirement
What are basic and diluted EPS in each of the years 20X7 – 20X9?

Solution
The cumulative target of 3 years × 100,000 units is not met in 20X7 and 20X8, therefore no dilution is
accounted for.
In 20X9, the cumulative target is met as is the average target, therefore a DEPS is disclosed:
Basic EPS Diluted EPS
20X7 £780,000 £0.26 Not relevant

3,000,000 shares
20X8 £655,000 £0.22 Not relevant

3,000,000 shares
20X9 £745,000 £0.25 £745,000 £0.21
 
3,000,000 shares 3,500,000 shares
7.3 Issue of contingently issuable shares

Where contingently issuable shares are issued at the end of a contingency period, they must be included
within the calculation of basic EPS. Any outstanding contingently issuable shares are included in DEPS as
discussed above.
Worked example: Contingently issuable shares

was £200 million and the number of its ordinary shares in issue at 1 January 20X5 was 80 million.
Under an agreement relating to a business combination, 12 million additional shares were to be issued each
time the entity's products were ranked in the top three places in a consumer satisfaction survey conducted by
a well-known magazine. A maximum of 36 million shares was issuable under this agreement and the
products appeared in the top three places in surveys dated 28 February and 30 September 20X5.
There were no other issues of ordinary shares.
Requirement
Determine the basic and diluted EPS.
C
H
Solution A
P
Basic earnings per share T
E
The 24 million additional shares are weighted by the period they have been in issue: R
Adjusted
Issued Weighting number
1 January 20X5 – 28 February 80,000,000 2/12 13,333,333 14
Issued 28 February 12,000,000
1 March – 30 Sept 92,000,000 7/12 53,666,667
Issued 30 September 12,000,000
30 September – 31 December 104,000,000 3/12 26,000,000
Basic earnings per share = £200m/93m = £2.15

Diluted earnings per share
As the 24 million additional shares do not result in any additional resources for the entity, the diluted
calculation assumes all the new shares were issued at the start of the year (see section 2.4).
Diluted earnings per share = £200m / (80m +12m + 12m) = £1.92

8 Retrospective adjustments and presentation and
disclosure
Section overview
 This section deals with retrospective adjustments to EPS and the provisions of IAS 33 concerning
presentation and disclosure.
8.1 Retrospective adjustment

Bonus issues, share splits and share consolidations
If the number of ordinary or potential ordinary shares outstanding increases as a result of a
capitalisation, bonus issue or share split, or decreases as a result of a share consolidation, the calculation
of basic and diluted earnings per share for all periods presented must be adjusted retrospectively.
If these changes occur after the year end but before the financial statements are authorised for issue, EPS
calculations for all periods presented must be based on the new number of shares.
The fact that EPS calculations reflect such changes must be disclosed.
Prior period adjustments and errors
Basic and diluted earnings per share of all periods presented must be adjusted for the effects of errors
(IAS 8) and adjustments resulting from changes in accounting policies accounted for retrospectively.
DEPS
An entity does not restate diluted earnings per share of any prior period presented for changes in the
assumptions used in earnings per share calculations or for the conversion of potential ordinary shares
into ordinary shares.
8.2 Presentation
 Basic and diluted EPS for continuing operations must be presented on the face of the statement of
profit or loss and other comprehensive income with equal prominence for all periods presented.
 Where a separate statement of profit or loss is presented, basic and diluted EPS should be
presented on the face of this statement.
 Earnings per share is presented for every period for which a statement of comprehensive income is
presented.
 If diluted earnings per share is reported for at least one period, it shall be reported for all periods
presented, even if it equals basic earnings per share.
 If basic and diluted earnings per share are equal, dual presentation can be accomplished in one line
on the statement of comprehensive income.
 An entity that reports a discontinued operation shall disclose the basic and diluted amounts per
share for the discontinued operation either on the face of the statement of comprehensive income
or in the notes.
 An entity shall present basic and diluted earnings per share, even if the amounts are negative (ie a
loss per share).

8.3 Disclosure
An entity shall disclose the following:
 The amounts used as the numerators in calculating basic and diluted earnings per share, and a
reconciliation of those amounts to profit or loss attributable to the parent entity for the period.
The reconciliation shall include the individual effect of each class of instruments that affects
earnings per share.
 The weighted average number of ordinary shares used as the denominator in calculating basic and
diluted earnings per share, and a reconciliation of these denominators to each other.
The reconciliation shall include the individual effect of each class of instruments that affects
earnings per share.
 Instruments (including contingently issuable shares) that could potentially dilute basic earnings per
share in the future, but were not included in the calculation of diluted earnings per share because
they are antidilutive for the period(s) presented.
 A description of ordinary share transactions or potential ordinary share transactions, other than
retrospective adjustments, that occur after the reporting date and that would have changed
significantly the number of ordinary shares or potential ordinary shares outstanding at the end of
the period if those transactions had occurred before the end of the reporting period.
Examples of transactions referred in the paragraph above include:
 An issue of shares for cash
 An issue of shares when the proceeds are used to repay debt or preference shares outstanding at
the reporting date
 The redemption of ordinary shares outstanding
 The conversion or exercise of potential ordinary shares outstanding at the reporting date into
ordinary shares
 An issue of options, warrants, or convertible instruments
 The achievement of conditions that would result in the issue of contingently issuable shares.
Earnings per share amounts are not adjusted for such transactions occurring after the reporting date
because such transactions do not affect the amount of capital used to produce profit or loss for the
period. C
H
Financial instruments and other contracts generating potential ordinary shares may incorporate terms A
and conditions that affect the measurement of basic and diluted earnings per share. These terms and P
conditions may determine whether any potential ordinary shares are dilutive and, if so, the effect on the T
weighted average number of shares outstanding and any consequential adjustments to profit or loss E
attributable to ordinary equity holders. The disclosure of the terms and conditions of such financial R
instruments and other contracts is encouraged, if not otherwise required (refer also to IFRS 7 Financial
Instruments: Disclosures in Chapter 5).
14
Additional EPS
If an entity discloses, in addition to basic and diluted earnings per share, amounts per share using a
reported component of profit other than one required by IAS 33, such amounts shall be calculated
using the weighted average number of ordinary shares determined in accordance with this Standard.
Basic and diluted amounts per share relating to such a component shall be disclosed with equal
prominence and presented in the notes.
An entity shall indicate the basis on which the numerator(s) is (are) determined, including whether
amounts per share are before tax or after tax.
If a component of profit is used that is not reported as a line item in the statement of profit or loss and
other comprehensive income, a reconciliation shall be provided between the component used and a
line item that is reported in the statement of profit or loss and other comprehensive income.

Worked example: Allied Irish Bank plc
In addition to the required EPS under IAS 33 Allied Irish Bank plc reports an adjusted EPS measure
excluding hedge volatility, profit on disposal of property and business and construction contract
income. A comment to the disclosure states that the adjusted measure is presented to help better
understand underlying business performance.
Allied Irish Bank plc 31 December 2006
Extract from Notes to the accounts:
Profit attributable Earnings per share
2006 2005 2006 2005
19 Adjusted earnings per share €m €m € €
(a) Basic earnings per share
As reported (note 18(a)) 2,147 1,305 246.8 151.0
Adjustments:
Construction contract income (82) (38) (9.4) (4.4)
Hedge volatility 4 (6) 0.5 (0.7)
Profit on disposal of property (290) – (33.4) –
Profit on disposal of business (189) – (21.7) –
1,590 1,261 182.8 145.9
Although not required under IFRS, adjusted earnings per share is presented to help understand the
underlying performance of the Group. The adjustments in 2006 and 2005 are items that management
believe do not reflect the underlying business performance. The adjustment in respect of profit on sale
of property relates only to the profit on sale of properties that are subject to sale and leaseback
arrangements (note 12). The adjustments listed above are shown net of taxation.
9 IAS 33 Earnings per Share and UK GAAP

The ASB's FRS 22 applies to listed companies and those in the process of listing and is effective for
accounting periods beginning on or after 1 January 2005.
FRS 22 derives from IAS 33 and is almost identical to it, although it provides additional guidance in an
appendix on the calculation of EPS for business combinations.

Summary
Earnings per Share

IAS 33
Earnings Number of shares
Minus Plus rights

earning attributable issues and bonus
to preference shareholders issues
Earnings attributable Total number

to ordinary shareholders of shares
Basic EPS
Adjust for potential shares

Adjust earnings resulting due to
from change in convertible - Convertible debt C
debt H
- Options A
- Contingently issuable P
shares T
E
R
Diluted
EPS
14

Self-test
1 Puffbird
Puffbird is a company listed on a recognised stock exchange. Its financial statements for the year
ended 31 December 20X6 showed earnings per share of £0.95.
On 1 July 20X7 Puffbird made a three for one bonus issue.
Requirement
According to IAS 33 Earnings per Share, what figure for the 20X6 earnings per share will be shown
as comparative information in the financial statements for the year ended 31 December 20X7?
2 Urtica
The Urtica Company is listed on a recognised stock exchange.
During the year ended 31 December 20X6, the company had five million ordinary shares of £1 and
500,000 6% irredeemable preference shares of £1 in issue.
Profit before tax for the year was £300,000 and the tax charge was £75,000.
Requirement
According to IAS 33 Earnings per Share, what is Urtica's basic earnings per share for the year?
3 Issky
The following extracts relate to the Issky Company for the year ended 31 December 20X7.
Statement of comprehensive income £'000
Ordinary shares of £1 8,400
In addition, the company had in issue throughout the year 1,800,000 share options granted to
directors at an exercise price of £15. These were fully vested (ie conditions required before these
could be exercised were fulfilled and the options were exercisable) but had not yet been exercised.
The market price for Issky's shares was £24 at 1 January 20X7, £30 at 31 December 20X7, and the
average for 20X7 was £27.
Requirement
What is the diluted earnings per share for 20X7 according to IAS 33 Earnings per Share?
4 Whiting
The Whiting Company has the following financial statement extracts in the year ended 31
December 20X7.
Profit after tax £
Continuing operations 1,600,000
Discontinued operations (400,000)
Total attributable to ordinary equity holders 1,200,000

Ordinary shares of £1 9,600,000
On 1 January 20X7, Whiting issued £1.2m of 7% redeemable convertible bonds, interest being
payable annually in arrears on 31 December. The split accounting required of compound financial
instruments resulted in the following classification.
£
Equity component 100,000
Liability component 1,100,000
1,200,000

The effective interest rate on the liability component is 10%. The bonds are convertible on
specified dates in the future at the rate of one ordinary share for every £2 bond.
The tax regime under which Whiting operates gives relief for the whole of the charge based on the
effective interest rate and applies a tax rate of 20%.
Requirement
Based upon the total profit attributable to ordinary equity holders, what amount, if any, for diluted
earnings per share should be presented by Whiting in its financial statements for the year ended
31 December 20X7 according to IAS 33 Earnings per Share?
5 Garfish
The Garfish Company had profits after tax of £3.0 million in the year ended 31 December 20X7.
On 1 January 20X7, Garfish had 2.4 million ordinary shares in issue. On 1 April 20X7 Garfish made
a one for two rights issue at a price of £1.40 when the market price of Garfish's shares was £2.00.
Requirement
What is Garfish's basic earnings per share figure for the year ended 31 December 20X7, according
to IAS 33 Earnings per Share?
6 Sakho
The Sakho Company has 850,000 ordinary shares in issue on 1 January 20X7 and had the
following share transactions in the year ended 31 December 20X7.
(1) A one for five bonus issue on 1 May 20X7
(2) A two for five rights issue on 1 September 20X7 at £0.45 when the market price was £1.50.
Requirement
Indicate whether the following statements are true or false according to IAS 33 Earnings per Share.
(a) The basic earnings per share for the year ended 31 December 20X6 has to be adjusted by a
fraction of 5/6
(b) For the calculation of 20X7 basic earnings per share, the number of shares in issue prior to the
rights issue has to be adjusted by a rights fraction of 1.50/1.20
7 Sardine
The Sardine Company operates in Moldania, a jurisdiction in which shares may be issued at a C
discount. It has profit after tax and before preference dividends of £200,000 in the year ended 31 H
A
December 20X7.
P
On 1 January 20X7 Sardine has in issue 500,000 ordinary shares, and on 1 January 20X7 issues T
E
£300,000 of £100 non-convertible, non-redeemable preference shares. Cash dividends of 8% per R
annum will only start to be paid on the preference shares from 1 January 20X9, so the shares are
issued at a discount. The effective interest rate of the discount is 8%.
Requirement 14
According to IAS 33 Earnings per Share, what is the basic earnings per share for Sardine in the year
ended 31 December 20X7?
8 Citric
The following information relates to The Citric Company for the year ended 31 December 20X7.
Profit after tax £100,000
Ordinary shares of £1 1,000,000
There are warrants outstanding in respect of 1.7 million new shares in Citric at a subscription price
of £18.00. Citric's share price was £22.00 on 1 January 20X7, £24.00 on 30 June 20X7, £30.00 on
31 December 20X7 and averaged £25.00 over the year.

On 1 January 20X7 Citric issued £2 million of 6% redeemable convertible bonds, interest being
payable annually in arrears on 31 December. The split accounting required of compound financial
instruments resulted in a liability component of £1.75 million and effective interest rate of 7%. The
bonds are convertible on specified dates many years into the future at the rate of two ordinary
shares for every £5 bonds.
The tax regime under which Citric operates gives relief for the whole of the effective interest rate
charge on the bonds and applies a tax rate of 25%.
Requirement
Determine the following amounts in respect of Citric's diluted earnings per share for the year
ending 31 December 20X7 according to IAS 33 Earnings per Share.
(a) The number of shares to be treated as issued for no consideration (ie 'free' shares) on the
subscription of the warrants
(b) The earnings per incremental share on conversion of the bonds, expressed in pence (to one
decimal place)
(c) The diluted earnings per share, expressed in pence (to one decimal place)

Technical reference
IAS 33 Earnings per Share IAS 33.9-10
Earnings
 Amounts attributable to ordinary equity holders in respect of profit or loss from IAS 33.12
continuing operations adjusted for the after tax amounts of preference
dividends.
Shares
 For the calculation of basic EPS the number of ordinary shares should be the IAS 33.26
weighted average number of shares outstanding during the period adjusted
where appropriate for events, other than the conversion of shares, that have
changed the number of ordinary shares outstanding without a corresponding
change in resources.
Diluted earnings per share

 For the purposes of calculating diluted earnings per share an entity shall adjust IAS 33.30
profit or loss attributable to ordinary equity holders and the weighted number
of shares outstanding for the effects of dilutive potential ordinary shares. IAS 33.31
Dilutive potential ordinary shares

 Potential ordinary shares shall be treated as dilutive when, and only when, their
IAS 33.41
conversion to ordinary shares could decrease earnings per share or increase loss
per share from continuing operations.
Options, warrants and their equivalents IAS 33.45
Convertible instruments IAS 33.49
Contingently issuable shares IAS 33.52 C

H
Retrospective adjustments A
P
 Basic and diluted EPS should be adjusted retrospectively for all capitalisations, IAS 33.64 T
bonus issues or share splits or reverse share splits that affect the number of E
shares in issue without affecting resources. R
Presentation IAS 33.66

14
Disclosure IAS 33.70


1 Puffbird
23.75 pence
Last year's EPS figure is adjusted by the reciprocal of the bonus fraction:
Number of shares post issue 4
Bonus fraction = =
Number of shares pre issue 1
Therefore revised EPS = 95p × ¼ = 23.75p

2 Urtica
3.9 pence
IAS 33 12 - 13 define earnings for basic EPS as after tax and after dividends on irredeemable
preference shares.
£
Tax (75,000)
Preference dividend (£500,000 × 6%) (30,000)
Profit attributable to ordinary equity holders 195,000
Therefore BEPS = £195,000/5,000,000 shares = 3.9p

3 Issky
58.7 pence
Number of shares under option
Issued at average market price (£15 ×1,800,000)/£27 1,000,000
Issued at nil consideration (1,800,000 – 1,000,000) 800,000
Number of equity shares for basic EPS 8,400,000

Adjusted number of shares 9,200,000
DEPS (£5,400,000/9,200,000 shares) 58.7p
According to IAS 33.46, the proceeds of the options should be calculated using the average market
price during the year. The difference between the number of ordinary shares issued and the
number that would have been issued at the average market price are the 'free' shares that create
the dilutive effect.

4 Whiting
12.6 pence
Basic EPS £1,600,000
Based on continuing operations = 16.7 p
9,600,000
Incremental EPS Increment to profits after conversion of bonds:

£1,100,000 x 10% x (1-20%) = £88,000
Increase to number of shares:
£1,200,000/£2 = 600,000
£88,000
Therefore: = 14.7 p
600,000
Diluted EPS £(1,200,000  88,000)

= 12.6 p
9,600,000  600,000 shares
The shares issuable on conversion of the bonds are potentially dilutive, but IAS 33.41 only requires
them to be taken into account if they dilute the basic EPS figure based upon continuing operations.
It is worth noting that per IAS 33.33 and App A A3 this must be calculated, even though it is
antidilutive of the basic EPS on the same basis of (£1,200,000/9,600,000) = 12.5 pence.
5 Garfish
89.1 pence
Weighted average number of shares:
TERP: 2 shares @ £2.00 = £4.00
1 share @ £1.40 = £1.40
3 £5.40 therefore £5.40/3 = £1.80
Market value of share £2.00

Adjustment factor: 
TERP £1.80
1 Jan X7 – 31 March X7 2,400,000 × 2.00 × 3/12 666,667

1.80
Rights issue 1,200,000
1 April X7 – 31 Dec X7 3,600,000 × 9/12 2,700,000 C
3,366,667 H
A
Basic EPS P
T
£3,000,000 E
= 89.1p R
3,366,667 shares
6 Sakho
14
(a) False
(b) True
Number of shares post issue 6
Bonus fraction = =
Number of shares pre issue 5
MV of share 1.50
Rights adjustment factor = =
TERP 1.20
TERP: 5 shares @ £1.50 = £7.50
2 shares @ £0.45 = £0.90
7 £8.40 therefore TERP = £8.40 / 7 shares = £1.20
The basic EPS for the prior year is multiplied by the inverse of the rights factor and the bonus
factor, so 1.20 / 1.50  5/6 = 2/3.

7 Sardine
35.9 pence
2
Issue price of preference shares = £300,000 / 1.08 = £257,202
Profit attributable to ordinary equity holders = £200,000 – (8% × £257,202) = £179,424
£179,424
Basic EPS = = 35.9p
500,000 shares
As no dividend is payable on the preference shares in 20X7, the discount on issue is amortised
using the effective interest method and treated as preference dividend when calculating earnings
for EPS purposes (IAS 33.15).
The £300,000 preference shares must be discounted at 8% for the two years between issue and
the date when dividends commence. A dividend is then calculated at 8% per annum compound
on that value.
8 Citric
(a) 476,000
(b) 11.5 pence
(c) 6.78 pence
(a) Shares issued at average market price (1,700,000 × £18)/£25 1,224,000
Shares issued at nil consideration (1,700,000 – 1,224,000) 476,000
(b) Incremental profits (£1,750,000 × 7% × (1-25%)) £91,875
Increase in number of shares (£2,000,000/£5 × 2) 800,000
Therefore incremental EPS (£91,875 / 800,000 shares) 11.5p
(c) Profits Number of shares EPS
Basic EPS £100,000 1,000,000 10p
Add in options £100,000 1,476,000 6.78p
The warrants (treated as issued for nil consideration) are more dilutive than the bonds, so are
dealt with first under IAS 33.44. As the 11.5 pence earnings per incremental share on
conversion of the bonds is antidilutive, under IAS 33.36 the conversion is left out of the
calculation of DEPS.


No, the 4% preference shares are classed as liabilities under IAS 32. The dividend has been charged to
profits as part of the finance cost and no adjustment is necessary.

£1.75
Being the total earnings £350,000 divided by the number of shares in issue (200,000).
The redeemable preference share dividend is included as a finance cost and deducted in arriving at
profit before tax.

Basic EPS
20X6
Trading results £
Profit before interest and tax 1,050,000
Interest on 7% convertible loan stock (105,000)
Taxation (283,500)
Number of shares outstanding 2,000,000
Basic EPS (£661,500 / 2,000,000 shares) £0.33
Testing for dilutive impact

Increase in earnings = interest saved (£1,500,000 × 7% × (1-30%)) £73,500
Increase in number of shares (£1,500,000/£100 × 140) 2,100,000 C
EPS (£73,500 / 2,100,000) 3.5p H
A
This is less than basic EPS and therefore the convertible loan stock is dilutive. P
T
E
20X7
Trading results £
14
Number of shares outstanding 3,000,000
Basic EPS £0.30
Number of shares under option
Issued at full market price (600,000 x 50p)/£1.50 200,000
Issued at nil consideration 600,000 – 200,000 400,000
Total number of shares under option 600,000
Number of equity shares for basic EPS 3,000,000
Adjusted number of shares 3,400,000
Diluted EPS (£900,000 / 3,400,000) £0.26

CHAPTER 15
Reporting performance
Introduction
Topic List
1 IFRS 8 Operating Segments
2 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
3 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
4 IAS 24 Related Party Disclosures
5 IFRS 1 First-time Adoption of International Financial Reporting Standards
6 Reporting corporate governance
7 The directors' report
8 International Financial Reporting Standard for Small and Medium-sized Entities
Technical reference
583
Introduction
 Demonstrate an understanding of and apply the requirements of IFRS 8 Operating

Segments
 Understand and apply the requirements of IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors
 Understand and apply the requirements of IFRS 5 Non-current Assets Held for Sale and
Discontinued Operations
 Understand and apply the requirements of IAS 24 Related Party Disclosures

1 IFRS 8 Operating Segments
An important aspect of reporting financial performance is segment reporting. This is covered by IFRS 8
Operating Segments.
Section overview
IFRS 8 is a disclosure standard.
 Segment reporting is necessary for a better understanding and assessment of:
– Past performance
– Risks and returns
– Informed judgements
 IFRS 8 adopts the managerial approach to identifying segments.
 The standard gives guidance on how segments should be identified and what information
should be disclosed for each.
It also sets out requirements for related disclosures about products and services, geographical areas
and major customers.
1.1 Introduction
Large entities produce a wide range of products and services, often in several different countries. Further
information on how the overall results of entities are made up from each of these product or
geographical areas will help the users of the financial statements. This is the reason for segment
reporting.
 The entity's past performance will be better understood
 The entity's risks and returns may be better assessed
 More informed judgements may be made about the entity as a whole
Risks and returns of a diversified, multi-national company can be better assessed by looking at the
individual risks and rewards attached to groups of products or services or in different geographical areas.
These are subject to differing rates of profitability, opportunities for growth, future prospects and risks.
1.2 Objective and scope

An entity must disclose information to enable users of its financial statements to evaluate the nature and
financial effects of the business activities in which it engages and the economic environments in which it
operates.
Only entities whose equity or debt securities are publicly traded (ie on a stock exchange) need
disclose segment information. In group accounts, only consolidated segmental information needs to be
shown. (The statement also applies to entities filing or in the process of filing financial statements for the
purpose of issuing instruments.)
1.3 Definition of operating segment C

H
A
Definition P
T
Operating segment: This is a component of an entity: E
R
(a) That engages in business activities from which it may earn revenues and incur expenses (including
revenues and expenses relating to transactions with other components of the same entity)
(b) Whose operating results are regularly reviewed by the entity's chief operating decision maker to 15
make decisions about resources to be allocated to the segment and assess its performance, and
(c) For which discrete financial information is available.
Reporting performance 585

The term 'chief operating decision maker' identifies a function, not necessarily a manager with a specific
title. That function is to allocate resources and to assess the performance of the entity's operating
segments.
1.4 Aggregation
Two or more operating segments may be aggregated if the segments have similar economic
characteristics, and the segments are similar in all of the following respects:
 The nature of the products or services
 The nature of the production process
 The type or class of customer for their products or services
 The methods used to distribute their products or provide their services, and
 If applicable, the nature of the regulatory environment
1.5 Determining reportable segments

An operating segment is reportable where:
1 It meets the definition of an operating segment, and
2 Any of the following size criteria are met:
(a) Segment revenue ≥ 10% of total (internal and external) revenue, or
(b) Segment profit or loss ≥ 10% of the profit of all segments in profit (or loss of all segments
making a loss if greater), or
(c) Segment assets ≥ 10% of total assets.
At least 75% of total external revenue must be reported by operating segments. Where this is not the
case, additional segments must be identified (even if they do not meet the 10% thresholds).
1.5.1 Aggregating segments

Two or more operating segments below the thresholds may be aggregated to produce a reportable
segment if the segments have similar economic characteristics, and the segments are similar in a
majority of the aggregation criteria above.
1.5.2 Non-reportable segments

Operating segments that do not meet any of the quantitative thresholds may be reported separately
if management believes that information about the segment would be useful to users of the financial
statements.
1.6 Disclosures
1.6.1 Segment disclosures
Disclosures required by the IFRS are extensive and best learned by looking at the example and pro
forma, which follow the list. Disclosure is required of:
 Factors used to identify the entity's reportable segments
 Types of products and services from which each reportable segment derives its revenues
 For each reportable segment:
– Operating segment profit or loss
– Segment assets
– Segment liabilities
– Certain income and expense items

External
Revenue
Inter segment
Interest revenue
Interest expense
Depreciation and amortisation
Other material non-cash items
Material income/expense (IAS 1)

Profit, assets Share of profit of associates/jointly controlled entities equity
& liabilities accounted
Profit or loss (as reported to chief operating decision maker)
Income tax expense
Non-current assets
Investments in associates/jointly controlled entities
Expenditures for reportable assets
Segment liabilities
A reconciliation of each of the above material items to the entity's reported figures is required.
Reporting of a measure of profit or loss by segment is compulsory. Other items are disclosed if included
in the figures reviewed by or regularly provided to the chief operating decision maker.
1.6.2 Entity wide disclosures

The following disclosures are required for the whole entity:
 External revenue by each product and service (if reported basis is not products and services)
 Geographical information:
by:
Geographical External revenue
• entity's country of domicile, and
areas
Non-current assets • all foreign countries (subdivided if material)
Notes
(1) External revenue is allocated based on the customer's location.
(2) Non-current assets excludes financial instruments, deferred tax assets, post-employment
benefit assets, and rights under insurance contracts.
 Information about reliance on major customers (ie those who represent more than 10% of
C
external revenue) H
A
P
T
E
R
15

1.6.3 Disclosure example from IFRS 8
The following example is adapted from the IFRS 8 Implementation Guidance, which emphasises that this
is for illustrative purposes only and that the information must be presented in the most understandable
manner in the specific circumstances.
The hypothetical company does not allocate tax expense (tax income) or non-recurring gains and losses
to reportable segments. In addition, not all reportable segments have material non-cash items other
than depreciation and amortisation in profit or loss. The amounts in this illustration, denominated as
dollars, are assumed to be the amounts in reports used by the chief operating decision maker.
Car Motor All
parts vessel Software Electronics Finance other Totals
$ $ $ $ $ $ $
Revenues from external
customers 3,000 5,000 9,500 12,000 5,000 1,000 35,500
Intersegment revenues – – 3,000 1,500 – – 4,500
Interest revenue 450 800 1,000 1,500 – – 3,750
Interest expense 350 600 700 1,100 – – 2,750
Net interest revenue – – – – 1,000 – 1,000
Depreciation and
amortisation 200 100 50 1,500 1,100 – 2,950
Reportable segment profit 200 70 900 2,300 500 100 4,070
Other material non-cash
items:
Impairment of assets – 200 – – – – 200
Reportable segment assets 2,000 5,000 3,000 12,000 57,000 2,000 81,000
Expenditure for reportable
segment non-current assets 300 700 500 800 600 – 2,900
Reportable segment liabilities 1,050 3,000 1,800 8,000 30,000 – 43,850
 'All other' segment results are attributable to four operating segments of the company which do
not meet the quantitative thresholds. Those segments include a small property business, an
electronics equipment rental business, a software consulting practice and a warehouse leasing
operation. None of those segments has ever met any of the quantitative thresholds for determining
reportable segments.
 The finance segment derives a majority of its revenue from interest. Management primarily relies
on net interest revenue, not the gross revenue and expense amounts, in managing that segment.
Therefore, as permitted by IFRS 8, only the net amount is disclosed.

1.6.4 Suggested pro forma
Information about profit or loss, assets and liabilities
Segment Segment Segment All other Inter Entity
A B C segments segment total
Revenue – external customers X X X X – X
Revenue – inter segment X X X X (X) –
X X X X (X) X
Interest revenue X X X X (X) X
Interest expense (X) (X) (X) (X) X (X)
Depreciation and
amortisation (X) (X) (X) (X) – (X)
Other material non-cash
items X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Material income/expense
(IAS 1) X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Share of profit of
associate/JVs X X X X – X
Segment profit before tax X X X X (X) X
Income tax expense (X) (X) (X) (X) – (X)
Unallocated items X/(X)
Profit for the period X
Segment assets X X X X (X) X
Investments in
associate/JVs X X X X – X
Unallocated assets X
Entity's assets X
Expenditures for reportable

assets X X X X (X) X
Segment liabilities X X X X (X) X
Unallocated liabilities X
Entity's liabilities X
Information about geographical areas

Country of Foreign
domicile countries Total
Revenue – external customers X X X
Non-current assets X X X
Interactive question 1: Segments [Difficulty level: Intermediate]

Endeavour, a public limited company, trades in six business areas which are reported separately in its
internal accounts provided to the chief operating decision maker. The results of these segments for the
year ended 31 December 20X5 are as follows.
Operating segment information as at 31 December 20X5
Revenue Segment Segment Segment
External Internal Total profit/(loss) assets liabilities C
£m £m £m £m £m £m H
Chemicals: Europe 14 7 21 1 31 14 A
Rest of world 56 3 59 13 P
778 34
T
Pharmaceuticals wholesale 59 8 67 9 104 35 E
Pharmaceuticals retail 22 0 22 (2) 30 12 R
Cosmetics 12 3 15 2 18 10
Hair care 11 1 12 4 21 8
Body care 18 24 42 (6) 54 19 15
192 46 238 21 336 132

Requirement
Which of the operating segments of Endeavour constitute a 'reportable' operating segment under IFRS 8
Operating Segments for the year ending 31 December 20X5?
2 IAS 8 Accounting Policies, Changes in Accounting Estimates

and Errors
Section overview
 This is an overview of material covered in earlier studies.
Accounting policies
 Accounting policies are determined by applying the relevant IFRS or IFRIC and considering any
relevant Implementation Guidance issued by the IASB for that IFRS/IFRIC.
 Where there is no applicable IFRS or IFRIC management should use its judgement in developing
and applying an accounting policy that results in information that is relevant and reliable.
Management should refer to:
(a) The requirements and guidance in IFRSs and IFRICs dealing with similar and related issues.
(b) The definitions, recognition criteria and measurement concepts for assets, liabilities and
expenses in the Framework.
Management may also consider the most recent pronouncements of other standard setting bodies
that use a similar conceptual framework to develop standards, other accounting literature and
accepted industry practices if these do not conflict with the sources above.
 An entity shall select and apply its accounting policies for a period consistently for similar
transactions, other events and conditions, unless an IFRS or an IFRIC specifically requires or permits
categorisation of items for which different policies may be appropriate. If an IFRS or an IFRIC
requires or permits categorisation of items, an appropriate accounting policy shall be selected and
applied consistently to each category.
Changes in accounting policies
 These are rare: only if required by statute/standard-setting body/results in reliable and more
relevant information.
 Adoption of new IFRS: follow transitional provisions of IFRS. If no transitional provisions:
retrospective application.
 Other changes in policy: retrospective application. Adjust opening balance of each affected
component of equity, ie as if new policy has always been applied.
 Prospective application is not allowed unless it is impracticable to determine the cumulative
effect of the change.
 An entity should disclose information relevant to assessing the impact of new IFRSs/IFRICs on the
financial statements where these have been issued but have not yet come into force.
Changes in accounting estimates
 Estimates arise because of uncertainties inherent within them, judgement is required but this
does not undermine reliability.
 Effect of a change in accounting estimate should be included in profit or loss in:
– Period of change, if change affects only current period, or
– Period of change and future periods, if change affects both.

Errors
 Prior period errors: correct retrospectively.
 This involves:
(a) Either restating the comparative amounts for the prior period(s) in which the error occurred
(b) Or when the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for that period
so that the financial statements are presented as if the error had never occurred.
 Only where it is impracticable to determine the cumulative effect of an error on prior periods can
an entity correct an error prospectively.
Interactive question 2: Accounting errors [Difficulty level: Exam standard]

During 20X7 Lubi Co discovered that certain items had been included in inventory at 31 December
20X6, valued at £4.2m, which had in fact been sold before the year end. The following figures for 20X6
(as reported) and 20X7 (draft) are available.
20X6 20X7 (draft)
£'000 £'000
Sales 47,400 67,200
Cost of goods sold (34,570) (55,800)
Profit before taxation 12,830 11,400
Income taxes (3,880) (3,400)
Net profit 8,950 8,000
Retained earnings at 1 January 20X6 were £13m. The cost of goods sold for 20X7 includes the £4.2m
error in opening inventory. The income tax rate was 30% for 20X6 and 20X7.
Requirement
Show the profit or loss section of the statement of profit or loss and other comprehensive income for
20X7, with the 20X6 comparative, and retained earnings.
3 IFRS 5 Non-current Assets Held for Sale and Discontinued

Operations
Section overview
 IFRS 5 requires assets and groups of assets that are 'held for sale' to be presented separately on
the face of the statement of financial position and the results of discontinued operations to be
presented separately in the statement of profit or loss and other comprehensive income. This is
required so that users of financial statements will be better able to make projections about the
financial position, profits and cash flows of the entity based on continuing operations only.
C
H
A
Definition P
T
Disposal group: a group of assets to be disposed of, by sale or otherwise, together as a group in a E
single transaction, and liabilities directly associated with those assets that will be transferred in the R
transaction. (In practice a disposal group could be a subsidiary, a cash-generating unit or a single
operation within an entity.) (IFRS 5)
15

A disposal group could form a group of cash-generating units, a single cash-generating unit or be part
of a cash-generating unit.
The disposal group should include goodwill if it is a cash-generating unit (or group of cash-generating
units to which goodwill has been allocated under IAS 36. Only goodwill recognised in the statement of
financial position can be included in the disposal group. If a previous GAAP allowed goodwill to be
recorded directly in reserves, this goodwill does not form part of a disposal group.
A disposal group may include current assets and current and non-current liabilities. However, only
liabilities that will be transferred as part of the transaction are classified as part of the disposal group. If
any liabilities remain with the vendor, these are not included in the scope of IFRS 5.
IFRS 5 does not apply to certain assets covered by other accounting standards:
 Deferred tax assets (IAS 12)
 Assets arising from employee benefits (IAS 19)
 Financial assets (IAS 39)
 Investment properties accounted for in accordance with the fair value model (IAS 40)
 Agricultural and biological assets that are measured at fair value less estimated point of sale costs
(IAS 41)
 Insurance contracts (IFRS 4)
3.1 Classification of assets held for sale

A non-current asset (or disposal group) should be classified as held for sale if its carrying amount will be
recovered principally through a sale transaction rather than through continuing use. A number of
detailed criteria must be met:
(a) The asset must be available for immediate sale in its present condition.
(b) Its sale must be highly probable (ie, significantly more likely than not).
For the sale to be highly probable, the following must apply.
(i) Management must be committed to a plan to sell the asset.
(ii) There must be an active programme to locate a buyer.
(iii) The asset must be marketed for sale at a price that is reasonable in relation to its current fair
value.
(iv) The sale should be expected to take place within one year from the date of classification.
(v) It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
An asset (or disposal group) can still be classified as held for sale, even if the sale has not actually taken
place within one year. However, the delay must have been caused by events or circumstances beyond
the entity's control and there must be sufficient evidence that the entity is still committed to sell the
asset or disposal group. Otherwise the entity must cease to classify the asset as held for sale.
Subsidiaries acquired exclusively with a view to resale

If an entity acquires a disposal group (eg, a subsidiary) exclusively with a view to its subsequent disposal
it can classify the asset as held for sale only if the sale is expected to take place within one year and it is
highly probable that all the other criteria will be met within a short time (normally three months).
Abandoned assets
An asset that is to be abandoned should not be classified as held for sale. This is because its carrying
amount will be recovered principally through continuing use. However, a disposal group that is to be
abandoned may meet the definition of a discontinued operation and therefore separate disclosure may
be required (see below).

Interactive question 3: Available-for-sale [Difficulty level: Exam standard]
On 1 December 20X3, a company became committed to a plan to sell a manufacturing facility and has
already found a potential buyer. The company does not intend to discontinue the operations currently
carried out in the facility. At 31 December 20X3 there is a backlog of uncompleted customer orders. The
subsidiary will not be able to transfer the facility to the buyer until after it ceases to operate the facility
and has eliminated the backlog of uncompleted customer orders. This is not expected to occur until
spring 20X4.
Requirement
How should the manufacturing facility be accounted for as at 31 December 20X3?
3.2 Measurement of assets held for sale

A non-current asset (or disposal group) that is held for sale should be measured at the lower of its
carrying amount and fair value less costs to sell (net realisable value).
An impairment loss should be recognised where fair value less costs to sell is lower than carrying
amount. Note that this is an exception to the normal rule. IAS 36 Impairment of Assets requires an entity
to recognise an impairment loss only where an asset's recoverable amount is lower than its carrying
value. Recoverable amount is defined as the higher of net realisable value and value in use. IAS 36
does not apply to assets held for sale.
Non-current assets held for sale should not be depreciated, even if they are still being used by the
entity.
A non-current asset (or disposal group) that is no longer classified as held for sale (for example,
because the sale has not taken place within one year) is measured at the lower of:
(a) Its carrying amount before it was classified as held for sale, adjusted for any depreciation that
would have been charged had the asset not been held for sale.
(b) Its recoverable amount at the date of the decision not to sell.
3.3 Presenting discontinued operations
Definitions
Discontinued operation: a component of an entity that has either been disposed of, or is classified as
held for sale, and:
(a) Represents a separate major line of business or geographical area of operations.
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical
area of operations, or
(c) Is a subsidiary acquired exclusively with a view to resale.
Component of an entity: operations and cash flows that can be clearly distinguished, operationally and
C
for financial reporting purposes, from the rest of the entity. H
A
P
An entity should present and disclose information that enables users of the financial statements to T
E
evaluate the financial effects of discontinued operations and disposals of non-current assets or disposal R
groups.
15

An entity should disclose a single amount on the face of the statement of profit or loss and other
comprehensive income (or statement of profit or loss where presented separately) comprising the total
of:
(a) The post-tax profit or loss of discontinued operations and
(b) The post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or disposal group(s) constituting the discontinued operation.
An entity should also disclose an analysis of the above single amount into:
(a) The revenue, expenses and pre-tax profit or loss of discontinued operations
(b) The related income tax expense
(c) The gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of
the assets or the discontinued operation
(d) The related income tax expense
This may be presented either on the face of the statement of profit or loss and other comprehensive
income or in the notes. If it is presented on the face of the statement of profit or loss and other
comprehensive income it should be presented in a section identified as relating to discontinued
operations, ie separately from continuing operations. This analysis is not required where the
discontinued operation is a newly acquired subsidiary that has been classified as held for sale.
An entity should disclose the net cash flows attributable to the operating, investing and financing
activities of discontinued operations. These disclosures may be presented either on the face of the
statement of cash flows or in the notes.
Gains and losses on the remeasurement of a disposal group that is not a discontinued operation but is
held for sale should be included in profit or loss from continuing operations.
Interactive question 4: Closure [Difficulty level: Intermediate]

On 20 October 20X3 the directors of a parent company made a public announcement of plans to close
a steel works. The closure means that the group will no longer carry out this type of operation, which
until recently has represented about 10% of its total revenue. The works will be gradually shut down
over a period of several months, with complete closure expected in July 20X4. At 31 December 20X3
output had been significantly reduced and some redundancies had already taken place. The cash flows,
revenues and expenses relating to the steel works can be clearly distinguished from those of the
subsidiary's other operations.
Requirement
How should the closure be treated in the financial statements for the year ended 31 December 20X3?
3.4 Presentation of a non-current asset or disposal group classified as

held for sale
Non-current assets and disposal groups classified as held for sale should be presented separately from
other assets in the statement of financial position. The liabilities of a disposal group should be presented
separately from other liabilities in the statement of financial position.
(a) Assets and liabilities held for sale should not be offset.
(b) The major classes of assets and liabilities held for sale should be separately disclosed either on the
face of the statement of financial position or in the notes.
3.5 IFRS 5 and impairment

There are particular rules on impairment in the context of IFRS 5. These are covered in Chapter 2,
Section 1.5 of this study manual.

3.6 Additional disclosures
In the period in which a non-current asset (or disposal group) has been either classified as held for sale
or sold the following should be disclosed.
(a) A description of the non-current asset (or disposal group)
(b) A description of the facts and circumstances of the disposal
(c) Any gain or loss recognised when the item was classified as held for sale
(d) If applicable, the segment in which the non-current asset (or disposal group) is presented in
accordance with IFRS 8 Operating Segments.
Where an asset previously classified as held for sale is no longer held for sale, the entity should disclose
a description of the facts and circumstances leading to the decision and its effect on results.
4 IAS 24 Related Party Disclosures

Section overview
 The objective of IAS 24 is to ensure that an entity's financial statements contain the disclosures
necessary to draw attention to the possibility that its financial position, and/or profit or loss may
have been affected by the existence of related parties or by related party transactions.
4.1 Overview of material from earlier studies

Scope
IAS 24 requires disclosure of related party transactions, and outstanding balances, in the separate
financial statements of:
 A parent
 A venturer or
 An investor
What constitutes a related party?
A related party is a person or entity that is related to the entity that is preparing its financial statements.
(a) A person or a close member of that person's family is related to a reporting entity if that person:
(i) has control or joint control over the reporting entity;
(ii) has significant influence over the reporting entity; or
(iii) is a member of the key management personnel of the reporting entity or of a parent of
the reporting entity.
(b) An entity is related to a reporting entity if any of the following conditions applies:
(i) The entity and the reporting entity are members of the same group (which means that
each parent, subsidiary and fellow subsidiary is related to the others).
C
(ii) One entity is an associate or joint venture of the other entity (or an associate or joint H
A
venture of a member of a group of which the other entity is a member).
P
(iii) Both entities are joint ventures of the same third party. T
E
(iv) One entity is a joint venture of a third entity and the other entity is an associate of the R
third entity.
(v) The entity is a post-employment defined benefit plan for the benefit of employees of either
15
the reporting entity or an entity related to the reporting entity. If the reporting entity is
itself such a plan, the sponsoring employers are also related to the reporting entity.
(vi) The entity is controlled or jointly controlled by a person identified in (a).

(vii) A person identified in (a)(i) has significant influence over the entity or is a member of the
key management personnel of the entity (or of a parent of the entity).
Exclusions
(a) Two entities simply because they have a director or other key management in common
(notwithstanding the definition of related party above, although it is necessary to consider how
that director would affect both entities).
(b) Two venturers, simply because they share joint control over a joint venture.
(c) Certain other bodies, simply as a result of their role in normal business dealings with the entity
(i) Providers of finance
(ii) Trade unions
(iii) Public utilities
(iv) Government departments and agencies
(d) Any single customer, supplier, franchisor, distributor, or general agent with whom the entity
transacts a significant amount of business, simply by virtue of the resulting economic dependence.
What constitutes a related party transaction?
Definition
Related party transaction: A transfer of resources, services or obligations between related parties,
regardless of whether a price is charged.
What must be disclosed?

 A related party relationship between parent and subsidiaries
 Compensation, being the consideration in exchange for their services, received by key
management personnel
 Disclosures required about related parties only if transactions have taken place between them
during the period:
– The nature of the relationship (but remember this must always be disclosed in respect of a
parent)
– The amount of the transactions
– The amount of any balance outstanding at the year-end
– The terms and conditions attaching to any outstanding balance (for example, whether
security or guarantees have been provided and what form the payment will take)
– If an amount has been provided against or written off any outstanding balance due
 Disclosure of the fact that transactions are on an arm's length basis. (The term 'arm's length'
continues to be used in the context of IAS 24, even though it has been removed from the
definition of fair value in IFRS 13 (see Chapter 2, Section 2).)

Interactive question 5: Related party transactions [Difficulty level: Intermediate]
P owns S and a number of other subsidiaries. The following details relate to amounts due to the key
management personnel (KMP) of P and of S for the year ended 31 December 20X5.
£
Salaries and related taxes payable by S to its KMP for services rendered to S 500,000
Salaries and related taxes payable by P to S's KMP for services rendered to S 60,000
Salaries and related taxes payable by S to its KMP for services rendered to P 20,000
Pension benefits accruing within the group-wide pension scheme to S's KMP for 50,000
services rendered to S
Share options granted under the group-wide share option scheme to S's KMP for 28,000
services rendered to S
658,000
Requirement
What transactions should be disclosed as key management personnel compensation in the financial
statements of S?
5 IFRS 1 First-time Adoption of International Financial

Reporting Standards
Section overview
 IFRS 1 gives guidance to entities applying IFRS for the first time.
The adoption of a new body of accounting standards will inevitably have a significant effect on the
accounting treatments used by an entity and on the related systems and procedures. In 2005 many
countries adopted IFRS for the first time and over the next few years other countries are likely to do the
same.
In addition, many Alternative Investment Market (AIM) companies and public sector companies adopted
IFRS for the first time for accounting periods ending in 2009 and 2010. US companies are likely to move
increasingly to IFRS, although the US Securities and Exchange Commission has not given any definite
timeline for this in its 2012 work plan.
As discussed in Chapter 1 of this manual, the regulatory shift away from UK GAAP means that all entities
except those small enough to use the FRSSE will be required to report in accordance with FRSUKI with
an option to use IFRS.
IFRS 1 First-time Adoption of International Financial Reporting Standards was issued to ensure that an
entity's first IFRS financial statements contain high quality information that:
(a) is transparent for users and comparable over all periods presented;
(b) provides a suitable starting point for accounting under IFRSs; and C
(c) can be generated at a cost that does not exceed the benefits to users. H
A
P
5.1 General principles T
E
An entity applies IFRS 1 in its first IFRS financial statements. R
An entity's first IFRS financial statements are the first annual financial statements in which the entity
adopts IFRS by an explicit and unreserved statement of compliance with IFRS.
15
Any other financial statements (including fully compliant financial statements that did not state so) are
not the first set of financial statements under IFRS.

5.2 Opening IFRS statement of financial position
An entity prepares and presents an opening IFRS statement of financial position at the date of
transition to IFRS as a starting point for IFRS accounting.
Generally, this will be the beginning of the earliest comparative period shown (ie full retrospective
application). Given that the entity is applying a change in accounting policy on adoption of IFRS 1
Presentation of Financial Statements requires the presentation of at least three statements of financial
position (and two of each of the other statements).
Illustration: Opening IFRS SOFP

st
Comparative year 1 year of adoption
1.1.20X8 31.12.20X8 31.12.20X9
Transition
date
Preparation of an opening IFRS statement of financial position typically involves adjusting the amounts
reported at the same date under previous GAAP.
All adjustments are recognised directly in retained earnings (or, if appropriate, another category of
equity) not in profit or loss.
5.3 Estimates
Estimates in the opening IFRS statement of financial position must be consistent with estimates made at
the same date under previous GAAP even if further information is now available (in order to comply
with IAS 10).
5.4 Transition process

(a) Accounting policies
The entity should select accounting policies that comply with IFRSs effective at the end of the first
IFRS reporting period.
These accounting policies are used in the opening IFRS statement of financial position and
throughout all periods presented. The entity does not apply different versions of IFRS effective at
earlier dates.
(b) Derecognition of assets and liabilities
Previous GAAP statement of financial position may contain items that do not qualify for recognition
under IFRS.
Eg IFRS does not permit capitalisation of research, staff training and relocation costs.
(c) Recognition of new assets and liabilities
New assets and liabilities may need to be recognised.
Eg deferred tax balances and certain provisions such as environmental and decommissioning costs.
(d) Reclassification of assets and liabilities
Eg compound financial instruments need to be split into their liability and equity components.
(e) Measurement
Value at which asset or liability is measured may differ under IFRS.
Eg discounting of deferred tax assets/liabilities not allowed under IFRS.

5.5 Main exemptions from applying IFRS in the opening IFRS statement of
financial position
(a) Property, plant and equipment, investment properties and intangible assets
 Fair value/previous GAAP revaluation may be used as a substitute for cost at date of transition
to IFRSs.
(b) Business combinations

For business combinations prior to the date of transition to IFRSs:
 The same classification (acquisition or uniting of interests) is retained as under previous GAAP.
 For items requiring a cost measure for IFRSs, the carrying value at the date of the business
combination is treated as deemed cost and IFRS rules are applied from thereon.
 Items requiring a fair value measure for IFRSs are revalued at the date of transition to IFRSs.
 The carrying value of goodwill at the date of transition to IFRSs is the amount as reported
under previous GAAP.
(c) Employee benefits
 Unrecognised actuarial gains and losses can be deemed zero at the date of transition to IFRSs.
IAS 19 is applied from then on.
(d) Cumulative translation differences on foreign operations
 Translation differences (which must be disclosed in a separate translation reserve under IFRS)
may be deemed zero at the date of transition to IFRS. IAS 21 is applied from then on.
(e) Adoption of IFRS by subsidiaries, associates and joint ventures
If a subsidiary, associate or joint venture adopts IFRS later than its parent, it measures its assets and
liabilities:
 Either: At the amount that would be included in the parent's financial statements, based on
the parent's date of transition.
 Or: At the amount based on the subsidiary (associate or joint venture)'s date of
transition.
Disclosure
(a) A reconciliation of previous GAAP equity to IFRSs is required at the date of transition to IFRSs and
for the most recent financial statements presented under previous GAAP.
(b) A reconciliation of profit for the most recent financial statements presented under previous GAAP.
5.6 Organisational and procedural changes

The technical changes involved in adopting a new body of standards will provide a challenge to
company management and their advisers. These are some of the key issues:
(a) Accurate assessment of the task involved. Underestimation or wishful thinking may hamper the C
H
effectiveness of the conversion and may ultimately prove inefficient.
A
(b) Proper planning. This should take place at the overall project level, but a detailed task analysis P
T
could be drawn up to control work performed.
E
(c) Human resource management. The project must be properly structured and staffed. R
(d) Training. Where there are skills gaps, remedial training should be provided.
(e) Monitoring and accountability. A relaxed 'it will be all right on the night' attitude could spell 15
danger. Implementation progress should be monitored and regular meetings set up so that
participants can personally account for what they are doing as well as flag up any problems as early
as possible. Project drift should be avoided.

(f) Achieving milestones. Successful completion of key steps and tasks should be appropriately
acknowledged, ie what managers call 'celebrating success', so as to sustain motivation and
performance.
(g) Physical resources. The need for IT equipment and office space should be properly assessed.
(h) Process review. Care should be taken not to perceive the conversion as a one-off quick fix. Any
change in future systems and processes should be assessed and properly implemented.
(i) Follow-up procedures. Good management practice dictates that follow-up procedures should be
planned and in place to ensure that the transfer is effectively implemented and that any necessary
changes are identified and implemented on a timely basis.
(j) Contractual terms may be affected, such as covenants related to borrowing facilities based on
statement of financial position ratios. The potential effect of the new Standards on these
measurements should be assessed and discussed with the lenders at an early stage.
Interactive question 6: IFRS 1 [Difficulty level: Intermediate]

Europa is a listed company incorporated in Molvania. It will adopt International Financial Reporting
Standards (IFRSs) for the first time in its financial statements for the year ended 31 December 20X8.
The directors of Europa are unclear as to the impact of IFRS 1 First-time Adoption of International Financial
Reporting Standards.
Requirement
Advise the directors of Europa on the following.
(a) The procedure for preparing IFRS financial statements for the first time (as required by IFRS 1).
(b) The practical steps that the company should take in order to ensure an efficient transfer to
accounting under IFRS.
(c) In its previous financial statements for 31 December 20X6 and 20X7, which were prepared under
local GAAP, the company:
(i) made a number of routine accounting estimates, including accrued expenses and provisions,
and
(ii) did not recognise a provision for a court case arising from events that occurred in September
20X7. When the court case was concluded on 30 June 20X8, Europa was required to pay $10
million and paid this on 10 July 20X8, after the 20X7 financial statements were authorised for
issue.
In the opinion of the directors, the company's estimates of accrued expenses and provisions under local
GAAP were made on a basis consistent with IFRSs.
Required
Discuss how the matters above should be dealt with in the financial statements of Europa for the year
ended 31 December 20X8.
6 Reporting corporate governance
Section overview
 Annual reports must convey a fair and balanced view of the organisation. They should state
whether the organisation has complied with governance regulations and codes, and give specific
disclosures about the board, internal control reviews, going concern status and relations with
stakeholders.

6.1 Introduction
Governance is the system by which organisations are directed and controlled. It focuses on the
relationship between the board of directors, shareholders and other stakeholders and the effects on
corporate strategy and performance. The published financial statements are therefore of key
importance.
The main source of guidance on corporate governance in the UK is the UK Corporate Governance Code
(previously called the Combined Code). This is considered in detail in Chapter 3 of the Advanced Stage
Audit and Assurance Study Manual. The section below deals with corporate governance reporting
requirements.
6.2 Reporting requirements

The London Stock Exchange requires the following general disclosures:
 A narrative statement of how companies have applied the principles set out in the Corporate
Governance Code, providing explanations which enable their shareholders to assess how the
principles have been applied.
 A statement as to whether or not they complied throughout the accounting period with the
provisions set out in the Corporate Governance Code. Listed companies that did not comply
throughout the accounting period with all the provisions must specify the provisions with which
they did not comply, and give reasons for non-compliance.
The corporate governance reports also suggest that the directors should explain their responsibility for
preparing accounts. They should report that the business is a going concern, with supporting
assumptions and qualifications as necessary.
In addition further statements may be required depending on the jurisdiction such as:
 Information about the board of directors: the composition of the board in the year, information
about the independence of the non-executives, frequency of and attendance at board meetings,
how the board's performance has been evaluated.
 Brief report on the remuneration, audit and nomination committees covering terms of
reference, composition and frequency of meetings.
 Information about relations with auditors including reasons for change and steps taken to ensure
auditor objectivity and independence when non-audit services have been provided.
 A statement that the directors have reviewed the effectiveness of internal controls, including risk
management, also sufficient disclosures for shareholders to understand the main features of the risk
management and internal control processes. Boards should also give details of, or at any rate
confirm, action taken to remedy significant failings or weaknesses.
 A statement on relations and dialogue with shareholders.
 A statement that the company is a going concern.
 Sustainability reporting, including the nature and extent of social, transformation, ethical, safety,
health and environmental management policies and practices (see Advanced Audit Study Manual,
Chapter 8).
C
 An operating and financial review. The UK's Accounting Standards Board summarised the H
A
purpose of such a review:
P
'The Operating and Financial Review (OFR) should set out the directors' analysis of the business, in T
E
order to provide to investors a historical and prospective analysis of the reporting entity 'through R
the eyes of management'. It should include discussion and interpretation of the performance of the
business and the structure of its financing, in the context of known or reasonably expected
changes in the environment in which it operates.' 15
You have studied the Operating and Financial Review in your Professional Stage Financial Reporting
studies.

6.3 Management commentary
6.3.1 Need for management commentary
In the UK, companies have been encouraged to produce an Operating and Financial Review, explaining
the main factors underlying a company's financial position and performance, and analysing the main
trends affecting this. A Reporting Statement on the OFR was issued in January 2006.
Financial statements alone are not considered sufficient without an accompanying explanation of the
performance, eg highlighting a restructuring that has reduced profits or the cost of developing a new
business channel in the current period which will generate profits in the future.
Perhaps more importantly a good management commentary not only talks about the past position and
performance, but how this will translate into future financial position and performance.
The Conceptual Framework for Financial Reporting acknowledges, 'general purpose financial reports do
not and cannot provide all of the information that existing and potential investors, lenders and other
creditors need. Those users need to consider pertinent information from other sources, for example,
general economic conditions and expectations, political events and political climate, and industry and
company outlooks.' (para OB6)
Typically, larger companies are already making disclosures similar to a management commentary, eg as
a 'Directors' Report', but the aim of the IASB is to define internationally what a management
commentary should contain. For example, a good commentary should be balanced and not just
highlight the company's successes.
A management commentary would also address risks and issues facing the entity that may not be
apparent from a review of the financial statements, and how they will be addressed.
6.3.2 IFRS Practice Statement

In December 2010, the IASB issued an IFRS Practice Statement Management Commentary, which is the
international equivalent of the Operating and Financial Review.
The main objective of the Statement is that the IASB can improve the quality of financial reports by
providing guidance 'for all jurisdictions, in order to promote comparability across entities that present
management commentary and to improve entities' communications with their stakeholders'. In
preparing this guidance, the IASB team has reviewed existing requirements around the world, such as
the OFR, Management's Discussion and Analysis (MD&A) in the USA and Canada, and the German
accounting standard on Management Reporting.
6.3.3 Scope
The IASB has published a Practice Statement rather than an IFRS on management commentary. This
'provides a broad, non-binding framework for the presentation of management commentary that relates
to financial statements that have been prepared in accordance with IFRSs'.
This guidance is designed for publicly traded entities, but it would be left to regulators to decide who
would be required to publish management commentary.
This approach avoids the adoption hurdle, ie that the perceived cost of applying IFRSs might increase,
which could otherwise dissuade jurisdictions/ countries not having adopted IFRSs from requiring their
adoption, especially where requirements differ significantly from existing national requirements.
6.3.4 Definition of a management commentary

The following preliminary definition is given in the Practice Statement:
Definition
Management commentary: a narrative report that provides a context within which to interpret the
financial position, financial performance and cash flows of an entity. It also provides management with
an opportunity to explain its objectives and its strategies for achieving those objectives.
(IFRS Practice Statement )

6.3.5 Principles for the preparation of a management commentary
When a management commentary relates to financial statements, then those financial statements
should either be provided with the commentary or the commentary should clearly identify the financial
statements to which it relates. The management commentary must be clearly distinguished from other
information and must state to what extent it has followed the Practice Statement.
Management commentary should follow these principles:
(a) To provide management's view of the entity's performance, position and progress;
(b) To supplement and complement information presented in the financial statements;
(c) To include forward-looking information; and
(d) To include information that possesses the qualitative characteristics described in the Conceptual
Framework.
6.3.6 Elements of a management commentary

The Practice Statement says that to meet the objective of management commentary, an entity should
include information that is essential to an understanding of:
(a) The nature of the business
(b) Management's objectives and its strategies for meeting those objectives
(c) The entity's most significant resources, risks and relationships
(d) The results of operations and prospects
(e) The critical performance measures and indicators that management uses to evaluate the entity's
performance against stated objectives
The Practice Statement does not propose a fixed format as the nature of management commentary
would vary between entities. It does not provide application guidance or illustrative examples, as this
could be interpreted as a floor or ceiling for disclosures. Instead, the IASB anticipates that other parties
will produce guidance.
However, the IASB has provided a table relating the five elements listed above to its assessments of the
needs of the primary users of a management commentary (existing and potential investors, lenders and
creditors).
Element User needs
Nature of the The knowledge of the business in which an entity is engaged and the
business external environment in which it operates.
Objectives and To assess the strategies adopted by the entity and the likelihood that those
strategies strategies will be successful in meeting management's stated objectives.
A basis for determining the resources available to the entity as well as

obligations to transfer resources to others; the ability of the entity to
Resources, risks and
generate long-term sustainable net inflows of resources; and the risks to C
relationships H
which those resource-generating activities are exposed, both in the near
A
term and in the long term.
P
T
The ability to understand whether an entity has delivered results in line E
with expectations and, implicitly, how well management has understood R
Results and prospects
the entity's market, executed its strategy and managed the entity's
resources, risks and relationships.
15
Performance The ability to focus on the critical performance measures and indicators
measures and that management uses to assess and manage the entity's performance
indicators against stated objectives and strategies.

6.3.7 Advantages and disadvantages of a compulsory management commentary
Entity Entity
 Promotes the entity, and attracts investors,  Costs may outweigh benefits
lenders, customers and suppliers  Risk that investors may ignore the financial
 Communicates management plans and statements
outlook
Users Users
 Financial statements not enough to make  Subjective
decisions (financial information only)  Not normally audited
 Financial statements backward looking  Could encourage companies to de-list
(need forward looking information) (to avoid requirement to produce MC)
 Highlights risks  Different countries have different needs
 Useful for comparability to other entities
6.3.8 Management commentary in the UK

Management commentary in the UK has, to date, been provided in the form of an operating and
financial review (see above). The Companies Act 2006 further introduced a requirement for all
companies, other than those classified as small, to provide a business review within the directors' report.
This is discussed in further detail in the next section.
6.4 Sustainability
6.4.1 What is sustainability?
Pressure is mounting for companies to widen their scope for corporate public accountability. Many
companies are responding by measuring and disclosing their social impacts.
Examples of social measures include: philanthropic donations, employee satisfaction levels and
remuneration issues, community support, and stakeholder consultation information.
The next step beyond environmental and social reporting is sustainability reporting which includes the
economic element of sustainability (such as wages, taxes and core financial statistics) and involves
integrating environmental, social and economic performance data and measures.
6.4.2 Global Reporting Initiative (GRI)

The Global Reporting Initiative arose from the need to address the failure of the current governance
structures to respond to changes in the global economy.
It is 'a long-term, multi-stakeholder, international undertaking whose mission is to develop and
disseminate globally applicable Sustainability Reporting Guidelines for voluntary use by organisations
reporting on the economic, environmental and social dimensions of their activities, products and
services'.
6.4.3 GRI Guidelines

The GRI published revised guidelines (G3) in 2006. In 2011 the GRI launched G3.1, an update with
expanded guidance for reporting on human rights (application of risk assessments, grievance
remediation), local community impacts and gender (return and retention rates after employee leave,
equal remuneration).
The Guidelines set out the framework of a sustainability report. It consists of five sections:

GRI Report content Detail of GRI requirements
1 Strategy and Analysis Provides a high-level, strategic view of the organisation's

relationship to sustainability in order to provide context for
subsequent and more detailed reporting, including a
statement from the CEO.
2 Organisational Profile The organisation's structure including brands, location of
operations, geographical markets served and size of
operations.
3 Report Parameters The reporting period, materiality, report boundaries (eg
countries), data measurement techniques and a GRI Content
Index.
4 Governance, Commitments Governance structure of the organisation, commitments to
and Engagement external initiatives and how the organisation engages the
stakeholders in its business.
5 Management Approach Organised by economic, environmental, and social categories.
and Performance Each category includes a Disclosure on Management Approach
Indicators and a corresponding set of Core and Additional Performance
Indicators.
6.4.4 Indicators in the GRI framework

GRI structures key performance indicators according to a hierarchy of category, aspect and indicator.
Indicators are grouped in terms of the three dimensions of the conventional definition of sustainability –
economic, environmental, and social.
CATEGORY ASPECT
Economic Economic performance

Social
Market presence
Indirect economic impacts
Environmental Materials
Energy
Water
Environmental
Biodiversity
Emissions, effluents, and waste
Products and services
Compliance
Transport
Overall
Labour Practices and Employment
Decent Work Labour/management relations C
Occupational health and safety H
A
Training and education P
Diversity and equal opportunity T
E
Human Rights Investment and procurement practices
R
Non-discrimination
Freedom of association and collective bargaining
Child labour 15
Forced and compulsory labour
Social
Security practices
Indigenous rights

CATEGORY ASPECT
Society Community
Social
Corruption
Public policy
Anti-competitive behaviour
Compliance
Product Responsibility Customer health and safety
Product and service labelling
Marketing communications
Customer privacy
Compliance
6.4.5 Influence of GRI

There is a trend to report on broader sustainability issues and to include social and economic
information alongside environmental disclosures.
An increasing number of companies, including BT, Vauxhall Motors Ltd, British Airways and Shell are
following the GRI guidelines to some extent in their reporting.
7 The directors' report
Section overview
 Under UK company law a directors' report must be published.
7.1 Introduction
You will have studied the directors' report in the Professional Stage Financial Reporting paper. The
section below summarises the key points.

 In addition to the financial statements, the Companies Act 2006 (CA06) requires a directors' report
to the shareholders to be published within the annual report.
 Most private companies merely comply with the minimum requirements of the CA06. However,
many quoted companies go beyond these legal minimum requirements, and often beyond the
additional requirements laid down by the Stock Exchange. Since the annual report is one of the
main ways in which such companies communicate with their shareholders, they often take the
opportunity to include statements of the objectives and values of the company (or group).
 The directors' report gives the directors a platform from which they can make their shareholders
aware of how well, in outline, they have managed the company over the previous year. Indeed, for
many small stakeholders (a class of investor which has expanded rapidly in recent years), this report
may be the only part of the financial statements to which they pay attention.
 The requirements to produce a directors' report are contained within UK company law. There is no
equivalent requirement under IFRS. However, UK companies adopting IFRS will still have to comply
with the legislation to prepare a directors' report.
7.3 Requirement for a business review

The Companies Act 2006 introduced the requirement for a business review for all UK companies other
than those subject to the small companies' regime. The business review should be a balanced and
comprehensive analysis of:

 The development and performance of the company's business during the financial year, and
 The position of the company's business at the end of that year
consistent with the size and complexity of the business.
For quoted companies the requirements are extended to include information about environmental
matters, company employees and social and community issues. The directors of these companies must
also provide information about the main trends and factors likely to affect the future development,
performance and position of the company's business.
The Business Review is, in effect, an operating and financial review, and as such the UK Accounting
Standards Board have stated that their guidance on Operating and Financial Reviews is also applicable
to the Business Review.
7.4 Other communication

Other communication with stakeholders may take place via
 The disclosure requirements of the Corporate Governance Code and other corporate governance
regulations (see Advanced Audit and Assurance Study Manual, Chapter 3)
 Social and environmental reporting (see Advanced Audit and Assurance Study Manual, Chapter 8)
 Employee and employment reports (see Advanced Audit and Assurance Study Manual, Chapter 8)
7.5 Restraints on directors

Restraints are placed on directors via requirements to disclose related party transactions, including
transactions between the company and the directors themselves.
8 International Financial Reporting Standard for Small and

Medium-sized Entities
Section overview
 In the UK the FRSSE applies to small entities.
 The IASB has issued an IFRS for small and medium-sized entities.

 In the UK the Financial Reporting Standard for Smaller Entities (FRSSE) recognises that the
information needs of users of smaller entity financial statements are different from those of users of
the financial statements of other entities.
 The FRSSE includes all of the accounting, disclosure and measurement requirements for smaller
entities plus the related legal requirements.
 The FRSSE applies to: C
– Companies that qualify as small under the Companies Act, and H
A
– Other entities that would have qualified as small if they were incorporated. P
T
E
8.2 Scope and application of IFRS R
Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRSs are not
intended to be applied to immaterial items, nor are they retrospective. Each individual IFRS lays out
15
its scope at the beginning of the standard.
Within each individual country local regulations govern, to a greater or lesser degree, the issue of
financial statements. These local regulations include accounting standards issued by the national
regulatory bodies and/or professional accountancy bodies in the country concerned.

IFRS concentrates on essentials and is designed not to be too complex, otherwise the standards would
be impossible to apply on a worldwide basis.
IFRS does not override local regulations on financial statements. Entities should simply disclose
whether IFRS is complied with in all material respects. Entities in individual countries will attempt to
persuade local authorities, where current regulations deviate from IFRS, that the benefits of
harmonisation make local change worthwhile.
8.3 Application of IFRS to smaller entities

8.3.1 Big GAAP/little GAAP divide
In most countries the majority of companies or other types of entity are very small. They are generally
owned and managed by one person or a family. The owners have invested their own money in the
business and there are no outside shareholders to protect.
Large entities, by contrast, particularly companies listed on a stock exchange, may have shareholders
who have invested their money, possibly through a pension fund, with no knowledge whatever of the
company. These shareholders need protection and the regulations for such companies need to be more
stringent.
It could therefore be argued that company accounts should be of two types.
(a) 'Simple' ones for small companies with fewer regulations and disclosure requirements
(b) 'Complicated' ones for larger companies with extensive and detailed requirements
This is sometimes called the big GAAP/little GAAP divide.
8.3.2 Possible solutions

There are two approaches to overcoming the big GAAP/little GAAP divide:
1 Differential reporting, ie producing new reduced standards specifically for smaller companies, such
as the UK FRSSE or the IFRS for SMEs (see below).
2 Providing exemptions for smaller companies from some of the requirements of existing standards.
8.3.3 Differential reporting

Differential reporting may have drawbacks in terms of reducing comparability between small and larger
company accounts.
Furthermore, problems may arise where entities no longer meet the criteria to be classified as small.
8.3.4 Exemptions from IFRS

Some IFRSs do not have any bearing on small company accounts, for example, a company with equity
not quoted on a stock exchange has no need to comply with IAS 33 Earnings per Share. Also an entity
with a small local market may find IFRS 8 Operating Segments to be superfluous.
Other standards always have an impact. In particular, almost all small companies will be affected by the
IFRSs on:
 Property, plant and equipment
 Inventories
 Presentation of financial statements
 Events occurring after the reporting period
 Taxes on income
 Revenue
 Provisions and contingencies
Does this mean that companies below a certain size should be exempt from other IFRSs? An alternative
approach would be to reduce the exposure of small companies to IFRSs on a standard by standard
basis. For those 'core' standards listed above, small companies would be required to follow all or most of
their provisions. For more complicated standards, small companies would face nothing but very brief
general obligations.

It is difficult to see how the IASB could impose any kind of specific size limits to define small companies
if such an approach were adopted. Instead, it might specify that size limits which are already given in
national legislation or standards could be adopted for the purpose.
Cost of compliance
If the cost of compliance exceeds the benefits to users, an entity may decide not to follow an IFRS. This
applies to all reporting entities, not just smaller ones. However, smaller entities are more likely to make
use of this exception.
For example, impairment reviews can be time-consuming and a smaller entity may not have sufficient
staff to spare to carry out these reviews.
Materiality
Another point to note is that IFRSs apply to material items. In the case of smaller entities, the amount
that is material may be very small in monetary terms. However, the effect of not reporting that item
may be material in that it would mislead users of the financial statements. A case in point is IAS 24
Related Party Disclosures. Smaller entities may well rely on trade with relatives of the
directors/shareholders and this needs to be disclosed.
8.4 International Financial Reporting Standard for Small and Medium-sized

Entities
The IFRS for Small and Medium-Sized Entities (IFRS for SMEs) was published in July 2009. It is only 230
pages, and has simplifications that reflect the needs of users of SMEs' financial statements and cost-
benefit considerations. It is designed to facilitate financial reporting by small and medium-sized entities
in a number of ways:
(a) It provides significantly less guidance than full IFRS.
(b) Many of the principles for recognising and measuring assets, liabilities, income and expenses in full
IFRSs are simplified.
(c) Where full IFRSs allow accounting policy choices, the IFRS for SMEs allows only the easier option.
(d) Topics not relevant to SMEs are omitted.
(e) Significantly fewer disclosures are required.
(f) The standard has been written in clear language that can easily be translated.
8.4.1 Scope
The IFRS is suitable for all entities except those whose securities are publicly traded and financial
institutions such as banks and insurance companies. It is the first set of international accounting
requirements developed specifically for small and medium-sized entities (SMEs). Although it has been
prepared on a similar basis to IFRS, it is a stand-alone product and will be updated on its own timescale.
There are no quantitative thresholds for qualification as an SME; instead, the scope of the IFRS is
determined by a test of public accountability. As with full IFRS, it is up to legislative and regulatory
authorities and standard setters in individual jurisdictions to decide who is permitted or required to use
the IFRS for SMEs.
C
H
8.4.2 Effective date A
The IFRS for SMEs does not contain an effective date; this is determined in each jurisdiction. The IFRS P
T
will be revised only once every three years. It is hoped that this will further reduce the reporting burden E
for SMEs. R
8.4.3 Accounting policies

15
For situations where the IFRS for SMEs does not provide specific guidance, it provides a hierarchy for
determining a suitable accounting policy. An SME must consider, in descending order:

 The guidance in the IFRS for SMEs on similar and related issues.
 The definitions, recognition criteria and measurement concepts in Section 2 Concepts and Pervasive
Principles of the standard.
The entity also has the option of considering the requirements and guidance in full IFRS dealing with
similar topics. However, it is under no obligation to do this, or to consider the pronouncements of other
standard setters.
8.4.4 Overlap with full IFRS

In the following areas, the recognition and measurement guidance in the IFRS for SMEs is like that in the
full IFRS.
 Provisions and contingencies
 Hyperinflation accounting
 Events after the end of the reporting period
8.4.5 Omitted topics

The IFRS for SMEs does not address the following topics that are covered in full IFRS.
 Earnings per share
 Interim financial reporting
 Segment reporting
 Classification for non-current assets (or disposal groups) as held for sale
8.4.6 Examples of options in full IFRS not included in the IFRS for SMEs
 Revaluation model for intangible assets and property, plant and equipment
 Financial instrument options, including available-for-sale, held to maturity and fair value options
 Choice between cost and fair value models for investment property (measurement depends on the
circumstances)
 Options for government grants
8.4.7 Principal recognition and measurement simplifications

(a) Financial instruments
Financial instruments meeting specified criteria are measured at cost or amortised cost. All others
are measured at fair value through profit or loss. The procedure for derecognition has been
simplified, as have hedge accounting requirements.
(b) Goodwill and other indefinite-life intangibles
These are always amortised over their estimated useful life (or ten years if it cannot be estimated).
(c) Investments in associates and joint ventures
These can be measured at cost, but fair value must be used if there is a published price quotation.
(d) Research and development costs and borrowing costs must be expensed.
(e) Property, plant and equipment and intangibles
There is no need to review residual value, useful life and depreciation method unless there is an
indication that they have changed since the most recent reporting date.
(f) Defined benefit plans
All actuarial gains and losses are to be recognised immediately (in profit or loss or other
comprehensive income). All past service costs are to be recognised immediately in profit or loss. To
measure the defined benefit obligation, the projected unit credit method must be used. (Note that
IAS 19 has been revised and incorporated several of these simplifications.)

(g) Income tax
This follows the now withdrawn ED Income tax, which simplifies IAS 12.
(h) Available-for-sale assets
There is no separate available-for-sale classification; holding an asset or group of assets for sale is an
indicator of impairment.
(i) Biological assets
SMEs are to use the cost-depreciation-impairment model unless the fair value is readily
determinable, in which case the fair value through profit or loss model is required.
(j) Equity-settled share-based payment
If observable market prices are not available to measure the fair value of the equity-settled share-
based payment, the directors' best estimate is used.
8.4.8 Likely effect

Because there is no supporting guidance in the IFRS for SMEs, it is likely that differences will arise from
full IFRS, even where the principles are the same. Most of the exemptions in the IFRS for SMEs are on
grounds of cost or undue effort. However, despite the practical advantages of a simpler reporting
framework, there will be costs involved for those moving to IFRS – even a simplified IFRS – for the first
time.
8.4.9 SMEs in the UK
For all entities choosing not to apply IFRS or IFRS with reduced disclosures, the ASB is proposing the use
of a new standard, the FRSUKI, based on the IASB's IFRS for SMEs. This will apply to all entities except
those small enough to use the FRSSE, and will effectively mean the end of current UK GAAP. This is
covered in more detail in Chapter 1, Section 3.
8.4.10 Advantages and disadvantages of the IFRS for SMEs

Advantages
(a) It is virtually a 'one stop shop'.
(b) It is structured according to topics, which should make it practical to use.
(c) It is written in an accessible style.
(d) There is considerable reduction in disclosure requirements.
(e) Guidance not relevant to private entities is excluded.
Disadvantages
(a) It does not focus on the smallest companies.
(b) The scope extends to 'non-publicly accountable' entities. Potentially, the scope is too wide.
(c) The standard will be onerous for small companies.
(d) Further simplifications could be made. These might include:
(i) Amortisation for goodwill and intangibles
(ii) No requirement to value intangibles separately from goodwill on a business combination C
H
(iii) No recognition of deferred tax
A
(iv) No measurement rules for equity-settled share-based payment P
(v) No requirement for consolidated accounts (as for EU small and medium sized entities T
currently) E
(vi) All leases accounted for as operating leases with enhanced disclosures R
(vii) Fair value measurement when readily determinable without undue cost or effort.
15

612
– Change in accounting Corporate
Summary
policies (retrospective) governance

– Change in estimate Accounting
Corporate Reporting
(prospective) policies, estimates Reporting performance Other
– Prior period errors and errors (IASB) Directors’
(retrospective)
report
IFRS 5 Non-current Segment reporting Related parties IFRS for

assets held for sale (IFRS 8) (IAS 24) SMEs
and discontinued
operations
Related party Related party
Operating segments relationship transactions
Non-current assets Discontinued

held for sale operations
Reportable Aggregated Substance Zero Artificial Arm’s
segments segments over form price price length
Classification – Statement of
comprehensive
income Control Influence Management Other
– Statement of
Profits, assets
Measurement cash flows and liabilities
– Statement of
financial position UK: Only material
Disclosure related party
– External revenue transactions disclosed
– Geographical information
Reconciliation
Disclosure
Self-test
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
1 Kamao
Statement of financial position extracts for the Kamao Company show the following.
31 December 20X7 31 December 20X6
£'000 £'000
Development costs 812 564
Amortisation (180) (120)
632 444
The capitalised development costs related to a single project that commenced in 20X4. It has now
been discovered that one of the criteria for capitalisation has never been met.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, by what amount
should retained earnings be adjusted to restate them as at 31 December 20X6?
2 Hookbill
The Hookbill Company was updating its inventory control system during 20X7 when it discovered
that it had, in error, included £50,000 in inventories in its statement of financial position for the
year to 31 December 20X6 relating to items that had already been sold at that date. The 20X6
profit after tax shown in Hookbill's financial statements for the year to 31 December 20X6 was
£400,000.
In the draft financial statements for the year to 31 December 20X7, before any adjustment for the
above error, the profit after tax was £500,000.
Hookbill pays tax on profits at 25%.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, what figures
should be disclosed for profit after tax in the statement of profit or loss and other comprehensive
income of Hookbill for the year ended 31 December 20X7, for both 20X7 and the comparative
year 20X6?
3 Carduus
The Carduus Company manufactures motor boats. It has invested heavily in developing a new
engine design. As a result by 1 January 20X2 it had capitalised £72 million of development costs,
which it was amortising over 10 years on a straight-line basis from that date.
Until 1 January 20X7, Carduus's new engine had been selling well and making substantial profits. A
new competitor then entered the market, however, such that revised estimates were that the new
engine would cease to generate any economic benefits after 31 December 20X9 and that the
remaining amortisation period should be to this date on a straight-line basis. The entry of the new
competitor led to an impairment review, but no impairment loss was identified.
Retained earnings at 31 December 20X6 were £400 million. Profit before tax and any amortisation
C
charges was £70 million for the year ended 31 December 20X7. H
A
Requirement
P
Ignoring tax, determine the retained earnings figure for Carduus at 1 January 20X7 in the financial T
E
statements for the year to 31 December 20X7 and the profit before tax for the year then ended R
after adjusting for the change in amortisation according to IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors.
4 Aspen 15
The Aspen Company was drawing up its draft financial statements for the year to 31 December
20X7 and was reviewing its cut-off procedures. It discovered that it had, in error, at the previous
year end, omitted from inventories in its statement of financial position a purchase of inventories

amounting to £100,000 made on the afternoon of 31 December 20X6. The related purchase
transaction and the trade payable had been correctly recorded.
The retained earnings of Aspen at 31 December 20X6 as shown in its 20X6 financial statements
were £4,000,000. In the draft financial statements for the year to 31 December 20X7, before any
adjustment of the above error, the profit after tax was £800,000. Aspen pays tax on profits at 30%.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, what figures
should be disclosed in the financial statements of Aspen for the year ended 31 December 20X7 for
profit after tax for the year and for retained earnings at 1 January 20X7?
5 Polson
The Polson Company appointed Rayner as finance director late in 20X7. One of Rayner's initial
tasks was to ensure a thorough review was carried out of Polson's accounting policies and their
application in the preparation of Polson's consolidated financial statements for the year ended 31
December 20X6. This review identified the following issues in relation to the 20X6 consolidated
financial statements which were approved for publication early in 20X7.
(1) The £840,000 year-end carrying amount of a major item of plant in a wholly-owned
subsidiary comprised costs incurred up to 31 December 20X6. Depreciation was charged
from 1 January 20X7 when the item was for the first time working at normal capacity. The
depreciation charge takes account of residual value of £50,000 on 30 September 20Y4, the
end of the item's useful life. The overall construction and installation of the item was
completed on 30 September 20X6, when the item was first in full working order. Between 1
October and 31 December 20X6 the item was running below normal capacity as employees
learnt how to operate it. The year-end carrying amount comprises: costs incurred to 30
September 20X6 of £800,000 plus costs incurred in October to December 20X6 of £50,000
less £10,000 sales proceeds of the output sold in October to December.
(2) On 1 January 20X6 Polson acquired a 30% interest in The Niflumic Company for £240,000,
which it classified in its consolidated financial statements as an available-for-sale investment
under IAS 39 Financial Instruments: Recognition and Measurement, despite Polson having
representation on Niflumic's board of directors. Niflumic's shares are dealt in on a public
market and the year-end carrying amount of £360,000 was derived using the market price
quoted on that date. The fair value increase of £90,000 (360,000 – 240,000 less 25% deferred
tax) was recognised in an available-for-sale reserve in equity. In its year ended 31 December
20X6 Niflumic earned a post-tax profit of £80,000 and paid no dividends.
(3) At 31 December 20X6 the total trade receivables in a 60% owned subsidiary was £360,000
according to the accounting records, while the separate list of customers' balances totalled
£430,000. The accounting records were adjusted by adding the difference to both the
carrying amount of trade receivables and revenue. It was revealed that the difference arose
from double-counting certain customers' balances when taking the list out.
The 20X6 consolidated financial statements showed £400,000 as the carrying amount of retained
earnings at the year end. The effect of taxation is immaterial in respect of the item of plant and the
trade receivables adjustment.
Requirement
Determine the following amounts for inclusion as comparative figures in Polson's 20X7
consolidated financial statements after the adjustments required by IAS 8 Accounting Policies,
Changes in Accounting Estimates and Errors.
(a) The carrying amount of the item of plant at 31 December 20X6
(b) The increase/decrease in equity at 31 December 20X6 in respect of the investment in Niflumic
(c) The carrying amount of retained earnings at 31 December 20X6
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
6 Viscum
The Viscum Company accounts for non-current assets using the cost model.

On 25 April 20X6 Viscum classified a non-current asset as held for sale in accordance with IFRS 5
Non-current Assets Held for Sale and Discontinued Operations. At that date the asset's carrying
amount was £30,000, its fair value was estimated at £22,000 and the costs to sell at £3,000.
On 15 May 20X6 the asset was sold for net proceeds of £18,400.
Requirement
In accordance with IFRS 5, what amount should be included as an impairment loss in Viscum's
financial statements for the year ended 30 June 20X6?
7 Reavley
The Reavley Company accounts for non-current assets using the cost model.
On 20 July 20X6 Reavley classified a non-current asset as held for sale in accordance with IFRS 5
Non-current Assets Held for Sale and Discontinued Operations. At that date the asset's carrying
amount was £19,500, its fair value was estimated at £26,500 and the costs to sell at £1,950.
The asset was sold on 18 October 20X6 for £26,000.
Requirement
In accordance with IFRS 5, at what amount should the asset be stated in Reavley's statement of
financial position at 30 September 20X6?
8 Smicek
The Smicek Company classified an asset as being held for sale on 31 December 20X6. The asset
had been purchased for a cost of £1.2 million on 1 January 20X4, and then had a 12 year useful
life. On 31 December 20X6 its carrying amount was £900,000, its fair value was £860,000, and the
expected sale costs were £20,000.
On 31 December 20X7 the board of Smicek, having failed to sell the asset during 20X7, decided to
reverse their original decision and therefore use the asset in the business. At 31 December 20X7
the asset had a fair value of £810,000 and expected sale costs of £20,000. The directors estimate
that annual cash flows relating to the asset would be £200,000 per year for the next 6 years. The
effect of discounting is not material.
Requirement
What is the effect on profit or loss of Smicek's ceasing to classify the asset as held for sale,
according to IFRS 5 Non-current Assets Held for Sale and Discontinued Operations?
9 Ndombe
The Ndombe Company classified a group of assets as held for sale on 31 December 20X6. Their
fair value less costs to sell was £1,180,000.
During 20X7 the company decided that one of the assets, a polishing machine, should no longer
be treated as an asset held for sale. The sale of the other assets was delayed due to events beyond
the control of Ndombe and the company remains committed to their sale, which is highly
probable in 20X8.
Asset values and dates are as follows:
Polishing Other assets C

machine H
£ £ A
Cost at 1 January 20X5 400,000 1,500,000 P
T
Accumulated depreciation to 31 December 20X6 (160,000) (600,000)
E
Carrying amount on 31 December 20X6 240,000 900,000 R
Useful life 5 years 5 years
Fair value less cost to sell 31 December 20X6 210,000 970,000
Fair value less costs to sell 31 December 20X7 190,000 880,000 15
Value in use at 31 December 20X7 170,000 810,000

Requirement
Under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations what are the amounts
that should be shown under assets on the statement of financial position at 31 December 20X6
and 31 December 20X7?
10 Sapajou
The Sapajou Company bought a property with a useful life of 10 years for £1,200,000 on 1 January
20X4.
On 1 July 20X6 the board of Sapajou made a decision to sell the property, and immediately
vacated it and advertised it for sale. At this date fair value less costs to sell was estimated at
£880,000. Negotiations with a buyer appeared successful, and a sale was provisionally agreed for 1
August 20X7 for £880,000. At the last minute the buyer withdrew and Sapajou had to re-advertise
the property.
A new buyer was found in November 20X7 and a new price was agreed at fair value less costs to
sell of £995,000. The sale is scheduled to take place in February 20X8.
Requirement
What are the amounts that should be included in profit or loss for the years ending 31 December
20X6 and 31 December 20X7?
IAS 24 Related Party Disclosures
11 Sulafat
The Sulafat Company has a 70% subsidiary Vurta and is a venturer in Piton, a joint venture
company. During the financial year to 31 December 20X6, Sulafat sold goods to both companies.
Consolidated financial statements are prepared combining the financial statements of Sulafat and
Vurta.
Requirement
Which transactions should be disclosed under IAS 24 Related Party Disclosures, in the separate
financial statements of Sulafat for 20X6?
12 Phlegra
In the year ended 31 December 20X7, the Phlegra Company undertook transactions with the
following entities to the value stated.
(a) The Nereidum Company, one of whose non-executive directors is an executive director of
Phlegra £300,000
(b) The Chub Company, which sources 100% of its raw materials requirements from Phlegra
£190,000
Requirement
Under IAS 24 Related Party Disclosures, what is the total amount to be disclosed in respect of
transactions with related parties in Phlegra's financial statements for the year ended 31 December
20X7?
13 Mareotis
The Mareotis Company is a partly-owned subsidiary of the Bourne Company. In the year ended
31 December 20X7 Mareotis undertook transactions with the following entities to the value stated.
(a) The Hayles Company, in which the Wrasse Company holds 55% of the equity. Bourne holds
40% of the equity of Wrasse and has the power to appoint 3 out of the 5 members of
Wrasse's board of directors: £300,000.
(b) The Galaxius Company, which is controlled by Danielle (the aunt of Agnes, a member of
Mareotis's board of directors): £500,000.
Requirement
Under IAS 24 Related Party Disclosures, what is the total amount of transactions with related parties
to be disclosed in Mareotis's financial statements for the year ended 31 December 20X7?

Technical reference

IAS 8.7-13
Accounting policies
IAS 8.14-31
Change in accounting policies
 Retrospective application is applying a new accounting policy as if that
policy had always been applied
 If impracticable to determine the period-specific effects, apply prospectively
IAS 8.32-40
Changes in accounting estimates
IAS 8.5, IAS 8.42 and IAS 8.49
Prior period errors
Discontinued operations
 Definition IFRS 5.31-32
 Disclosures on the face of the statement of profit or loss and other IFRS 5.33(a)
comprehensive income:
– A single amount comprising the total of:

– The post-tax profit or loss of discontinued operations, and
– The post-tax gain or loss recognised on related assets
 Disclosures on the face or in the notes IFRS 5.33(b) (c)
– An analysis of the single amount on the face

 Comparative figures must be restated IFRS 5.34
 Narrative disclosures are also required IFRS 5.41
IFRS 1 First Time Adoption of International Financial Reporting Standards

 Opening IFRS SOFP IFRS 1.6
 Accounting policies IFRS 1.7-12
 Estimates IFRS 1.23-33
 Transition process IFRS 1 App C,D
 Exemptions IFRS 1.20-33

C
 Disclosure H
A
IAS 24 Related Party Disclosures P
T
 Definition of a related party and related party transaction IAS 24.9 E
R
 Exclusions from definition of related party IAS 24.11
 Disclosures IAS 24.12,16,17,18

15
Overview
IFRS for SMEs


1 Kamao
£444,000
Per IAS 8.42 a correction of a material error should be applied retrospectively by restating the
opening balances of assets, liabilities and equity for the earliest prior period presented.
2 Hookbill
20X7: £537,500
20X6: £362,500
20X7 20X6
£ £
Draft profit after tax 500,000 400,000
Inventory adjustment 50,000 (50,000)
Tax thereon at 25% (12,500) 12,500
Revised profit after tax 537,500 362,500
The comparative amounts for the prior period should be restated, per IAS 8.42.
Correction of opening inventory will increase profit for the current period, by the amount of the
after tax adjustment. Conversely, the closing inventory for the previous period is reduced, thereby
reducing profit by the after tax effect of the adjustment.
3 Carduus
Retained earnings: £400 million
Profit before tax: £58.0 million
The change in useful life is a change in an accounting estimate which is accounted for
prospectively (IAS 8.36). So retained earnings brought forward remain unchanged, at £400m.
The carrying amount of development costs at 1 January 20X7 (half-way through their previously
estimated useful life) is (£72m  5/10) = £36m. Writing this off over 3 years gives a charge of £12m
per annum. So the profit before tax is £70m - £12m = £58m.
4 Aspen
Profit after tax: £730,000
Retained earnings: £4,070,000
The comparative amounts for the prior period should be restated, per IAS 8.42.
The correction of opening inventories will decrease profit for the current period, by the after-tax
value of the adjustment. Thus current period profits are £800,000 – (£100,000  70%) =
£730,000.
The closing inventories of the previous period are increased by the same amount. So retained
earnings are £4,000,000 + (£100,000  70%) = £4,070,000.
5 Polson
(a) £776,562
(b) (£66,000)
(c) £318,562
All these matters give rise to prior period errors which require retrospective restatement of financial
statements as if the prior period error had never occurred (IAS 8.5).
(a) Recognition of cost in the carrying amount of PPE should cease when it is in the condition
capable of being operated in the manner intended, so on 30 September 20X6, and
depreciation should begin on the same date (IAS 16.20 and 55). So gross cost should be
adjusted to £800,000 (£840,000 - £50,000 + £10,000) and depreciation, taking into account

overall useful life and residual value, charged for 3 months, so £23,438 ((£800,000 - £50,000)
 1/8  25%). The restated carrying amount is £776,562 (£800,000 – £23,438).
(b) The investment in The Niflumic Company is an associate and should be accounted for
according to IAS 28, not IAS 39.
The value of the investment will therefore increase by 30% of Niflumic's post-tax profit rather
than according to fair values.
£
Amount recognised in available-for-sale reserve 90,000
30% x Niflumic's profit after tax (retained earnings) 24,000
Adjustment to equity (66,000)
(c)
£
Draft retained earnings 400,000
(1) Reduction in carrying value of plant (£840,000 - £776,562) (63,438)
(2) Niflumic's earnings (£80,000 × 30%) 24,000
(3) Error in trade receivables (£70,000 × 60%) (42,000)
318,562
Trade receivables, revenue, and therefore profit, were overstated by £70,000 in respect of the
trade receivables. Polson's share is 60%, so end-20X6 retained earnings must be reduced by
£42,000.
The share of Niflumic's profits is recognised in retained earnings, not in a separate reserve,
giving rise to an increase of £24,000.
6 Viscum
£11,000
IFRS 5.15 requires assets classified as held for sale to be measured at the time of classification at the
lower of (i) the carrying value (£30,000) and (ii) the fair value less costs to sell (£19,000).
IFRS 5.20 requires recognition of the resulting impairment loss (£30,000 - £19,000). The gain or
loss on disposal is treated separately per IFRS 5.24.
7 Reavley
£19,500
IFRS 5.15 requires that a non-current asset held for sale should be stated at the lower of (i) the
carrying amount (£19,500) and (ii) the fair value less costs to sell (£24,550).
8 Smicek
£40,000
At the end of the current year, a non-current asset that has ceased to be classified as held for sale
should be valued at the lower of:
(i) The carrying amount had it not been recognised as held for sale, ie to charge a full year's C
depreciation of £100,000 for 20X7 and reduce the carrying amount from £900,000 at H
31 December 20X6 to £800,000. A
P
(ii) The recoverable amount, which is the higher of the £790,000 fair value less costs to sell T
(£810,000 less £20,000) and value in use (the cash flows generated from using the asset) of E
R
£1,200,000.
Therefore the asset should be carried at £800,000 in the statement of financial position at
31 December 20X7. 15
At the end of the prior year, when the asset was classified as held for sale, the asset would have
been carried at the lower of carrying amount (£900,000), and fair value less costs to sell of

£840,000 (£860,000 less £20,000). Therefore the asset has fallen in value from £840,000 to
£800,000 in the current year, giving a charge to profits of £40,000.
9 Ndombe
31 December 20X6 the assets should be shown in the statement of financial position at a value of
£1,140,000
31 December 20X7 the assets should be shown in the statement of financial position at a value of
£1,040,000
At the end of 20X6 the assets are classified as held for sale. The assets should be measured at the
lower of carrying amount and fair value less costs to sell (IFRS 5.15). The carrying amount was
£1,140,000 and the fair value less costs to sell was £1,180,000 so they were measured at
£1,140,000.
No depreciation is charged on these assets in 20X7 (IFRS 5.25).
At the end of 20X7, it is still possible to classify the 'other' assets as held for sale as the company is
still committed to the sale (IFRS 5.29). These assets would be measured at fair value less costs to
sell of £880,000 as this is lower than the carrying amount of £900,000.
However the polishing machine should be valued at the lower of £160,000 carrying amount had
classification as held for sale not occurred (£400,000  2/5) and the higher of fair value less costs to
sell (£190,000) and value in use (£170,000) (IFRS 5.27). This gives a value of £160,000.
This gives a total value of £1,040,000 at 31 December 20X7.
10 Sapajou
An expense of £20,000 is shown in the profit or loss part of the statement of profit or loss and
other comprehensive income for the year ended 31 December 20X6.
Income of £20,000 is shown in the profit or loss part of the statement of profit or loss and other
comprehensive income for the year ended 31 December 20X7.
Under IFRS 5.15 an asset classified as held for sale is measured at the lower of carrying amount
immediately prior to the reclassification of £900,000 (£1,200,000 – 2.5  £120,000), and fair value
less costs to sell of £880,000. The £20,000 impairment loss is charged to profits (IFRS 5.20).
In the following year, the increase in fair value less costs to sell is £115,000, but only £20,000 of
this can be recognised in profit (IFRS 5.21) as this is the reversal of the previous impairment loss.
IAS 24 Related Party Disclosures
11 Sulafat
Both Vurta and Piton: disclosure is required of transactions with both Vurta and Piton. See IAS 24.3,
which states that entities under both direct and common control are related parties.
12 Phlegra
Nil under IAS 24.11 (a) Two entities are not related parties simply because they have a director in
common, nor per IAS 24.11 (b) simply because the volume of transactions between them results in
economic dependence.
So neither Nereidum nor Chub is a related party of Phlegra.
13 Mareotis
£300,000. Under IAS 24.9, Hayles is a related party of Mareotis. Bourne 'controls' Wrasse (by virtue
of the power to appoint the majority of directors) and Wrasse 'controls' Hayles (by virtue of holding
the majority of the equity). So Bourne 'controls' both Mareotis and Hayles, which are therefore
related parties as a result of being under common control.
Being an aunt does not make Danielle a close member of Agnes's family, so although Galaxius is
controlled by a relative of Agnes, the relationship is not close enough to make Galaxius a related
party of Mareotis. So only transactions with Hayles have to be disclosed.


IFRS 8 Operating Segments states that an operating segment is separately reportable if it has been
identified as a separate operating segment meeting the operating segment definition, and:
(a) Its reported revenue is 10% or more of the combined revenue (external and internal) of all
operating segments, or
(b) The absolute amount of its reported profit or loss is 10% or more of the greater of the combined
profit of all operating segments that did not report a loss and the combined reported loss of all
operating segments that reported a loss, or
(c) Its assets are 10% or more of the combined assets of all operating segments.
Profit or loss as % of
Revenue as % of total profit of all segments in Assets as % of total
revenue (£238m) profit (£29m) assets £336m
Chemicals * 33.6% 48.3% 32.4%
Pharmaceuticals 28.2% 31.0% 31.0%
wholesale
Pharmaceuticals retail 9.2% 6.9% 8.9%
Cosmetics 6.3% 6.9% 5.4%
Hair care 5.0% 13.8% 6.3%
Body care 17.6% 20.7% 16.1%
* The chemicals segments are aggregated due to their similar economic characteristics
At 31 December 20X5 four of the six operating segments are reportable operating segments:
Chemicals
All size criteria are met
Pharmaceuticals wholesale
All size criteria are met
Pharmaceuticals retail
The Pharmaceuticals retail segment is not separately reportable as it does not meet the quantitative
thresholds. It can, however, still be reported as a separate operating segment if management believes
that information about the segment would be useful to users of the financial statements. Alternatively,
the group could consider amalgamating it with the Pharmaceuticals wholesale segment, providing the
two operating segments have similar economic characteristics and share a majority of the 'aggregation'
criteria, which, excluding the type of customer, may be the case. Otherwise it would be disclosed in an C
'All other segments' column. H
A
Cosmetics P
T
The Cosmetics segment does not meet the quantitative thresholds and therefore is not separately
E
reportable. It can also be reported separately if management believes the information would be useful to R
users. Alternatively the group may be able to amalgamate it with the Body care segment, providing the
operating segments have similar economic characteristics and share a majority of the 'aggregation'
criteria. Otherwise it would also be disclosed in an 'All other segments' column. 15
Hair care
The Hair care segment is separately reported due to its profitability being greater than 10% of total
segments in profit.

Body care
All size criteria are met.
Note:
IFRS 8.15 states that at least 75% of total external revenue must be reported by operating segments.
This condition has been met as the reportable segments account for 82% of total external revenue
(158/192)

20X6 20X7
£'000 £'000
Sales 47,400 67,200
Cost of goods sold (W1) (38,770) (51,600)
Profit before tax 8,630 15,600
Income tax (W2) (2,620) (4,660)
Retained earnings
Opening retained earnings
As previously reported 13,000 21,950
Correction of prior period
error (4,200 – 1,260) – (2,940)
As restated 13,000 19,010
Closing retained earnings 19,010 29,950
WORKINGS
1 Cost of goods sold 20X6 20X7

£'000 £'000
As stated in question 34,570 55,800
Inventory adjustment 4,200 (4,200)
38,770 51,600
2 Income tax 20X6 20X7
£'000 £'000
As stated in question 3,880 3,400
Inventory adjustment (4,200 × 30%) ( (1,260) 1,260
2,620 4,660

The facility will not be transferred until the backlog of orders is completed; this demonstrates that the
facility is not available for immediate sale in its present condition. The facility cannot be classified as
'held for sale' at 31 December 20X3. It must be treated in the same way as other items of property,
plant and equipment: it should continue to be depreciated and should not be separately disclosed.

Because the steel works is being closed, rather than sold, it cannot be classified as 'held for sale'. In
addition, the steel works is not a discontinued operation. Although at 31 December 20X3 the group was
firmly committed to the closure, this has not yet taken place and therefore the steel works must be
included in continuing operations. Information about the planned closure could be disclosed in the
notes to the financial statements.

In its financial statements S must disclose all benefits provided in exchange for services rendered to S
(but not those rendered to P), whether they are provided by S, by P, or on behalf of S (as are the
pension benefits and the share options). All the amounts listed should be disclosed by S, with the
exception of the £20,000 payable in respect of services rendered to P.

(a) Europa's first IFRS financial statements will be for the year ended 31 December 20X8. IFRS 1
requires that at least one year's comparative figures are presented and therefore the date of
transition to IFRSs is the beginning of business on 1 January 20X7 (or close of business on 31
December 20X6).
Therefore the procedure for adopting IFRSs is:
(i) Identify accounting policies that comply with IFRSs effective at 31 December 20X8 (the
reporting date for the first IFRS financial statements)
(ii) Restate the opening statement of financial position at 1 January 20X7 (the date of transition)
using these IFRSs retrospectively, by:
(1) Recognising all assets and liabilities whose recognition is required by IFRSs
(2) Not recognising items as assets or liabilities if IFRSs do not permit such recognition
(3) Reclassifying items that were recognised under previous GAAP as one type of asset,
liability or component of equity, but are a different type of asset, liability or component
of equity under IFRSs
(4) Measuring all recognised assets and liabilities in accordance with IFRSs.
The company will almost certainly need to change some of its accounting policies and to
adjust some of the amounts that it reported previously at the same dates using previous
GAAP. It should recognise these adjustments directly in retained earnings (ie in equity).
(iii) Explain the effect of the transition from previous GAAP to IFRSs, by presenting:
(1) A reconciliation of equity reported under previous GAAP to equity under IFRSs at the date
of transition and at the last previous GAAP reporting date; and
(2) A reconciliation of the profit or loss reported under previous GAAP to profit or loss
reported under IFRSs for the last period presented under previous GAAP.
If Europa presented a statement of cash flows under previous GAAP, it should also explain any
material adjustments to the statement of cash flows.
Although the general rule is that all IFRSs should be applied retrospectively, a number of
exemptions are available. These are intended to cover cases in which the cost of complying fully
with a particular requirement would outweigh the benefits to users of the financial statements.
Europa may choose to take advantage of any or all of the exemptions.
(b) Changing from previous GAAP to IFRSs is likely to be a complex process and should be carefully
planned. Although previous GAAP and IAS/IFRS may follow broadly the same principles there are C
still likely to be many important differences in the detailed requirements of individual standards. H
A
If Europa has foreign subsidiaries outside Molvania it will also need to ensure that they comply with P
any previous reporting requirements. This may mean that subsidiaries have to prepare two sets of T
financial statements: one using their previous GAAP; and one using IFRSs (for the consolidation). E
R
The process will be affected by the following:
(i) The differences between previous GAAP and IFRSs as they affect the group financial
statements in practice. The company will need to carry out a detailed review of current 15
accounting policies, paying particular attention to areas where there are significant differences
between previous GAAP and IFRSs. These will probably include deferred tax, business
combinations, employee benefits and foreign currency translation. It should be possible to
estimate the effect of the change by preparing pro-forma financial statements using IFRSs.

(ii) The level of knowledge of IFRSs of current finance staff (including internal auditors). It will
probably be necessary to organise training and the company may need to recruit additional
personnel.
(iii) The group's accounting systems. Management will need to assess whether computerised
accounting systems can produce the information required to report under IFRSs. They will also
need to produce new consolidation packages and accounting manuals.
Lastly, the company should consider the impact of the change to IFRSs on investors and their
advisers. For this reason management should try to quantify the effect of IFRSs on results and other
key performance indicators as early as possible.
(c) (i) Accounting estimates
Estimates under IFRSs at the date of transition must be consistent with those made at the
same date under previous GAAP (after adjustments to reflect any difference in accounting
policies). The only exception to this is if the company has subsequently discovered that these
estimates were in error. This is not the case here and therefore the estimates are not adjusted
in the first IFRS financial statements.
(ii) Court case
The treatment of this depends on the reason why Europa did not recognise a provision under
previous GAAP at 31 December 20X7.
If the requirements of previous GAAP were consistent with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets, presumably the directors concluded that an outflow of
economic benefit was not probable and that the recognition criteria were not met. In this
case, Europa's assumptions under IFRSs are consistent with its previous assumptions under
previous GAAP. Europa does not recognise a provision at 31 December 20X7 and accounts for
the payment in the year ended 31 December 20X8.
If the requirements of previous GAAP were not consistent with IAS 37, Europa must determine
whether it had a present obligation at 31 December 20X7. The directors should take account
of all available evidence, including any additional evidence provided by events after the
reporting period up to the date the 20X7 financial statements were authorised for issue in
accordance with IAS 10 Events After the Reporting Period.
The outcome of the court case confirms that Europa had a liability in September 20X7 (when
the events that resulted in the case occurred), but this event occurred after the 20X7 financial
statements were authorised for issue. Based on this alone, the company would not recognise a
provision at 31 December 20X7 and the $10m cost of the court case would be recognised in
the 20X8 financial statements. If the company's lawyers had advised Europa that it was
probable that they would be found guilty and suggested the expected settlement amount
before the financial statements were authorised for issue, the provision would be recognised
in the 20X7 financial statements reporting under IFRS for that amount.

CHAPTER 16
Financial statement analysis
Introduction
Topic List
2 Objectives and scope of financial analysis
3 Business strategy analysis
4 Accounting analysis
5 Accounting distortions
6 Improving the quality of financial information
7 Financial ratios interpretation
8 Forecasting performance
9 Summary
10 Current issues
625
Introduction
 Demonstrate an understanding of the motives for the presentation of misleading

information in the financial statements and the scope of audit to eradicate this
 Demonstrate an understanding and application of the steps that a financial analyst needs
to take in order to assess the quality of financial statements and in particular to identify
cases of creative accounting
 Demonstrate an understanding and application of standardising financial statements by
adjusting the statements of financial position and comprehensive income
 Demonstrate and apply knowledge of the key financial ratios and the issues involved in
their construction and interpretation
 Apply knowledge and understanding of forecasting financial statements
 Apply knowledge and understanding of financial statement analysis in identifying the

impact on the value of a firm of operating, investment and financing decisions of a firm

1 Overview of material from earlier studies C
H
A
Section overview P
T
 This section covers the material covered at professional level, mainly the definition and E
construction of financial ratios. R
The professional level devotes a substantial part to financial analysis. It covers in detail the definition of
financial ratios and relationships, statements of cash flows and their interpretation and reporting 16
complications in the analysis of financial information. It also discusses the impact of various economic
events, other business aspects and accounting choices on financial performance. It also discusses ethical
issues in the construction of financial statements and introduces aspects of industry analysis and the use
of disaggregated information. The professional level also provides an introduction to some advanced
topics such as advanced earnings measures, financial statement analysis and the limitations of ratios.
Main financial ratios

Financial ratios are the main tools of financial analysis and they will be used extensively at the advanced
level. The most important ratios are therefore reproduced here.
Return on capital employed (ROCE)
Pr ofit before int erest and tax (PBIT)  associates' post-tax earnings
 100
Capital employed
Where capital employed = equity + net debt
Where net debt = current and non-current interest bearing debt minus cash and cash equivalents
Remember that:
– Equity includes irredeemable preference shares and the equity element of the non-controlling
interest
– Net debt includes redeemable preference shares
Many different versions of this ratio are used in practice, but all are based upon the same idea: identify
the long-term resources available to a company's management and then measure the financial return
earned on those resources. It is important that numerator and denominator are consistent, ie the return
in the numerator is attributable to the resources included in the denominator.
Return on shareholders' funds (ROSF)
Net profit for the period
Share capital + Reserves
Gross profit percentage/margin

Gross profit
 100
Re venue
Operating cost percentage
Operating cos ts/overheads
 100
Re venue
Operating profit margin
PBIT Profit from operations
 100 or  100
Re venue Revenue
Current ratio
Current assets
(usually expressed as X:1)
Current liabilities
Financial statement analysis 627

Quick (acid test or liquidity) ratio
Receivables + Investments + Cash
(usually expressed as X:1)
Current liabilities
Gearing ratio
Net debt (per ROCE) Net debt
 100 or  100
Equity (per ROCE) Net debt  Equity
Interest cover
Profit before interest payable (ie PBIT + investment income)
Interest payable
Net asset turnover

Revenue Revenue
or
Capital employed Non-current assets
Inventory turnover
Cost of sales Inventories
or  365
Inventories Cost of sales
Trade receivables collection period
Trade receivables
 365
Revenue
Trade payables payment period
Trade payables
 365
Credit purchases
Working capital cycle

These last three ratios are often brought together in the working capital cycle, calculated as inventory
days plus trade receivables collection period minus trade payables payment period.
Cash cycle = Inventory days + Receivables days – Payables days
Capital expenditure to depreciation
Capital expenditure (additions)
Depreciation
Ageing of non-current assets

Accumulated depreciation
Gross carrying amount of non-current assets
Dividend yield
Dividend per share
× 100
Current market price per share
Dividend cover
Earnings per share
Dividend per share
Price/earnings (P/E) ratio

Current market price per share
Earnings per share

Earnings yield
EPS C
Earnings yield   100
Current market price per share H
A
Net asset value P
T
Net assets (ordinary share capital and reserves) E
R
Number of ordinary shares in issue
16
Interactive question 1: Financial ratio construction [Difficulty level: Easy]
You are given the following information on Apple Cart plc.
INCOME STATEMENT 20X6
£'000
Revenue 6,000
Cost of sales (4,500)
Gross profit 1,500
Operating expenses (680)
Operating profit 820
Finance costs (600)
Income tax (80)
Profit for the period 140
There was no other comprehensive income in the period.

STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X6
£'000 £'000
ASSETS
Non-current assets
Property, plant and equipment 5,900
Current assets
Property held-for-sale 120
Inventories 500
Trade and other receivables 570
Cash and cash equivalents 280
1,470
Total assets 7,370
Issued capital (£1 shares) 3,640
Revaluation reserve 60
4,090
Interest-bearing borrowings / finance lease liabilities 1,175
Other creditors 1,270
2,445
Current liabilities
Trade and other payables 640
Interest-bearing borrowings 195
835
Requirement
Calculate the return on capital employed (ROCE), the profit margin and the net asset turnover for Apple
Cart plc. Investigate the sensitivity of the results to different definitions of the return on capital
employed.

Interactive question 2: ROCE and ROSF 1 [Difficulty level: Easy]
You are given the following information on two companies.
Company 1 Company 2
£m £m
Shareholders' funds (A) 80 20
Loans at 10% 20 80
Capital employed (B) 100 100
PBIT (C) 20 20
Loan interest at 10% (2) (8)
Tax at 30% (5) (4)
Profit after tax (for shareholders) (D) 13 8
Requirement
Consider the ROCE and ROSF of these two companies without associates in the same industry but with
different capital structures.
Interactive question 3: ROCE and ROSF 2 [Difficulty level: Easy]

Name five considerations that you should consider when drawing conclusions from ROCE and ROSF
calculations.
2 Objectives and scope of financial analysis
Section overview
 Financial analysis is the process through which the stakeholders of a company, such as
shareholders, debt holders, government and employees are able to assess the historical
performance of the company and form a view about its future prospects and value.
Financial analysis involves the following:

 The evaluation of a firm's business strategy, risks and profit potential
 The assessment of a firm's accounting policies and its conformity to its business strategy
 The evaluation of a firm's current and future performance and its long-term prospects
 The prediction of a firm's future performance
3 Business strategy analysis
Section overview
 This section analyses the business strategy of a firm by looking at the industry in which the firm
operates, the competitive positioning of the company and the organisational structure and wealth
creation potential.

3.1 Business strategy analysis
C
A company can claim to create value if the rate of return on its capital employed (ROCE) exceeds its H
weighted average cost of capital (WACC). The WACC is the return that the capital contributors to a A
company, ie its equity and bond holders, require and is determined in the financial markets. Thus the P
T
WACC is largely exogenous to the management of a firm. (This has been discussed in your Business E
Analysis Study Manual). R
The ROCE on the other hand is largely determined by the management of the company and it is a
reflection of the decisions that management has made with regard to investment, production, and
pricing policies, as well as the structure of the industry in which the company operates. A company that 16
operates in a highly competitive industry has less freedom to raise prices than a company that operates
in a less competitive industry. Similarly investment in research and development will allow a firm to
produce more innovative products, to create patents and so on.
The various aspects of the operation of a firm that determine its return on capital will be investigated in
three stages. The first stage involves the investigation of the profit potential of the industry in which a
firm operates. The second stage will investigate the competitive positioning of a firm within a given
industry. The third stage investigates the sources of value of a particular firm.
3.2 Industry analysis

It is a fact of life that different industries have different rates of profitability. Industry analysis deals with the
analysis of the factors that determine the profit potential of a particular industry. Since profit is the
difference between revenues and costs, and since price setting in the output or input markets depends on
the competitive structure of each market, industry analysis explains the profitability of an industry by the
degree of competition in the industry. The degree of competition within an industry depends on
 The degree of rivalry between the firms of an industry
 The barriers to entrance into the industry
 The substitutability of the industry's products
 The price elasticity of the industry's products
 The structure of the input markets
3.2.1 Degree of rivalry

In some industries such as retailing, firms compete aggressively by cutting prices, whereas in other
industries such as those involving services, there is less aggressive competition through prices, and the
competition takes the form of branding or some other distinctive product differentiation. The factors
that determine the degree of rivalry are:
 The growth rate of the industry: If the demand for the products of an industry grows rapidly,
then revenues can grow through expanding production, without the need to cut prices. If on the
other hand the growth in demand for the products of the industry grows slowly, then firms may be
inclined to compete on price. Similarly in a low growth situation, excess capacity in the industry
may force prices down.
 The number and relative size of the firms in the industry: The number of firms in an industry
determines the ability of firms to collude, as it is easier to coordinate price fixing when the number
of players is small. In addition where there is a small number of equally sized companies, then the
companies can simply collude to divide up the market without any pressure on the prices. When
an industry consists of a large number of different sized companies, then price competition is more
likely. The UK airline industry is a good example of a fragmented market with high degree of price
competition.
 The degree of product differentiation in the industry: Industries which allow product
differentiation at low costs will also tend to compete on non-price terms, as differentiated products
are imperfect substitutes and therefore less sensitive to price changes.
 The existence of scale economies: Scale economies exist when average production costs fall as
the scale of operation of a company increases. Thus larger firms can reduce costs because of larger
cost efficiencies and in order to achieve this larger size they may have to cut prices to increase
production.

 The degree of operating leverage: The operating leverage of a firm measures the ratio of fixed
costs to variable costs at a given level of output. When the degree of operating leverage is high
companies may be inclined to reduce prices to expand the operations and thus utilise more the
fixed factors of production that give rise to fixed costs.
 Capital specificity: If there is excess capacity in an industry an alternative to cutting prices is for a
company to leave the industry and move into a different industry. However, the ability to do this
may be limited by the specificity of the capital (human and physical) to an industry and the heavy
costs of converting the existing capital for a different use.
3.2.2 Barriers to entrance

Barriers to entrance make it difficult for new entrants to enter an industry and to increase competition.
The main barriers to entrance are:
 The minimum size of operation: In many industries there is a minimum size of operation that only
a small number of firms can attain.
 Early entry advantage: In certain industries the first entrant generates an advantage that makes it
difficult for other entrants. An example is a company that has secured for a number of years the
supply of material.
 Distribution channels: In certain industries distribution channels are controlled by competitors
and it is therefore difficult for the products to reach the consumer.
 Regulation and legal constraints: There may be regulations that prevent the entry into a specific
industry of companies unless they meet certain requirements.
3.2.3 Product substitutability

For a number of industries there are substitute goods and the degree of substitutability affects the price
setting behaviour of the entire industry. Whereas there is some degree of substitutability between cars
and bicycles, it is unlikely that car users will switch to cycling. Public transport on the other hand is a
closer substitute and it is much easier for motorists to switch to public transport.
3.2.4 Price elasticity

The price elasticity of the demand for the products of an industry is also an important factor in the
determination of the industry structure. The price elasticity measures the sensitivity of demand changes
in the price of a product. When demand is highly sensitive to price changes, then companies may not
be able to increase revenues by raising prices, since this will be offset by a fall in the demand.
The price sensitivity of a product also depends on the number of buyers of the product. Where the
number of buyers is small, a firm may be in a weak position. Firms that sell their products to the public
sector are in a particularly weak position as there is no alternative market for their products.
3.2.5 The structure of the input markets

The structure of the input markets determines the price that firms pay for their inputs. In markets where
there is a larger number of suppliers it is easier for a firm to negotiate lower prices.
3.3 Competitive analysis

In the previous section we analysed the factors that affect the structure and consequently the
profitability of an industry. In this section we shall discuss the factors that determine the positioning of a
firm within a given industry.
There are basically two options that a firm has in deciding where to position itself relative to the industry
in order to create a competitive advantage. The first option is to produce at a lower cost than the other
firms in the industry. The second option is to produce products that are sufficiently differentiated so as
to be less sensitive to prices.

3.3.1 Low cost strategy
C
A low cost strategy can be achieved by a company through: H
A
 Economies of scale: As we discussed above, economies of scale exist when the cost of production P
per unit of output decreases as the level of production increases. Thus companies which reach a T
certain size may be able to follow a low cost strategy. E
R
 Economies of scope: Economies of scope exist when the average cost per product decreases as
the number of products produced by the company increases. This is due to the existence of fixed
factors of production which can be utilised more efficiently when used by a larger number of 16
products. The attainment of economies of scope is sometimes the main reason for the merger of
companies.
 Efficient organisation and production: The efficient organisation of a company which reduces
duplication of responsibilities, and reduces operational costs, as well the adoption of more efficient
production methods may also lead to lower costs.
 Lower input costs: If a firm can achieve lower input costs because it has for instance
monopsonistic power, then the firm can achieve lower costs of production.
3.3.2 Product differentiation

The second strategy for the creation of competitive advantage is through product differentiation. As
we already discussed in the previous section, product differentiation reduces the competitive pressure
on a firm and thus it allows for greater profitability.
Product differentiation can take several forms such as branding, product quality, product appearance,
delivery timing, terms of purchase or service, after sale service and so on.
3.3.3 Assessing a competitive strategy

An understanding of a company's strategy will require, amongst other things, an appreciation of its key
success factors and risks. One aim of financial analysis is to evaluate how well the company is managing
these factors.
For example, in the pharmaceutical industry, a key factor for success might be the number of new drugs
brought to the market through the research and development (R&D) process. Expenditure on R&D
might be one factor to indicate the extent of the R&D process. Whilst expenditure does not guarantee
successful products, any changes in expenditure might be indicative of longer-term commitment.
Further examples might be the level of bad debt write-offs on loans for banks and the level of warranty
provisions for any company where product quality is a key indicator.
A key factor in financial analysis is evaluating a company not just in isolation but by comparison with its
competitors. Where companies in the same industry adopt different accounting policies, analysts may
need to apply adjustments to the financial statements in order to compare like with like.
This does not, however, mean that all companies in the same industry should have the same accounting
policies, and the same measurement bases. Similarly, a company might make lower warranty provisions
or bad debt write-offs than other companies in the industry. This might be through imprudent
accounting, or because the company in question has better quality products and better credit
management. An analyst's judgment and wider knowledge of the company is needed rather than a
blanket adjustment to adopt the same accounting policies for all companies in the industry.
3.4 Corporate strategy and sources of value

The third step of business analysis deals with the investigation of the sources of value of the firm. We
have already discussed that value is created when the ROCE exceeds the WACC. We have already
discussed the factors that affect an industry's ROCE which is in a sense a constraint but also an estimate
of the ROCE for an individual firm. We have also covered the two strategies which firms adopt in order
to maximise their ROCE. In this last session of competitive analysis, we look at how the structure of a
firm and its corporate strategy affects its ability to create value.

3.4.1 The structure of a firm
A firm will be able to create value only if it is efficiently organised. The exact organisation of a company
will depend on the transaction costs which are incurred in carrying out transactions which are related to
the operations of a firm. The theory that underpins this view of corporate organisation is the transaction
costs theory of the firm which postulates that firms are formed because transaction costs within an
organisation are lower than the costs of transacting through the markets. Depending on the nature of
the business, an organisation may reduce its transaction costs by engaging in multiproduct production
instead of producing a single product. This rationale underpins the diversification for example of the
banking industry into other areas such as insurance and securities trading.
3.4.2 Assessing value creation ability

How do we assess whether the organisational structure of a particular firm generates value? The
fundamental test is whether transaction costs within a firm are higher than in the market. An example of
a situation where value is created by resorting to the market is outsourcing. A second test is the
existence of scope economies which can be exploited to reduce costs and create value. Economies of
scope are generated by the more intensive use of a fixed factor of production. Such a fixed factor of
production could be a brand name, a unique delivery channel etc. The third test is the existence in a
company of mechanisms that reduce agency costs. If a company passes all three tests then it is highly
likely that the company has the ability to generate value.
3.4.3 Link with Business Analysis

You should link in your studies of Business Analysis, as a question may ask you to project forward once
you have resolved certain financial reporting issues.
4 Accounting analysis
Section overview
 This section analyses the sources of financial information that are needed for the financial analysis
of a company and the steps that need to be taken in order to identify potential problems and
resolve them.
4.1 Scope of accounting analysis

The second stage of financial analysis is the evaluation of the accounting policies of the company and its
conformity with the business strategy of the firm. Accounting analysis involves the following steps:
 Evaluation of key accounting policies
 Evaluation of disclosure quality
 Identification of 'red flags'
 Elimination of accounting distortions
4.1.1 Evaluation of key accounting policies

An assessment needs to be made as to whether the accounting policies adopted attempt to inflate or
deflate earnings and asset values in a systematic way. If, where options for accounting policies exist, the
directors have always selected the option that inflates profits, then there may be concerns over the
quality of the reported earnings measure and whether it reflects (or distorts) underlying cash flows and
economic circumstances.
Companies also have to exercise judgement and make assumptions in the application of accounting
policy. Assumptions include, for example, figures for employee turnover, mortality rates, future increases
in salaries (if these will affect the eventual size of future benefits such as pension payments).

4.1.2 Evaluation of disclosure quality C
Good quality disclosure makes it easier for valid financial analysis to take place. While GAAP sets a H
A
minimum level of disclosure, there is nothing to prevent companies disclosing more than the minimum. P
Indeed, many would expect a management keen on accessing capital markets to provide full disclosures T
of key information, whether or not these were required by accounting standards. E
R
Consideration might be given to:
 Whether any disclosure is made in addition to the minimum required by accounting regulations
16
 Whether the company has taken advantage of any exemptions from disclosure in accounting
standards, or produced the bare minimum disclosure
 Whether additional disclosure is quantitative and detailed; or alternatively qualitative and only
indicative
 Whether the information is disclosed in the notes to the financial statements and thus subject to a
statutory audit; or only in the accompanying information in the annual report and therefore only
subject to review
 The details in the supplementary statements, which are largely unregulated (such as in the
operating and financial review) and whether they provide an adequate explanation of current
performance
 Where alternative performance measures are used, clear explanations of the reconciling items to
the amounts in the financial statements
 Whether unusual items and policies are adequately explained and justified
 Clear explanations of any uncertainties and assumptions used in arriving at the amounts recognised
in the accounts
 The level of detail and relevance of segmental disclosure, where management has significant
discretion as to the method of analysis
 Whether non-accounting disclosures during the year have been consistent with the picture
presented in the financial statements
4.1.3 Identification of 'red flags'

The information contained in the financial statements will be used for the analysis of the historical
performance of a company or as the basis for the formation of expectations about the future
performance of the company and the estimate of its value. The validity of all three tasks will depend on
the reliability of the information derived from the financial statements. If the information is misleading
then it may lead to erroneous conclusions about the past and future performance of a company. Thus
the information contained in the financial statements should, as a first step, be assessed for its quality.
There are three basic aspects that need to be taken into account when interpreting financial ratios
namely compliance of financial statements with the GAAP, the quality of audit and the presence of
creative accounting. Of the three creative accounting is by far the main way of manipulating
information and for this reason we devote more attention to it.
Creative accounting is the active manipulation of accounting results for the purpose of creating an
altered impression of the underlying financial position or performance of an enterprise by using
accounting rules and guidance in a spirit other than that which was intended when the rules were
written.
The spectrum of creative accounting practices may include the following (commencing with the most
legitimate):
 Exercise of normal accounting policy choice within the rules permitted by regulation (eg FIFO or
average cost for inventory valuation).
 Exercise of a degree of estimation, judgement or prediction by a company within reasonable
bounds (eg non-current asset lives).

 Judgement concerning the nature or classification of a cost (eg expensing or capitalising
development costs).
 Systematic selection of legitimate policy choices and estimations to alter the perception of the
position or performance of the business in a uniform direction.
 Systematic selection of policy choices and estimations that fall on the margin of permitted
regulation (or are not subject to regulation) in order to alter materially the perception of the
performance or position of the business. For example the timing of revenues and receivables.
 Setting up of artificial transactions to create circumstances where material accounting
misrepresentation can take place.
 Fraudulent activities.
The following have been put forward as incentives for companies/managers engaging in creative
accounting:
 Income smoothing: Companies normally prefer to show a steady trend of growth in profits, rather
than volatility with significant rises and falls. Income smoothing techniques (eg declaring higher
provisions or deferring income recognition in good years) contribute to reducing volatility in
reported earnings.
 Achieving forecasts: Where forecasts of future profits have been made, reported earnings may be
manipulated to tie in with these forecasts.
 Profit enhancement: This is where current year earnings are boosted to enhance the short-term
perception of performance.
 Maintain or boost share price: Where markets can be made to believe that increased earnings
represents improved performance, then share price may rise, or at least be higher than it would be
in the absence of creative accounting.
 Accounting based contracts: Where accounting based contracts exist (eg loan covenants, profit
related pay) then any accounting policy that falls within the terms of the contract may significantly
impact upon the consequences of that contract. For example, the breach of a gearing based debt
covenant may be avoided by the use of off-balance sheet financing.
 Incentives for directors: There may be personal incentives for directors to enhance profit in order
to enhance their remuneration. Examples might include: bonuses based upon EPS, share incentive
schemes, share option schemes. Directors may also benefit more indirectly from creative
accounting by increasing the security of their position.
 Taxation: Where accounting practices coincide with taxation regulations there may be an incentive
to reduce profit in order to reduce taxation. In these circumstances, however, it may necessary to
convince not only the auditor, but also the tax authorities.
 Regulated industries: Where an industry is currently, or potentially, regulated then there may be
an incentive to engage in creative accounting to influence the decisions of the regulator. This may
include utilities where regulators may curtail prices if it is perceived that excessive profits are being
earned. It may also be relevant to avoid a reference to the Competition Commission.
 Internal accounting: A company as a whole may have reason to move profits from division to
division (or subsidiary to subsidiary) in order to affect tax calculations or justify the
closure/expansion of a particular department.
 Losses: Companies making losses may be under greater pressure to enhance reported
performance.
 Commercial pressures: Where companies have particular commercial pressures to enhance the
perception of the company there is increased risk of creative accounting. For example, a take-over
bid, or the raising of new finance.
Questionable accounting policies and inadequate disclosures may be regarded as warning signs that
there are undue pressures on management to improve performance or that there is poor corporate
governance. This might be reflected in both accounting policies and estimates adopted, but also by
manipulation of underlying transactions that might be revealed by financial statement information, or
hidden by inadequate disclosure.

'Red flags' and detection
C
The best detection techniques for creative accounting are a good knowledge of financial accounting H
regulation and a good understanding of the business. There may, however, be more general A
techniques and indicators that can suggest that a company is engaging in creative accounting practice. P
These include: T
E
 Cash flows: Operating cash flows are systematically out of line with reported profits over time. R
 Reported income and taxable income: Is financial reporting income significantly out of line with
taxable income with inadequate explanation or disclosure? 16
 Acquisitions: Where a significant number of acquisitions have taken place there is increased scope
for many creative accounting practices.
 Financial statement trends: Indicators include: unusual trends, comparing revenue and EPS
growth, atypical year end transactions, flipping between conservatism and aggressive accounting
from year to year, level of provisions compared to profit indicating smoothing, EPS trend, timing of
recognition of exceptional items.
 Ratios: Aging analyses revealing old inventories or receivables, declining gross profit margins but
increased net profit margins, inventories/receivables increasing more than sales, gearing changes.
 Accounting policies: Consider if there is the minimum disclosure required by regulation, changes
in accounting policies, examine areas of judgment and discretion. Consider risk areas of: off-
balance sheet financing, revenue recognition, capitalisation of expenses, significant accounting
estimates.
 Changes of accounting policies and estimates: Is the nature, effect and purpose of these changes
adequately explained and disclosed?
 Management: Estimations proved unreliable in the past, minimal explanations provided.
 Actual and estimated results: Culture of always satisfying external earnings forecasts, absence of
profit warnings, inadequate or late profit warnings leading to 'surprises', interim financial
statements out of line with year end financial statements.
 Incentives: Management rewarded on reported earnings, profit-orientated culture exists, other
reporting pressures, eg a take-over.
 Audit qualifications: Are they unexpected and are any auditors' adjustments specified in the audit
report significant?
 Related Party Transactions: Are these material and how far are the directors affected?
The above is not a comprehensive list, but merely includes some main factors. Also, it is not suggested
that the above practices necessarily mean there is creative accounting, but where a number of these
factors exist simultaneously, further investigations may be warranted. Any review of such 'red flags' as
warning signs needs to be seen within the bigger picture of the current commercial situation of the
company, and the strategy it is adopting.
4.1.4 Elimination of accounting distortions and restatement

The final step of the accounting analysis is the elimination of the distortions from the financial
statements and their restatement with the correct information. We shall devote a whole section to this
topic later.
4.2 Sources and problems of accounting information

Accounting information is contained in the financial statements of a firm, namely:
 The statement of financial position
 The statement of profit or loss and other comprehensive income or income statement and separate
statement of profit or loss and other comprehensive income disclosing other comprehensive
income

 The statement of changes in equity
 The statement of cash flows
as well as the notes to the financial statements and market values or prices.
Unfortunately, the accounting information contained in the above sources can be manipulated by the
management of a company, for a variety of reasons. For even when a company follows closely the
accounting standards, there may be some discretion afforded in the presentation of the accounts. That
is why the first two aspects of the financial analysis process as defined in the previous section, deal with
the assessment and correcting of financial information.
Every financial statement produced by a corporate entity should be produced according to some
accounting standard. All European Union member states, and many other countries outside the EU,
have adopted the International Financial Reporting Standards (IFRS) for listed companies. The adoption
of common accounting standards restricts the freedom of management to record the same transaction
in different ways. The uniformity of accounting standards makes comparison between firms and across
time easier. However this comes at the expense of flexibility in the accounting treatment of genuinely
different businesses.
One example where such a rigidity and lack of management discretion may lead to distortion of
accounting figures is IAS 38 which requires firms to recognise assets for development expenditure when
they are likely to produce future economic benefits, but requires firms to expense the preceding
research outlays when they are incurred. Development expenditures are those incurred for the actual
development of a new product. Research expenditures on the other hand are not directly associated
with any product, although some research expenditure will give rise to a future product. IAS 38 does
not allow firms to distinguish between research and development expenditure in the early stages
leading to a systematic distortion of reported results.
The IASB has tried to reconcile consistency with rigidity and in many cases the standards define general
principles rather than specific rules. A good example of this approach is IAS 17 on leasing where the
directors have some discretion at the margin to decide which leased assets are finance leases. It is
interesting to note that the US FASB (Financial Accounting Standards Board) does not afford this
discretion and instead specifies detailed rules for the classification of leased assets.
Another source of potential distortion of accounting information is the requirement that management
predict the future outcome of current transactions. When a firm makes a sale on credit, accrual
accounting principles require that managers estimate the probability of collecting the future payments
from the customer. If the probability is high the transaction is treated as a sale creating trade receivables
on its statement of financial position. Managers then have to make an estimate of the receivables that
will be collected, which may differ from the realised payments.
The broad-based approach of the IASB which affords a certain degree of discretion to the management
of a company, and the nature of accrual accounting impose an additional burden of interpretation and
judgment on the auditor and the user of the financial information.
4.3 Audit and financial statement quality

The first verification of the integrity of any financial statements produced by a company is performed by
the external independent auditors of the company. In the EU minimum auditing standards are laid
down by the Eighth Company Law Directive, which among other provisions specifies audits should be
carried out in accordance with the International Standards on Auditing (ISAs).
Although auditing presents an independent assessment of the firm's financial statements, auditing is not
sufficient to prevent fraudulent presentation of the financial health of a company by management,
which as the cases of Enron and Parmalat show, might not be detected by the auditors.
These failures of the auditing processes may be due to inadequate adherence to auditing rules, lack of
understanding of the business, or simply connivance on the part of the auditing team. Given these
auditing failures, the audited accounts of a company should not be accepted uncritically as the basis for
drawing conclusions on a company's historical or predicted performance.
In the following section we look at some of the areas of the financial statements and the accounting
policies that may give rise to distortions of the financial information.

5 Accounting distortions C
H
A
Section overview P
T
 This section discusses the most common distortions in the accounting information contained in E
the financial statements. R
In the previous section we discussed the potential for distortion of accounting information. In this
section we discuss the most common distortions and how these may arise. 16
5.1 Distortions in assets

Distortion in assets takes the form of overstating assets which is reflected in increased reported earnings
(increased revenue or reduced expenses) or understating assets which is reflected in deflated earnings
(reduced revenue or increased expenses).
The main reason for the distortion of assets is due to the ambiguity or the freedom of accounting
reporting rules. We look at some of the most salient examples of the international accounting standards
and how they can give rise to this kind of distortions.
Asset distortion can be the result of earnings smoothing where earnings are overstated or understated
so as to eliminate volatility and present a smooth pattern over time.
5.1.1 Depreciation and amortisation of non-current assets

The decrease over time in the value of non-current assets must be recorded in profit or loss. The
depreciation of a non-current asset should match the decline in its economic life, which needs to be
estimated. The salvage value of the asset at the end of its economic life also needs to be estimated. Thus
the depreciation expenditure recognised in profit or loss is partly at the discretion of the management.
Two different companies operating in the same industry may end up with different depreciation
schedules because of the different assumptions on economic life and residual values. Lufthansa for
example assumes a shorter economic life for its aeroplanes than British Airways but the interpretation of
this accounting policy difference may be unclear.
Illustration: British Airways and Lufthansa

The German Airline Lufthansa reported in its financial statements that it depreciates its aircraft over 12
years on a straight-line basis using an estimated residual value of 15% of the original cost.
By contrast, British Airways reported in its financial statements that it depreciates its aircraft over 20
years on a straight-line basis using an estimated residual value of 8% of the original cost.
The difference could lie as much in the companies' asset replacement policies as in their depreciation
policies.
The difference might be one of mere accounting policy choice where financial analysis would need to
make adjustments to compare like-with-like when interpreting the underlying performance of the two
companies. Alternatively, there may be differences of commercial substance that would make a different
depreciation policy acceptable as reflecting commercial reality, in which case no adjustment would be
needed.
Possible commercial explanations to justify the different depreciation treatment would be: different
utilisation of aircraft, different types of aircraft being used, different maximum speeds, more long or
short haul flights, different levels of maintenance, use of older planes.
In fact, any difference is likely to be a mix of accounting and commercial differences and any analysis
needs to exercise careful judgement in making relevant adjustments. An understanding of
management motivations may also help. In the case of Lufthansa the depreciation rates were used for
tax purposes whereas this was not the case with British Airways.

5.1.2 Capitalisation of development costs and intangible assets
The growth of internet, telecommunications and service companies has made the measurement of
intangibles a key issue, even though it is difficult to measure precisely their value. With financial
statements treating many intangibles as off-balance-sheet assets, there may be little information to make
such valuations within the financial statements.
In many traditional industries such as the pharmaceutical industry where research and development
expenditure plays an important role, the non-recognition of research and development as capital due to
the uncertainty of future benefits may lead to valuable assets being ignored or overlooked.
The impact of ignoring intangible assets or not valuing them properly on all ratios that involve the use
of asset estimates can be significant. Profitability ratios such as the return on assets or activity ratios will
be overstated, making it difficult to analyse historical performance, to forecast performance or to value a
company.
5.1.3 Leased assets

The main issue regarding leased assets is whether lease payments should be recognised as capital
expenses and hence capitalised and depreciated, or whether lease payments should be treated as an
expense. In the first cases the lease is a finance lease, whereas in the second case it is an operating lease.
The distinction between the two types of leases is guided by the criteria of IAS 17 which specifies that a
lease will be classified as a finance lease if the following criteria are met:
 Ownership of the asset is transferred to the lessee at the end of the lease.
 The lessee has the option to purchase the asset at the end of the lease.
 The lease term constitutes a large part of the life of the asset.
 The present value of the lease payments is close to the fair value of the asset.
 The asset cannot be used by somebody else without major modification.
Despite the criteria there is still scope for discretion on the part of management leading to an
understatement of assets classified as held under finance leases and therefore of the total assets of the
company. This will affect the gearing ratio where finance leases are treated as part of long term debt
whereas operating leases are not. Research shows that adjustment to capitalise operating leases has
significant effects on gearing and other key ratios.
5.1.4 Sale and leaseback transactions

Some companies use sale and leaseback transactions (see Chapter 4) as a means of raising finance. This
is a common feature of certain industries such as retailing and hotels where the entity may have a
significant number of high value properties.
Where a sale and leaseback transaction results in an operating lease and the transaction is established at
fair value, any profit or loss should be recognised immediately.
Illustration: Tesco
The UK retailer Tesco boosted profit for the year ending February 2007 by 4.1% by entering into a sale
and leaseback transaction with a joint venture in which the retailer had a 50% share.
As a result Tesco recognised 50% of the gain on the sale and leaseback of 16 properties representing
£110 million and boosting profit by 4.1%. Tesco continues to utilise the stores in its business and
reports these as operating leases.
In its 2006 financial statements Tesco disclosed that since 1988 it has entered into sale and leaseback
transactions with a joint venture under various terms which included sale at market value, rent reviews
and an option for Tesco to repurchase at market value. The company includes in its list of critical
assumptions the classification of leases into operating and finance.

5.1.5 Mergers and acquisitions
C
Accounting for mergers and acquisitions follows two approaches: the pooling of interests method H
(merger accounting) and the acquisition method (acquisition accounting). A
P
Under the acquisition method, the cost of merger for the acquiring firm is the actual value that was paid T
for the acquisition of the target company's shares. If the price paid plus the value of the non-controlling E
interest is above the value of the acquiree's net assets, then the excess is recorded as goodwill on the R
acquiring firm's statement of financial position.
While the pooling of interests method is not permitted by IFRS 3 Business Combinations, there is no 16
requirement for retrospective adjustment of previous mergers. This creates problems when financial
ratios are used for the evaluation of the historical performance of a company. To standardise the
method of consolidation, the pooling of interests needs to be reversed and replaced by the acquisition
method, which requires fair value adjustments and recognition of goodwill.
5.1.6 Revenue recognition

Managers sometimes have incentives to recognise future revenues overstating earnings and receivables.
This will, of course, be followed by a decline in the earnings in subsequent years, so unless a company
experiences a consistent growth in earnings, revenue recognition will not help the long-term
performance of the company.
5.1.7 Allowances
Management may sometimes find it to its advantage to underestimate the expected default loss from
receivables and thus to underestimate allowances and overstate earnings and assets.
5.1.8 Discounted receivables

Companies may sell their receivables in order to boost their liquidity. There are two options for the
recording of such a sale. The first is for the transaction to be recorded as a sale. The second is for the
transaction to be recorded as a loan with the receivables being collateral. Such a transaction will be
recorded as a sale if the IAS 39 criteria for derecognition are met and the buyer undertakes all the risks
and rewards of the receivables.
5.2 Distortions in liabilities

The most common distortion on the liability side involves:
 Provisions
 Unearned revenues
 Post-employment benefit obligations
5.2.1 Provisions
A firm that expects a future outflow of cash due to a contractual obligation but whose exact amount is
not known, will need to make a provision for such a liability. Firms, however, have the discretion to
estimate these future liabilities and the possibility to understate them on their statement of financial
position.
5.2.2 Unearned revenues

Unearned revenues arise when a company receives payments in advance of selling the good or service.
Such unearned revenues create liabilities that need to be recognised. Companies may understate such a
liability.
5.2.3 Post employment benefit obligations

Under IFRS, firms that provide pension benefits or other post-employment benefits to their employees,
need to recognise the present value of future payments net of the assets that are dedicated to the
payment of these future benefits. The company needs to adjust these liabilities every year in the light of
current service costs, interest costs, actuarial gains and losses, past service costs and benefits paid.

Illustration: BG pension deficit
BG Group plc elected in 2006 to use the corridor method to account for pensions, and it recognised a
£167 million deficit, whereas a further £78 million was not recognised in the statement of financial
position as it was within the 10% corridor. This is a serious understatement of the pension liability on
the statement of financial position since £78m represents about 47% of the recognised pension deficit.
5.3 Distortions in equity

Distortions in equity arise either from contingent claims or the recycling of gains and losses
(reclassification from equity to profit or loss). Contingent claims take the form of stock options or
conversion options.
Stock options
Stock options give the right to employees to buy a company's shares at a predetermined price within a
specific period of time. IFRS 2 Share-based Payment requires that firms should report the cost of options
as an expense in profit or loss using the fair value of the option, which can be estimated using option
valuation models. Such models are not, however, very accurate as they depend on the volatility of share
prices which is not observable and has to be estimated from market data. Thus it is possible that the
cost of stock options may not be stated correctly.
Conversion options
Convertible bonds can be considered as being made up of an ordinary bond and a call option on the
shares of the company. IAS 39 requires that the company values the ordinary bond component
separately from the call option component.
Reclassification (recycling) of gains and losses
Gains or losses on some items may be recorded as other comprehensive income and accumulated in
equity, and later reclassified to profit or loss. Gains or losses on other items may not be reclassified to
profit or loss. (The 2011 amendment to IAS 1 distinguishes between to two types of gains/losses.)
6 Improving the quality of financial information
Section overview
 This section suggests ways of undoing the accounting distortions in the financial statements, and
produces a measure of sustainable earnings. The possibility of using cash flow data instead of
earnings is also discussed.
6.1 Undoing accounting distortions

If financial analysis reveals that a company's financial statements are deemed to be inadequate,
misleading, or atypical of the industry, then it is important that adjustments are made to undo the
inadequate policies, as far as possible, in order to produce 'standardised' accounts which can form the
basis for decision making, forecasting future performance on a comparable and valid basis and,
ultimately, contribute to an appropriate valuation.
It should be noted that accounting manipulation and 'red flags' could arise not only where management
are attempting to inflate profit. Over-conservative accounting, or excessive prudence, may be as much
of an issue as aggressive earnings management when attempting to forecast future earnings from a
current earnings basis.
Key information as a starting-point to make such adjustments is disclosed in the notes to the financial
statements, and the statement of cash flows. Other information in the public domain about the
company should also be used.
The following sections give examples of specific adjustments that can be made to the statement of
financial position and the statement of profit or loss (and other comprehensive income) as part of the
process of standardisation.

6.2 Statement of financial position adjustments
C
The statement of financial position shows the assets, liabilities and equity of a company. The two major H
issues arising from accounting policies, even when they are in full compliance with GAAP, are: A
P
 The amounts at which assets and liabilities are measured may differ significantly from their T
economic values. E
R
 Some valuable assets and significant liabilities may not be recognised at all.
Any forecast based on accounting information which is to be used for cross sectional comparison
16
purposes, or as an input into a valuation model, first needs to address these issues by making
appropriate adjustments by:
 Re-measuring assets and liabilities at fair market values
 Adding back (ie recognising) off-balance sheet liabilities and assets with commercial value
 Adding back assets that have been previously written off (goodwill, impairment reviews etc)
In practice, most acquirers and investors determine firm value by calculating the sum of the market
value of the debt and the equity invested in the business. In this case, a separate valuation of individual
operational assets and liabilities rarely takes place. A large proportion of firm value is likely to be related
to the present value of future growth opportunities, and is not represented by current earnings or assets.
In contrast, lenders calculate firm value from the worst-case perspective. They often estimate the fair
value of assets in place assuming a break-up, to check that the capital of their loan is secure.
6.3 Adjusting the assets

If the carrying amount (ie 'book value') of assets is either understated, or overstated, by comparison with
their economic values and with those of comparable companies, this can have important implications
for forecasting and valuation. As an example, some companies may wish to state assets at cost rather
than a revalued amount as, although revaluation 'improves' the statement of financial position, it does
so at the cost of higher depreciation and lower reported profit. This may affect some companies (eg
with profit-related remuneration schemes or with earnings-based covenants) more than others. Some
examples and motivations were discussed in the previous section.
Non-current assets
There are a number of areas that affect the recognition and recording of non-current assets such as fair
value recognition, depreciation and amortisation, inflation, impairment and interest capitalisation. In
order to adjust the financial statements financial analysis will be required to:
 Revalue to fair value non-current assets which are currently recognised in accordance with the cost
model and/or assets which have not been revalued recently.
 Standardise the depreciation method.
 Review asset lives compared with competitors and recent replacement policy (eg consider
profit/loss on disposal, readjustments of asset lives). See the 'British Airways and Lufthansa'
illustrative example above.
 Review residual values (eg a weakness in the market for second-hand aircraft caused a significant
depreciation adjustment by EasyJet in 2004).
 Impact of foreign currency – for non-monetary assets no adjustments are made under IAS 21 The
Effects of Changes in Foreign Exchange Rates for exchange rate movements after purchase (although
there will be an impact of foreign currency changes over time if there are consistent asset
replacements).
 Look for evidence of adequacy of impairment charges (eg poor trading conditions, decline in fair
values, previous recent revaluations, rival companies' recognition of impairment in similar assets).
 Impact of general inflation or sector inflation.
 Capitalisation of interest policy to be standardised with comparable companies, normally by
treating the interest as an expense and deducting it from the asset value.

Intangible assets
There are two general approaches to resolving the problems generated with the accounting treatment
of intangibles. The first approach is to leave the accounting numbers as they are, but in analysing
historical performance and in forecasting the analyst should be aware that the rate of return is
understated and it represents the lower end of the estimates. The second approach involves recognition
of the intangible asset and amortisation over their expected life.
 Revalue at fair value intangible assets which are currently recognised in accordance with the cost
model, or that have not been revalued recently. This process may be very difficult in some
circumstances, and could amount to valuing the company as a whole. However, if the purpose of
adjustments is to forecast firm values, then the process becomes circular.
 Recognise internally-generated intangible assets at fair value where IAS 38 and other asset
recognition criteria are not satisfied, but the assets have commercial value. (For many 'asset-light'
companies the statement of financial position would be largely meaningless unless unrecognised
intangibles are reinstated at some estimated value.)
 Consider capitalisation of the commercial value of unrecognised R&D costs, particularly where
these are significant, and a key factor for success such as in the pharmaceuticals industry.
 Review the amortisation policy for intangible assets for consistency and comparability, in terms of
both asset life and residual value.
 Look for evidence of adequacy of impairment charges.
 Consider changes in the fair value of goodwill on acquisitions.
Leased assets
The distinction between finance and operating leases affects the statement of financial position and the
profit or loss and hence a large number of key ratios. A solution is to consider the recognition of long-
term operating leases on a comparable basis to finance leases. This will increase assets and thus reduce
asset turnover ratios. However, the liability will be brought on the statement of financial position and
increase debt and gearing ratios. In addition, the expensed lease costs need to be converted to interest
and a depreciation charge. Most credit rating companies follow this approach and capitalise all
operating leases.
But even when finance leases are explicitly recognised as such in the statement of financial position, it
may be sensible to:
 Consider, and if necessary recompute, the method of allocating finance charges on finance leases
over the period of the lease
 Consider whether the value of assets under finance leases is understated and needs to be revalued
 Review depreciation policy and asset lives as for owned assets
Worked example: Rolls Royce

Rolls Royce treats some of its leased assets as operating leases and they are excluded from its statement
of financial position. This makes it difficult to compare it with other companies that have a different mix
of operating and finance lease. This could be corrected if all operating leases were capitalised.
Non-cancellable operating lease rental
2007 2006
£million £million
Within one year 77 78
Between one and five years 179 213
After five years 99 106
Total 355 397
Requirement
Outline the steps required in order to capitalise operating leases and the adjustments made to the
statement of financial position and profits for the purpose of financial analysis.

Solution
C
The following steps are required: H
A
First an estimate is required for the annual allocation of rental payments. P
Second, a discount factor needs to be adopted in order to discount the rental payments and calculate T
E
the present value of rental payments under the operating lease. An appropriate discount rate would be R
the cost of long-term debt for the company.
Third, a depreciation schedule needs to be adopted for the depreciation of the asset represented by the
operating lease. 16
Fourth, the rental payments need to be added to operating profit and a finance charge calculated
representing the financing costs.
Inventories
 Standardise for the effects of different inventory identification policy choices, including FIFO,
average cost, and standard cost.
 Consider specific price changes in the industry.
 Consider adequacy of write-downs to net realisable value, particularly where inventory volumes
have increased, or where prices have fallen.
 To the extent of available disclosure, consider the impact of overheads being included in
inventories on a reasonable basis, particularly where inventory volumes have changed in the year.
 Impact of foreign currency – as inventories are a non-monetary asset, no adjustments are made
under IAS 21 for exchange rate movements after purchase (although there will be an impact of
foreign currency changes over time as there are consistent inventory replacements).
Receivables
 Consider adequacy of bad debt write-offs (eg compared with competitors, prior experience, known
insolvencies amongst customer base, increases in receivables days ratio).
 Consider the likely timing of any bad debt recovery, and how it might affect liquidity.
 Review, in conjunction with revenue recognition, methods in statement of profit or loss and other
comprehensive income.
 Consider impact if any factoring has taken place.
Long-term assets
 If stated at fair value, consider valuation method used if disclosed, and any post-year-end changes.
 Review companies on the border of control and significant influence. Equity accounting would take
only net assets into consideration, and would take an associate's liabilities off the consolidated
statement of financial position. The restatement of an associate on a full consolidation basis may be
appropriate where significant influence borders on de facto control. This may significantly affect
reported consolidated figures for highly-geared associates. The information would be available to
the analyst on the basis of the disclosure in the financial statements of the individual companies.
6.4 Adjusting liabilities

The main adjustments to liabilities are:
Long-term debt
The liability may not reflect its fair value if stated at amortised cost. The appropriate adjustment is to
review the value of the liability, eg where interest rates or the credit rating of the company have
changed.
Also financial instruments containing equity and debt elements, such as convertibles, would need to be
reviewed for likelihood of conversion, and any changes in the fair value of the instruments since issue.

Deferred tax
 Here we should consider how much, if any, of the provision is likely to crystallise and thus create a
future cash outflow. All will reverse on individual assets. However, we must consider the different
reversal horizons (eg there may collectively be no reversals if there is a constantly-expanding pool of
non-current assets).
 Estimate the effects of likely changes in future tax rates which have not been recognised.
 Discount future cash flows arising from reversals, and calculate the present value benefit of paying
tax later.
 Assess recoverability of deferred tax assets (eg on losses).
Employee benefits
 Any underfunding of the pension liability may not be fully recognised within IAS 19 Employee
Benefits (eg if it falls within the corridor limits). Estimates would need to be made of unrecognised
or undisclosed costs.
 The present value of future obligations can be very sensitive to the assumptions made. Adjustments
to the value of the obligation may be required if the assumptions are considered unreasonable. IAS
19 requires that the assets and liabilities are valued using the rate applicable to 'high quality
corporate bonds'. This has the effect of automatically overstating the present value of liabilities in
pension funds.
 Stock options under IFRS 2 only reflect the market value at the granting date. The future value
sacrifice from strongly in-the-money employee options may therefore be far greater than is
reflected in the financial statements if share prices have risen since the options were granted.
In contrast, gains arising from pension scheme curtailments should result in immediate recognition in
profit or loss and a reduction in the present value of the defined benefit obligation.
Illustration: British Airways

UK airline British Airways recognised a credit of £396 million in its income statement for the year ended
31/3/07, with respect to changes in a pension scheme. The recognition of £396 million represents 65%
of pre tax profit.
The changes made to the pension scheme included a restriction in future pension increases to
movements in the Retail Price Index and an increase in the retirement age to 65.
British Airways plc
Year end 31.3.07 31.3.06
£million £million
Turnover 8,495 8,515
Provisions
Assess probability of provision occurring, and consider including expected values based on probabilities.
Contingent liabilities
Consider recognition on the basis of expected values based on possibility of occurrence of certain
events.
6.5 Adjustments in the statement of profit or loss (and other comprehensive

income)
In the same way that reported statement of financial position items need to be restated into a
standardised format that reflects their fair value, income and expense items need to be adjusted on a
similar basis to improve the quality of earnings. The main adjustments needed are:

 The removal of 'non-operating items' from reported income, in order to provide a better measure
of operating earnings that are driven by sales to make more valid like-for-like inter-period C
comparisons, and to highlight sales margins on a consistent basis. H
A
 The removal of non-recurring elements of operating earnings, in order to gain a measure of P
sustainable earnings. This provides better profit forecasts and improved valuations. The most T
E
common non-recurring elements are: R
– Exceptional items
– Discontinued operations
– Acquisitions 16
– Elements recognised as other operating income
 The adjustment of costs and revenues to a fair value basis, so that they better reflect the fair value
of resources consumed and earned in the period. Frequently, this is the other side of the coin to
the statement of financial position adjustments highlighted above, but this can also involve
correcting for aggressive earnings management.
The above distinctions are not always clear, and different judgments may be formed as to what 'normal'
earnings are, and what might be termed 'noise'. Moreover, even where there is agreement as to a
transaction having a non-recurring element, there is not always sufficient disclosed information in order
to make adjustments with any precision. In such cases, estimates would need to be made on the basis of
Keynes's dictum that it is better to be roughly right, than precisely wrong!
It might be worth noting, however, that in normal operating contexts, historical cost measures have
been shown by empirical evidence to be both good predictors of current performance and significant
valuation tools.
Exceptional items
As exceptional items would not normally recur, they would not form part of future earnings, and thus
should be removed. However, whilst any one type is unusual, exceptional items are generally very
common, and are likely to recur in some form in years to come. Indeed, it might be said that the only
exceptional thing about such costs is that it is extraordinary for companies not to have them. Care,
therefore, needs to be exercised in judging whether an item disclosed separately is, in fact, unlikely to
recur.
It is also important not always to accept the judgment of management as to what is exceptional and
what is part of normal recurring activities. One view is that exceptional costs are more likely to be
separately disclosed by management than exceptional income.
IAS 1 Presentation of Financial Statements requires that where items of income or expenditure are
material, their nature and amount should be disclosed separately. These are sometimes called
'exceptional items', although IAS 1 does not use that phrase. The following list illustrates some such
items:
 Write-downs of inventories or of non-current assets
 Reversals of previous asset write-downs
 Restructuring costs and provisions
 Disposal of major non-current assets
 Disposals of major investments
 Litigation settlements
 Foreign currency exchange losses or gains
 Government grants
 Significant changes in the fair values of investment properties
Disclosure requirements are that the items must:
 Appear as a separate line item
 Be disclosed 'above the line' (ie as part of pre-tax profit)
 Be disclosed as part of continuing activities (unless specifically covered by IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations)
IAS 1 expressly forbids the disclosure of 'extraordinary items' (ie 'below-the-line' disclosures).

Worked example: Trump Hotels & Casino Resorts
On 25 October 1999 Trump Hotels & Casino Resorts reported a third quarter EPS of $0.63 after a one-
off write-off charge for the closure of the Trump World Fair Casino Hotel.
This reported EPS was a significant increase from the 1998 third quarter EPS of $0.24. It was also well in
excess of the consensus EPS forecast of analysts, which had been $0.54. As a consequence, the share
price rose from $4 to around $4.31.
The surge in profits was initially explained by a combination of increased revenues, improved profit
margins and reduced marketing costs. All of these factors would have implied that the profit increase
was part of a like-for-like comparison and thus would form the basis for forecasting future earnings.
A key contribution to the improved profit was however not initially available. It was only on the later
publication of the more detailed 10-Q Quarterly Report that it became known that $17.2 million of
profit had been generated as a one-time gain following the abandonment of a lease for the All Star Café
at a Trump Hotel by Planet Hollywood.
Without this one-off gain revenue would have declined and EPS would have undershot analysts'
expectations. In the year to May 2000 Trump's share price fell 56%.
Requirements
(a) In the Trump Case above, explain, with reasons, whether the key issue was primarily recognition,
measurement or disclosure.
(b) Why would the problem affect share price by so much?
Solution
(a) The issue here was not one of revenue recognition. The gain was appropriately recognised in the
year. The issues were disclosure and classification. With adequate disclosure, the one-off gain of
$17.2 million could have been identified by analysts as a non-recurring item and thus excluded
from sustainable profit.
(b) Forecasts of future profit based on current earnings would have been much lower as sustainable
earnings forecasts would have been lower. As a result, any valuation of the company derived from
the initially disclosed basis was overstated, resulting temporarily in an excessive share price.
The Trump case therefore highlights how important it is for forecasting and valuation to separate
permanent from transitory earnings and the need for adequate disclosures to be made.
Note that, in a valuation context, historic performance is only relevant to determining share price
in so far as it acts as a guide to forecasting future performance. The greater the adjustment of
consensus future forecasts the greater the impact on share prices. If a large proportion of the share
price value is attributable to growth (rather than assets in place), small changes in forecasts can
lead to large changes in share prices.
Discontinued operations
A discontinued operation is a component of a company which, according to IFRS 5:
 Has been disposed of in the current period; or
 Is classified as held-for-sale, where there would normally be a co-ordinated plan for disposal in the
following period.
The component might, for example, be a major line of business, operations in a particular geographical
area, or a subsidiary.
The profit or loss after tax from discontinued operations is disclosed as a single figure on the face of the
statement of profit or loss and other comprehensive income or statement of profit or loss. An analysis
should be disclosed (normally in the notes to the financial statements) to show the revenue, expenses,
pre-tax profit or loss, related income tax expense, and the profit or loss on asset disposals.
These items will not form part of sustainable future earnings, and should be removed when forecasting
future performance.

In addition, for a discontinued operation, the company should disclose the net cash flows attributable to
the operating, investing, and financing activities of that operation. C
H
Acquisitions A
P
Where a company has made an acquisition of a subsidiary, or an associate, during the period, only the T
post-acquisition profit or loss will have been included in the consolidated statement of profit or loss (and E
other comprehensive income) of the period. In determining sustainable profit, consideration needs to R
be given to the fact that in subsequent years a full year's profit or loss will be consolidated and,
therefore, a time adjustment will need to be made.
16
Also, however, a series of other factors will need to be considered including:
 Restructuring costs
 Profit or loss on sale of redundant assets
 New transfer pricing arrangements
 Other costs of integration
 Changes in accounting policies to make subsidiary consistent with group policies
 Change in accounting year end to make subsidiary coterminous with the group
Some of these items will be disclosed, but in other cases analysts would need to make a 'best guess' on
the basis of any information that is available.
Elements recognised as other comprehensive income
IAS 1 requires certain items to be recorded as other comprehensive income and accumulated in equity.
These are:
 Revaluations of tangible and intangible non-current assets (IAS 16 Property, Plant and Equipment
and IAS 38)
 Particular gains and losses arising on translating the financial statements of a foreign operation (IAS
21)
 Gains and losses on remeasuring available-for-sale financial assets (IAS 39)
 Gains and losses on cash flow hedges (IAS 39)
 Tax (including deferred tax) on items recognised as other comprehensive income (IAS 12)
In addition, certain items are recognised directly in reserves and disclosed in the statement of changes in
equity. These are:
 Equity dividends (IAS 1)
 The correction of errors from prior periods (IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors)
 The effects of changes in accounting policies (IAS 8)
While some of these items might reasonably be expected to recur, they are likely to do so in a random
and uncertain manner, with varying effects. Overall, therefore, their non-predictability needs to be
considered in evaluating future performance based on current period financial reporting. Note that
these items will not affect EPS and reporting earnings directly, but they do form part of a wider measure
of comprehensive income achieved by a company.
Accounting estimates
The preparation of financial statements requires many estimates to be made on the basis of the latest
available, reliable information.
Key areas in which estimates are made include:
 The recoverability of amounts owed by customers
 The obsolescence of inventories
 The useful lives of non-current assets
 The values of non-current assets

As more up-to-date information becomes available, estimates should be revisited to reflect this new
information. These are changes in estimates and are not changes in accounting policies or the
correction of errors.
Changes in estimates are recognised in the period in which the change arises. The effect of a change in
an accounting estimate is, therefore, recognised prospectively, ie by recognising the change in
accounting estimate in current and future periods affected by the change. As a consequence, such items
should not normally result in large one-time charges, but may cause a reassessment of management's
ability and willingness to make reasonable estimates elsewhere in the financial statements.
Prior period errors
A prior period error is an error that has occurred even though reliable information was available.
Examples of such errors are:
 Mathematical errors
 Mistakes in applying an accounting policy
 Oversights, or misinterpretation, of facts
 Fraud
It should be noted that auditing standards clearly distinguish between fraud and errors, in that fraud is
intentional and errors are not. It is normally important to distinguish between misstatements, errors and
frauds, but the retrospective accounting treatment is the same in this instance in accordance with IAS 8.
As such, errors may relate to a number of reported periods. IAS 8 requires that these errors are to be
adjusted in those past periods rather than in the current period. They will not, therefore, affect current
earnings, but may cause doubt about the efficiency of internal controls and raise the possibility that
other similar undisclosed errors may have been made.
Re-estimating costs and revenues to fair values
It is necessary to adjust costs and revenues to a fair value basis, so that they better reflect the fair value
of resources consumed and earned in the period. This might include making adjustments that
correspond to those for the statement of financial position, but also correcting for aggressive earnings
management.
Examples of this type of adjustment might include:
 Adjustment of historical cost depreciation to a fair value basis
 Adjustment of historical cost amortisation of intangibles to a fair value basis
 Expensing of capitalised interest
 Adjustment for the impact of share-based payments, such as stock options, to the extent that they
do not reflect fair value changes since issue (as required by IFRS 2)
 Consideration of how much, if any, of the provision for deferred tax charged in the period is
actually likely to reverse, and thus create a future cash outflow
 Adjustment for revenue recognition if there is evidence of aggressive earnings management
through accounting policies and estimates, or through unduly advancing actual transactions
Interactive question 4: The effect of business issues on financial reporting

A listed company operating in the electronics manufacturing sector has decided that due to cost
pressures it will downsize its UK based operations. A number of manufacturing facilities will close and
the activities will be outsourced to South East Asian countries.
Requirement
Identify six IFRSs that may need to be considered and briefly give examples of why.

6.6 Normalising earnings
C
Both basic and diluted earnings can be manipulated by the management of a company directly or H
indirectly. In order to render the earnings figure into a meaningful piece of information the earnings A
figure needs to be adjusted to reflect the true potential and sustainable earnings of a company. The end P
T
result of the standardisation process is a normalised/sustainable earnings schedule which adjusts not E
only for the differences in recognition and measurement, but also provides a template for standardising R
presentation, terminology and categorisation.
The following table represents a pro forma, although this is likely to vary with differences between
analysts and between the reporting regimes under which the companies being analysed operate. 16
£'000 £'000
Sustainable operating income
Sustainable revenue X
Sustainable cost of sales (X)
Sustainable gross profit X
Sustainable operating expenses (X)
Sustainable operating profit before tax XX
Income tax as reported (X)
Tax benefit from finance costs X
Tax on exceptional items X
Tax on other sustainable operating income X
Element of deferred tax charge unlikely to crystallise X/(X)
Tax on sustainable operating profit (X)
Sustainable operating profit from sales XX
Sustainable other operating income X
Tax on sustainable other operating income (X)
Sustainable other operating income after tax X
Sustainable operating profit after tax XX
Non-recurring and unusual items
Profit from discontinued operations X
Changes in estimates X/(X)
Profit/losses on sale of non-current assets X/(X)
Impairment charges X/(X)
Start-up costs expensed (X)
Restructuring costs expensed (X)
Redundancy costs (X)
Unusual provisions (X)
Changes in fair values X/(X)
Foreign currency gains/(losses) X/(X)
Other unusual charges and credits X/(X)
Tax on unusual items (X)
Non-recurring and unusual items after tax XX
Profit for the period before finance charges XX
Note: the above items are stated after standardisation adjustments to individual costs and revenues.
6.7 Statement of profit or loss (and other comprehensive income adjustments

for comparison
The items adjusted above are primarily concerned with determining a comparable trend in operating
earnings over time for one company. A key part of financial analysis is also comparing the performance
of companies in the same industry.
Such a process will involve normalising accounting policies and estimates across companies as well as
over time. As the above illustrative example on British Airways and Lufthansa illustrates, however, this
does not mean merely applying the same policy mindlessly to all companies irrespective of
circumstances. It may be that different policies and estimates are appropriate to the different economic
circumstances of different companies.
A particular difficulty of comparisons arises internationally, where two companies report under different
GAAP. For instance, it might be necessary to compare one company reporting under US GAAP with

another reporting under IFRS. In these circumstances, there are differences not only in accounting policy
selection within a given set of GAAP, but also between the two sets of GAAP. Further adjustments have to
be made but any comparisons may be weakened.
Items adjusted as part of pre-tax profit under any of the above headings will also require estimates to be
made of the taxation effects, including deferred tax. In so doing, the marginal rate of tax will need to be
used where this differs from the average rate.
6.8 Cash flow alternatives to earnings

One solution to the quality of earnings problems sometimes put forward is to examine cash flows instead
– the 'cash is king' view. It may be argued that operating cash flows are at least hard figures which are
independent of judgment and accounting manipulation. In particular, it may seem as though operating
cash flows are recurring and sustainable. Such a view would be inappropriate in many circumstances.
'Depreciation and free cash flow'
First, operating cash flow adds back depreciation as an accounting number that does not involve a
movement of cash. Further down the statement of cash flows, however, there is likely to be a significant
outflow under investment activities on the acquisition of non-current assets. Such expenditure, to
sustain the asset base of the business, should be regarded as part of recurring cash outflows, as without
it the business would decline. Thus, while an arbitrary depreciation figure is excluded, a figure of cash
outflows on non-current assets which is under the discretion of management replaces it. R&D
expenditures would be a particular example of an item where there is significant management
discretion over cash flow expenditure.
'Timing of payments'
Management may have significant discretion over the timing of some types of payment. In the period
leading up to the reporting date, cash payments can be delayed to reduce cash outflows on operations,
and increase cash balances. Arguably, there is more discretion on the timing of payments in the
statement of cash flows than there is over the timing of the transactions themselves in the statement of
profit or loss and other comprehensive income.
'Unusual items'
Exceptional items are normally included in operating profit. They need to be distinguished from recurring
items in cash terms in the statement of cash flows, as well as in accruals terms in the statement of profit
or loss and other comprehensive income.
Smoothing and the long term
Some costs are recognised in profit or loss, but will not be cash transactions for some time into the
future, and thus would not appear in the current year's statement of cash flows. Examples would include
provisions under IAS 37 where the statement of profit or loss and other comprehensive income
recognises a future cash flow in the current period as an early warning signal. It is only identified in the
statement of cash flows at a much later stage.
A more extreme example is decommissioning costs which are a cash flow, perhaps a long time into the
future, but are recognised in present value terms in the statement of profit or loss and other
comprehensive income as each year passes.
In both these examples, the statement of profit or loss and other comprehensive income provides a
better guide to future forecast cash flows than the historical statement of cash flows.
'Non-cash costs'
Some costs are recognised in the statement of profit or loss and other comprehensive income but will
never be recognised in the statement of cash flows. Share-based payments under IFRS 2 involve an
annualised cost of share-based payments, such as employee share options. Such a cost may be
inaccurate, being based on the market value at the grant date, but the statement of cash flows does not
recognise this cost of equity settled share based payments at all. As such, the statement of cash flows
fails to capture an important element in assessing performance that is recognised in accruals-based
statements.

'Bringing forward receipts'
C
Companies can manipulate cash flow from receivables, in a number of ways, including settlement H
discounts, factoring, invoice discounting, and securitisation. Such manipulation is at the discretion of A
the directors in the same way, if not to the same extent, as revenue recognition in the statement of P
profit or loss and other comprehensive income. Both practices have the problem of 'sustainability', but T
E
they can artificially inflate short-term measures of performance.
R
Assessing the quality of cash flows is perhaps as difficult as assessing the quality of earnings, although for
different reasons. Forecasting future cash flows is a key to financial analysis and corporate valuation.
However, historical cash flows are not necessarily any better than historical earnings in achieving this – 16
and in many cases they are worse. In any case, restatement and normalisation is as difficult as it is
necessary.
From a valuation perspective, the normalised cash flow and earnings figures are used together to
estimate the free cash flows of a business. It is the free cash flow that is discounted to deduce an
enterprise value for the business.
7 Financial ratios interpretation
Section overview
 This section discusses issues of interpretation of ratios, including those based on cash flow data.
Ratio analysis is the most potent tool of financial analysis. Ratios reduce the dimensionality of the
information provided in the financial statements by summarising important information in relative
terms. Ratios are based primarily on financial information from the financial statements which as we
have already discussed, can be manipulated by the management of a company. Attention should
therefore be paid to the accounting quantities that determine the financial ratios.
7.1 Interpretation of ratios

Some of the ratios that are used in financial analysis, beyond the accounting problems that have been
identified, convey very little information if the underlying business operation is not well understood.
Good examples are both the trade receivables and the trade payables ratios. A large sale, or a large
receipt, immediately prior to the year end may distort the trade receivables ratio. Furthermore, the year-
end receivables figure is likely to depend far more on the sales in the final month of the year rather than
the average. If the final month is unusual (eg owing to seasonality or growth), the ratio may convey very
little information.
The trade payables ratio can be extremely misleading, as it is purchases that generate payables rather
than cost of sales. Even if a purchases figure is used, however, this is only possibly valid for retail
companies. For manufacturing companies, cost of sales includes not only raw material costs but also
production labour costs and overheads, many of which are unrelated to trade payables. This is, thus, a
poor ratio to use for manufacturing companies.
A second example is the gearing ratio. It has already been discussed that both non-current assets and
liabilities should reflect fair values. In addition this ratio can be useless as a relative measure unless the
operation of the company is well understood. For example many service-based companies may be 'asset
light'. This might include, for instance, IT and internet companies which may have intangibles such as
intellectual property rights, but would normally borrow primarily on the strength of their tangible asset
base. This may give the impression that the risk of insolvency is higher than in reality and shows that to
assess solvency, much more information is needed, such as: the realisable value of assets on sale; timing
of debt redemption; conversion rights; replacement or additional financing capacity.
In what follows we concentrate on the problems that arise when the return on invested capital is
calculated.

Return on capital employed
It is common for the return on invested capital to be decomposed into its constituent parts using the so
called DuPont analysis, as follows
Profits Profits Revenue
ROCE =   = Profit margin  Asset turnover
Capital employed Revenue Capital employed
To understand what determines the return on capital employed we need to understand what
determines the profit margin and the asset turnover. There are two issues here that need to be assessed.
The first is the source of the return on capital, ie whether it comes from a high profit margin or a high
asset turnover. This distinction is important when comparing companies. The second issue is the
understanding of the problems associated with the construction and interpretation of the constituent
ratios. As it was discussed already in strategic analysis, beyond the accounting issues, the financial ratios
need to be seen in the context of the overall strategy of a firm both in the medium and the short term.
Profit margin in retailing and manufacturing
A key figure in all the profit margin ratios is cost of sales. This figure is, however, rather different for
retailing companies and manufacturing companies. For retailing companies, most of the cost of sales is
made up of the cost of buying goods which are later sold in the same condition. One might, therefore,
expect issues such as pricing policy, product mix, and purchasing activity, to affect gross profit margin,
but otherwise this figure should be reasonably comparable for companies in the same industry
operating in similar markets.
For manufacturing companies, however, the 'cost of sales' figure is more difficult to assess, as it includes
all costs in bringing goods to their final location and condition. This includes costs of production, as well
as the costs of raw materials. As a result, the gross profit margin for manufacturing companies needs to
consider additional factors to those of retail companies that relate to operating efficiency. In particular, it
is important to consider the increased possibility of manipulation of inventory value and gross profit
through allocations of overheads.
Profit margins – the base data
While profit margins, in effect, consider the relationship between two figures, it is important to
understand the individual 'line items' that make up these ratios. Without this, it is difficult to answer
such fundamental questions as why revenue has decreased.
Part of the story is in understanding the type of industry, as in the previous section but, in addition, it is
necessary to understand the strategy that drives the numbers and the accounting rules that dictate the
way they are recognised.
The following is a guide to the factors to consider in determining operating profit.
Revenue
 How is revenue changing – is there a consistent pattern over time? At what rate is revenue
increasing/decreasing?
 Is the change in revenue consistent with announced price changes?
 Has sales volume been a factor, eg new competitor, industry trends, cycles, production capacity
constraints, inventory accumulation?
 Has the sales mix changed between high-margin and low-margin products?
 Have new products been launched?
 Effect of disposals or acquisitions?
 Effects of currency translation on revenue?
Cost of sales
 Retail or manufacturing
 Impact of raw-material price changes
 Foreign currency changes

 Labour changes – wages rates or quantity of labour
C
 Impact of overhead costs H
A
 Changes in inventories between opening and closing can affect overhead allocation between profit P
and closing inventory T
E
Other costs R
 What are key costs (eg R&D for pharmaceuticals, bad debts for banks)?
 Marketing and advertising costs – are these related to revenue changes?
16
 What proportion of costs is fixed (eg administration)?
Fixed costs versus variable costs
Fixed costs are those that do not change significantly when sales volumes change. Variable costs are
costs that tend to change in line with sales volumes. Unfortunately, IAS 1 does not require companies to
disclose which costs are fixed and which are variable. However, certain costs may be regarded as fixed
(eg long-term lease rentals, depreciation and, perhaps, even labour costs in the medium term). Other
costs, such as raw materials, are likely to be variable.
It is clear that some industries have high fixed costs, eg hotels and leisure, airlines, train and bus
operators, and heavy industry processes such as glass and steel manufacture. These types of company
have high 'operating gearing', which means that profits are sensitive to changes in sales volumes.
This topic of sensitivity is dealt with in more detail below, but for now it is important to appreciate that
the relationship between revenue and profit is not linear as revenue changes. Financial analysis should,
therefore, expect profit margin changes with sales volumes, and should expect differences in comparing
large companies with smaller companies because of efficiency in the use of the asset base.
Intercompany comparisons of profit margins
Any assessments of the value of the ratios are only valid after comparisons with industry norms, or similar
competitor companies, as cost structures will vary significantly from industry to industry, so there are
few absolute benchmarks.
Rivals will often be similar but they are unlikely to be identical, and many types of differences can occur.
These may include differences in:
 Size
 Product mix
 Market positioning, or market strategy
 Cost structures
 Accounting treatments that have not been possible to standardise precisely
 Timings in product life cycles, or business life cycles
While it is important to identify inter-firm differences when calculating profit margin ratios, it is
necessary to treat such figures with care.
Activity ratios
Asset turnover ratio
The main activity ratio is the asset turnover ratio, which has been defined in section 1 as revenue over
capital employed. However as activity ratios measure the efficiency with which the assets have been
used in generating revenue, the relationship between assets and revenue is only valid for the types of
assets which help to generate revenue ie 'operating assets'. These include: non-current assets,
intangibles, inventory, and receivables. Investments do not generate revenue, so no logical relationship
exists with respect to this type of asset. Thus a more appropriate asset turnover ratio might be a ratio
that is based on non-current assets.
Revenue
Non-current asset turnover ratio =
Non-current assets
This is one of the most problematic ratios in comparing different companies because companies in
different industries vary vastly in terms of the proportion of their assets in the statement of financial
position that gives rise to revenues. For a large number of companies in the service industries such as

advertising, or financial services, there may be few assets, with revenue being generated by off-balance-
sheet 'assets' such as human resources. In this case, there is likely to be a weak and largely meaningless
relationship between revenue and non-current assets. Conversely, in heavy industries such as
engineering, non-current assets and their efficient use are a key to generating revenue and profits, and
thus a much more meaningful relationship exists.
Some problems which arise when we use the non-current asset to turnover ratio are:
 Assets must be revalued to compare like with like.
 Assets added late in the year will contribute little to revenue, so the average of opening and closing
non-current assets should be used.
Inventory turnover ratio
The inventory turnover ratio should also be applied with caution. A high number of inventory days may
indicate that sales forecasts are not being met, or that there are other marketing-based problems that
mean inventories are not being sold as planned. This might be a cause of concern for analysts if it is out of
line with competitors or with previous periods.
The ratio is also useful as an inventory-efficiency measure. If the number of inventory days is high, then
it might raise the question of whether inventory is being managed appropriately, although the precise
level will vary from industry to industry. Industries that have just-in-time supplying, or make goods to
order, are likely to have the lowest inventory days. Moreover, some industries sell at a high profit margin
but only sell infrequently. Other companies sell at a low profit margin but, as a result, aim to turn
inventory around quickly.
Where a business is growing, it might be appropriate to take the average of opening and closing
inventories, rather than the closing inventories alone.
Problems with this ratio include:
 It can be easily managed as inventories can be run down towards the year end, but maintained at
high levels the rest of the year.
 If a business is seasonal, then inventories will vary at different times of the year, and the ratio may
say little.
7.2 Cash flow ratios

As the discussion so far has shown, there are potentially serious problems with the use of accounting
based ratios. An alternative set of ratios based on data from the statement of cash flows have been
proposed, known as cash flow ratios.
As the name suggests, these are ratios that are based not on accounting data from the statements of
financial position or comprehensive income but on cash data. Although these ratios are free of the
vagaries of accounting figures, one must be cautious of cash flow ratios in much the same way as
accruals-based ratios taken from financial statements. While cash flows may not be subject to the same
type of manipulation as accounting data, they can be distorted by management, as noted above.
More importantly, understanding cash flow is about understanding the inflows and outflows over time.
Capturing a snapshot in a ratio is potentially misleading without an understanding of the underlying
dynamics of the business. Nevertheless, cash flow ratios may at least highlight some issues and raise
questions even if they do not provide many answers.
7.2.1 EBITDA
Earnings before Interest, Taxes, Depreciation and Amortisation (EBITDA) is perhaps the most commonly-
quoted figure that attempts to bridge the profit-cash gap. It is a proxy for operating cash flows,
although it is not the same. It takes operating profit and strips out depreciation, amortisation and
(normally) any separately-disclosed items such as exceptional items.
EBITDA is not a cash flow ratio as such, but it is a widely used, and sometimes misused, approximation.
Particular reservations include:
 EBITDA is not a cash flow measure and, while it excludes certain subjective accounting practices, it
is still subject to accounting manipulation in a way that cash flows would not be. Examples would

include revenue recognition practice and items that have some unusual aspects but are not disclosed
separately and, therefore, not added back. C
H
 EBITDA is not a sustainable figure as there is no charge for capital replacement such as depreciation A
in traditional profit measures or CAPEX (capital expenditure) as in free cash flow. P
T
E
7.2.2 EBITDAR R
EBITDAR adds back operating lease rental costs to the EBITDA figure. Certain user groups view
operating leases as a form of off-balance sheet finance. By adding back operating lease rentals,
consistency is achieved between companies that use finance and operating leases. 16
The EBITDAR figure is sometimes used when calculating valuations of companies for acquisition
purposes.
Worked example: Calculate EBIT, EBITDA and EBITDAR

Fin plc and Op plc operate in the same industry and are of similar size. Both have entered into a number
of significant lease arrangements to obtain the use of key operating assets. Fin plc has classified these
lease arrangements as finance leases in accordance with IAS 17 Leases. Conversely, Op plc has classified
its lease agreements as operating leases. The following amounts have been extracted from the income
statements of Fin plc and Op plc.
Fin plc Op plc
£'000 £'000
Gross profit 300 300
Depreciation of leased assets (60) –
Operating lease rentals – (80)
Other operating expenses (100) (100)
Operating profit 140 120
Finance lease interest expense (20) –
Other interest expense (30) (30)
Profit before taxation 90 90
The profitability measures can be calculated as follows:

£'000 £'000
EBIT 140 120
EBITDA (140 + 60)/120 200 120
EBITDAR (140 + 60)/(120 + 80) 200 200
This simple example demonstrates the objective of calculating EBITDAR to facilitate comparison where
operating leases are significant.
7.2.3 EBITDA/Interest
This is a variant of the interest cover ratio referred to in your earlier studies and the overview. It uses
EBITDA instead of operating profit on the grounds that EBITDA is a closer approximation to sustainable
cash flows generated from operations.
7.2.4 Total Debt/EBITDA

This ratio looks at how difficult a company finds it to service its debt commitments from operations. This
figure is often used as the basis of a lending covenant by a bank to a company. The higher the ratio, the
higher the perceived risk of default on the loan.
7.2.5 Operating cash flows

This shows the ability to generate cash from assets. Again this is similar to calculating the ratio of
operating profit to revenue or to total assets.
Net operating cash flows
Operating cash flows   100%
Re venue

This ratio is the amount of cash generated relative to sales. Revenues can also be adjusted by opening
and closing receivables so that both the numerator and the denominator are in cash terms. Essentially,
this is the cash flow equivalent of 'operating profit/revenue', but it should be greater as operating profit
is stated after depreciation whereas there is no equivalent charge for non-current assets in net operating
cash flows.
An alternative ratio to look at is:
Operating cash flows   100%
Total assets
7.2.6 Investment cash flows

Investment cash flows   100%
CAPEX
This is a ratio showing capital expenditure cover, ie the number of times CAPEX is covered by operating
cash flow. In a service industry this ratio would be high, whereas in a capital-intensive industry a lower
ratio would be expected in most years. Where CAPEX is variable from year to year, the ratio is likely to be
volatile, so it is particularly important to look at a trend over a number of years.
7.2.7 Financing cash flows

'Financing cash flows' normally concern the availability of cash to repay debt (ie the free cash flow). This
can be defined in a number of ways, and free cash flow measures (eg net operating cash flows less
CAPEX) would be one proxy.
Total Debt
Debt repayments (in years) =
Free cash flow
This ratio shows the potential to repay debt in a given time, rather than when debt will actually be
repaid.
Free cash flow
Cash flow interest cover =
Interest payments
As noted above, this shows the number of times interest payments are covered, but after replacing non-
current assets.
Free cash flow
Debt servicing =
Interest + Principal payments
This shows the number of times interest and capital repayments (where debt is repayable by
instalments) are covered, after replacing non-current assets.
7.2.8 Market-to-book ratio

This is not a cash-flow ratio but the market value element is free of accounting distortions. The market
to book ratio shows the relationship between the going-concern value of the company, and the carrying
amount of its net assets. It thus reflects asset backing. This ratio is likely to be highest for companies
with unrecognised intangible assets, such as IT companies. If non-current assets have not been revalued,
this would also increase this ratio. A ratio of less than 1:1 is common in some industries such as
investment trusts, but otherwise it may indicate going concern issues or, possibly, asset-stripping
potential.
Market value of equity shares
Market-to-book ratio =
Carrying value of equity (ie net assets)

8 Forecasting performance C
H
A
Section overview P
T
 This section presents a number of methodologies for forecasting the future performance of a E
company and discusses the various issues involved, such as aggregate versus disaggregated R
forecasts and the forecasting of the effects of discrete events such as mergers and acquisitions.
Once the data from the financial statements of the company have been adjusted and through the 16
analysis of the business strategy of the firm the drivers of sustainable earnings have been identified, then
the future performance may be predicted taking into account the future macroeconomic and industry
conditions.
8.1 The production of forecasts

The production of financial forecasts is based on a model of business operation which attempts to
identify the long-term drivers of growth of a company. To identify these drivers, a historical analysis of
the company should be undertaken based on the financial information derived from company accounts
and market data. To obtain the right picture we need to follow the steps of accounting analysis and
possible restatement of the accounts as explained in the previous section. We also need to perform a
strategic, competitive and corporate analysis in order to assess the underlying economic conditions of
the company.
Growth drivers and business strategy
The growth drivers are the factors that affect the revenues and costs of an enterprise and hence its
earnings. To understand these drivers, and how they will change over time, it is essential that the analyst
understands a company's business model. This includes understanding:
 The main strategies available to the company
 Its product or service
 Its manufacturing technology and production methods
 Its marketing strategy
 Its knowledge and skills base
 The competitive and industry environment within which it operates
 Its competitive advantage within an industry (if any)
 The durability of that competitive advantage
 The regulatory and other constraints upon the company
The analysis of the business strategy would explain certain characteristics of the firm, for example high
profit margins due to competitive advantages. Similarly higher efficiency will be reflected in better
activity ratios. However forecasting is not a mere extrapolation of the past. The future industry
conditions as well as the future macroeconomic environment will be a significant factor in the
determination of performance.
Industry conditions
The industry conditions that may affect the performance of a company include:
 Price competition
 Product/service innovation
 Marketing and distribution innovation
 Technology, and cost reduction
 Quality improvement
 Imitation
 New entrants
 Diversification
 Mergers and acquisitions

8.2 Forecasting revenues
Revenue is normally the starting point in setting up a forecasting model. As in the case of earnings,
though, we need to find the sustainable revenue figure to forecast. Revenues can be forecast either for
the whole company or according to IFRS 8 Operating Segments for each business or geographical
segment.
Segment reporting allows separate revenue and profit margin forecasts to be made for each segment,
together with a separate analysis of risk. These could then be aggregated to produce a more accurate
company-wide performance forecast. There are many methods to forecast revenues, and we shall review
some of them below.
8.2.1 Market share method

In the market share method, the assumption made is that the share of a company's sales in the industry
remains stable. Forecasting takes place in two stages. In the first stage, the sales for the whole industry
are forecast. In the second stage the revenue of a specific company may be predicted using its market
share.
Industry revenue can be predicted by postulating a relationship between industry sales and some
macroeconomic aggregates such as gross domestic product (GDP), inflation rate, interest rates or tax
rates.
An alternative method of forecasting industry revenue is to identify microeconomic factors that affect
the demand and price of the products of an industry. These include factors such as the price and
income elasticity of demand for the products of the industry, seasonality in demand and as other factors
which are particular to the industry.
Interactive question 5: Forecasting revenue [Difficulty level: Easy]

You are given the following information on GeroCare a company operating for the last ten years in the
health care industry.
Year Industry sales GeroCare sales
£ million £ million
20X2 1,200 180
20X3 1,325 198
20X4 1,450 218
20X5 1,600 240
20X6 1,780 264
If industry sales are expected to grow by 20% in 20X7, what is a reasonable forecast for the GeroCare
sales in 20X7?
8.2.2 Modelling company-specific revenue

An alternative approach to forecasting revenues, which may be more appropriate for a company which
does not have a stable market share, is to construct a model for a specific company, which makes
revenues a function of various factors. The factors that affect revenue generation normally are:
Capital expenditure
In stable markets, revenue growth comes from expanding the volume of sales and this comes either
from increased productivity, or more commonly from new investment for replacement of existing
capital or expansion. Thus capital expenditure (CAPEX) is a key variable that impacts on revenue. Where
a company is expanding its non-current asset base by engaging in capital expenditure in excess of that
needed merely to sustain its asset base, one might expect additional revenues to be generated.
The impact of this increase needs to be modelled by the relationship between non-current assets and
revenue. The existing relationship is captured as we have seen in earlier sections by the non-current
asset turnover ratio. The key question in modelling this is whether this ratio remains fairly constant over
time.

The acquisition of intangibles
C
The acquisition of intangibles would clearly impact on revenue forecasts. If a company were to acquire a H
valuable brand, then revenue might be expected to increase as a result, independently of any other A
factors. However as IAS 38 Intangible Assets stands it creates problems of recognition and measurement of P
intangible assets. Indeed, the problem is not so much assessing the revenue impact of recognised T
E
intangibles as attempting to model the impact and value of off-balance-sheet intangibles.
R
8.3 Forecasting costs

16
The key factor in modelling costs is to determine the profit margin. This involves establishing a
relationship between costs and revenues.
Fixed costs and variable costs
One possible approach is to separate out cash costs from accounting costs. To the extent possible on
the basis of public information, the cash costs should then be separated into fixed costs and variable
costs. This is because revenue grows over time (if indeed it does), but not all costs behave linearly, and it
is important to have a clear idea how costs are to change in relation to revenues.
Non-cash items in recurring earnings include depreciation and amortisation. These may be regarded as
fixed costs, and are dealt with in more detail below.
In terms of other costs, the standard line-by-line presentation in published financial statements does not
make a ready distinction between fixed and variable costs, so estimates need to be made.
While all costs tend to be variable in the longer term, for large changes in revenue, there are some costs
which do not vary proportionally with sales in the short run. This is not to say that they do not change
at all, as inflationary and other factors may impact on them. They should be adjusted independently of
other variable costs, and using separate considerations.
Potentially the largest fixed costs are employment costs, although much will depend on how employees
are paid and the company's current policy on recruitment or redundancies, but this comes back to an
analyst's knowledge of the business. Fortunately, employee costs are separately disclosed under IAS 19,
so these costs can be estimated separately.
One difficulty is that, for a manufacturing company, cost of sales includes fixed cost and variable cost
estimates, and it is not always clear which employee costs are included and what proportion of
employee costs has been rolled into inventories.
The major variable cost is often raw materials, although this varies from industry to industry. For retail
companies, the assumption that cost of sales is entirely variable is normally reasonable, and there are
fewer problems.
Operating leverage
The separation of fixed and variable costs in forecasting helps these costs to be separately modelled
according to the factors that drive them, but it also has another purpose. The relationship between fixed
and variable costs, once established, can be used to estimate a company's operating gearing, and this
has important implications for risk assessment.
In essence, operating gearing means that, the greater the level of fixed costs, then the more variable the
profit margin as revenue changes. Thus high operating gearing means high risk from revenue changes.
As a result, for high operating gearing firms in particular, profit margin is unlikely to be proportional to
revenues where there is growth, or a decline. For example, a manufacturing company with high fixed
costs will more than double profits if sales double, as fixed costs do not increase with the extra sales.
Structural changes
In modelling cost structures, care needs to be taken that there are not structural changes in the
company, or the industry, within the planning horizon, that will alter the overall level of costs or the
balance of fixed and variable costs.
These changes may be difficult to foresee, but may include:
 Technology changes
 Sale and leaseback arrangements

 Shifts in the product mix – perhaps identified in segment disclosures
 Increased CAPEX to replace labour
Any known disclosure by the company or trends should be considered in this respect.
8.4 Forecasting non-current assets, depreciation and CAPEX

The significance of non-current assets varies from industry to industry. For some service industries, they
are immaterial, and thus very simple assumptions will suffice. For heavy manufacturing industries, where
there are cycles, there are many more problems.
It is not just the level of non-current assets that matters. Some companies have a large number of small
items, while other companies may have a small number of large items (eg oil rigs). Similarly, one non-
current asset may be acquired as a unit, but be replaced and depreciated in several components.
As already noted, the relationship between non-current assets and revenue is important. The impact is
likely to vary from industry to industry, but it needs to be established whether the company is growing,
the demands this will make on CAPEX, and the nature of the non-current asset turnover ratio in
measuring the efficiency with which non-current assets generate revenue.
The simplest assumption – that revenue and non-current assets will vary linearly (ie the ratio is constant)
– may be reasonable in many cases. If so, it gives us a CAPEX forecast, as well as assisting in a revenue
forecast. Caution must, however, be exercised in this assumption.
Thus, if we can forecast depreciation, then we can forecast the CAPEX to sustain non-current assets, and
the additional CAPEX necessary to accommodate growth. For this to be valid, depreciation will, however,
need to be based on fair values rather than historical cost, but this should have resulted from our earlier
standardisation process.
A key forecasting error can be to obtain reasonable profit projections but underestimate the CAPEX
required to sustain and grow the business. Given that free cash flow is essentially calculated as cash from
earnings less CAPEX less working capital changes, then this can result in an over-valuation of a business.
Thus, a valid depreciation forecast is crucial in this respect, even though it is not, of itself, a cash flow.
Depreciation can be difficult to forecast, as different assets are depreciated at different rates and,
although IAS 16 requires disclosures, they are frequently ranges of asset lives rather than for each
individual asset.
Estimates can be made from the gross asset values where straight-line depreciation is used, but this
assumes that no assets are already fully depreciated. Alternative methods are to estimate average lives
for each type of asset or remaining lives.
If asset lives are not too long, we can retrace the additions to each type of non-current asset from
previous years' financial statements, then attempt to model forward separate depreciation charges,
disposals, and other types of derecognition. Any disclosed profit or loss on disposal may give an
indication of whether depreciation policies are proving inadequate or over-prudent.
In terms of CAPEX, to grow the business – rather than merely compensate for depreciation – it is
important to develop growth or no growth scenarios over the planning horizon. More obviously,
however, for the forthcoming 12 months companies may disclose, in the notes to the financial
statements, the level of capital commitments entered into, and this can be used as an element of a
short-term CAPEX forecast.
Intangibles amortisation can be forecast in the same way, although in this case there needs to be more
care with unrecognised expenditure under IAS 38. Although unrecognised as an asset, such expenditure
may have important implications for future revenue, and costs and will need to be modelled separately.
Interactive question 6: Forecasting capital expenditure [Difficulty level: Easy]

SouthWest Electric is an electricity supplier in England. Revenues have been stable for the last 5 years
and all the capital expenditure has been dedicated to updating its network. Approval for the creation of
a new town of 50,000 people has been given by the government and SouthWest Electric expects sales
to increase by 15% over the next five years.

Requirement
C
Which of the financial ratios will you use to get a rough idea of the capital requirements of SouthWest H
Electric, and what are the factors that may affect its accuracy? A
P
E
R
8.5 Forecasting working capital needs

Working capital is needed to sustain the business, and constantly needs to be replaced. If the business is 16
not growing, then the cost of circulating working capital is already included in the profit forecast. If,
however, the business is growing, then it is likely that more investment in working capital will be
needed. For example, if revenue is increasing, then more inventories are normally needed to supply
customers, and more receivables will usually arise from increased sales. The increase in working capital
as a business grows can thus be viewed as an additional cash expenditure on financing the incremental
working capital. Conversely, if a business is declining, then working capital is released, generating
additional cash.
The simplest way to forecast changes in working capital requirements is to assume a linear relationship
between changes in working capital and changes in revenues. This can be achieved using an
appropriate financial ratio. Using the historical ratio values and revenue changes as the driver, non-cash
working capital needs can be estimated. These then become part of our forecast free cash flow
estimation.
There are other components of working capital such as prepayments and accruals, but these normally
have little causal relationship with revenue drivers and should therefore be considered on the basis of
individual circumstances.
8.6 Forecasting equity

The simplest forecast model is the so-called 'clean surplus' model, according to which any changes in
equity result merely from retained profits. Equity at the end of a period is equal to the beginning of
period value plus earnings minus dividend payments. With dividends being determined by
management, equity is simply determined by earnings.
The 'dirty surplus' model on the other hand, assumes that equity is affected by items of other
comprehensive income. These items are likely to prove difficult to estimate, unless there are some
known or systematic effects (eg with the foreign currency translation of an overseas subsidiary). Much
will depend on understanding the particular circumstances of individual companies in this case.
In addition, changes in equity include capital items such as new share issues and share buy-backs. These
changes in the equity capital of a company should be considered when forecasting statements of
financial position, as they change the financial structure of the company.
Unfortunately, unless the company has announced a share buy-back or a share issue, then any attempt
to forecast these is largely guesswork. Even if a share issue, or a share buy-back, seems likely within the
forecasting horizon, the timing is at best uncertain. Similarly, the pricing of any issue or buy-back is
unknown, as the current share price is unlikely to be a good predictor of future price, which is itself
uncertain.
Interactive question 7: Forecasting equity [Difficulty level: Easy]

At the reporting date of 31 December 20X6, equity capital for Granthar plc was £50 million. The
company predicts earnings of £27 million for 20X7 and has announced a dividend for 20X7 of 20p per
share. There are 40 million shares issued.
Requirement
Using the clean surplus model what is your prediction of the level of the company's equity at 31
December 20X7?

8.7 Forecasting funding requirements
Forecasting funding requirements is equivalent to forecasting the needs of the company in long-term
debt, short-term debt, and cash. Some models simply forecast net debt as a single item which arises
from the operating and investment activities and working capital needs of the company. This simple
approach leaves open the question of how, specifically, the funding will be put in place, and loses key
pieces of information available in the financial statements such as maturity dates on existing debt.
One approach is, therefore, to consider how long-term debt will be raised, and how it will mature.
Long-term debt is thus the independent variable. Short-term debt and cash are therefore the residuals
(or the dependent variables) needed to match the funding needs from other forecasts.
8.8 Forecasting and acquisition and consolidation

In most situations of financial analysis of listed companies it will be necessary to evaluate not an
individual company, but a group of companies. In order to do this it is necessary to understand the
impact of consolidation on performance forecasting, and the potential for value creation (or value
destruction) in mergers and acquisitions.
It will first be necessary to understand the basic regulation of this topic. The following table provides a
summary of the different types of investment and the required accounting for them:
Investment Criteria Required treatment in group accounts
Subsidiary Control (> 50% rule) Full consolidation (IFRS 10)

Associate or joint Significant influence (20% Equity accounting (IAS 28)
venture + rule)/joint arrangement
where parties with joint
control have rights to net
assets
Joint operation Joint arrangement where Line-by-line recognition of assets, liabilities
parties with joint control and revenue (IFRS 11)
have rights to assets and
obligations for liabilities
Investment which Asset held for accretion of As for single company accounts (per IAS 39)
is none of the wealth
above
IAS 28 requires that associates and joint ventures should normally be accounted for using the 'equity
method'. Equity accounting is sometimes called 'one-line consolidation', as there is only one amount
shown for an associate in profit or loss (being the parent company's share of the associate's profit), and
one amount shown in the statement of financial position (being the cost of investment plus share of
post acquisition reserves).
As the statement of cash flows begins with profit before tax, it already includes the parent's share of the
associate's profit. It is, therefore, necessary to adjust the associate's profit so that only the dividends from
associates are recognised.
In terms of modelling the associate's contribution to the group, it is normal to consider the associate
separately, as it is likely to be affected by different factors from other group revenue and group margins.
8.9 Forecasting the impact of mergers and acquisitions

Modelling would normally assume that there are no major structural changes. Thus, when a merger,
acquisition, disposal, or spin-off takes place, the forecasting model needs to be amended to take
account of these changes. For a company that acquires another company, there are two major effects
that need to be incorporated in the forecasting model. These are synergies and the financing of
acquisition.

There are three types of synergies that must be modelled:
C
 Synergies that lead to revenue enhancement; H
 Synergies that lead to cost reduction; and A
 Synergies that lead to capital efficiency. P
T
Revenue enhancement E
R
Revenue enhancement can come from a range of beneficial factors including increased market presence;
enhanced market power; cross-selling opportunities; reduced price competition; and improved ability to
service customers. 16
It might be noted, however, that most of these factors refer to horizontal integration where the
acquisition is made in a similar or overlapping market. Where there is vertical integration, such as where
a company buys a major customer or supplier, then there is a perverse effect that consolidated revenue
in the financial statements may fall. This is because sales from one group company to another are not
external sales, and are not reported as revenue. Cost of sales to the purchasing company will also fall, and
so – because of this accounting treatment – profit will not change. However, the profit margin would
appear much greater in the consolidated accounts than it was in the sum of the two previously
independent companies.
A further note of caution in assessing post-acquisition performance is that where an acquisition takes
place during a year, only the post-acquisition element of profit or loss items is consolidated.
Cost reduction
The most obvious cost reductions are common costs, eg head office and functions such as marketing,
administration, treasury and distribution. Other areas include reductions in management and, perhaps,
procurement economies in terms of discounts.
In modelling such costs, an assessment will need to be made of the proportion of total costs that can be
eliminated in the merged entity.
A word of warning, however, may be necessary. In the period immediately following the merger, there
may be reorganisation and integration costs such that, in the short term, costs may actually increase
compared with the two independent entities. Such costs are, however, transitory and do not form part
of the normalised earnings of the combined entity. If fully disclosed separately they should be reversed
but, if not, an estimate will need to be made.
Capital efficiency
The combined entity may be able to utilise non-current assets more efficiently, thus enabling some
disposals to take place or at least reductions in CAPEX in the short term. Similarly, there may be more
efficient use of inventories where there is some overlap of product ranges, resulting in greater working
capital efficiency. This might well be a significant value driver for forecast synergies.
Financing the acquisition
It is important to separate out the investment decision from the finance decision in modelling any
acquisition.
An extreme case is a leveraged buy-out where most of the cash to make the acquisition is borrowed in
the expectation that future operating profits will be sufficient to repay the debt and interest. In these
circumstances there is likely to be a significant increase in financial risk, due to increased financial
gearing. As such, the financing cash flows and net debt need to be considered carefully, as does the
discount rate that must be used in relation to forecast operating flows.
8.10 Forecasting the impact of reorganisation and reconstructions

Companies periodically tend to change the scope and nature of their existing activities as part of
strategic change projects. This can involve reconstructing, reorganising, downsizing, cost reduction
exercises and similar schemes. The intention of such schemes is normally to improve profitability in the
short or long run and, ultimately, to add value to the business.
When such schemes are announced, however, analysts need to estimate the impact of these changes on
value. Financial analysis, and financial disclosures, are part of the jigsaw in making such estimates of
value creation (if any) arising from the changes.

If a closure, withdrawal, or reconstruction relates to a separate segment which is separately disclosed
under IFRS 8, then the impact, at least historically, is isolated. Reasonable predictions can then be made
of the consequences of the closure, withdrawal, or reconstruction. Unfortunately, such happy
coincidences are rare, and it is more likely that financial statements will provide only some general clues
as to the consequences of reconstructions, even when used alongside other available information.
Nevertheless, the above performance forecasting methodology can be used to estimate changes in
future profits arising from a reconstruction and thereby help to assemble a revised valuation for the
company.
Moreover, in the set of financial statements published after any material reconstruction, financial
reporting disclosures can provide additional, if retrospective, information about the consequences of any
reconstruction (eg exceptional items under IAS 1). Any initial forecasts can then be amended to re-
evaluate longer-term valuation consequences.
Key point summary
 When a merger, acquisition, disposal, or spin-off takes place, there are important effects that will
need to be reassessed by forecasting performance in the context of the proposed changes in
ownership, structure and financing.
 Synergies enhance value: These may include revenue enhancement, cost reduction, and capital
efficiency.
 Financing the acquisition: It is important to separate out the investment decision from the finance
decision as, in modelling any acquisition, these will have separate effects.
 Operating decisions impact on value creation: Two key value drivers are profit margins and asset
activity. These can be analysed by the use of accounting ratios.
 Financial reporting information, alongside other sources of information, can help estimate the
impact of reorganisations and reconstructions on corporate value.
8.11 Forecasting the effects of funding policy

Financial statement analysis can help analysts measure and model some of the consequences of
financing decisions for valuation. In so doing, financial statements can act as one input into valuation
models to assess how corporate values are affected by financing decisions.
Raising equity finance in a perfectly efficient capital market should not impact on value. Economic
theory tells us that it is operating and investing activities, not financing decisions, that impact on value.
The reason for this is that value creation is not about increasing the value of the company: it is about
increasing the wealth of the shareholders. Raising new equity at market value in an efficient market will
increase the value of the company, but only by the value of the share issue, leaving shareholder wealth
constant. Share price would be constant if the shares were issued at market value.
However, to the extent that markets are not efficient, financing can impact on shareholder value. If, on
the basis of inside information, directors perceive that market prices are in excess of the intrinsic value of
shares, then a share issue may add to the wealth of existing shareholders.
Conversely, if directors perceive that market prices are lower than the intrinsic value of shares, then a
share repurchase may add to the wealth of existing shareholders.
This is not the same as saying that, when a share issue is announced, share prices may change. This will
depend on the 'news' value on the announcement day, and any perceived positive net present value from
the project that is being financed by the share issue.
The role of financial statement analysis is that the new shares, the new cash flows from any project, and
any changes in financial or operating risk, can be built into a model to provide new forecasts of the
value creation of the new financing and associated operations.
8.12 Forecasting scenarios and sensitivity analysis

Having made a range of individual forecasts, it might seem logical to assume that the overall outcome
will be reasonable. Unfortunately, this is not necessarily the case.

The estimates are likely to be single values, or 'point estimates', which only really represent our 'best guess'
from a range of possible outcomes in each case. Once these point estimates have been put together, C
however, it is necessary to test the reasonableness of the whole picture to ensure that, for instance, we H
A
have not estimated revenues at one end of a reasonable range and CAPEX at the other end of its
P
reasonable range, producing an unreasonable and inconsistent result. T
E
One way to test the reasonableness and consistency of the forecast figures is to recompute the basic
R
ratios based on the forecast figure, to see if they make sense.
Another feature of checking reasonableness is to consider various scenarios and see if the modelled figures
change significantly when the scenarios change. This might include some strategic effects such as a new 16
entrant into the industry, declining industry demand perhaps due to new substitutes, or suppliers
forcing price increases for raw materials.
8.13 Risk assessment

In order to assess the impact of estimation errors, sensitivity analysis is a useful tool, but it does not say
how probable the alternative outcomes are, and does not of itself measure risk.
Consideration should, however, be given to risk and the potential for variation in the estimate that has
been forecast. Consideration can be given to the following:
 How well diversified is the company (eg does it depend on one product or service)?
 Volatility of earnings can be specifically measured using standard deviations.
 If the business is cyclical, do the variations change according to the economic business cycle and is
the risk largely systematic? If so, an accounting beta can be estimated by plotting the covariance of
a company's earnings against an index such as market earnings of FTSE 100 companies, or even
GDP variation.
 If the business is risky, is it appropriate to make prudent estimates of variables in forecasting
performance? This may, however, just result in a pessimistic forecast without regard for upside
variation.
If the risk is default risk, then an assessment of the company's liquidity arrangements, including
contingent funding, may be appropriate. Credit rating agencies such as Standard & Poor's, or Moody's,
may also give an indication of default risk.
8.14 Cash flow forecasting and valuation

The end-product of forecasting is normally the valuation of an enterprise based on discounting future cash
flows. The forecasting process has, therefore, taken earnings and figures in the statement of financial
position and produced a free cash flow forecast. From this, appropriate risk-adjusted discount rates can
be used to determine value, or test the value creation of various strategic and corporate finance
decisions. The internal rate of return can also be used, based on cash flows, as the economic equivalent
of ROCE.
The end product of financial analysis is the understanding of how value is created and how forecasting
earnings can be built into valuation models to assess the impact of different operating, investment, and
financing decisions. The last issue requires the use of spreadsheet models that capture the relationship
between drivers and value.
Value creation can be affected by a variety of investment, operating, and financing decisions taken by a
company. This section looks at examples of some of these decisions, and considers the role of financial
analysis in assessing the consequences of such decisions for value creation by those external to the
company concerned.
Having made forecasts, then other cash flow measures such as payback can also be used or, similarly,
other expressions of profit and adjustments thereto can be made such as economic value added (or
TM
EVA ).
Although we have concentrated so far on forecasting individual quantities for the statement of profit or
loss and other comprehensive income or the statement of financial position, the most common use of
forecasting financial statements is to produce a valuation of the entity.

The quantity that is forecast for valuation purposes is the free cash flow to the firm defined as
FREE CASH FLOW = FCFF = EARNINGS BEFORE INTEREST AND TAXES (EBIT)
Less: TAX ON EBIT
Plus: NON CASH CHARGES
Less: CAPITAL EXPENDITURES
Less: NET WORKING CAPITAL INCREASES
Plus: SALVAGE VALUES RECEIVED
Plus: NET WORKING CAPITAL DECREASES
The future FCFF will need to be discounted using an appropriate discount factor that will be consistent
with the risk of the cash flow.
9 Summary
Section overview
 This section provides a summary of the areas covered so far in this chapter.
Financial statements can assist analysts in evaluating a company's activities by:

 Providing disclosures about a firm's current financial position and historical performance
 Providing information from which financial models can be constructed to forecast future
performance and position
 Assisting in evaluating the value creation potential of financial decisions using valuation models
While financial statements may have other uses for other users, for the analyst the key link is that
between financial statements and the valuation process. This is not to suggest that financial statements
provide a valuation. Rather, they are an input, along with other sources of information, into valuation
models.
This chapter has attempted to provide a methodology for how the raw financial reporting information
contained in the financial statements of a company can be interpreted, adjusted and standardised and
then used for analysis, decision making, forecasting and valuation. In this way the information will assist
in the assessment of the impact on value of key operating, investment, and financing decisions.
The chapter considered how weaknesses of financial reporting information, such as weaknesses inherent in
accounting practice, as well as any 'creativity' by management, can distort the usefulness of such
information. Any forecasting or valuation model, no matter how sophisticated, is likely to be of little
worth if it uses inappropriate information. The quality of earnings and of other accounting information
was thus considered in order to normalise earnings as a prerequisite for any consistent forecasting of
sustainable earnings and valuation modelling.
Accounting ratios then considered how the adjusted figures could be interpreted by examining ratios
and other relationships against predetermined benchmarks to highlight unusual features and changes.
This analysis helps us understand the current financial position and historical performance of the company.
Also, however, to the extent that the relationships represented by ratios are sustainable over time, they
can be built into valuation models in order to predict the consequences of changing one variable for
other variables.
Forecasts of future earnings were examined based on adjusted financial information. In this context,
forecasting depends on many sources of information, of which financial statements are only one. For
financial statements to be useful, however, it is necessary to:
 Understand their integrated nature
 Recognise how separate components interact
 Comprehend the many pages of detailed supporting information presented in an annual report
Moreover, it is necessary to understand the strategic and behavioural context within which financial
reporting is taking place, in order to forecast future performance on the basis of financial reporting
information.

10 Current issues C
H
A
Section overview P
T
 This section covers several areas in which the IASB are developing new accounting standards. E
R
10.1 Proposed amendments to IAS 37

16
An Exposure Draft issued in June 2005 proposes amendments to IAS 37. These were supplemented by
a further Exposure Draft in January 2010. A full replacement of IAS 37 is expected.
(a) The Standard would be re-named 'Liabilities' and be extended to include all liabilities not covered
by other Standards.
(b) The terms contingent liability and contingent asset would be removed, and unconditional and
conditional obligations introduced.
(c) Expected values would be used.
The most obvious change is that the term 'provision' is no longer used; instead it is proposed that the
term 'liability' is used.
Definition
A liability is a liability other than a financial liability as defined in IAS 32 Financial Instruments:
Presentation.
10.2 Scope and terminology

IAS 37 defines a provision as a liability of uncertain timing or amount. The ED does not use the term
provision, but proposes the use of the term 'liability' as defined above. This includes items previously
described as provisions, but also all other liabilities not covered by other Accounting Standards.
10.3 Contingent liabilities

10.3.1 IAS 37 treatment
IAS 37 defines a contingent liability as a possible obligation or a present obligation that is not
recognised. A contingent liability could be a present obligation that is not recognised either because it
is not probable that an outflow of resources will be required to settle the obligation or because the
amount of the obligation cannot be measured with sufficient reliability. The Standard does not permit
contingent liabilities to be recognised but requires them to be disclosed, unless the possibility of any
outflow of economic resources in settlement of the contingent liability is remote.
10.3.2 The proposals

The ED proposes changing the treatment as follows.
 The term 'contingent liability' will be eliminated.
 The term 'contingency' will be used to refer to uncertainty about the amount that will be
required to settle a liability rather than uncertainty about whether a liability exists. The 2010
Exposure Draft clarified that liabilities will be (initially and subsequently) measured at the amount
an entity would rationally pay to be relieved of the present obligation.
 The ED specifies that a liability for which the settlement amount is contingent on one or more
uncertain future events is recognised independently of the probability that the uncertain future
event(s) will occur (or fail to occur).

The purpose of these amendments is twofold.
 To clarify that only present obligations (rather than possible obligations) of an entity give rise to
liabilities and that liabilities arise from unconditional obligations
 To require uncertainty about future events that affect the amount that will be required to settle a
liability to be reflected in the measurement of the liability
10.4 Contingent assets

IAS 37 defines a contingent asset as a possible asset. It does not permit contingent assets to be
recognised, but requires them to be disclosed if an inflow of economic benefits is probable.
10.4.2 The proposals

The ED proposes changing the treatment as follows.
 The term 'contingent asset' would be eliminated.
 The term 'contingency' would be used to refer to uncertainty about the amount of the future
economic benefits embodied in an asset, rather than uncertainty about whether an asset exists.
The purpose of this amendment is to clarify that only resources currently controlled by the entity as a
result of a past transaction or event (rather than possible assets) give rise to assets, and that assets arise
from unconditional rights.
10.5 Constructive obligations

IAS 37 defines a constructive obligation as an obligation that derives from an entity's actions when the
entity has (a) indicated to other parties that it will accept particular responsibilities and (b) as a result has
created a valid expectation on the part of those other parties that it will discharge those responsibilities.
10.5.2 The ED proposals

 The definition of a constructive obligation will be amended to clarify that the actions of an entity
must result in other parties having a valid expectation that they can reasonably rely on the entity
to discharge its responsibilities.
 Additional guidance will be provided to help determine whether an entity has incurred a
constructive obligation.
10.6 Probability recognition criterion

The ED proposes omitting the probability recognition criterion (currently in IAS 37) from the
Standard because, in all cases, an unconditional obligation satisfies the criterion. Therefore, items that
satisfy the definition of a liability are recognised unless they cannot be measured reliably.
10.6.1 Rationale for proposed treatment

The Basis for Conclusions on the ED emphasises that the probability recognition criterion is used in the
IASB's Framework to determine whether it is probable that settlement of an item that has previously
been determined to be a liability will require an outflow of economic benefits from the entity. In other
words, the Framework requires an entity to determine whether a liability exists before considering
whether that liability should be recognised. The Basis notes that in many cases, although there may be
uncertainty about the amount and timing of the resources that will be required to settle a liability, there
is little or no uncertainty that settlement will require some outflow of resources.

Worked example: Product warranty
C
In the case of a product warranty, the question is not whether it is probable that the entity will be H
required to repair or replace the product. Rather, the question is whether the entity's unconditional A
obligation to provide warranty coverage for the duration of the warranty (ie to stand ready to honour P
warranty claims) will probably result in an outflow of economic benefits. T
E
R
10.7 Measurement 16
The obligation is measured as the amount the entity would rationally pay to settle the obligation at
the reporting date or to transfer it to a third party. This is the lower of:
 The present value of the resources required to fulfil an obligation
 The amount that an entity would have to pay to cancel the obligation and
 The amount that the entity would have to pay to transfer the obligation to a third party
Expected values would be used, whether measuring a single obligation or a population of items.
For future services (eg decommissioning), outflows are based on contractor prices. The exception is for
onerous contracts, where the amount to be used is the amount the entity, rather than the contractor,
would pay.
10.8 Reimbursement
IAS 37 states that when expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement should be recognised when it is virtually certain that the
reimbursement will be received. Consistently with the revised analysis of a contingent asset, the ED
proposes that if an entity has an unconditional right to receive reimbursement, that right should
be recognised as an asset if it can be measured reliably.
10.9 Onerous contracts

The ED provides additional recognition guidance relating to onerous contracts. The amount to be used
is the amount the entity, rather than the contractor, would pay.
10.10 Restructuring provisions

IAS 37 states that an entity that (a) has a detailed formal plan for restructuring and (b) has raised a valid
expectation in those affected that it will carry out the restructuring has a constructive obligation.
Therefore, it recognises a liability for the direct expenditures arising from the restructuring.
10.10.2 The ED proposals

The ED proposes the following changes.
 The application guidance will be revised to specify that a liability for a cost associated with a
restructuring is recognised only when the definition of a liability has been satisfied for that
cost. Accordingly, a cost associated with a restructuring is recognised as a liability on the same
basis as if that cost arose independently of a restructuring.
 More specific guidance will be given for costs associated with a restructuring.
10.11 Example of change from IAS 37

An entity is being sued for damages of £15 million. Legal proceedings have started, but the entity
disputes liability. The entity estimates that it has a 20 per cent chance of losing the case. Under IAS 37,
the entity would disclose a contingent liability of £15 million in the notes to the accounts. Under the

new proposals, the entity has an unconditional obligation to stand ready to pay the damages if
awarded. In this case, it would recognise a liability of £3 million.
Worked example: Present obligation

Shortly before 31 December 20X0, a patient dies in a hospital as a result of a mistake made during an
operation. The hospital is aware that a mistake occurred. In these circumstances, the hospital's past
experiences and lawyer's advice indicate that it is highly likely that the patient's relatives will start legal
proceedings and, if the matter comes to court, that the hospital will be found guilty of negligence.
At the time that the financial statements are authorised for issue in early 20X1, the hospital has not
received notice of legal proceedings against it.
Explain the accounting treatment required, in terms of recognition or otherwise and measurement.
Solution
There is a present obligation as a result of a past event, this being the operation in which negligence
occurred. Accordingly, a liability is recognised.
Measurement of the liability reflects the likelihood that the hospital will be required to pay
compensation because of the mistake, and the amount and timing of that compensation.
10.12 Fair Value Measurement

In May 2011, the IASB issued IFRS 13 Fair Value Measurement. This is covered in Chapter 2, Section 2.
10.13 Financial Statement Presentation

In June 2011, the IASB published an amendment to IAS 1 called Presentation of items of other
comprehensive income, changing the presentation of items contained in Other Comprehensive Income
(OCI) and their classification within OCI. This is covered in Chapter 1.
10.14 Improvements to pension accounting

In June 2011, the IASB published a revised version of IAS 19 Employee Benefits. The main change is the
elimination of the 'corridor method' for recognition of actuarial gains and losses and the introduction of
interest on the net defined benefit liability or asset. The revised standard is covered in Chapter 8.
10.15 Changes to group accounting

In June 2011, the IASB published a revised version of IAS 27 and 28 and issued IFRSs 10 to 12. The new
and revised standards are covered in Chapter 10.

Summary and Self-test C
H
A
P
T
E
R
Summary
Accounting ratios 16
Performance Liquidity Investor Solvency Cash flow Efficiency
Current Dividend Cash return

ROCE Gearing Net asset
ratio yield on capital
employed turnover
Quick Dividend Interest

ROSF cover Cash from
ratio cover Inventory
ops/profit
from ops turnover
GP% P/E ratio

Cash Receivables
interest collection
cover period
Operating
Net asset value
cost %
Payables
Cash flow
payment
Operating per share
period
margin
Cash Non-current
dividend asset
cover analysis

Analysis and interpretation
Users and
user focus
Ratios and Cash Business strategy Accounting Ethical

relationships flow analysis and analysis issues
economic factors
Non-financial Financial - Industry analysis Choice of accounting

performance performance - Competitive analysis treatments, judgements
measures measures and disclosure notes
Reporting Accounting
requirements distortions
arising from
business and
economic
events Improving the
quality of
financial information
Adjusting
assets and Adjusting
liabilities income

Self-test
C
1 Digicom Distributors Ltd H
A
You are Paula Jones, a manager of John Mills and Co. Your client, Digicom Distributors Ltd, has for P
several years been a family-owned company selling telephones and answering machines through T
its own dealer network in the South of England. In May 20X0 the company was bought by two E
brothers, Peter and Charles Brown. R
Shortly thereafter the company acquired the exclusive United Kingdom distribution rights to a
revolutionary new video mobile phone, manufactured in South Korea, which sells for about half the 16
price of competitive products and is fully compatible with all British mobile telephone networks.
During the year ended 31 August 20X1 expansion has been rapid under the new management.
The following points should be noted.
(1) The distribution rights for the South Korean phone cost £850,000. The rights were acquired
for a period of ten years, and the directors of Digicom Distributors Ltd decided to capitalise
the initial cost and amortise it over the ten-year period on a straight line basis. The current
carrying amount is £744,000.
(2) The new phone received extensive media acclaim during October and November 20X0,
accompanied by regional television advertising campaigns. Since then monthly sales have
increased from £500,000 to £1,600,000.
The advertising campaign cost the company £1,000,000. The directors believe that it will
have long-term benefits for the sales of the phone and, consequently, they decided to
capitalise the advertising cost and amortise it over the same period as the distribution rights.
The current carrying amount for the advertising expenditure is £925,000.
(3) Sales of the new phone now account for 75% of the company's revenue. The level of credit
sales has remained constant at 30% of total sales.
(4) The company has purchased dealer networks from three other companies and is negotiating
to purchase two more, which will then complete its national coverage.
(5) Employee numbers have increased rapidly from 40 to 130. This includes administration staff at
head office, where numbers have risen from 12 to 28.
(6) In June 20X1 the central distribution and servicing department moved from head office into
larger premises in Milton Keynes. The total cost of the relocation was £625,000, which has
been included in administrative expenses.
The move was necessary to handle not only the increased inventory and pre-delivery checks,
but also the rising level of after-sales warranty work caused by manufacturing defects in the
new phone.
The company has maintained its warranty policy of providing for 1% of revenue each year.
The movements in the warranty provision for the current year are as follows.
£'000
At 31 August 20X0 262
Provision for year 160
Provision utilised (94)
At 31 August 20X1 328

Draft accounts of Digicom Distributors Ltd as at 31 August 20X1 were as follows:
statement of profit or loss and other comprehensive income FOR THE YEAR ENDED 31 AUGUST
20X1
20X1 20X0
£'000 £'000
Revenue 16,000 5,200
Cost of sales (12,400) (4,264)
Gross profit 3,600 936
Distribution costs (837) (425)
Administrative expenses (2,253) (609)
Operating profit/(loss) 510 (98)
Finance costs (320) (35)
Profit/(loss) on ordinary activities before tax 190 (133)
Tax on profit or loss on ordinary activities (15) (10)
Profit/(loss) for the period 175 (143)
Revaluation surplus 400 –
Total comprehensive income 575 (143)
STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X1

20X1 20X0
Non-current assets £'000 £'000 £'000 £'000
Intangible assets 1,669 829
Property, Plant and Equipment 6,623 2,564
8,292 3,393
Current assets
Inventories 778 520
Receivables 814 215
Cash and cash equivalents 250 400
1,842 1,135
Current liabilities
Bank overdrafts 975 150
Trade payables 2,734 678
3,709 828
Net current assets/(liabilities) (1,867) 307
Total assets less current liabilities 6,425 3,700
Bank loan (2,084) –
Provisions (328) (262)
4,013 3,438
Share capital 100 100
Revaluation reserve 900 500
Retained earnings 3,013 2,838
4,013 3,438
Requirement
Assess the profitability, liquidity and solvency of the company.

2 Raport
C
The following is an extract from the financial statements of Raport Ltd for the year ended H
31 December 20X4. A
P
Note 1 Plant and
T
equipment E
£'000 R
Cost
At 1 January 20X4 2,757
Additions 137 16
Disposals (94)
Accumulated depreciation
At 1 January 20X4 1,922
Depreciation 302
Disposals (60)
Carrying amount 1 January 20X4 835
Carrying amount 31 December 20X4 636
Note 2 20X4 20X3
£'000 £'000
Profit from operations is stated after charging
Depreciation 302 289
Loss on disposal of plant and equipment 25 32
Requirement
Provide an analysis of the plant and equipment of Raport Ltd.
3 Tiger
On 1 January 20X1, Tiger Ltd buys a non-current asset for £120,000, which has an estimated useful
life of 20 years with no residual value. Tiger Ltd depreciates its non-current assets on a straight line
basis. Tiger Ltd's year end is 31 December.
On 31 December 20X3, the asset will be carried in the statement of financial position as follows:
£'000
Non-current asset at cost 120
Accumulated depreciation (3  (120,000 ÷ 20)) (18)
102
Situation A
The asset continues to be depreciated as previously at £6,000 per annum down to a carrying
amount at 31 December 20X6 of £84,000.
On 1 January 20X7, the asset is sold for £127,000, resulting in a profit of £43,000.
Situation B
On 1 January 20X4, the asset is revalued to £136,000, resulting in a gain of £34,000. The total
useful life remains unchanged. Depreciation will therefore be £8,000 per annum, ie £136,000
divided by the remaining life of 17 years.
On 1 January 20X7, the asset is sold for £127,000, resulting in a reported profit on disposal of
£15,000.
Requirement
Ignoring the provisions of IFRS 5 summarise the impact on reported results and net assets of each
of the above situations for the years 20X4 to 20X7 inclusive.

1 Digicom Distributors Ltd

Assessments
Profitability
The company's gross profit margin is strengthening due to the South Korean phone, which can be
purchased at very competitive prices and still be sold at half the price of competitive products. This
can be further illustrated by comparing the 207% increase in revenue with a 285% increase in
gross profit.
Similarly, overheads have only increased by 199%, even including one-off relocation expenses.
Therefore, costs are being controlled despite the expansion, and the net margin is also
strengthening. However, the overheads do not include all charges for advertising (see below). If
these were included net profit would clearly fall. In addition, the company's warranty provisions do
not appear to be calculated correctly and the expense is probably understated.
Return on capital employed has improved on the previous year, as the company has turned from a
loss-making position to a profit. However, ROCE may be misleading as there is some doubt as to
the suitability of capitalising advertising expenditure and/or the cost of distribution rights. If these
were charged as expenses, the company would continue to be in a loss-making position.
The improving profitability of the company is very reliant on the continued success of the South
Korean phone, and in a rapidly changing industry, this cannot be guaranteed.
Liquidity
Liquidity has deteriorated in the period, as evidenced by both the current and quick ratios. The
company has insufficient current assets from which to meet its current liabilities as they fall due.
This is coupled with very clear signs of overtrading, whereby the inventory turnover ratio has
increased dramatically on the previous year. The company is holding very low levels of inventory
compared to its increased levels of revenue, which may result in stock-outs and loss of goodwill.
This low level of inventory appears to be caused by insufficient funds to finance the purchase of
inventory. The company must raise further long-term finance if serious liquidity problems are to be
avoided.
Solvency
The company is highly geared. Moreover, the gearing ratio in the appendix does not include the
excessive overdraft included in current liabilities. Hence, actual gearing is even higher. Similarly,
interest cover at 1.6 times is poor.
The company must raise more funds to survive, particularly if further expansion is to continue.
However, lenders will see Digicom Distributors Ltd as a high risk investment and will therefore
expect a high return.
Appendix: Accounting ratios
Year ended 31 August
20X1 20X0
Profitability
Return on capital employed
Operating profit 510 (98)
  7.9%  (2.6)%
Total assets – Current liabilities 6,425 3,700
Gross profit margin
Gross profit 3,600 936
  22.5%  18.0%
Revenue 16,000 5,200

Year ended 31 August
20X1 20X0 C
Efficiency H
A
Asset turnover P
Revenue 16,000 5,200 T
  2.5 times  1.4 times E
Total assets – Current liabilities 6,425 3,700 R
Inventory turnover
Cost of sales 12,400 4,264
  15.9 times  8.2 times
Inventories 778 520 16
Receivables collection period
Re ceivables 814 215
  365  365  62 days  365  50 days
Credit sales 16,000  30% 5,200  30%
Payables payment period
Payables 2,734 678
  365  365  80 days  365  58 days
Cost of sales 12,400 4,264
Liquidity
Current ratio
Current assets 1,842 1,135
  0.50  1.37
Current liabilities 3,709 828
Quick ratio
Current assets – Inventory 1,842 – 778 1,135 – 520
  0.29  0.74
Current liabilities 3,709 828
Solvency
Debt/equity ratio
Long - term debt 2,084
  0.52
Capital and reserves 4,013
Interest cover
Operating profit 510
  1.6
Interest 320
2 Raport
 137 
 Capital expenditure represents 45%   100%  of the depreciation expense for the year.
 302 
This could suggest that management is not investing in an expansion of capacity.
 2,164 
 Accumulated depreciation represents 77%   100%  of the cost of the assets.
 2,800 
 1,922 
This has increased from the 70%   100%  in the previous year.
 2,757 
This confirms that plant and equipment is ageing without replacement. On average the plant
and equipment is entering the last quarter of its useful life. This could indicate that the plant is
becoming less efficient.
 The losses on disposal could indicate that the depreciation rates are too low and economic
lives have been overestimated. The accounting policies should be reviewed. If this is the case
then this confirms that the plant and equipment is aged and raises further concerns about its
renewal and efficiency. The nature of the equipment would need to be determined when
considering this.

3 Tiger
Situation A – asset is not revalued
20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Profit from operations
Includes depreciation of (6) (6) (6) –
Profit on disposal of non-current assets – – – 43
Total impact on reported profit for 20X4 to 20X7 = £25,000
= proceeds of £127,000 less carrying amount of £102,000 at 1 January 20X4
Carrying amount of asset at year end 96 90 84 –
(included in capital employed)
Situation B – asset is revalued

20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Profit from operations
Includes depreciation of (8) (8) (8) –
Profit on disposal of non-current assets – – – 15
Other comprehensive income – revaluation 34 – – –
surplus
Total impact on reported profit for 20X4 to 20X7 =
£(9,000)
Total impact on comprehensive income for 20X4 to 20X7 = £25,000
20X4 20X5 20X6 20X7
£'000 £'000 £'000 £'000
Carrying amount of asset at year end 128 120 112 –
(included in capital employed)
Summary
Situation A Situation B
No Revaluation
revaluation
£'000 £'000
Aggregate impact on profits (20X4 to 20X7) 25 (9)
Aggregate impact on total comprehensive income (20X4 to 20X7) 25 25

Answers to Interactive questions C
H
A
P
T
E
ROCE = 820/6,450 = 12.71%

Profit margin = 820/6,000 = 13.67% 16
Asset turnover = 6,000/6,450 = 0.93 times
Capital employed = equity + non-current liabilities + current liability for interest bearing borrowings –
cash and cash equivalents = 4,090 + 2,445 + 195 – 280
Using the two alternative definitions of the capital employed yields
(a) Capital employed = total assets – current liabilities = 7,370 – 835 = 6,535
ROCE = 820/6,535 = 12.55%
(b) Capital employed = total assets – adjusted current liabilities = 7,370 – 640 = 6,730
ROCE = 820/6,730 = 12.18%
When alternative definitions of capital employed are used there is a small impact on ROCE.

Company 1 Company 2
ROCE (C) as % of (B) 20% 20%
ROSF (D) as % of (A) 16% 40%
ROCE is the same, so the companies are equally good in generating profits. But with different capital
structures, ROSF is very different.
If it wished, Company 1 could achieve the same capital structure (and therefore the same ROSF) by
borrowing £60m and using it to repay shareholders.
It is often easier to change capital structures than to change a company's ability to generate profits.
Hence the focus on ROCE.
Note that Company 2 has much higher gearing and lower interest cover.

When drawing conclusions from ROCE/ROSF consider:
 Target return on capital (company or shareholder)
 Real interest rates
 Age of plant
 Leased/owned assets
 Upward revaluations of non-current assets, which increase capital employed, increase depreciation
charges and reduce ROCE/ROSF

Decisions to dispose of a group company or to close down a business activity within the group result in
restructurings. The decision to restructure a major part of the business will require consideration of:
 IAS 7 Statement of Cash Flows' requirements as to disclosure within investing activities of the cash
flows resulting from disposals.
 IAS 10 Events After the Reporting Period's requirements as to events occurring after the reporting
date, whether they are adjusting events (ie, confirmation of assets/liabilities values) or non-
adjusting events (eg, the disclosure of a decision to restructure).
 IFRS 8 Operating Segments' requirements as to segment reporting – a disposal could well affect the
segments which are reportable.
 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations' requirements – a decision to
restructure a major part of the business is likely to lead to disclosures of both discontinued
operations in the statement of profit or loss and other comprehensive income and non-current
assets held for sale in the statement of financial position.
 IAS 36 Impairment of Assets' requirements as to impairment of assets – impairment will almost
certainly result from a restructuring decision.
 IAS 37 Provisions, Contingent Liabilities and Contingent Assets' requirements as to provisions –
liabilities which previously were only contingent may well now require recognition and provisions
for restructuring costs may need to be recognised.
Other standards such as IAS 2 Inventories may also be relevant. Any surplus or excess inventory may
require disposal at below cost. In addition, the presentation of these events may need the consideration
of IAS 1 Presentation of Financial Statements.

Industry revenues are expected to grow by 20% in 20X7 to reach £2,136 million. The market share of
GeroCare has been stable at about 15% for the last 5 years. Assuming the market share remains the
same in 20X7, the forecast revenues for GeroCare are £320m (= 0.15  £2,136 million).

Revenue
The asset turnover ratio defined as will produce a rough estimate of the assets
Non-current assets
required to produce the new level of sales. The factors that will affect the accuracy of this ratio are: (a)
its stability over time (b) the mix between new capital expenditure for expansion and replacement and
(c) the level of capital efficiency.

According to the clean surplus model, equity is determined solely by retained earnings. For 20X7 the
predicted earnings are £27 million and dividend payments £8 million. Retained earnings therefore for
20X7 amount to £19 million and adding this amount to the value of equity at 31 December 20X6 yields
the level of equity for 31 December 20X7, namely £69 million.

Index
683
Corporate governance, 600
Cost, 29
A Cost model, 514
Credit risk, 142
Accounting for derivatives, 190 Creditors' buffer, 332
Accounting policies, 143 Cumulative preference shares, 555, 556
Acquisition method, 359, 369 Currency swap, 189
Actuarial assumptions, 271 Currency swaps, 189
Actuarial risk, 265 Current ratio, 627
Additional EPS, 571 Current service cost, 278
Adjusting events, 83
Agricultural activity, 518
Agricultural produce, 518 D
Amortised cost, 173
Antidilution, 560 Dealer lessor, 109
Antidilutive potential ordinary shares, 560 Deductible temporary differences, 476
Asset, 29 Deferred tax, 491
Assets held for sale, 592, 593 Deferred tax assets, 476
Associate, 353, 392, 493, 664 Deferred tax liabilities, 475
Associate's losses, 374, 375, 378 Defined benefit liability, 272
Available-for-sale financial assets, 171 Defined benefit obligation, 269
Defined benefit plans, 265, 529
Defined benefit plans:, 282
B Defined contribution plans, 264, 267, 528
Demographic assumptions, 270
Balance sheet: historical cost, 452 Derecognition of financial assets, 163
Basic earnings per share, 547 Derivative financial instruments, 231, 232
Big GAAP/little GAAP, 608 Derivatives, 158, 188
Biological asset, 518 Diluted earnings per share, 547, 560, 562, 565
Biological transformation, 518 Dilutive potential ordinary shares, 560
Black-Scholes model, 316 Disclosure let out, 87
Bonus and right issues, 550 Disclosure of financial instruments, 176
Bonus issue, 550 Discontinued operations, 593
Borrowing costs, 118 Discount rate, 273
Discounting to present value, 87
Disposal group, 591
C Disposal of a foreign operation, 446
Capital redemption reserve, 327, 331 Disposal of a subsidiary, 385
Carrying amount, 29 Dissident shareholders, 330
Cash flow hedge, 237 Distributable profit, 326
Cash flow hedge accounting, 239 Distributing dividends, 325
Cash flows to the minority interest, 392 Dividend, 325, 327
Cash-generating unit (CGU) , 37, 38 Dividend cover, 628
Cash-settled share-based payment transaction, Dividend yield, 628
318
Cash-settled share-based payment transactions,
302, 317 E
Change of use, 516 Earnings per Share (EPS), 324
Closely related embedded derivatives, 195 EBITDAR, 657
Closing rate, 422 Effective interest method, 173
Component of an entity, 593 Effective interest rate, 173
Consolidated financial statements, 355 Embedded derivative, 191, 193, 194, 196
Construction contracts, 33 Embedded forward contract, 193
Constructive obligations, 670 Employee share options, 566
Contingent assets, 670 Equity, 373
Contingent liabilities, 85, 669 Equity instruments, 159
Contingently issuable shares, 567 Equity method, 354
Control, 353 Equity-settled share-based payment
Convertible bond, 137, 138 transactions, 302
Convertible instruments, 562 Exchange difference, 422
Index 685
Exchange differences, 431, 438, 443 Grant date, 304
Exchange of shares, 174 Grants related to assets, 117
Exchange rate, 422 Grants related to income, 117
Exclusion of a subsidiary from consolidation, Gross profit percentage, 627
356, 357 Group, 422
Exit route, 330 Group accounts, 354
Exposure Draft: Expected credit losses, 202
H
F
Hedge accounting, 143, 233, 245
Factoring, 166 Hedge effectiveness, 246
Factoring with full recourse, 167 Hedge ineffectiveness, 248
Factoring without recourse, 167 Hedged forecast transaction, 238
Fair value, 29, 40, 270, 305, 363 Hedged instrument, 222
Fair value adjustments, 444 Hedged item, 222, 225, 226
Fair value hedge, 232, 235, 236 Hedging an overall net position, 227
Fair value hedge accounting, 234 Hedging instrument, 231
Fair value measurement, 323 Hedging of firm commitments, 237
Fair value model, 514 Held for sale, 592
Finance income, 108 Held-to-maturity investments, 170, 230
Finance lease, 105, 107 Historical volatility, 316
Finance lease classification, 105 Hyperinflationary currency, 439
Finance lease liabilities, 106
Financial asset, 41, 158, 159, 162, 172
Financial asset or liability at fair value through I
profit or loss, 170
Financial assumptions, 270 IAS 7 Statement of Cash Flows, 406
Financial instrument, 157 IAS 8 Accounting Policies, Changes in
Financial instruments, 159 Accounting Estimates and Errors, 368, 590
Financial liabilities, 158, 159, 168, 169, 177 IAS 12 Income taxes, 471
Financial Reporting Standard for Smaller Entities IAS 20 Government Grants, 117
(FRSSE), 607 IAS 23 Borrowing Costs, 118
Financial risk, 226, 524 IAS 34 Interim Financial Reporting, 10
Firm commitment, 225 IAS 34 Interim Financial Reporting, 7
Firm commitments as hedged items, 228 IAS 37 Provisions, Contingent Liabilities and
Forecast transaction, 225, 238 Contingent Assets, 86
Forecast transactions as hedged items, 228 IAS 39 Derecognition steps, 164
Foreign currency, 422 IAS 40 Investment Property, 513
Foreign currency and consolidation, 440 IAS 41 Agriculture, 518
Foreign currency cash flows, 450 IFRIC 12 Service concession arrangements, 47
Foreign currency translation, 437 IFRIC 13 Customer loyalty programmes, 48
Foreign operations, 422 IFRS 2 Share-based Payment, 319
Forgivable loans, 117 IFRS 3 Business combinations, 396
Forward contract, 223 IFRS 4 Insurance contracts, 525
Framework, 45 IFRS 5 Non-current assets held for sale and
FRSSE, 15 discontinued operations, 593
FRSUKI, 15 IFRS 6 Exploration for and Evaluation of Mineral
Functional currency, 422, 423, 424, 425, 436 Resources, 522
Functional currency determination, 423, 424 Impact of preference shares, 555
Future, 223 IFRS 7 Financial Instruments: Disclosures, 138
IFRS 8 Operating Segments, 585
IFRS 9 Financial Instruments, 197
G IFRS 12 Disclosure of interests in other entities,
379
Gain or loss on net monetary position, 453 IFRS 13 Fair value measurement, 323
Gearing ratio, 628 IFRS 13, 144
Goodwill, 363 Impairment in non-monetary item, 435
Goodwill adjustment, 444 Impairment indicators, 36
Government assistance, 117
Government grants, 117, 118

Impairment losses, 374 Market risk, 146
Impairment of assets, 34, 42, 43, 44 Minimum lease payments, 106
Income statement: historical cost, 453 Minority interests, 447
Indicators of hyperinflation, 451 Monetary items, 422, 427, 431
Initial accounts, 328
Insurance contract, 524
Insurance risk, 524 N
Intangible assets, 34
Inter-company dividends, 446 Net asset turnover, 628
Interim accounts, 328 Net asset value, 629
Interim financial report, 7 Net investment in a foreign operation, 422
Interim financial reporting, 14 Non-adjusting events, 83
Interim period, 7 Non-cumulative preference shares, 555
International Financial Reporting Standard for Non-hyperinflationary currency, 437
Small and Medium-sized Entities, 607 Non-market based vesting conditions, 304,
Intra-entity hedging transactions, 228 309, 310
Intra-group hedge, 227 Non-monetary items, 428, 433
Intra-group hedging transactions, 228 Not closely related embedded derivatives, 196
Intra-group trading transactions, 446
Inventories, 32
Inventory turnover, 628 O
Investment, 353, 664 Obligation to dismantle, 89
Investment hedge, 243 Offsetting, 138, 498
Investment property, 434, 514, 515 Onerous contracts, 86, 671
Investment risk, 265 Operating and financial review, 601
Investments in associates, 353 Operating cost percentage, 627
Investments in joint ventures, 354 Operating leases, 106
Investments in subsidiaries, 353 Operating margin, 627
Operating segment, 585
Option, 223
J Options and diluted EPS, 564
Joint, 353 Options and warrants, 564
Joint arrangement, 375 Options contract, 138
Joint control, 375 Originating timing differences, 472
Joint operation, 375 Other adjustments in respect of preference
Joint venture, 375, 493 shares, 556
Other long-term employee benefits, 282
L
P
Lease term, 106
Leased assets, 106 Participating equity instruments, 559
Leases, 513 Participating securities and two-class ordinary
Lessor, 107, 108 shares, 558
Liability, 669 Plan assets, 269
Liability adequacy test, 525, 526 Post-employment benefits, 264
Liability at fair value through profit or loss, 170 Preference shares classified as equity, 555
Loans and receivables, 170 Preference shares classified as liabilities, 555
London & General Bank (No 2) 1895, 328 Presentation currency, 422
London Stock Exchange, 601 Price/earnings (P/E) ratio, 628
Long-term disability benefits, 283 Profits available for distribution, 326
Long-term employee benefits, 282 Profit-sharing and bonus plans, 263
Property, plant and equipment, 29
Provision, 86
M Published prices, 182
Purchased options in cash flow hedges, 232
Management commentary, 602
Manufacturer or dealer lessors, 109
Market based vesting conditions, 304 Q
Market prices, 182
Index 687
Qualifying asset, 118 Shearer v Bercain Ltd 1980, 329
Qualitative disclosures, 145 Short-term compensated absences, 262
Quick ratio, 628 Short-term employee benefits, 261
Significant influence, 353
Special dividend and share consolidation, 552
R Spot exchange rate, 422
Structured entity, 379
Reclassifying financial assets, 175 Subsidiary, 353, 664
Recycling gains and losses from equity, 240 Swap, 189
Related party relationship, 596
Related party transaction, 596
Relevant accounts, 327 T
Replacement property, 517
Reportable segments, 586 Tax base, 473, 474, 475
Re-pricing of share options, 313 Taxable temporary differences, 475, 479
Repurchase agreements, 166 Temporary differences, 475
Residual value, 29 Termination benefits, 283
Restructuring, 89 Testing for dilution, 564
Restructuring provisions, 671 Theoretical Ex Rights Price (TERP)", 554
Retirement benefit plans, 527 Trade date accounting, 161
Return on capital employed (ROCE), 627 Trade payables payment period, 628
Return on plan assets, 271 Trade receivables collection period, 628
Return on shareholders’ funds (ROSF), 627 Transaction costs, 513
Revaluations, 31 Transactions with a choice of settlement, 302
Reversal of past impairments, 39 Translation of a foreign operation, 440
Reverse acquisitions, 367, 368 Translation of financial instruments, 435
Review Draft: Hedge accounting section of IFRS Translation of property - revaluations, 434
9, 203
Rights issue, 552
Risks from financial instruments, 140 U
UK GAAP, 15
S Undistributable reserves, 327
Unguaranteed residual value, 107
Sabbatical leave, 283 Unvested options, 566
Sale and leaseback as a finance lease, 110 Unwinding the discount, 87
Sale and leaseback as an operating lease, 111
Sale and leaseback transactions, 110
Securitisations, 166 V
Segment reporting, 585
Self-constructed investment properties, 513 Valuation of large holding, 182
Sensitivity analysis, 146 Vested options, 566
Settlement, 276 Vesting conditions, 304
Settlement date accounting, 161 Vesting date, 304
Share consolidation, 551 Vesting period, 304
Share options and diluted earnings per share,
565
Share premium account, 329 W
Share-based payment, 319, 321, 322 Weighted average number of shares, 548
Share-based payment and UK GAAP, 324 Working capital cycle, 628
Share-based payment with a choice of
settlement, 319

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The Institute of Chartered Accountants in England and Wales

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© The Institute of Chartered Accountants in England and Wales

The knowledge level

2.2 Specification grid

viii Corporate Reporting

4.2 Assessing your professional skills

Initial Professional Development

4.3 Assessment grids

Preface to International Financial Reporting Standards A  

xiv Corporate Reporting

6 ICAEW publications for further reading

xvi Corporate Reporting

• Corporate Financier magazine, ISSN 1367-4544

Corporate governance – icaew.com/corporategovernance

xviii Corporate Reporting

Corporate responsibility – icaew.com/corporateresponsibility

Financial Reporting Faculty – icaew.com/frfac

Financial Services Faculty – icaew.com/fsf

Tax Faculty – icaew.com/taxfac

Learning objectives Tick off

 Understand and apply the requirements of IAS 1Presentation of Financial Statements

 Demonstrate an understanding of the requirements of IAS 34 Interim Financial Reporting

 Apply recognition and measurement principles to the preparation of interim financial

1.1 Main features

Profit or loss for period

1.2 Statement of financial position

Presentation of financial statements 3

1.3 Statement of profit or loss and other comprehensive income

Presentation of financial statements 5

Earnings per share ($)

1.4 Statement of changes in equity

A comparative statement for the prior period is also required.

2 IAS 34 Interim Financial Reporting

The following definitions are used in IAS 34.

Presentation of financial statements 7

2.2 Minimum components

2.3 Form and content

Worked example: Disclosure

Presentation of financial statements 9

2.4 Periods covered

2.6 Recognition and measurement principles

Revenues received occasionally, seasonally or cyclically

Costs incurred unevenly during the financial year

Cost of a planned major periodic maintenance or overhaul

Other planned but irregularly-occurring costs

Worked example: Bonus

Presentation of financial statements 11

Foreign currency translation gains and losses

Worked example: Taxation charge

Interactive question 1: Interim financial statement [Difficulty level: Intermediate]

Worked example: Inventory valuations

2.7 Use of estimates

Presentation of financial statements 13

2.8 IFRIC 10 Interim Financial Reporting and Impairment

2.9 IAS 34 Interim Financial Reporting and UK GAAP